China's 2012 Challenges
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China's 2012 Challenges


China enters the New Year confronting challenges and opportunities that will be shaped in turn by how its government and populace respond to them. Here outlined are twelve key items and issues that will help define 2012 for China, both at home and abroad. 2012 will be a “two-level” year in which internal and external factors are linked ever-more-clearly. As a new generation of leadership prepares to govern China, millions of citizens and netizens and their foreign counterparts will be watching Beijing’s actions more closely than ever before.

1) The run-up to Beijing’s once-in-a-decade political transition in October 2012 is likely to generate intensified clampdowns internally and assertive rhetoric abroad as China faces rising domestic challenges, and finds itself constrained internationally. Fearful neighbors may further strengthen ties with the United States. Pariah/failed state “allies” North Korea, Pakistan, and Iran will likely experience problems that affect China’s own interests. Externally, China is likely to be more intransigent than before. Internally, Beijing will resist making difficult decisions about economic reforms, particularly reforms that might harm key state-owned enterprises and monopolistic/oligopolistic concerns connected with families of political elites. Domestically and internationally, Chinese leaders will attempt to postpone difficult policy decisions until after the transition.

2) Slowing economic growth will likely increasingly expose the flaws and unsustainable nature of China’s infrastructure-driven growth model.One local banking regulator cited by Minxin Pei claims only 1/3 of the investment projects currently under construction will produce cash flows large enough to cover their debt service burden. This may rapidly reduce economic growth and commodity demand in 2012.

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3) China’s local government debt situation will generate global concern.The U.S. and Europe are the current poster children for financial problems, but China’s ballooning (and significantly under-reported) local government debts will likely become a front-page story. Local government debts, already reportedly nearing US$1.7 trillion, are probably larger. Local government finance companies still have at least 2.3 trillion RMB (US$364 billion) in untapped credit lines. While policy makers still have sufficient maneuvering room to try to coast through October 2012, the problem remains of building infrastructure that likely won’t generate the cash flows needed to service the debts that financed those projects. Expect non-performing loans to once again become an albatross for Chinese banks.

4) Falling real estate prices will likely hamper GDP growth.Agricultural Bank of China recently estimated that real estate prices in First Tier cities like Beijing and Shanghai would need to fall by as much as 25%, and those in Second Tier cities like Changsha would need to decline by as much as 15%, to return to reasonable levels in 2012. Given the outsized role that real estate investment has played in China’s economic growth in recent years, such price declines bode poorly for GDP growth prospects. Bank of China recently trimmed its 2012 GDP forecast from 9.3% to 8.8% growth. Other banks have followed suit. We believe that in 2012, China’s economy will require active policy measures just to meet the 7% growth target laid out in the 12thFive Year Plan.

5) China’s debt problems, slowing growth, and continued demand weakness in major Chinese export markets like the U.S., EU, and Japan are likely to have major repercussions for countries benefitting from China’s commodity demand boom.Australia, Brazil, Indonesia, Chile, and Russia will be in especially vulnerable positions if a Chinese slowdown triggers significant price declines for raw materials like iron ore, coking coal, copper, and crude oil.

6) China’s government will likely tighten domestic media reporting guidelines, as it remains highly concerned about social unrest and seeks to suppress newsthat might create controversy ahead of October 2012. Investors will have totake particular care that important data points are not swept under the table.

7) To forestall social instability, Beijing may intensify policies to drive growth in Central and Western China. Despite the availability of older migrant workers returning to rural areas, Beijing’s infrastructure-based approach to growth promotion is decelerating. Excavator sales, one indicator of construction activity, fell by 33.2% year-on-year (YoY) in Western China and by 29.5% YoY in Central China in November 2011. Policies aimed at reviving construction activity to sustain growth in these regions will almost certainly exacerbate already substantial local debt challenges.

8) There is a heightened risk that inflation will exceed expected levels. If growth falters as real estate prices continue to fall and the economies of major trading partners remain weak, Beijing may be forced to loosen lending restrictions. Such monetary supply expansion would very likely push inflation well beyond the 2.8% figure that Li Daokui of People’s Bank of China forecasts for 2012.

9) 2012 is likely to feature increased outbound investment as Chinese businesses and affluent private investors from China seek safe havens from a possible domestic economic slowdown and domestic inflation. The U.S., UK, Canada, Australia, and New Zealand are among the countries best placed to benefit from private investments in real estate and other assets by wealthy Chinese. Chinese companies will continue to search globally for assets, with natural resources firms especially focused on Australia, Africa, and Latin America.

10) We expect continued friction and possible skirmishes in the South China Sea, especially between Chinese and Vietnamese maritime forces.The Chinese government’s assertive approach regarding maritime issues in the South and East China Seas will likely generate additional friction with Japan, South Korea, Vietnam, and the Philippines. South Korea plans to begin using military special forces personnel armed with firearms on fishing enforcement missions. Serious confrontations involving Chinese fishermen are highly likely.

11) China is expected to begin drilling its first ultra-deepwater oil/gas well with a domestically-made drillship. Vietnam and the Philippines will likely be unsettled, despite the fact that the initial deepwater well will most likely be drilled in the northern South China Sea within the undisputed portion of China’s claimed EEZ.

12) Beijing will augment its ongoing Gulf of Aden/Indian Ocean anti-piracy mission, perhaps with limited access and forward positioning in such locations as the Seychelles. This is part of a larger pattern in which Beijing continues to focus its most high-intensity military capabilities on the Near Seas (Yellow, East, and South China Seas) and their immediate approaches, while developing lower-intensity capabilities, more gradually, further afield.

Andrew Erickson is an associate professor in the Strategic Research Department at the U.S. Naval War College. Gabe Collins is the co-founder of China SignPost and a former commodity investment analyst and research fellow in the US Naval War College's China Maritime Studies Institute. 

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