China’s Defense Spending Detaches From GDP Growth

CHINA’S RAPID GROWTH over the past quarter of a century has provided the wherewithal to create the world’s second best-funded military after the United States. Beijing has kept its annual military expenditure to within a few points of 2% of GDP during that time. That has still let annual military spending rise from $1.8 billion in 1998 to $188.5 billion in 2013, according to the widely respected estimates of the Stockholm International Peace Research Institute (SIPRI), which is also the source of the data in the charts below.

That represents a more than eightfold increase in real terms. China’s spending successively outstripped that of regional neighbours India (late-1980s), Russia (late-1990s) and Japan (early-2000s). Only the US, at more than $600 million a year, now spends more on its military than China.

China, Japan, Russia and India Total Defence Spending, 1988-2013

Last year, China’s total military expenditures in all likelihood passed the $200 billion mark for the first time. This year, the official defense budget, due to be presented to the National People’s Congress in the next couple of weeks, could well top $150 billion for the first time, up from 2014’s $132 billion. That would be at least a 13% increase and would follow last year’s more than 12% increase on the previous year. Those numbers are well in excess of the economy’s 7.4% growth last year, and more in keeping with the double-digit rates of growth in their budgets that the People’s Liberation Army (PLA) has been accustomed to for a couple of decades.

The official budget undercounts total defence spending by at least a third, on best guesses. It doesn’t include some military-related R&D expenditure, overseas weapons procurement, contributions by local and provincial governments through such as covering the operating costs of local military bases and earnings from PLA-owned commercial enterprises. Most significantly, it does not include the cost of the 1 million-strong paramilitary People’s Armed Police, which is primarily responsible for internal security, civil defense and border control.

China vs U.S. Total Defence Spending, 1988-2013

Those are opaque areas in which to find hard numbers. However, despite the slowing of economic growth, spending on modernising and professionalising the armed forces and strengthening air and coastal defense remains a high priority for Beijing, as is beefed up spending on internal security.

President Xi Jinping remains committed to a robust Chinese presence in the region, especially in the disputed waters of the East and South China Seas. A 2015 budget of $150 billion would be three times the size of Japan’s recently announced record defense budget for fiscal 2015. Xi, conscious of the U.S.’s pivot to Asia, also wants China to be able to project force ever further out into the Pacific and Indian Oceans.

That all means expensive kit, not just aircraft carriers but also new submarines, frigates, destroyers and missile-firing catamarans. It also means anti-ship ballistic missiles, and maritime reconnaissance aircraft and combat planes like the J-10 and J-11 fighters and the forthcoming J-20 and J-31 stealth fighters. Regardless of how much the economy softens, spending on hard power looks immune from any budget cuts that slowing growth might eventually make necessary elsewhere in China’s economy.

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China’s Unwanted Kokang Conundrum

THE ESCALATION OF the fighting just over Yunnan’s border in the Kokang region of Myanmar’s Shan state leaves Beijing with an unwanted humanitarian, security and strategic headache. China is providing food and shelter for some 30,000 refugees that have fled across the border into Yunnan, state media say. Most of the refugees can be assumed to be Kokang, who are ethnically Chinese, and Chinese migrant workers.

China first set up refugee camps following the outbreak of hostilities between the separatist Kokang National Democratic Alliance Army (MNDAA) and Myanmar government forces on February 9. The clashes have since intensified leaving 70 dead, including at least one Red Cross worker after an attack on a Red Cross convoy. The government in Naypyidaw has declared a state of emergency and martial law in the region.

China does not like such instability along its borders at the best of times and has sent troops to reinforce its side of this particular one. Beijing will initially be hospitable to those fleeing the fighting, firstly because they are Chinese, and secondly because the MNDAA was once part of the Chinese-backed Communist Party of Burma.

The MNDAA’s former leader Peng Jiasheng has been in exile in China, if not very publicly, since being driven out of power in 2009 — an event that triggered a similar influx of refugees fleeing the fighting, and which China was less prepared to deal with then than this time. It is Peng’s return now that has caused the renewed flare-up of fighting, ending the ceasefire than has existed since he was driven out.

Peng’s return, this Bystander would hazard, is neither sanctioned nor wanted by Beijing. It has been trying to broker peace deals between the Myanmar government and a score of ethnic groups in the northeast of Myanmar who want varying degrees of autonomy. Naypyidaw wants to strike a comprehensive peace deal ahead of national legislative elections due to be held later this year.

Beyond ensuring peace and stability along its borders, China’s bigger strategic imperatives in Myanmar have changed. The country has natural resources such as jade and desirable crops such as sugar. But more importantly, Naypyidaw’s growing rapprochement with the United States has undermined Beijing’s position as Myanmar’s principal political ally. It is not going to damage that relationship any further by backing separatist groups.

Myanmar is also an important link in President Xi Jinxing’s ‘One Belt One Road’ strategy. This is the development of the ‘Silk Road Economic Belt’ and the ’21st Century Maritime Silk Road’ — or China’s overland and maritime shipping routes to the Middle East and Europe through which political ties and strategic influence are intended to flow as voluminously as energy, natural resources and manufactures. Myanmar is a particular way station in this endeavour between China and Southeast Asia and the Indian Ocean as well as being a prime candidate for Xi’s ‘periphery diplomacy’.

To that end, Beijing wants a stable Myanmar. Its preference is for Naypyidaw to reach a peace settlement with its ethnic rebels to put and to conflicts such as that with the Kokang and with the Kachins, which flared up in 2012 and 2013. It has called for just that course of action.

If, against the odds, Peng does regain control of Kokang, China will be at least passively accommodative towards him. It has done the same in Pakistan or Afghanistan, where it has proven deft at working with local warlords and the central governments. However, that is not a situation Beijing wants to see as it will furnish it with neither border stability nor strategic leverage.

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China’s Debt Trifecta: Property Loans, Muni Debt and Shadow Banking

REAL ESTATE AND shadow banking has driven a quadrupling of China’s debt since 2007, the year when the bursting of a global credit bubble brought the world’s financial system to its knees. Since then China’s total debt has risen to $28 trillion (as of mid-2014) from $7 trillion. As a share of GDP, it is now 282% — larger than the comparable figure for developed economies like the U.S., Canada, Australia and Germany.

One would expect China’s total debt to have increased as its economy grew. Though slowing it has still been growing at more than 7% a year since 2007 let us not forget. But the increase in the country’s debt-to-GDP ratio, from 158% in 2007, shows the country has been piling up debt far faster than its GDP growth rate alone would suggest.

Even that relatively high level of debt is still manageable, in the sense that “China’s government has the capacity to bail out the financial sector should a property-related debt crisis develop,” the McKinsey Global Institute (MGI) says in a new report on global debt and deleveraging. The report covers well-trodden ground, but it still provides a sobering reminder. Seven years of the world’s great and good espousing the virtues of austerity have resulted in a $57 trillion increase in global debt outstanding.

China has accounted for one-third of that growth, and, this Bystander notes, is bucking the trend of the debt burden moving from the private to the public sector, where is relatively less systemically risky. Non-financial corporations have been the bigger driver of this increase in China’s debt; the country now has one of the highest levels of corporate debt, at 125% of GDP (U.S. 67%; Germany 54%, by way of comparison).

MGI is relatively sanguine about the big-picture consequences, but it still sees three potentially worrisome developments, all of which will be familiar to regular readers here:

  • half of all loans (excluding financial-sector debt) are linked, directly or indirectly, to China’s cooling but still inflated real-estate market;
  • unregulated shadow banking accounts for nearly one-half of new lending and one-third of outstanding debt; and
  • the debt of many local governments is probably unsustainable; with the $1.7 trillion in outstanding loans to local governments’ off-balance-sheet special financing vehicles the particular worry.

History teaches us — repeatedly — that financial crises often follow rapid debt growth. The most plausible route to that happening in China is that overextended property market meets local government debt bomb. A wave of loan defaults is set off, particularly among the country’s many small property developers (who number into the high tens of thousands). That then ripples through the construction industry, and the city commercial banks and other small lenders that finance developers and building firms.

A government bailout would limit the damage, as it did when Beijing bailed out the big state-owned banks more than a decade ago. But the economy would likely slow dramatically with consequential social unrest and other political implications that the Party just won’t entertain. “The question today,” MGI says, “is whether China will avoid this path and reduce credit growth in time, without unduly harming economic growth.”

MGI’s prescription is conventional: more of what Beijing is already doing, but with greater urgency. That means:

  • reforming municipal finance (allowing local taxation to be raised, deepening the nascent muni-bond market);
  • improving transparency and risk management among lenders (including corporations that are making loans through the shadow banking system);
  • more robust data on real estate markets;
  • improved bankruptcy procedures; and
  • new retail savings and investment products from mainstream financial institutions that can be an alternative to those offered by real estate developers and informal lenders in the shadows and on the curb.

Will all those things happen? Eventually. Such reforms have the backing of the top leadership because the risks of not implementing them are greater than those of doing so — and the latter set are considerable to a Party trying to pull off the unprecedented feat of retaining a monopoly on political power while ceding its monopoly on economic power.

However, it is widely if, not universally accepted that present arrangements are unsustainable. Unwinding them requires time. First, to deal with vested interests that will lose out. China’s are uncommonly thorny because they mostly get their economic interests because they are politically powerful (elite families), rather than drawing their political clout from their economic success.

Second, to phase in the changes so that the cure is not worse than the disease. Just as China has learned from Japan about the importance of managing its currency, so it has learned from Russia the need to avoid a rapid grafting of free-market capitalism onto a socialist economy.

The question is not, does China have too much debt. The question is can the Party buy itself enough time to create the conditions in which the country’s debt is sustainable?

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More Trouble Beyond China’s Western Reaches

PARTS OF YUNNAN’S border with Myanmar have been closed following a flare-up of fighting on the Myanmar side. Deadly exchanges between government forces and Kokang ethnic rebels in north-eastern Shan state have sent thousands of refugees fleeing into Yunnan province.

The Myanmar army has reportedly bombed around the town of Laukai leading locals and Chinese traders to seek safety in Zhengkang and Namping on the Chinese side of the border barely 5 kilometers away. Beijing has sent PLA troops to patrol the border and has created a camp to feed and shelter refugees. A foreign ministry spokesman told Reuters news agency that the refugees ‘had been looked after’. The group involved in the fighting is the Myanmar National Democratic Alliance Army, formerly part of the China-backed Communist Party of Burma.

There has been sporadic fighting in the mountainous area since December between government forces and the rebels. The Kokang have been trying to regain ground around the town lost in 2009, when a long-standing truce broke down and there was a large-scale exodus from the region into China caused Beijing some consternation.

A broad ceasefire agreement between the Myanmar government and some 17 armed ethnic groups in the north of the country seeking greater autonomy remains deadlocked. Achieving one is part of the political and economic reforms Naypyidaw committed to in 2011 to bolster its case for the lifting of international sanctions.

China has played an active role in truce talks between the various parties, particularly those involving the Kachin Independence Army that remains at open war with Naypyidaw, and which controls territory in which Chinese jade miners operate. Beijing again called for talks to resume after the latest clashes. It wants stability along its western reaches and control over what is thought to be smuggling routes for arms to dissidents in Tibet and Xinjiang and drugs into China’s heartland.

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China’s GDP Growth: Feel The Quality Not The Quantity

IF THERE IS one thing that is consistently less than the sum of its parts, it is China’s GDP. At least, if you add up provincial GDPs they usually total more than the national figure — confirming long-standing suspicions about the variable quality of China’s statistics below the national level. Which makes it all the more surprising that every province save for Tibet missed its 2014 GDP target, and mostly by a much more handsome margin than the national government.

For this year, provinces are lowering their targets numerically and downplaying their importance. One, Shanghai, is scrapping its altogether, becoming the first provincial-level government to do so. Shanghai missed its 7.5% GDP growth target for last year by a full one-half a percentage point, coming in at 7%.

That though was a closer miss than in Guangdong, which came in at 7.8% against a target of 8.5%. That, in turn, was a better performance than achieved in the rust-bucket northeastern provinces caught between China’s industrial restructuring and a sluggish global economy. Shanxi, Heilongjiang, Jilin and Liaoning all fell short of their 8-9% targets, growing at just 5-6%.

In all provinces, though, unemployment is becoming the more closely watched indicator. This year, Guangdong is shooting for 7.5% GDP growth with an unemployment rate of 3.5% as its primary target.

Beijing needs to focus more on structural reform than GDP growth. The provinces look to be prologue as Beijing seeks to wriggle off the hook of high growth targets from which the career prospects of layers of officials have dangled for three decades.

The question now is not whether ‘around’ 7%, 6% or even 5% growth is the correct level for sustainable long-term growth. It is rather whether the economy is providing sufficient jobs to ensure that the Party’s bargain of delivering rising living standards in return for a monopoly on political power holds.

Beijing is expected to announce next month a GDP target for this year of around 7%, down from last year’s around 7.5%. And it could morph from a target to a forecast. However, the new GDP maths is how many points of old-school headline GDP growth can be replaced by drinkable water,  breathable air — and a decent job.

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Beijing Takes Another Small Step To Reform Local Government Finances

BEIJING IS MAKING another attempt to rein in wasteful public spending at the local level. It is restricting the cash transfers it makes to local governments to bridge a structural gap in China’s public spending: local governments responsible for 80% of public spending, but raising only 50% of public revenues.

More than two-fifths of those covering cash transfers are for specific projects. Beijing now wants to bring the share to below 40% to impose more discipline on local governments in their spending, which is running at levels causing increasing concern to central policy makers. Some estimates put local government debt levels as high as 22 trillion yuan ($3.5 trillion) as of the end of last year.

Local administrations have long been reliant on land sales to raise their revenue. However, the cooling of the property market has cut revenues from that source, and the real fiscal impact of that is only now being felt. As much as one-fifth of outstanding local government debt may be tied up in projects that ought to be written off, according to some estimates.

Few local administrations have access to the nascent municipal bond market. For some years, most have been using off-balance sheet financing through captive special investment vehicles, causing a ticking time bomb of local government debt to build up across the country. The audit of these investment vehicles’ liabilities conducted late last year reportedly puts them 30% to 40% higher than at the time of the previous audit – levels that were perturbing enough then.

This fiscal ordinance is all the more dangerous because of the weakening property market. Some 40% of local government debt is pledged against future land sales revenues. Beijing tightened the screws on local government’s off-balance sheet lending late last year when the China Bond Clearing House said it would not consider paper issued by such vehicles as equivalent to government issued bonds.

That is a prelude to phasing out off-balance sheet financing and bringing more transparency to local government finances. It has already decimated, in the correct use of the word, new issuance, from more than 100 billion yuan ($16 billion) a month to 10 billion yuan.

That staunches the flow of new lending but doesn’t heal the wound. The prospect for the first half of this year is that local governments will find their finances squeezed in a way not experienced by many local officials in their working lifetimes.

China’s local government finances are a creaking edifice facing if, not collapse, at the very least an increasing likelihood of something once unimaginable de facto defaults. That puts the stability of the whole financial system at risk. Central government would step in to prevent defaults that threatened systemic risk, but it underlines the urgency of the need for Beijing to press ahead with its plans for comprehensive reform of local governance financing.

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China Takes Small Steps In Limited Local Judicial Reform

CHINA HAS INAUGURATED its first two circuit courts, one in Shenyang and the other in Shenzen, to spread the workload of the Supreme Court. This echo of Imperial China is one of the early pilot schemes as judicial reform kicks off in one-third of the country’s 33 provinces.

The most intriguing aspect of the proposed reforms is President Xi Jinping’s gamble on increasing the independence and professionalism of the judiciary, which has hitherto been an extension of the Party’s legal arm. But trusted courts are one of the essential requirements if the Party is not to corrode from the inside.

As this Bystander has noted before this first step in judicial reform will only effectively apply at local and municipal levels. The Party will retain its sway over national and provincial courts through the Central Politics and Law Commission, the Party body that oversees the legal system in its broadest sense — from police to prosecutors, judges, internal security, surveillance and prison administration.

Nor should anyone be under any illusion that judicial independence even at local level heralds the introduction of the rule of law. Xi is pursuing rule by law, altogether a different thing. No legal proceedings on which the Party has a national interest will be left to the vicissitudes of independent judges. Judges will be expected to declare their loyalty to the Party, and to take preemptive action in cases of threats to state security.

Where judicial reform will make an impact is that local judges will no longer be appointed and funded by local officials but by provincial or national authorities. That should break the commonly cosy relationship between local officials and local courts. It would then be more difficult for corrupt local officials to remain immune from accountability, a widespread popular grievance.

Not only would that give Xi’s anti-corruption drive some mass support but it will also provide some ‘flies’ whose squashing would warn a new set of ‘tigers’ now Xi is pushing his anti-corruption drive against police and security officials including Zhou Yongkang, the former and much feared head of the country’s security apparatus and the most senior official to date brought down by Xi’s anti-corruption drive.

More independent local courts would also provide a safety valve for the social unrest that has been escalating to the Party’s concern, without the reforms going nearly far enough to satisfy legal activists. It could also create courts that are more robust in their handling of commercial disputes, which would be to the benefit of foreign businesses operating in China and which have long felt local courts to be stacked against them.

As with all reform, it will proceed slowly; what is starting now is the first pilot schemes. The target date for broad based implementation of judicial reform is 2020. The goal is to reinforce the Party’s legitimacy to maintain its monopoly on political power by showing it can govern cleanly and fairly.

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