China is struggling with its own economic imbalances. STRATFOR has long been perceived as bearish on the Chinese economy. We are less bearish than realistic, and the reality is that the longer an economic miracle continues to be miraculous, the more likely it is to end its amazing run. We cannot help but notice the similarities between China and its East Asian economic predecessors: Japan, South Korea and the Southeast Asian “Tigers.” The Chinese have shown great resilience, but the global economic crisis revealed the weaknesses of China’s export-based model. While government investment now makes up the lion’s share of the Chinese economy, Beijing is walking a very difficult path between rampant inflation and rapid economic slowing.
As China’s leaders search for a solution and try to avoid the social consequences of a slip in either direction, they are also focused on the next major generational leadership transition, slated to begin in 2012. This discourages any radical or daring economic policies, and stability will remain the watchword as the politicians jockey for position. But given the status of the Chinese economy, and the continued effects internationally of the global slowdown, daring policies and ideas are perhaps what China needs. While Beijing is likely to procrastinate in making any radical economic policy changes, and thus avoid the likely short-term chaos that could entail, the longer the leaders delay fundamental action, the worse things may be when the system starts to unravel.
Beijing was concerned that rolling back stimulus policies enacted in late 2008 would put economic growth at risk, and with it employment. STRATFOR has learned that, given these circumstances, Beijing has decided to keep that stimulus intact. This will solve the employment problem, but it comes at the certain price of higher inflation. China’s challenge in 2011 will be to maintain sufficient services and subsidies to keep social forces in check at a time when the country’s economic model will exacerbate inflationary problems.
Though growth may slow, STRATFOR does not anticipate it to collapse beneath the government’s target level. This will require a tightrope walk between excessive inflation on one side and drastic slowing on the other. China’s leaders want a smooth transition to the next generation of leaders in 2012, and do not want the economy to collapse on their watch. They will err on the side of higher inflation, which could exacerbate social troubles, but Beijing is betting this will remain manageable.
China’s exports recovered in 2010 from the lows of 2009, but export growth is expected to slow in 2011. Wages, energy and utilities costs are rising; the government is letting the currency slowly appreciate; workers are demanding better conditions and more compensation while the demographic advantage and the amount of new migrant labor entering markets is slowing. All of these processes will continue in 2011 to the detriment of export sector stability. Already some manufacturers of cheap goods are operating at a loss. Reports of loss-making enterprises are not yet widespread, but they indicate the real strains from rising costs that will worsen in 2011. However, as long as the American recovery continues and there are no other big external shocks, the export sector will not collapse.
China’s primary hope for maintaining targeted growth rates is investment. Since 2008, Beijing has relied on government spending packages and, most important, gargantuan helpings of bank loans to drive growth. The central government will continue these stimulus policies in 2011. Meanwhile, Beijing will allow banks to continue high levels of lending, and the banks appear just capable of surging credit for another year. Deposits are still growing and outnumber loans, several major banks raised capital in 2010, and Beijing has toughened regulatory requirements to increase capital adequacy, reserves and bad loan provisions. Nevertheless the credit boom cannot last much longer, and the sector is sitting on a volcano of new non-performing loans worth at least $900 billion. Without credible reform in lending practices, continued high levels of lending in China will increase systemic financial risks as companies take out new loans to roll over bad debt and invest in inefficient or speculative projects, while adding to inflation and compounding the sector’s future burdens. Though a banking crisis may be averted in 2011, it cannot be averted for long.
With Beijing willing to use government investment and bank lending to avoid a deep slowdown, inflation will rise and cause economic and socio-political problems in 2011, generating outbursts of social discontent along the lines of previous inflationary periods, such as 2007-2008, or even, conceivably, 1989. Inflation is hitting all the essential commodities, and STRATFOR sources perceive unusually high levels of social frustration from Beijing to Hong Kong. The government will use social policies, price controls and subsidies to alleviate the problem, but will not be able to prevent major incidents of unrest. Security forces are capable of dealing with protests and riots, but such incidents will reveal the depth of the problems the country faces.
Internationally, China will continue playing a more assertive role. Beijing will accelerate its foreign resource acquisition and outward investment strategy. It will continue pursuing large infrastructure projects in border areas and in peripheral countries despite resulting tensions with India and Southeast Asian states. It will increase maritime patrols in its neighboring seas and maintain a hard-line position on territorial and sovereignty disputes, increasing the risk of clashes with Japan, Vietnam, South Korea and others. China’s military modernization will continue to focus on areas like anti-access and area denial and cyber capabilities, and the lack of transparency will continue to feed foreign suspicions. China’s trade disputes with other nations — especially the United States — will worsen, though Beijing will make token policy changes and increase imports to reduce political friction. The United States will make bigger threats of imposing concrete trade measures against China as the year progresses, taking at least symbolic action, perhaps toward the end of the year as the 2012 election campaign starts to warm up.