China's Great Leap Forward in Weapons - UPDATE

“When a country is corrupt to the point that a single lightning strike can cause a train crash, the passing of a truck can collapse a bridge, and drinking a few bags of milk powder can cause kidney stones, none of us are exempted. China today is a train traveling through a lightning storm. None of us are spectators; all of us are passengers.”

China netizen

Source: www.chinageek.org

It was only last week that I reiterated my point that China is going through a Great Leap Forward in Weapons and the evidence for this can be seen in other high-end projects such as high-speed rail. After the weekends deadly train collision it sadly hits home as a, “I told you so moment.”

Now weibo and the likes are alight with accusations by netizens and finger pointing over who is responsible for this latest disaster. Vice premier Zhang Dejiang, has come forward and lamely announced that those responsible will be punished, refusing to see that it is not any one person that is responsible, but the entire system that demands staggering world-beating achievements in record breaking time. It happened in the Great Leap Forward, it happened on the Three Gorges dam, it is clearly happening in China’s high-speed rail experiment and it is certainly happening in China’s defense industry.

The PLA is heading towards a huge folly of their own making, egged on by the CCP and a Chinese populace that really should know better by now.

Despite the obvious lessons that could be learned from this horrific train crash the CCP will continue to blunder on, rolling a few heads, shaming some officials, but ultimately sidestepping any criticism of itself or correcting this time-honoured glitch in its modus operandi. So, the same mistake will be made in the coming years when an overly, bloated, pumped-up Chinese navy will steam head-long into a calamitous situation that it is totally unprepared for and once again a furious Chinese population will scream out in consternation, “Where is our navy, where is the Shi-lang, our stealth bombers and elite forces”? Just like Groundhog Day, the same mistakes will have been made all over again such as, faulty workmanship, corrupt skimming on materials, under-skilled sailors, corner cutting on safety and a completely unreasonable expectation on performance and the navy will sink or not even manage to leave port. There are so many clear signs that this is happening.

Once again, heads will roll and the CCP will look for people to blame and demand that the population not be so demanding on the military.

Unfortunately, not only can the CCP not stop it, they’re driving the military forward.

George Friedmen tells it like it is and callls a spade a spade on China!

Colin: The world is full of pundits who predict that China will, sometime in the first half of this century, overtake the United States as an economic power. The only difference between them is when this will happen. STRATFOR doesn’t believe this will happen and as China’s economy slows down while facing inflation, many others have doubts also. For his latest assessment, we turn to George Friedman, who we welcome back to Agenda.

George, China argues that the United States should treat it as an equal. For the United States, this seems a step too far. Is this a chasm that can be resolved peacefully?

George: The United States doesn’t treat China as an equal or an unequal, it treats it as China. As a country it has interests and those interests may coincide with American interests or they may not. But the United States, and any other country treats any other country as its interests. In many cases, the problem really is that observers of China have bought into the Chinese view that China is a superpower economically, militarily, politically, and therefore the United States should it treat it as such. But the fact is that China is far from a superpower in any of these realms. It remains a relatively weak economic power and certainly a weak military and political power, and the United States treats it as it is: a significant regional power with a great many weaknesses, and when it threatens American interests, the United States is quite happy to slap it back.

Colin: With the possibility of confrontation between the world’s first and second largest economy troubles many countries in the Asia Pacific region. First of all Japan and Korea but also many nations of Southeast Asia: Indonesia, Vietnam and a resources giant, Australia.

George: Well I mean it’s interesting that they’re troubled. I must admit that I’ve never understood what it meant for a nation to be troubled—I understand people being troubled. Look, there can’t be confrontation militarily between the United States and China. Firstly because the United States is incapable of intruding on mainland China militarily—it’s a vast population, a large army. And China has no naval capability worthy of the name. They have launched their first aircraft carrier. That means they have one aircraft carrier. They don’t have the cruisers, they don’t necessarily have the advanced attack submarines, they don’t have the Aegis defense systems. In other words they’ve launched a ship and now they have to train their pilots to land and takeoff from the ship and the aircraft that take off from the ship have to be able to engage and survive American F-14s. The distance between being a challenge to the United States and having one aircraft carrier is vast and generational. Not only do they have to train the people to fly off the deck, they have to train naval commanders, admirals, to command carrier battle groups, and even more admirals who know how to command groups of carrier battle groups. The United States has been in the business of handling carrier battle groups since the 1930s. The Chinese have not yet floated their first carrier battle group, and one isn’t enough. So it’s really important to understand that while China has made a minor movement in floating aircraft carrier, a technology that is now just about 80 years old—that’s very nice but it does not make them a power.

Colin: Now, financial analysts and economists talk up China as an economic power but at STRATFOR we’re doubters. China has slowed down this year, but do we still believe that Chinese growth is unsustainable?

George: The question of Chinese growth is the wrong question. I can grow anything if I cut profit margins to the bone or take losses. According to the Chinese Ministry of Finance, Chinese profits on their exports are about 1.7 percent, which means that some of these people are exporting at almost no level. The Chinese grow their economy not in the way that Western economies grow that when you sell more products, you make more money. The Chinese grow their economy to avoid unemployment. The Chinese nightmare is unemployment because in China unemployment leads to massive social unrest. Therefore the Chinese government is prepared to subsidize factories that really should be bankrupt because they’re so inefficient in order to keep these companies going. They will lend money to these companies not to grow them but in order to make certain that they don’t default on other loans. So I think one of the mistakes we make is the growth rate of China being the measure of Chinese health. I want everyone to remember that in the 1980s Japan was growing phenomenally and yet their banking system crashed in spite of the fact of having vast dollar reserves. So when you look at the Japanese example you see a situation where growth rates, which Westerners focused on, were seen to be a sign of health when in fact they were simply a solution to a problem of unemployment and underneath it the economy was quite unhealthy. This doesn’t mean that China doesn’t have a large economy, but having a large economy and being able to sustain healthy, balanced growth are two very different things.

Colin: Wouldn’t it be in the interests of both countries to find more common ground, perhaps to work together to make the Western Pacific a zone of peace involving Japan and other countries?

George: Well first of all, there is a zone of peace in that region. There’s no war going on. Secondly, the guarantor that it’s a zone of peace is the American 7th Fleet—the Chinese can’t do anything about it. As for tension bubbling about, so much of this is what I’ll call newspaper babble. Some minister or some secretary says something hostile, something is said—these are merely words. Here’s the underlying fact: China cannot sell the products it produces in China because over a billion people living in China live in absolute poverty and can’t buy it. They’re the hostage to European and American consumers, and their great fear is that those consumers, if they go into a recession, won’t buy those products. The problem the Chinese have is that they can’t invest their own money into the Chinese economy—there’s no room to put it, there aren’t enough workers, there’s not enough land and so on. So they have this massive hangover that they’re willing to invest in the world to get out of China. So there is a very good relationship between the United States and China. The Chinese get to sell products to the Americans; the Americans get these products. The problem the Chinese have is that their wage rates are now higher than those of other countries. It is cheaper to hire workers in Mexico today than in China. Their great historic advantage is dissolving yet they must continue to export. The American desire that the Chinese change the value of the yuan, that they float it, of course will never happen. The Chinese can’t afford to let that happen because of course that would make their exports even more expensive and place them in even more difficult trouble. So the United States enjoys jerking their chain by saying they should float the yuan. The Chinese respond saying that they will do that in a few years as soon as something else happens that’s unnamed. And the Chinese condemn the United States for their naval activities, and all of these are words. These two countries are locked together in a very beneficial relationship. In the long run it’s more beneficial to the United States than to the Chinese, and that’s one of the paradoxes. But again it takes a long time for people to realize that economies have failed or recovered. I remember back in 1993, people were still speaking about the Japanese super-state long after the banking system collapsed. One of the interesting things about the global financial community is that they always seem to be about two years behind reality, and the China situation is that they are in the midst of a massive slowdown. They’re admitting to a certain degree of slowdown—we suspect it’s much more substantial than that. In fact, given Chinese inflation rate, they may be entering negative territory. So this is a country that has had a magnificent run up in 30 years, it is going to be an important economic and military and political power over the next century but for right now it’s got problems.

STRATFOR

The end of the bubble is nigh

Prior to the 2008 Financial Meltdown there were ample signs that the US economy was heading for calamity, but no one chose to believe it.

Now in 2011 China's economy is showing equal amounts of red flags that its economy is is going to become unhinged in the near future. This is is happening, one can choose to believe it or not.

China’s National Audit Office has completed a review of the scope of local government debt. The report is politicized and conflicts with a similar report released by the People’s Bank of China, but it reveals some of the country’s risky financial practices. It also calls into question Beijing’s ability to manage its debt.

Analysis

China’s National Audit Office (NAO) has completed a long-awaited review of local government debt and submitted it to the National People’s Congress, Xinhua reported June 27. The report claims that total local government debt amounted to 10.72 trillion yuan ($1.7 trillion) by the end of 2010. This sum is close to the 10 trillion yuan estimate leaked in late May. The NAO’s 10.7 trillion yuan total is lower than the 14.4 trillion yuan estimated by the People’s Bank of China (PBOC) earlier in June. (The PBOC claimed its estimate covered only the “local government financing vehicles,” or LGFVs, that were set up to handle investment projects for local governments, which are, with a few exceptions, forbidden by law to run deficits and issue bonds.)

The NAO report is obviously politicized and has been used to argue that the local government debt problem is not as bad as many had assumed — indeed, the report downplays China’s local government debt problem. However, the report provides insight into China’s systemically risky practices, and it calls into question the assumption that China can manage its debt.

The NAO Report

The NAO investigation, launched by Premier Wen Jiabao in March 2011, was a long-anticipated attempt by China’s central government to get a reliable measurement of the full size of the local government debt problem. The office claims to cover a wider range of local government debt than the PBOC, relating to multiple types of agencies and entities in addition to LFGVs (though it did not survey as many LFGVs as the PBOC claimed to have surveyed). The NAO estimated LGFV-specific debt at about 5 trillion yuan — much lower than the PBOC’s estimate. The NAO’s estimate would put total local government debt at 27 percent of GDP, whereas the PBOC’s estimate for LGFVs would put that debt at around 35 percent of GDP.

If the NAO’s estimate for non-LGFV debt (5.7 trillion) is combined with the PBOC’s estimate for LFGV debt (14.4 trillion), then total debt amounts to around 20 trillion yuan, or 50 percent of GDP, for the fullest estimate of total local government debt, according to Victor Shih, an authority on China’s local debt issues. When combined with the central government’s debt — around 20 percent of GDP — the country’s gross public debt would be somewhere in the vicinity of 70 percent of GDP, making its public finances appear much worse than official announcements would indicate. Though this amount would still not reach the highest debt levels seen in some crisis-hit developed countries, it would be higher than China has heretofore allowed. More important, this moment of transparency reveals much that remains opaque in China’s public liabilities — and that debt is rapidly growing in the investment-driven economy.

It is unsurprising that the NAO report differs from the PBOC report and other reports, estimates and leaks. There is a fierce debate taking place in Beijing about the size the debt problem and ways to manage it, with the Ministry of Finance having proposed a 3-4 trillion yuan bailout plan — yet to be adopted — that suggests a large portion of local government debt could turn sour. Notably, the NAO did not provide an estimate for how much of the 10.72 trillion yuan local government debt would go bad. (Previous estimates suggest as much as 20-30 percent could go bad, an estimate conforming to China’s supposed 35 percent bad-debt ratio in the round of state bank bailouts in the 1990s and 2000s.) Nevertheless, the fact that official government reports differ not only on the total amount of debt but also on which organizations are liable and to what extent, suggests serious systemic financial risk.

Moreover, the NAO report gives some insight into the situation beyond the size of the debt, and what it reveals is fairly grim. This is because it reinforces the notion that local governments are rapidly accruing debt. It estimated local debt growth at 62 percent in 2009 and 19 percent in 2010, roughly supporting the PBOC’s previous estimates. It also reinforces the view that LGFVs are borrowing without sufficient collateral, and that they have used borrowed funds to speculate in stocks and property. Moreover, they are using new credit to pay off old debts, with 5 percent of LGFV’s reported to have done so but no specified value of the loans involved. As a result, there is widespread and rapidly building credit risk with ill-defined parameters, confusion as to liability (the NAO report says local governments are only directly liable for 63 percent of the debt, though indirectly for all of it), and the practice of state banks issuing evergreen loans. This practice of rolling over debt endlessly was characteristic of Japan and other Asian financial systems before suffering financial crises in the 1990s. And this is merely the “official” account of the situation; it therefore is likely to hide factors that would be deemed detrimental to the country’s stability if widely disseminated.

The ongoing bailout and bond issuance debate in leadership circles suggests that the local government debt is not felt to have reached a crisis yet. The PBOC claims 50 percent of the debt is not due till 2014-15, whereas the NAO claims 70 percent of the debt is not due until 2014-15. And according to the NAO, some LGFV debt is not being paid on time, but so far only 8 billion yuan is overdue.

Managing the Debt

The net effect of these varied reports is that China is sitting on a massive stock of debt amounting to around 27-50 percent of GDP that was incurred mostly within the past two years. This rapid debt accumulation has proved difficult to control in 2011, with government attempts to restrain bank lending leading companies and banks to evade controls by borrowing through channels outside of banks. The total new credit (total social financing) in 2011 is likely to equal the total in 2010, at roughly 14 trillion yuan. In other words, the build-up is continuing, as is the disguising of the problem.

Chinese authorities appear to be coming closer to authorizing wider local government debt issuance, which they have allowed as part of a trial program in recent years to provide the governments with a more reliable and transparent means of financing their spending. This would alleviate financial pressures on local governments that have led to their operating in gray areas, such as creating financing vehicles and disguising debt. However, such a move would also bring its own threats to central control. Wider allowances for local government bond issuance are likely to come only after wiping off bad debt from their accounts to make their bonds more attractive to investors, along the lines with the rumored Finance Ministry plan. The size of the local government debt suggests a massive bailout plan is in the works, even if it is not implemented immediately. The country’s financial system and economic planners must face these massive debt and bailout challenges — even as a leadership transition is under way.

It has been said that China’s rapid growth makes this debt manageable; this assumption is inaccurate. Though China has maintained an average of 10 percent growth per year for 30 years, this means a correction is coming sooner rather than later. Worrying signs in the export sector point to the fact that the current economic model is expiring. China may be able to delay debt payments, reshuffle among government entities and bail out indebted entities for a period of time, but ultimately the financial burdens on the system will further delay the process of building up household wealth and increasing household consumption. The result will be that rebalancing the economy will be further away than ever and growth rates will fall.

STRATFOR

Smaller Companies' Troubles Challenge China's Economic Policy

There are reports that without special government support, 40 percent of Wenzhou’s small- to medium-sized businesses could face at least a partial halt of operations, with bankruptcy for some. Also, Chinese media report that profits for 35 export-oriented businesses of this size have fallen by 30 percent. With Wenzhou seen as an economic model for other cities, this may have important ramifications. Growing financial troubles among small- and medium-sized businesses pose an immediate challenge to China’s tightening economic policy.

Analysis

Reports of failing small-to medium-sized enterprises (SME) have trickled out of China in recent months. An official from the association for those enterprises in Wenzhou, Zhejiang province, said that if the central government’s economic tightening policy does not change, or if the government does not give special support for struggling businesses, then 40 percent of the SMEs in the area may at least partially halt operations. Also, some may suffer bankruptcy soon, the association said. This statement comes after reports of three high-profile bankruptcies of SMEs in Wenzhou in April and claims in the Chinese media that profits for 35 export-oriented small and medium-sized businesses in Wenzhou have fallen by 30 percent. Other reports suggest a high number of businesses are on the verge of failure elsewhere in the manufacturing hubs of the Yangtze and Pearl river deltas.

Growing financial troubles among small and medium-sized businesses pose an immediate challenge to China’s economic tightening policy, and reveal a fundamental challenge to its economic model.

The Challenges for Smaller Companies

Reports of bankruptcies suggest that in the current economic climate, Chinese SMEs face greater challenges to their survival than was hitherto acknowledged. In the first two months of 2011, the Chinese Ministry of Industry and Information Technology recorded a slight uptick in bankruptcies, reporting that 15.8 percent of the country’s SMEs were facing bankruptcy, up by 0.3 percent since 2010, and that the financial losses involved had grown by 22.3 percent. The ministry ordered local governments to carry out financial surveys on the health of small and medium-sized businesses under their jurisdiction.

However, as is often the case, there are mixed indicators. The three SMEs that went bankrupt in Wenzhou are facing allegations of corruption and mismanagement in local courts, suggesting that their situation may not be indicative of broader economic problems affecting enterprises of their size. Of course, corruption and mismanagement are widespread, so the specific allegations against these companies do not rule out the possibility of negative conditions affecting numerous businesses. Local statistics say the number of businesses withdrawing from the market has actually fallen this year, but local statistics are geared toward showing positive economic news.

This trend is potentially of great importance because the bankruptcies are being attributed to the central government’s ongoing drive to tighten controls on the economy — especially on bank lending — in order to wind down the high levels of lending during the global economic crisis, reduce credit risks, and moderate the economy’s growth rate to prevent overheating. The tightening policy has moved at a very gradual pace, with the moderate reduction in bank lending and hikes to banks’ required reserves not translating to reduced credit expansion overall. However, the restriction of financial channels on the margins has begun to bite, especially for those who do not have the right political connections to ensure access to credit. SMEs fall under the latter category.

Small and medium-sized businesses have more trouble getting credit than the government’s favored state-owned enterprises (SOEs). While SOEs have benefited most from government policies since the global crisis, SMEs have borne the brunt of the post-crisis credit restrictions. While SME lending has surged, according to official statistics, the truth is that local governments can classify small and medium-sized businesses however they choose in order to make their statistics meet central government mandates that credit be extended to this sector, while not actually doing a better job of making credit available throughout the SME spectrum. Larger SMEs are more likely to get credit than the numerous smaller ones, which banks see as posing greater risks of default without the redeeming good connections or the extensive collateral that SOEs often have.

The problem of SMEs getting access to credit is an old one. Sometimes, powerful small- and medium-sized businesses trumped up complaints to get more favorable policies, but for others, it is a genuine problem. In the current context of government credit tightening, the problem appears to be getting exacerbated. The alternative, going to the underground lending sector, forces higher financing costs on SMEs.

Moreover, greater difficulty accessing credit comes at a time of other economic challenges. Businesses are facing demands for higher wages. As inflation pushes up prices for food, rent and some consumer goods, workers cannot keep pace. Across the country’s urban landscape, wages are estimated to have risen by more than 20 percent since 2010. This phenomenon adds great expense to businesses that already operate on thin profit margins. According to the Global Times, export companies’ average profit margin fell as low as 1.4 percent in the first two months of 2011.

Raw materials prices also pose a problem. Though the government attempts to limit domestic prices on commodities, international commodity prices have spiked, leading to price rises at home for goods needed as inputs for manufacturers. The gradual appreciation of the yuan against the U.S. dollar may also have added to concern among exporters, theoretically making Chinese products less attractive, though its pace has been gradual (barely more than 5 percent against the U.S. dollar in one year). Additionally, a stronger yuan can offset high prices of imported materials.

A massive challenge comes in the form of weak external demand. Most SMEs are built to export goods to customers abroad. The collapse in global trade in 2008-2009 did great damage to the SME sector, which did not receive anywhere near the amount of government support or stimulus that larger, more politically powerful SOEs did. Though trade recovered rapidly and exports boomed by around 30 percent in 2010, the anticipated slowdown in export growth in 2011 is taking its toll — exports are growing around 20 percent in May, down from 26.5 percent in the first quarter and plenty of downside risks are arising from China’s domestic economy, Europe’s debt troubles, and persistent problems with the American recovery. Many small SMEs are not accepting production orders in the fear they will incur greater losses; this behavior contrasts with the 2008 slowdown when they were desperately seeking new orders.

A Significant Part of the Economy

The threat of failing SMEs cannot be taken lightly. SMEs account for about 80 percent of China’s manufacturing employment. Because the supply chain is extensively connected, one failure can affect a number of other enterprises negatively, potentially leading to a wave of layoffs and unemployment. STRATFOR sources say that if Wenzhou companies are suffering, then others elsewhere certainly are — Wenzhou has a history of being an economic model for other cities and a leading indicator for new trends. Other STRATFOR sources say the majority of private small- and medium-sized businesses are technically bankrupt and survive through whatever government support they can get, and often, tax evasion.

The question, then, is how will the government respond? During the global financial crisis, the government stepped in to prevent the sector from collapsing. Beijing increased tax rebates for exporters and other subsidies, and presumably, the central government will do so in 2011 if bankruptcies become a broader problem. The China Banking Regulatory Commission announced in May that it has officially approved 75 percent of credit guarantees to companies that provide support for small- and medium-sized operations seeking loans. The commission hopes that by better regulating these companies, it can improve the financial situation for SMEs. However, more urgent and direct means of government support will be likely if bankruptcies grow rapidly.

This urgency raises a serious policy dilemma. The government’s current tightening policy may have to be abandoned if growth slows and joblessness looms. Unfortunately, doing so will encourage further spikes in inflation, which could result in the same outcome. The central government does not look kindly on private SMEs because they exist outside of its control. Beijing hopes to consolidate the sector ultimately, allowing restructuring to wipe away the inefficient or outdated enterprises and encouraging low-end manufacturing to move inland, while coastal operations are upgraded.

But progress is moving slowly. Consolidation faces resistance, as has happened in the steel sector. And SMEs on the coast do not have the funds to upgrade their production, which means that the move to boost production in the interior will simply add to overcapacity in low-end industry, and increase competitive pressure on all SMEs.

For China, an attempt to let SMEs go bankrupt and allow restructuring to run its course raises too great a risk of sudden, massive unemployment, and would add to social unrest among workers, particularly migrant workers, in an already precarious social and economic environment. Authorities are unlikely to allow deep retrenchment in the sector at present, though they will continue to seek to restructure the sector in the long run. Fortunately for China, while foreign demand is weak, it has not collapsed and exports continue to grow, albeit at a slower pace.

Yet, the fact that problems are emerging, despite exports holding up, points to flaws in the internal structure. China’s likely deferral of structural reform points to its larger economic problem. The export-driven economic model is reaching a peak as foreign demand weakens and export growth slows. This decline will strain the weak portions of the export sector. State-driven investment cannot support the economy forever, and it heavily favors the state sector, further squeezing the private sector. Household consumption is not picking up the slack, and any attempt to boost people’s incomes or reduce their burdens in a serious way will put greater financial stress on the industrial and corporate sector or government finances. The worst is yet to come for businesses, as workers’ demands for higher wages are set to continue, especially as the workforce peaks (expected to happen in 2013). This trend gives workers more bargaining power, placing more cost pressure on companies with thinning revenue streams. Thus, while it is not yet clear how extensive the latest round of bankruptcies will be — and while government support is fully expected — these signs of failing businesses point to grave challenges ahead.

STRATFOR