In the current global landscape, China teeters on the edge of financial collapse.1 Between current foreign military pressures and their domestic economic insecurity, they remain in a precarious position, set to be crushed by these two opposing forces. Currently, foreign military issues can be traced to their expansion into the South China Sea.

South China Sea

Much of the foreign military pressure on China comes from their recent actions in the South China Sea. In recent years, China has acquired 90 percent of the South China Sea, creating artificial islands using dredging equipment.2 This is much to the distaste of their neighbors who have competing claims. In 2016, it was discovered that China was using these artificial islands for military purposes. While this is hardly a surprise, it does bring to question exactly how helpful these territories will be for their military strategy.

Starting in 2009, China began their efforts to militarize the South China Sea by submitting a map to the UN with the (now infamous) Nine-Dash Line, boundary dashes across the South China Sea that declared it the territory of China. Since that time, China has expanded a minimum of seven different reefs and islets by using sand from the ocean floor, include Mischief Reef, Hughes Reef, Subi Reef, Johnson Reef, Fiery Cross Reef, Cuarteron Reef, and Gaven Reef. They have created more than 3,200 acres of land, according to the Asia Maritime Transparency Initiative.3

At first, China claimed to be using the South China Sea for non-military purposes, such as humanitarian aid and scientific research, yet several of these islands are now home to airfields, antiaircraft/antimissile guns, and naval guns. For example, Cuarteron Reef has a High Frequency radar for detecting aircrafts, which is hard to claim for “peaceful purposes”. On Woody Island, they have installed HQ-9 long-range missiles.

When considering former leader Hu Jintao’s movement towards “peaceful rise,” this clear territorial grab seems out of character.4 These actions have alienated their neighbors and brought in other powers such as India, Japan, and the US. A theory to rise out of these actions is that leadership decided that it was worth the potential diplomatic trouble to have a secure sea-based deterrent bastion.

This echoes the Soviet Union’s actions during the Cold War, when their missile submarines were operated from “bastions” in the Barents Sea and Sea of Okhotsk. This made it so that Soviet missile submarines could be covered by land-based and naval forces in the event of enemy attacks.

China’s land- and sea-based missile rely upon four Jin-class submarines. It is China’s belief that the US’s ballistic-missile defense are a threat to the credibility of their nuclear deterrent, which makes these protective bastions in the South China Sea much more important. Due to China’s geography, there is essentially one ocean for their bastion. The Northern Pacific is out due to the U.S. Navy and the Japan Maritime Self-Defense Force. In contrast, the South China Sea is bordered by countries that are no threat to China’s nuclear missile submarines.

By installing a permanent presence in the South China Sea, China’s regional dominance is unquestionable. It also allows for China to install a permanent sensor system. Further construction will most certainly lead to complete defense against any submarine warfare against China’s sea-based nuclear weapons. They will also likely develop more surface-to-air weapons and land-based antiship missiles to, at the very least, protect their current military installations. Heavier defenses are being justified due to freedom-of-navigation operations the US and other allies.

This shows the main weakness to China’s series of islands; there is only so long they can be defended. While ships can move, islands cannot. An island cannot be stocked with enough weaponry, food, water, and electricity to be a viable defense outpost. Islands’ inability to defend themselves is exemplified by Iwo Jima and Okinawa. Should a military confrontation arise between China and the US in the South China Sea, China’s at-sea outposts would have to be rolled back quickly in response to missile attacks and airstrikes, which would strand People’s Liberation Army Navy personnel on the island. The way China would respond to such an attack is an important question to be considered, as this victory could actually be a dangerous turn of events. While these islands offer strategic value, as a defensive solution, they are prone to destruction in the event of war. These military islands are a violation of China’s agreement to not militarize the sea, which is why it is of such concern to foreign militaries.5 This tension is putting more pressure on China’s economy.

fragility_china_blog_innerimageDomestic Economic Health

China’s economy is not only in peril due to foreign military pressures, but their own domestic economic well-being. Increasingly, central bankers fear a systemic collapse of China’s market. Their fears stand to reason: before the 2008 financial crisis, their debt-to-GDP ratio was 147 percent; now, it is at about 250 percent. Quietly, Chinese leadership has begun to lower growth expectations. While the official growth rate given was 7.5 percent, privately, the government believes that 6.5 percent is more realistic over the next year.6

The methodology used to calculate this figure is not publicly known, but it uses economic data that can be manipulated to make it appear that they have more success with their economic plans than is true. What components are used to determine GDP are shifted between quarters, and the aggregate numbers are often built upon inaccurate or intentionally manipulated data.

There are other metrics by which to analyze economic growth, such as through the ISM manufacturing index, which many countries use. The ISM can be somewhat unreliable, however, because the surveys upon which it is based may be inaccurate. Other indicators include coal, iron, cement, and copper inventories; though these can still be unreliable measures of growth. Recently, before taking his current position, Premier Li Keqiang suggested indicators such as electricity consumption and auto and excavator sales, indicating that this could be what China uses. However, these measures have actually recently seemed to suggest growth deceleration.

Domestically, there is growing anxiety about China’s financial market as well. Local banks are failing to perform, with non-performing debt increasing. Non-bank financial institutions referred to as the “shadow banking system” are spreading, with little regulation or common understanding. There is so little regulation that meaningful data about these systems is difficult to come by. While two of these financial intermediaries have failed at this point, it’s hard to say how quickly or how many more may fail. While the government claims to be trying to better control this system, they seem to be having difficulty balancing regulation with the possibility of systemic collapse. There also seems to be a degree of corruption, with local government official tolerating and perhaps even encouraging sketchy practices by investors, such as hyperbolic assessment of assets and little documentation to prove their claims. Between this and short-term debts from foreign banks, the entire shadow banking system is threatened with collapse.

Another Chinese economic issue is the real estate market. Commercial real estate bubbles are abundant, and residential real estate values have begun to fall. This threatens the possibility of social unrest, as many families begin to lose more and more money to this problem. As is typical with many countries, the Chinese government measures inflation by adjusting it downwards to conceal the impact it has on households.

While China has been able to rapidly grow recently with global trade, the Lehman collapse plateaued world trade, hitting China where it hurt, as exports accounted for more than 40 percent of their GDP. While global trade did pick back up eventually, but more recently, as started to slow again, rising slower than world production rates when in the past, it grew twice as fast. With this slow growth, China is losing competitiveness in the market place. With the growth of the Chinese economy came the need for higher wages. In turn, China escalated their export products to a higher value, beginning to manufacture more technologically advanced and complicated products. In turn, quality suffered, which caused foreign markets to stray away from Chinese components. More and more, foreign manufacturers moved away from China in favor of other countries, such as Vietnam. China is no longer the place for overseas production; foreign companies only enter when they are targeting the domestic market. World trade growth continues to slow as the consequences of the 2008 financial crisis live on today. Therefore, China must focus more on building their domestic economy. With a shrinking population, the aged population with be responsible for more and more economic output. This will prove to be difficult, and only more so given the fractious nature of their government.

A Fractious Regime

From an outside perspective, the Chinese government seems unified and orderly. However, this is hardly the case. In the United States, we are aware of the competitive powers in place. In the two-party system, we often see tension between the people in power, particularly if we have a democratic president and a republican Congress or vice versa. Yet we often fail to recognize these tensions in foreign governments. In China, just as in the United States, different political groups hold different views on what policies should be put in place and how they should be enforced. This stands true even within the Politburo itself.7

Currently, there are two separate factions within the Politburo that came out of Deng Tsao Ping’s death. These are the Shanghai bang, which is led by Jiang Zemin (former leader of China), and the Youth League Faction, led by Hu Jintao (another former leader). Xi Jinping, current leader, is of the Shangbai bang. However, once Jiang Zemin passes away, it could be that the Shangbai bang breaks into even more different segments. Two other political factors are the New Left (which emphasizes disciplined management) and the Princelings (sons of former Party leaders and their families).

Bo Xilai, now disgraced, was a Princeling, and used this to create a network within the New Left as well as with military and state security leaders, as well as a political base within the Chongqing province.8 Currently, Xi Jinping is leading an effort to eliminate this power network by accusing those connected with it of corruption. Xi has reformed the Politburo, Central Committee, and Standing Committee as of this time. He has also started in on state security, going so far as to arrest former head Zhou Yongkang for corruption. Xi has also begun a reconfiguration of the PLA leadership, but this has proven to be tricky.

The PLA is present in seven different military districts, the most power of which is the Shenyang district, which borders North Korea. The connection with the PLA, Bo Xilai, and Zhou Yongkang are quite strong in this region, and there are rumors that the generals are involved with North Korea. One way Xi has attempted to take greater power is by putting more of the military budget behind the Navy and Air Force, granting less money to the land-based military.

Thus far, Xi’s leadership has not been tested to see how long it can be sustained. While efforts against corruption have been launched, it is not expected that all corruption will be removed. In reality, some parts of Chinese authority are likely to lose power, while others will gain more. Since Xi came to power, many wealthy Chinese people have anticipated moving their wealth abroad, as little has been known about how Xi’s power will come to affect them. This can be demonstrated by the elevated demand by Chinese residents for properties in cities all around the world, including New York, London, Toronto, and Sydney. Wealthy Chinese children are increasingly educated abroad and left to manage the family wealth overseas.

fragility_china_blog_innerimage2Given the political turmoil, it is understandable why foreign central and private bankers are questioning whether the Chinese can handle reconfiguration of the financial market. The ability to make unified decisions is severely questioned by the fractured nature of the government. Bankers are apprehensive of China’s ability to navigate their bubble-ridden economy at the moment.

At the moment, China’s number one goal is to prevent social unrest. There are greater efforts to unify China as a whole against their neighbors (in particular, Japan) so that its citizens feel loyal to their country against another. While China may be able to reform certain economic issues such as that of shadow banking, it is also likely that they will damage their foreign interests in the process.

The fragility of China’s economy is important to understand given the current state of the global market. An understanding of the big-picture impact of the turmoil of foreign economies is one of the many ways our team of experts at Meraglim™ can help you understand what actions to take within the global market. If you need financial data analytics, we can help with our experienced staff and unique risk assessment software. Contact us today to learn more.