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Introduction
This is Stratfor’s third Decade Forecast. We publish one every five years, so they overlap. It is interesting to see how these forecasts have evolved. Our first forecast was only a few pages long; this one comes in at 45 pages. It is not clear to us whether increased size makes for increased accuracy, but there is no question that increased staff makes for increased size.
We were quite pleased with our first forecast’s accuracy, particularly with our forecast of an economic meltdown in East Asia. Our second forecast suffered a deep flaw when we failed to forecast the U.S-jihadist war and, in fact, miscalculated on the Middle East as a whole. However, the rest of the forecast was stronger. We included evaluations of our past performance in each of the sections, continuing our belief that our credibility rests both on accuracy and on honesty when we fail.
A decade forecast is the longest we attempt at this time, because anything greater than a 10-year forecast encounters history’s tendency to have wild discontinuities. Even a 10-year forecast has discontinuities built in. A 10-year forecast in 1980 would have had to forecast the collapse of communism in Eastern Europe. A forecast in 1910 would have contained World War I. The art and science of forecasting requires that you recognize that the least likely outcome is simple extrapolation. You can draw straight lines for a year, but drawing them out for 10 years is dangerous.
A decade forecast, therefore, is about predicting the unexpected. But it is precisely the wildly unanticipated that a decade of history throws up at you. Predicting in 1995 that the United States would invade Afghanistan in 2001 would have been enormously difficult. It would have been far easier to draw a straight line showing that the post-Cold War interregnum would be eternal.
It follows from this that expecting the U.S.-jihadist war to continue to dominate the world in 2015 — 14 years after the war started — is fairly unrealistic. If the Islamic world remains the focus of the international system, it will be on very different terms than today. In fact, it is our view that the jihadist issue will not go away, but will subside over the next decade. Other — currently barely visible — issues are likely to dominate the international scene.
Perhaps our most dramatic forecast is that China will suffer a meltdown like Japan and East and Southeast Asia before it. The staggering proportion of bad debt, enormous even in relation to official dollar reserves, represents a defining crisis for China. China will not disappear by any means, any more than Japan or South Korea has. However, extrapolating from the last 30 years is unreasonable. We also expect there to be significant political consequences. At the moment, there appears to be a buying frenzy in China, similar to the dot.com meltdown. Irrational exuberance rules the day.
At the same time that we see China shifting into a dramatically different mode, Russia is in the process of transforming itself once again. After 20 years of following the Gorbachev-Yeltsin-Putin line, which sacrificed geopolitical interests in return for strong economic relations with the West, the pendulum is swinging sharply away from that. The Russians no longer see the West as the economic solution, but as a deepening geopolitical threat. It is not clear whether it will be Putin or his successor who changes Russia’s course definitively, but we expect a dramatic change to come during this decade — a more authoritarian, state-dominated economy, coupled with intense efforts to recover its sphere of influence.
There is one curve that will not reverse itself. The long wave that has lifted the United States since 1880, perpetually increasing its economic, military and political power in the world remains intact. We see the U.S. economy continuing to be the consistent, dynamic presence in the world. The coming demographic crisis that will hit the rest of the world will not hit the United States nearly as hard. Not only is the United States not contracting its population domestically, but its ability to manage its population through relatively painless immigration patterns cushions what other problems might arise. Militarily, we expect the United States to maintain control of the seas as well as of space, ensuring strategic global domination.
As a result, the United States will continue its domination — and the world will increasingly resist that domination. Our core forecast is that the United States will remain an overwhelming but not omnipotent force in the world, and that there will be coalitions forming and reforming, looking for a means to control the United States.
We expect the main focus of the international system to gradually move away from the region between the Levant and the Hindu Kush, south to the Arabian Peninsula, farther north and east. The Eurasian heartland and the Western Pacific are both more likely to dominate world attention in a decade than the Middle East. In particular, the economic weakening of China and insecurity in the region is likely to create a focus for instability later in the decade.
The world will remain what it always has been: a dangerous place in which nation-states, and occasional non-nation-state actors, continue to struggle, compete and make war. What follows is our estimate of who the main actors will be, where the struggles will be, what sort of competition will take place and where wars might occur.
United States
In our first decade forecast, published in late 1995, we wrote: “The key to understanding the next decade will be to understand that the international system is in massive disequilibrium. One power — the United States — has an overwhelming economic and political advantage. Ordinarily, it would be in the interest of such a power to impose a pax on the world. However, because of geography — the location and size of the United States — the costs of imposing such a pax substantially outweigh the benefits. Any given intervention in Eurasia carries with it a higher cost than the benefits. The only exception to this might be interventions in the Persian Gulf, where the economics of oil occasionally make intervention beneficial.”
In our second decade forecast, published in January 2000, we wrote: “The United States remains at the center of the international system. It is the pre-eminent global military, economic and political power. Militarily, the U.S. Navy controls the world’s oceans more completely than any empire in history. As important, the United States exercises almost complete control of space, enabling its intelligence apparatus to see deep and its military to shoot deep and with precision. Economically, the United States is experiencing an unprecedented boom, surging past all other regions of the world. This military and economic power yields unprecedented political influence. This is complemented by geography. As the only great power native to both the Atlantic and Pacific oceans, it can influence events globally with an ease that magnifies its inherent power. Thus, the fundamental question of the next decade — for both individual countries and the international system as a whole — will revolve around the United States. The question, increasingly, will be this: How can other countries limit American power and control American behavior?”
Concerning the American economy, we wrote in 1995: “The United States is by far in the best financial and demographic position to capitalize on this tendency [increased wealth creating further investment and further consumption]. Interestingly, the national deficit, which is declining as a proportion of GDP, has not had the effect feared. The primary problem of the deficit — that it crowds out private borrowers and raises interest rates — has simply not happened and it will not happen. What it has done is cripple the federal government’s ability to finance new social initiatives. The key structural issue — the U.S. deficit with East Asia — is primarily a political rather than economic problem, and will be dealt with as such.”
We went on to say in 2000: “The United States will continue to lead the world economically, in spite of the probability of a recession some time in the first half of the decade. However, structural problems, including an aging population liquidating capital holdings in retirement and a severe labor shortage, indicate serious problems later in the decade.”
We regard these forecasts as generally accurate and continue to see the United States moving along this general path. The United States continues and will continue at least for the next 10 years to be the center of gravity of the international system. It continues to be economically, militarily and politically pre-eminent. The events of Sept. 11, 2001 — which we did not forecast — nevertheless fit with our general forecast that the United States will remain generally aloof from international entanglements, unless they affect the Persian Gulf and the region surrounding it. That will be — and has been — the primary cause of American intervention. It has resulted in the fulfillment of a second forecast. The international system continues to revolve around the question: “How can other countries limit American power and control American behavior?”
The U.S.-jihadist war has caused the United States to surge into the region between the Mediterranean and the Hindu Kush with overt, covert and political power. This has unbalanced the U.S. global posture militarily, and accelerated the process of resistance to U.S. power globally.
The United States is, first and foremost, a global hegemon. It has interests throughout the world, which it manages with tools ranging from economic influence to military intervention. The foundation of its power has been — and continues to be — the control of the seas. That control remains unchallenged, and the United States is therefore free to intervene in Eurasia as its interests dictate.
All interventions in Eurasia, however, pose a fundamental challenge to the United States: demography. The force that the United States can field, the force that it can deploy and the force that it encounters in Eurasia are always out of balance. Having inserted forces in Eurasia, the United States always finds itself at a massive demographic disadvantage if it must engage in manpower-intensive forms of warfare. In Korea, Vietnam and Iraq, the core demographic disadvantage of warfare in Eurasia created serious difficulties.
The greatest difficulties did not necessarily arise in the immediate theater of operations. Rather they arose from a trend toward an unbalanced force. The United States has global interests. U.S. naval and air power may or may not be engaged to its full capacity in a Eurasian war, but the Army always is. These wars tend to draw in ground forces disproportionately. As a result, an unsustainable imbalance in America’s global posture emerges. These postures always are corrected by systematic disengagement.
We expect the United States to disengage from Iraq — and also from the rest of the Islamic world — during the first half of the decade this forecast covers. This does not mean that a force may not be left in any or all of these countries. However, inasmuch as we forecast a general decline of jihadist capabilities and the emergence of an internal containment system in the Islamic world, we would expect that the level of effort in the region will decline.
This also will be driven by increasing resistance to American power that will manifest itself not so much in mere criticism of American policies, but in the formation of coalitions that can resist the United States. Most European states will lack sufficient interest in challenging the United States, but we expect that East Asia will become increasingly an area of instability, where resistance to the United States will become increasingly rational. Therefore, we expect that by the end of this decade, U.S. focus on the Islamic world, while far from disappearing, will become less significant than U.S. interest in the Pacific Basin. U.S. alliance structures currently driven by the U.S.-jihadist war will shift once again, to reflect increased tensions in the Western Pacific. We would expect a decline in U.S. foreign involvements in the years on either side of 2010, followed by increased involvement in Asia.
Economically, the United States continues to lead the world in spite of the recession in the first half of the decade. It is indeed facing serious structural problems — though the obstacles presented by an aging population should not crop up until around 2015.
We do not expect a return to growth rates seen in the 1990s, except sporadically. We would expect to see another recession during the first half of the decade, as we return to a more traditionally spaced expansion. However, we do not expect to see a major, long-term economic contraction or period of stagnation. We do not anticipate a return to the 1970s and certainly not to the 1930s.
The central factor we have been concerned with has been demographic. The United States has the least significant demographic problem of any major power. First, like the rest of the developed world, and unlike most of the developing world, the United States has a bulge in its population — there are more 40- to 50-year-olds than there are in any younger 10-year bracket. A similar, although less pronounced, bulge existed in the United States from 1995 to 2005.
While young workers are net consumers of credit, older workers who have often paid off their mortgages and already sent their children to college are net providers of credit. Having an unprecedentedly large demographic bulge in that age bracket enjoying unprecedentedly high per-capita incomes injects an unprecedentedly large amount of capital into the economy as their savings are converted into investments.
That abundance of capital radically reduces borrowing costs, allowing firms to successfully finance the complete replacement of their industrial plant in just a few short years. The positive impact on worker productivity formed the basis of the United States’ 1995-2005 economic boom. It also allowed American firms to capitalize on the technologies of the computer revolution and take them forward.
Research and development costs money. Implementation costs money. The golden age of the U.S. baby-boom generation allowed most firms to do both. Repeatedly.
The bulge in the next 10 years will be significantly larger than the bulge from the past 10. During the next decade the bulk of the baby boomers will be net creditors and moving toward retirement. They represent the largest demographic bulge in U.S. history.
Furthermore, the U.S. population is the youngest — and fastest-growing — population among all the major economies. U.S. baby boomers had kids — lots of them. So many that some demographers refer to them as the echo boomers, although they are more popularly known as Generation Y. But in the United States — unlike in Japan and most of Europe — there was no sharp contraction in birth rates before or after Gen Y. The American Gen X is certainly smaller than the baby-boom generation, but only by about 15 percent. In Germany, Italy and Spain the gap is around 35 percent.
This pattern is set to replicate in successive generations as well. The U.S. population increased by 13.2 percent between 1990 and 2000, while the European and Japanese populations barely held steady. The United States is set to grow even more; birth rates are up across all regions and races — even the dominant white population grew between 5.9 percent and 8.6 percent (depending upon how one defines “white”) between 1990 and 2000. Conversely, other countries such as Japan, Germany, Italy and Spain all face the prospect of shrinking populations in the decade to come.
The net result of this population structure is that the U.S. investment boom of the 1995-2005 decade is not only replicable, but repeatedly replicable. Also, by having a relatively robust demographic in younger generations, the United States can — for the next 10 years at least — manage both an investment boom and the funding of its social security system. Elsewhere, in contrast, smaller successive generations are creating a financial crunch. Italy already is spending about 13.8 percent of its GDP on funding its pension program; with its relatively youthful population, the United States spends only about 4.4 percent.
Far more important — and the single most important fact about the United States — is its institutionalized capacity to absorb immigrants. Unlike Europe or Asia, the United States is capable of relatively seamlessly absorbing migration at virtually any social level, from impoverished Central American immigrants to highly skilled professionals. As a result, it can shape whatever demographic order, within a matter of years, it requires. It generated an industrial working class in less than 20 years in the late 19th century and supplemented its skilled technical class during the 1980s.
This means that many fears about a collapsing social security system or housing prices based on existing demographics are inherently flawed. The United States can shape its demographics at will. Europe can do this only with massive social dislocation. Asia cannot do it at all on a broad scale. This, plus the fact that the worst-case scenarios have by now already been factored into expectations and therefore into the market, means expectations of calamity are irrational.
At the same time, there is a serious structural issue in the economy: the trade deficit.
When we look at the federal deficit, we see that there really is nothing out of the ordinary going on. Particularly when we look at a five-year moving index, we can see that we continue to operate well within normal bands. It is the trade deficit that has broken new ground.
The U.S. balance of trade broke into negative territory in the mid-1970s and has remained there since. This first break was driven by the surge in oil and other commodity prices. What is important about this index is not only that it has remained in negative territory since then but also that it has continued to trend higher, particularly when smoothed out by a five-year moving average. The five-year moving average reached a peak in the mid-1980s, fell back until the early 1990s and then began an uptrend that has continued until this point, rising to near 5 percent of GDP in 2004.
What is interesting about this 30-year trend is that it has had no impact on the economy. To the contrary, the massive expansion that began in the 1980s coincided with the expansion of the deficit, and the tremendous surge of the 1990s coincided with a major surge in the trade deficit. The deficit broke new highs in 1995, yet that period also saw the greatest economic expansion in history.
The issue facing the United States consists of two parts: the trade deficit has now moved from 3 percent to 5 percent of GDP. First, is there a percentage of GDP at which the trade deficit begins to do structural — as opposed to sectoral — harm to the U.S. economy? Second, are there any limiting forces on the expansion?
Empirically, this is an extraordinarily difficult question to answer, simply because, first, the U.S. economy has not had deficits of this level since World War II, and second, the conventional wisdom about trade deficits has always been wrong. The argument about trade deficits has always held that they represent an underlying weakness in the American economy and that they cause further damage. That argument has always, in the past, turned out to be false. That does not mean it will continue to be false. It does mean the deficit is not self-evidently harmful.
To understand the deficit, it is essential to understand how intimately it is linked with Asian economic dysfunction. As Asian economies mature, they surge exports to maintain cash flow for their banking system. These are low-profit to non-profit export surges. The surge in the 1980s represented Japan’s meltdown, concluding with a last surge in 1991. The mid-1990s surge represented the East Asian meltdown of 1997. It continued to surge as China cut in and is peaking now in a surge of profitless exports from there. Therefore, this is, in our view, a self-limiting phenomenon. As the Chinese surge subsides and China increases profit margins on its exports, the surge will end.
This is not to say this does not cause pressure on the economy. These surges are not devastating because they are transitory, they rotate by sector, and because they free capital for productivity rises in the United States. The Japanese surge destroyed sectors of the American economy. This clearing also left space for the emergence of new industries, such as the personal computer. This in turn opened the door for growths in productivity that helped, temporarily, compensate for structural damage.
It is our expectation, based on our Asian forecast, that pressure on the trade deficit will subside before the end of the decade. At the same time we continue to forecast productivity growths and smoothed demographic curves throughout this period. We expect two or more recessions during the coming decade — at least one of which will be triggered indirectly by Chinese problems. When China’s own version of the Asian model falters, China’s export sector will cease its current red-hot growth. This will gut Chinese exports to the United States, thereby removing China’s need to heavily invest in American government debt. For the past two years, China has not only been a leading source of U.S. trade deficit, it also has been a leading purchaser of U.S. government debt to finance that deficit. The Chinese crunch and step-back from U.S. debt purchases will cause the U.S. dollar to plummet on international markets, most likely triggering a recession until the U.S. economy’s inherent efficiencies allow it to regain its strength.
We do not expect to see a return to 1990s growth rates. At the same time, we regard the American economy very positively indeed.
Global Economy
In Stratfor’s 1995-2005 decade forecast we wrote: “The decade ending 2005 will be marked by two contradictory trends. On one hand it will be a period of unprecedented global economic prosperity and growth. On the other hand, it will become a period of increasing fragmentation and tension in the international system. As in the period prior to World War I, prosperity and instability will go hand in hand.”
As we said 10 years ago: “Prosperity leads to greater economic integration and dependency resulting in greater insecurity by increasing the importance of international economic relationships and therefore increasing the opportunities for friction. This, in turn, leads to greater insecurity.”
This pattern did not end with World War I or World War II. During the past 10 years we have seen record global economic growth accented by the Sept. 11 attacks and new heights of development as the computer revolution put down roots. This was in stark contrast to the financial crisis that struck Asia with its worst-ever recession at the same time. Europe is (unsuccessfully) attempting to square its internal political commitments with its newly diverse membership in the European Union, while Asian states are walking the love-hate tightrope of historical hatreds and economic cooperation. The world is richer than it has ever been but it is far from the united world that many dreamy-eyed forecasters predicted in the early years after the Cold War ended.
The United States has a number of advantages over potential competitors. From a military and economic standpoint, its single most important advantage is location: The United States is the only major, united continental economy with easy access to both the Atlantic and Pacific oceans. Though “Europe” controls a continent, it is not a united economy, no matter what Brussels says, and the Continent certainly does not bow to a singular economic and political structure. Japan is a united economy, but its reach is limited by location and it is not continental in scope. Russia might have (albeit constrained) access to global markets, but the tyranny of distance — not to mention the debris of empire — prevents it from unifying its internal economy.
The United States’ location guarantees it the opportunity to shape the global economic system — but opportunity does not equal fact. What will ensure that the United States will continue for the next decade as the center of the global economy is the same unique feature that Stratfor identified in 1995: demographics.
Demographically, the United States is unique among the world’s major economic centers. First, its population is aging — which results in the aforementioned “bulge” in the 40- to 50-year-old age group. This bulge will not be replicated in the other major developed economies in this decade, leaving the United States by far as the largest pool of capital.
Japan had a bulge, but it peaked in 2000, and its near-retirement generation is among the smallest in Japanese history. Most European countries have such a bulge, but are 10 to 15 years behind the United States.’ Only France has demographic patterns that indicate there will be anything but a dearth of investment capital outside the United States.
From 1995 to 2005, Europe also lacked such a bulge, to which Europe’s lackluster growth rates attest. Japan did possess a bulge during this period, but the government’s spendthrift policies soaked up all available local credit. During that period, Japan transformed from the largest sovereign creditor in human history to the largest sovereign debtor.
The youth and growth rate of the U.S. population is also not being replicated in other major economies. In the case of Japan, the World War II population bulge signaled the beginning of a slow hollowing out of the Japanese population. Their bulge already has passed and, with the exception of a smaller bulge that will mature around 2030, each successive Japanese generation has gotten smaller. In the decade to 2015, Japan faces a credit crunch that will only magnify its other problems. After 2030, Japan will have an ancient population that will likely number 10 million fewer than it does today.
In Europe, the problem is that there is no replacement bulge for the generation that will mature around 2020. With the possible exception of France, all the major European countries face a feature that demographers call a “population chimney,” as each successive generation is smaller than the one before it.
Finally, there is really only one way that Europe and Japan can correct this problem without drastically increasing their birth rates — a process that would take 50 years to work its way through the system. That solution is immigration. But again, the United States is the outlier, having proven itself the only country capable of absorbing wave after wave of immigrants.
At their core, Europe and Japan define themselves by ethnicity. Non-Japanese make up less than 1 percent of the Japanese population. Europe is far more diverse than that, but no major European states can approach the diversity of the United States, in which 25 percent of the citizenry defines itself as not purely white. Even then, many of Europe’s “minorities” are actually ethnicities from other European states (i.e., Germans living in the Netherlands). In all, the total non-European makeup of Europe is less than 10 percent.
For Europe and Japan, replicating the American success is structurally impossible. In theory, Europe could allow in massively increased numbers of immigrants — who would be almost exclusively Arab Muslims — in order to plug the demographic gap. And in theory, the Europeans could radically alter their labor laws and social contract and eliminate the expensive cradle-to-grave social welfare model that keeps their societies quiescent.
But even if they did both of these things — which could shatter their societies — they would then face an industrial plant flooded with imported labor and an insufficiently large mature population — such as the U.S. baby boomers — to supply enough capital to upgrade the overtaxed industrial base. Such a state of affairs would generate the same inflationary pressures that so effectively suppress economic growth and technological advances in the developing world.
At the end of the day, the United States is set for a decade of high investment, and by extension, high productivity growth. Europe and Japan simply cannot replicate these developments — even if they were willing to restructure their economies from the ground up. Building such an environment requires a generational effort, not one that can be implemented in a “mere” decade.
The replicability of economically healthy demographics in the United States does not mean it consistently will be the state of affairs.
As workers retire, income shrivels and the torrent of money reverses. Instead of being large-scale net suppliers of investment capital, former workers become hoarders and spenders. The bulk of their financial assets are switched from high-growth stocks into low- to no-growth bonds and even cash so they cannot lose their shirts in the stock market crash of the moment. In short, aside from their spending — which usually decreases after retirement — retirees cease to participate in the national economy and capital formation. At that point, investment slows, credit becomes far more expensive and growth falls off.
A reduced supply of capital means two things. First, the cost of doing any sort of financing — anything from getting a car loan to building a skyscraper — will increase, setting the stage for lessened consumption and, by extension, slower growth across all sectors of all economies. Second, less supply always increases volatility. Crunches are next to impossible in well- or over-supplied markets; lower supply means the swings from economic booms to busts will be far more rapid and far more disruptive overall.
For the United States, the above description will manifest itself sometime around 2015, as the bulk of the U.S. baby boomers pass into retirement. For Japan, it begins here and now.
East Asia
In its 1995-2005 decade forecast, Stratfor said: “We strongly feel that the last decade’s surge in East Asian economies will be peaking early during the 1997-98 cycle.” This proved very prescient. We also said it was “extremely unlikely” that China’s growth spurt would continue. And while China did see a dip in its growth rates following the Asian economic crisis, it hopped back on the wagon relatively quickly.
The 2000-2010 forecast for East Asia centered on China and Japan. Regarding the latter, we noted that “the country likely to take a leading role in Asia is Japan” — an assessment we see playing out. Japan’s shift toward formalizing its role as a military player rather than remaining solely an economic player has accelerated since the Sept. 11 attacks in the United States. Japan’s movement toward military power also illustrates Stratfor’s core idea for East Asia in the 2000-2010 forecast: Nations that had relied on their economies in the previous decade as the sole measure of their international standing and influence would move toward a “more balanced reality in which economic power by itself will be supplemented by political and military power.”
On China, we said, “Our forecast is for a deeply troubled China, increasingly torn by domestic strife, with a government, in the face of it, alternating between brutal repression and helplessness.” China appears to be facing no such intense struggle, at least on the surface. However, not far below these placid waters swirls a mix of economic, social, political and security issues waiting for the slightest external stimulus to bring them bubbling to the top.
As for the rest of East Asia, we said, “The Korean Peninsula will become the epicenter of tensions in Northeast Asia” — a forecast we see taking shape. In Southeast Asia, we said, “Indonesia will continue to be the center of attention as it struggles to maintain unity and redefine its role among its neighbors” - again, a prediction we still stand by.
On the whole, Stratfor’s long-term East Asian forecasts have been right on the money. However, we have always been bearish on China — not for ideological reasons but for structural ones — and our forecasts, which we believe remain fundamentally accurate, have not matched the bullish view that others give to the Chinese economy and national status. Our view of China’s future is in stark contrast with the positive outlooks we see coming from investment houses and others.
One key reason for the difference is that most forecasts on China are linear — in essence they say that since the Chinese economy is clipping along at 8 percent or 9 percent GDP growth each year, in 10 or 20 years China will dominate the global economy. Our basic supposition, however, is that the shape of the world today is probably the least likely shape of the world a decade or two out. The world operates in cycles, long and short, and linear extrapolations fail to take into account the reactions and arrestors on growth or decline. For example, in 1990, a year after the Tiananmen Square incident, the prediction that China would be the regional economic engine a decade later would have been laughable, as foreign investors fled the country and the hands of repression were clearly seen. A decade later, it was hard to keep foreign money out of China, and Beijing was even beginning to look at ways to slow the economy.
China is obviously a major factor for East Asia in the next decade. And in looking at China, the status of the economy — particularly growth — is the core issue. It is our view that China’s economic growth rates, driven largely by foreign investment, trade and government spending, will continue to slow. This slowing will exacerbate underlying structural tensions in the Chinese economic system — between the urban and rural areas, between the coast and the interior, between the north and south, between the rich and poor and between the center and the periphery — and at its core between the state-controlled and market economies.
Why, then, if Stratfor sees a China on the verge — if not already in the midst — of massive internal upheaval, is there a general global acceptance of the idea that not only is China on an unstoppable rise, but that people should pour their money into the Chinese economy? In part, this is due to tunnel vision — assessors of the Chinese economy are looking only at the booming center-coastal economies in and around Shanghai. In part, it is intentional self-delusion, a failure to connect the dots.
There is no shortage of reporting on the underlying weaknesses of the Chinese banking system, the state-owned enterprises (SOEs), the unemployment problems, the uneven distribution of wealth and labor and myriad equally troubling and seemingly insurmountable problems. However, the holy grail of selling a single orange to each of the 1.3 billion Chinese continues to blind others to the reality of the situation, and the desire for a piece of what someone else might get has fed a steady stream of investment into China, keeping the system on life support and “justifying” the positive outlooks.
But on this last point, something has been overlooked: In recent years, foreign direct investment (FDI) moving into China has declined, but this trend is hard to see clearly. U.S. investment in China was the key driver in bringing China up from the Asian economic crisis. Weary of waiting for the return on investment in China, U.S. investors slowed the flow of FDI. However, the herd mentality and the shiningly optimistic assessments of China as the next golden goose led to a successive wave of European investments. This was followed by Asian investors, who did not want to be left behind.
This rush of foreign investment and interest in China has masked the Chinese economy’s underlying weaknesses and given the government tools to maintain control. But it will not last. Already there is dissent forming in the international community, and the need for quicker profits — or any profits — is driving companies and investors to look elsewhere. Rising interest rates and the perception of strong market fundamentals are bringing investments to the United States. High energy prices, sector bubbles and the resurgence of “China threat” fears are taking the shine off the Chinese economy.
Beijing has enjoyed a brief respite from these fears. The external pressures on China were set to increase in late 2000 with the election of U.S. President George W. Bush. By early 2001, China and the United States were in a tense standoff as a U.S. E-P3 sat on a Chinese runway on Hainan Island. The incident was resolved, but the strains on U.S.-Chinese relations were not relieved. The came the Sept. 11 attacks in the United States, and suddenly China became a back-burner issue. Beijing even became, briefly, a fellow “target” of international terrorism, convincing Washington that Uighur militants were tied to Osama bin Laden and out to create a greater Islamist state in western China and Central Asia.
But while Beijing had some time — and took advantage of it to effect a relatively smooth transition from Jiang Zemin to Hu Jintao, the so-called Third and Fourth Generation leadership — Washington’s overwhelming infatuation with bin Laden, al Qaeda and international jihadism began taking a more proportional position in the American global strategy. For China, this means the return of U.S. pressure.
The same factors that led to the downfall of the Qing Dynasty in 1911 are still inescapable today. China is showing classic symptoms apparent before the end of dynasties: the disruption of internal economic wealth, increasing gaps between rich and poor and between regions, the economic encroachment of outside powers and the undermining of the social contract with the state. The central government has lost its legitimacy after trading ideology for money that is now supplied from afar rather than from within.
The balance between the center, which seeks to pacify and stabilize the vast interior population, and the coastal periphery, whose economic and political interests lie in foreign trade and are therefore ultimately aligned more with foreign nations than the center of China, continues to create friction. The center, in order to maintain control of the interior, must take money from the periphery. Fears of issues of social stability lead the center to take action in the interior, which might be anathema to the interests of the coastal provinces.
China today has two economies: the import/export economy based in the densely populated coastal regions and the remains of the old Maoist SOE-based economy in the interior and the Northeastern “rust belt.” FDI supports the import/export economy, while the central government must keep the SOEs afloat. In 2003, SOEs employed 375 million of 750 million workers and controlled 57 percent of the country’s industrial assets. The SOEs are kept alive — and at times bailed out — by preferential bank loans, but the inefficient enterprises are giant capital vacuums, compounded by corruption and continued mismanagement.
Bad loans in China, most of which stem from lending to SOEs, have been estimated to reach as high as $500 billion — by no less than the investment houses who have a vested interested in making this number appear as low as possible. That is not far off China’s $609.9 billion — as of Jan. 1, 2005 — in foreign currency reserves. Beijing is constantly pulling from its own reserves to feed the state banks, which in turn feed the SOEs. Since 1999, Beijing has spent about $275 billion in asset transfers and bailouts in attempts to solve the bad loan problem. All such “fixes” have failed, since they do not require the SOEs to change their operating policies. The SOEs, in turn, feed the people who, under the communist system, came to expect — and depend on — the continued existence of a state-sponsored Iron Rice Bowl.
The coastal areas, where the import/export economy is based, received 87 percent of China’s FDI in the last three years, but western China, which is home to many SOEs and farming operations, received only 3 percent of FDI in the same period. In these areas, where nearly a quarter of China’s population lives, per capita income fell from 84 percent of the national average to 56 percent from 1980 to 1999.
The forces at work within China’s SOE-based economy are preventing the country from capitalizing on its current growth and will eventually drain the energy from the import/export economy. Fearing the urban unemployed even more than the rural unemployed, since poor farmers at least have land and can feed themselves, Beijing is offering life support; but unemployment, which in 2002 was between 6.2 percent (official data) and 13.1 percent (estimated by a 2004 University of Michigan study), continues to rise. This triggers wave after wave of demonstrations and protests — which have thus far been isolated incidents — but the chances for coordination increase daily. And Beijing’s only response will be repression, sending in troops to end by force whatever opposition it perceives, as it did at Tiananmen Square.
China recovered from Tiananmen not because of the continued crushing of the students and their supporters but through capitulation to the population, which resulted in the state taking a steadily decreasing role in the lives of the average Chinese. But this capitulation to the masses, while initially resulting in pacification, also has served to raise material expectations. Turning back is no longer an option. Beijing is, therefore, stuck. It options are limited and time is running out. The mandate of heaven, it appears, is being repealed.
Beijing knows the troubles it is in. The strains between the coast and the interior, the rich and poor and the north and the south are growing more and more tense, and Beijing’s ability to maintain the system is fading. This is compounded by corruption, which not only drains government coffers but further de-legitimizes the Party.
China’s leadership is presented with few options.
First, it can implement a sudden and swift overhaul of the entire economic system, similar to South Korea’s actions following the 1997 economic crisis. This, however, would require a government characterized by lethargy and fear of social instability to make a sharp, painful and — if done effectively — relatively swift move. The massive social dislocation of such a move makes it untenable.
Second, Beijing could revert to the Deng and Jiang method of encouraging unabated and unequal growth at the expense of profit, occasionally trimming dead wood in SOEs, pumping money into the banks to recycle into the insolvent SOEs and thereby maintain the bare minimum of social stability to avoid significant unrest. Any small stirrings are met with crackdowns on social movements. This, however, only furthers the underlying structures that have rotted out China’s economic expansion, and, in relying on the “Asian” model and the “Communist” model, it fails to address the true problems.
A third method is that being attempted by Jintao. This involves slowing growth a few percentage points, more closely regulating the economy from the center and trying to direct FDI into the worst of the SOE areas, namely the northeast. In the midst of this, Beijing seeks to take a million small steps toward addressing underlying weaknesses. This simply prolongs the pain — even if regionally isolated — and builds tensions between haves and have-nots. And it relies on foreigners’ good will or poor judgment to invest in the worst of the Chinese state institutions. Ultimately, if social stability can be maintained (and this seems unlikely for long), China’s best case is a sustained slump, reminiscent of the past few decades in Japan.
The fourth option is the “Mao” method: Close the country and economy and undertake a massive social restructuring. This is not really an option among the Chinese leadership, which has a vested interest in expanding trade with the outside world. It also would result in a loss of international power, at least for a decade or so. Without the ideological underpinnings that allowed Mao Tse-Tung’s social revolutions, gaining any sense of national buy-in for another “Cultural Revolution” would be highly unlikely, and the opposition to such a path would be anything but quiet.
The first and fourth options appear untenable now and in the foreseeable future. The fight is not over closing the economy or keeping it open, but over the pace and scope of economic growth versus economic fundamentals. It is a core question of defining strength. While the “Hu” method has won out for now, if things start to bite — and they likely will — there will be a renewed push for the “Jiang” method, though whether China can entice others into a new “boom” too many times is unclear.
The government is challenged now to prove its legitimacy as the center of the nation. Under Mao, the underpinning was ideology and a sense of international embattlement. Under Deng and Jiang, that underpinning was the promise of money and material goods. China’s rapid growth economy is very young, and tearing that promise away — even in the name of market fundamentals — is extremely dangerous. The only way South Korea managed it was to rely on a very close sense of ethnic nationalism and to put the blame for the pain on a non-state actor, the International Monetary Fund. China has neither the ethnic homogeneity nor pervasive sense of nationalism to ask for much self sacrifice, and the stresses on the system will continue to compound.
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