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Friday, Sep. 21, 2012

Rift over Senkakus threatens to divert China from reform

Special to The Japan

HONG KONG — What is really going on in China?

Its internal politics have never been easy to fathom, but in the last few weeks China has had too many diverting distractions, such as the mysterious 10-day disappearance of its leader-in-waiting Xi Jinping, demonstrations against Japan over the disputed Senkaku Islands and, greatest of all, the foggy speculation over who will get what in the imminent changing of the top political leadership.

All of these things are preventing the leaders in Beijing from giving full attention to the country's main task of promoting vital economic change.

At least through the haze of gung-ho talk about China imminently overtaking the United States as the world's biggest economic power, there is a growing realization that China needs radical reforms. But, sadly, this may too easily be swept away if Beijing cannot get hold of nationalist protests over the Senkaku islands (known as Diaoyu in China), which are claimed by both Japan and China.

Michael Feller, an investment strategist at Macro Investor, compared China's economic plight to the 1994 film "Speed" where Keanu Reeves has to drive a commuter bus through the streets of Los Angeles without letting its speed drop below 50 miles an hour or it will detonate a bomb and kill all the passengers.

"With 1.3 billion passengers on board, the stakes are high for the Chinese Communist Party as it navigates the winding laneways of slowing exports, an uncertain property market, rising capital outflows and a Europe — the country's biggest trade partner — mired in recession," writes Feller.

He points out that China's helmsmen have been adept at the wheel in keeping growth above the 7.5 percent target. But, hey presto, that's one of the problems — that 7.5 percent magical target, above which China will be saved and below which it will be damned.

Western commentators regularly speak of 8 percent as the target needed to provide sufficient new jobs. Fixation with 7.5 or even 8 percent growth, this year and every year, is dangerous, not merely because it is not achievable but also because the only way of getting close to it would take China away from the essential reforms.

This month (September) Morgan Stanley presented an economic report on China headlined, "From mudding through to a bumpy macro ride".

Nevertheless, it still predicted growth of 7.5 percent this year and 7.9 percent in 2013, down from its previous forecasts of 8 percent and 8.6 percent.

Some investment bank economists are tracking the economy so carefully that they lose sight of the wood for all the trees. Cynical economists, of course, citing premier-in-waiting Li Keqiang's references to statistics being "man-made" and "for reference only", believe that all China's economic statistics are bogus, even though swallowed whole by international organizations like the International Monetary Fund and World Bank. Actual growth may be anywhere between 3 and 6 percent.

At the allegedly pessimistic extreme is Michael Pettis, who forecasts growth of 3 to 4 percent a year for the next decade for China. Pettis is credible because he has a good grasp of both micro- and macroeconomic factors and implications, of theoretical and practical economics, and is in touch with a variety of Chinese opinion from his post as professor of finance at Peking University.

Pettis pointedly describes himself as a skeptic, not a China bear. He makes the good point that the rise of the U.S. as the world's economic superpower took decades and had many bumps and roadblocks on the way. The U.S. was the leading power by the 1870s but, writes Pettis, "It took a horrible decade of steep economic decline in the 1930s and a devastating war that pretty much wiped out its competitors to create the U.S. century."

Enter the dangerous dispute over the tiny uninhabited islands in the seas west of Okinawa. The last thing that China needs today is a war with Japan. But Beijing allowed daily protests, and last week the state-run Beijing Evening News on its Weibo account suggested that China should use nuclear weapons.

"Just skip to the main course and drop an atomic bomb. Simpler," the newspaper declared. Other official sources have not been so extreme, but the People's Daily summed up Beijing's official mood by demanding that Japan "return to reason." The headline on its online news site demanded: "Is Japan prepared for the consequences of its odious acts?"

Beijing is keeping up the pressure and economic threats and trying to drive a wedge between Washington and Tokyo. Perhaps Beijing thinks it is worth testing U.S. resolve by threatening that it would risk losing China's friendship if it keeps its security treaty pledge to aid Japan in the event of an attack on the Senkakus.

Stirring nationalist passions may have started as a smokescreen to cover other difficult issues that politicians don't want discussed, but it may be difficult to calm passions.

Even Chinese writers who don't care for the Communist Party say they feel pride in the islands and would fight to prevent Japan's sovereignty. Japan has its own nationalists, and neither country seems to understand the damage that a skirmish could do, let alone war.

Even without the territorial disputes, China cannot expect that its own journey to economic greatness will be a continuously smooth ride, particularly when its current model is unsustainable and needs a major overhaul, as most economists apart from blind China bulls admit.

Pettis adds that it is "hyperventilated nonsense" to suggest that economic readjustment means that China will collapse: "It just means that an adjustment is needed, debt levels must one way or another be addressed, and the longer it takes to begin the adjustment, the more painful it will ultimately be." He also asserts that China could achieve rebalancing and still see household income growing at 5 to 6 percent a year — probably what counts if social stability is to be assured — even with lower headline GDP growth.

"There is a big 'if' of course," notes Pettis, "and requires that Beijing understand the risks and forces through what will be politically difficult measures, but so far it seems that they do." But understanding and actually achieving are different, especially when state-owned enterprises, powerful local governments and vested interests stand in the way, along with economists yearning for eternal 8 percent GDP growth.

Rebalancing, and raising household consumption to between 50 and 55 percent of GDP, would also be good for the global economy by boosting Chinese demand. But a government cannot snap its fingers and thereby reorganize its economy — as China's own historical record shows.

In 2005, consumption slumped to the then unheard of low of 40 percent, and the government responded by promising to boost it. Since then, consumption has fallen to 35 percent of GDP.

Critics such as Minxin Pei and Andy Xie have long complained that Chinese economic policy is digging a dangerous deep hole. Pei asks whether Chinese banks are hiding "the mother of all debt bombs." Xie says that the only way forward is to raise the productivity of Chinese workers, which would lift wages and consumption, but it also means challenging and changing the central allocation of resources.

The influential George Magnus, now at UBS, also made this point in a paper asking bluntly: "Asia: is the miracle over?" — in which he writes that China's record growth has owed much to the redeployment of labor from rural areas to feed the urban exporting factories, fueled by massive capital investment. But this system is showing diminishing returns and is past its sell-by date. China needs to promote efficiency and innovation to move up the competitive global ladder.

There are signs that the leaders recognize this. Constant chatter from leaders of new stimulus to achieve the magic GDP targets hides the repackaging of old projects, and leaders promise careful, concentrated spending, remembering the downside of the massive 2009 stimulus. There is also a lot of nervousness about social unrest if the leadership gets things wrong.

That is why the world should be worried if China's anti-Japan protests are an early smokescreen to divert attention from economic issues. Fighting would set everyone back; better to tackle the economic bulls by the horns.

Kevin Rafferty is editor in chief of PlainWords Media.

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