Some Tuesday China links:

The Financial Times reports that China’s state-owned Cnooc is making a bid for Arctic oil, the first time a Chinese company has done so.

After the U.S. ramped up its charges of cyber-espionage against China, Beijing responded by charging the U.S. with collecting mountains of data on China. In typical fashion, the Western world didn’t give much consideration to Beijing’s claims at the time, but over at Foreign Policy, Matthew Aid confirms that Beijing was spot on. From the report, “A highly secretive unit of the National Security Agency (NSA), the U.S. government's huge electronic eavesdropping organization, called the Office of Tailored Access Operations, or TAO, has successfully penetrated Chinese computer and telecommunications systems for almost 15 years, generating some of the best and most reliable intelligence information about what is going on inside the People's Republic of China.”

As China’s water crisis worsens, China’s central government has pledged to spend US$3.3 billion over the next five years on desalination plants in the northeastern part of the country, the BBC reports. This comes in addition to other actions Beijing is taking to solve the country’s water woes.

The honorary chairman of Taiwan's Kuomintang (KMT), Wu Poh-hsiung, will meet with Chinese President Xi Jinping to discuss cross-strait relations on Thursday, South China Morning Post reports.

CNN’s Nic Robertson is the only Western journalist on hand for China’s space launch. He reviews the “super-secret space base.”

Matt Schiavenza of The Atlantic highlights a recent survey on how Chinese people view the U.S.

One American Chinese social media users are particularly fond of these days is Edward Snowden, according to Vocativ’s review of Weibo. China Real Time confirms this.

Plus new issues of the Jamestown Foundation’s China Brief and the Hoover Institution’s Chinese Leadership Monitor.

What did we miss? Want to share an important article with other readers? Please submit your links in the comment box below!

A massive government backed state campaign of cyber espionage, with little accountability and almost limitless personnel and funds, which is regarded as a fundamental attack on hard won liberties and fundamental values. One would have expected concerns in this area to top of the list of issues President Obama would raise with President Xi Jinping when they met for their one-off summit in California over the weekend.

Domestic issues however overtook events. With extraordinary timing, a whistleblower working with the  U.S. National Security Agency (NSA) a document showing similar things were being done – but by the American government against its own citizens. Suddenly the discussion between the U.S. and China on the long standing issue of cyber-espionage became even more complicated than it already was.

Some years ago, an official in the UK government airily told me that Chinese activity in the cyber area was “off the scale.” It would be interesting to see if they were willing to revise this opinion in view of the current information we have. The simple fact is that when Xi and Obama met, they both shared a big dirty secret, although now a pretty open one. Despite them following one of the first rules when accused of infidelity – deny, deny and then deny again – everyone has plenty of reason to believe both governments are deeply engaged in creative ways of exploiting the internet, and very little assurance that they are able to restrain themselves.  This gift is too good.

In The Net Delusion, Evgeny Morozov maps out the ambiguous moral space of the internet. Yes, it is an amazing enabler of greater transparency as liberals love. But everyone has secrets. And the governments of any country can see an amazing new field in which, by consent, people release an enormous amount of information. Citizens can be empowered by the internet, but circumscribed by its shadowy forces. We have no excuses to surrender our vigilance even in this “new world” of connectivity and virtual free space.

For China, the internet is having profound social impact. Propagandists like Liu Yunshan, in charge of macro-information on the standing committee, show only hazy understanding of the new dynamics being created by social media in their country. They are grappling with a framework which allows them access to the positive things the internet gives them, but sees off the negatives. One of the wiser moves the Party might now consider it has made was to keep Facebook, Twitter and other US companies out of China and try to make their own versions of these popular sites instead. Beyond debates about freedom of expression, there is the hard issue of why you would allow your citizens to hand over so much information to foreign companies who have, at best, highly ambiguous relations with their host government. Best keep these things in house. China may well have saved us from a world wholly subject to the tyranny of Facebook!

The internet in China is, in many ways, a wonderful map of contention in society. It brings to the fore fissures, splits and forms of diversity we never used to see. The bland statement that China is 1.3 billion people lined up behind one particular view point was always suspicious. Now we have the proof. China is like a carnival of opinions. The internet maps this wonderful diversity.

And finally, the internet poses deep questions to both the U.S. and China, with their profoundly different polities, about the role of freedom versus stability and resistance to extremists groups, about how far they can covertly seek to break into each other’s spaces and use the internet’s penetrative abilities with malign intent. There are no good guys in this struggle. And the most remarkable thing about the revelations of the last few days is that, yes, we were right to worry about the ways in which forces of surveillance and invasiveness were swirling around us all. They were. But not from one source, or one dominant country, nor even from outside. It is time to move on from the complacent moans about one power like China being the bad guy in all of this. It is now becoming clearer that it was way, way, way more complicated than that. 

China’s lack of transparency has long posed a daunting challenge to outside observers trying to understand what the government’s interests, goals, and intentions are. Gary King, a Professor in Government at Harvard University, has provided telling new insights into these questions with his research on the government’s censorship of social media websites.

Using unique software developed for the project, King and his colleagues were able to capture posts on social media sites in China before censors removed them, and then analyze what kinds of subject matters and posts the censors were targeting.

After the team captured over 11 million posts over a 6-month period from popular social media sites in China like Weibo and Baidu, King and two of his colleagues at Harvard, Jennifer Pan and Margaret Roberts, published their findings in a recent article in the American Political Science Review.

The major conclusion from the study was that Chinese authorities do not often use censorship to prevent citizens from criticizing the government, its officials, or its policies. Instead, the results strongly suggest that censors are primarily interested in targeting posts with the potential to prompt “collective action,” such as organized protests and gatherings.

Indeed, according to the research, the actual substance of the post is of limited importance. As King explained in an interview with The Diplomat:

 “Our data show that the Chinese censorship program allows for a wide variety of criticisms of the Chinese government, its officials, and its policies. As it turns out, censorship is primarily aimed at restricting the spread of information that may lead to collective action, regardless of whether or not the expression is in direct opposition to the state and whether or not it is related to government policies.”

In fact, even some posts in support of CCP policies were targeted for censorship if they were likely to prompt collective action. Moreover, not all of the censored subject matters were even political in nature. Pornography, for instance, is one area of interest for censors.

Interestingly, the information gathered from the software allowed the team at Harvard to clearly identify when major decisions had been made by the Chinese government, which was often days before a public announcement was made. In the interim period, the government would begin ramping up censorship of the topic or event in anticipation of announcing the decision. For example, by monitoring social media censorship, King was able to anticipate how the government was going to handle the Bo Xilai scandal before any media source simply by noting the increase in censorship of Bo’s name and related topics.

As King explained to MIT Technology Review, “We have examples where it’s perfectly clear what the Chinese government is about to do. It conveys way more about the Chinese government’s intents and actions than anything before.”

The researchers note that the sheer efficiency of the censorship operation was astonishing. Much of the censored material, for instance, was removed within 24 hours of being posted online. As King and his co-authors point out, the level of coordination that needs to happen among so many different government actors in such a short span of time is remarkable. In the journal article they explain,

“Given the normal human difficulties of coming to agreement with many others, and the usual difficulty of achieving high levels of intercoder reliability on interpreting text… the effort the government puts into its censorship program is large, and highly professional.”

This strategy of censorship has other implications as well. As many scholars have argued, the Chinese national government has often been able to harness local protests to improve the Party’s legitimacy, by identifying what the citizenry’s largest grievances are, and then trying to address them before the protesters turn their criticisms to the central government. The same appears to be true with social media websites; by meticulously monitoring social media websites, the government can gauge what the strongest grievances are among Chinese netizens. In this way, monitoring social media sites may actually improve the government’s responsiveness to ordinary people’s concerns.

Still, without the ability to freely gather and associate, China’s civil society has a long way to go before it can flourish. As the authors write in the APSR article, “With respect to this type of speech, the Chinese people are individually free but collectively in chains.” 

Elleka Watts is an editorial assistant at The Diplomat.

The New York Times report that China purchases nearly half of Iraq’s oil exports set off something of a firestorm in the U.S this week. In fact, outrage over the NYT’s article offered a rare point of bipartisan consensus in the U.S.

Thus, billionaire businessman-turned-outrageous-right-wing-pundit, Donald Trump, took to Fox News to complain, “We spend $1.5 trillion, we lose thousands of lives, we destroy a country … but China is in there taking out all the oil, and we’re getting nothing…. I’ve said it a thousand times … we shouldn’t have been there, but if we’re there, take the oil. Take the oil…. Well guess what? China is taking the oil, but they didn’t have to fight.”

In a more humorous way, liberal comedian John Stewart, host of the popular-in-China Daily Show with John Stewart, wondered if there wasn’t some rule that required the biggest victor in a war to have actually fought in it.

“It’s not fair,” Stewart said. “China gets all that sweet, sweet, sweet oil. That’s our oil.”

These and similar comments illustrate the profound misconception surrounding how global energy markets operate in modern world. Once this misconception is corrected, it becomes clear that the U.S. more than any other country besides Iraq should be praising China for its energy operations in the Persian Gulf state.

Overwhelming public discourse depicts global energy markets as operating according to Mercantilist economic logic, whereby consumer nations compete intensely to own the oil resources in producer nations as many of today’s consumer countries once owned the resources of their colonies.

But this misconstrues how global energy markets actually operate. Although China itself does actually seek to own some of partner nations’ oil resources, these deviations are not enough to change the fact that global oil markets operate according to the free-market principles of supply and demand. Therefore, a net increase in the global supplies of oil, no matter where it is exported, will result in a lower price of oil everywhere (all things being equal).

Thus, even if China was purchasing all of Iraq’s oil this would still benefit the U.S. and its allies because they could purchase oil elsewhere at a lower cost. By contrast, if China wasn’t purchasing Iraqi oil it would be purchasing oil from these other producing nations. If, in this latter scenario, Iraq wasn’t producing or exporting the oil it had been to China in the first one, every importing nation would be paying a higher price for their supplies.

The misconception over how oil markets operate has been at the heart of the U.S. anti-Iraq war campaign from the outset. In particular, it was seen in the “no more blood for oil” bumper stickers that every American anti-war advocate proudly displayed on their SUVs or other automobiles without the slightest sense of irony.

To be sure, the Iraq War was a strategic blunder of epic proportions for the United States for a multitude of reasons. The popular notion that the U.S. was only invading Iraq for its oil resources was not among these reasons. After all, if all the U.S. wanted was Iraqi oil all it had to do was ask the UN to remove the sanctions against Iraq exporting oil during the 1990s. Saddam Hussein would have gladly sold Iraq’s oil given the revenues this would entail for his regime. It was the U.S. by leading the charge to maintain the sanctions that was preventing almost all of Iraq’s oil from reaching global markets.

Those now raising criticisms over the Iraq War because China is “winning” more of Iraq’s oil than the U.S. are equally misguided. To begin with, China isn’t winning Iraqi oil so much as the U.S. and Western oil companies have conceded it. This is because the U.S., some American lawmakers and pundits claims notwithstanding, bungled the Iraqi invasion and occupation from start to finish. Although the Iraq surge did improve the security situation enough to allow the U.S. to get out of the country, it failed to solve any of the political problems causing the Iraqi sectarian war in the first place.

As such, Iraq’s future stability has always been an open question at best. Political tensions between and within Iraq’s different ethnic and sectarian groups have intensified since the U.S. withdrawal, and violence is now at a level not seen in many years. In this context, most Western oil companies have been pulling out of southern Iraq deeming it too risky to make the needed investments in Iraq’s oil infrastructure given the uncertain returns.

Fortunately, as is true across the globe, Chinese oil companies are far less risk-adverse than Western oil companies and, therefore, are seeking to fill the vacuum being left by the West’s departure.

This is entirely to the United States and its allies benefit. Were Chinese companies not so interested in Iraqi oil, it is almost certain that the huge potential of the Iraqi oil industry would continue to go unrealized. In that case, there would be less oil available on the open market and global oil prices would be a lot steeper. In fact, were it not for China’s involvement in Iraq the West wouldn’t have been able to enact sanctions on Iran’s oil exports without causing severe disruptions in the global economy.

Furthermore, while Iraq’s future hardly looks bright, it would be in far worse shape were it not for its rising oil revenues. Without China’s continued involvement, these oil revenues would by and large not exist. It’s by no means certain that Iraq will end up stable over the long term; if it does, however, China’s willingness to continue building up its oil industry will have played an important role.

Notably, although China opposed the U.S. invasion, it is now the country assuming all the risk in its future by investing heavily in its oil industry. If the political order in Iraq breaks down, many will blame the U.S. for having invaded in the first place. It will be the Chinese (largely state-owned) companies whose balance sheets are the most affected, however.

This weekend, President Obama will meet with his Chinese counterpart, President Xi Jinping, for a two-day meeting in California. As the first meeting between the two since President Obama began his second term and President Xi became the leader of China, the event provides them with the chance to articulate their respective views on the future of the bilateral relationship.

For the United States, this is an opportunity to explicitly state U.S. concerns of Chinese activities that jeopardize improved relations. In particular, President Obama should call out concerns about Chinese harassment of U.S. treaty allies in Asia, Chinese government support for cyber espionage activities against U.S. targets, and China’s encouragement of U.S. intellectual property (IP) theft. While these concerns should not be relayed as threats, it is important to make clear to China that the onus for improving the relationship lies squarely with China.

In recent years, as China’s power has grown, it has increasingly asserted its parochial interests in East Asia. China has bullied U.S. treaty allies Japan and the Philippines over disputed maritime claims in the East and South China Seas. Chinese maritime security vessels frequently harass Japanese and Philippine fishing and coast guard vessels around these disputed territories. Oftentimes, Chinese naval vessels back up its civilian maritime forces, increasing the risk of escalation.

A second area of concern is Beijing’s continued support for cyber espionage activities against U.S. targets. Just this past weekend, U.S. Secretary of Defense Hagel expressed concern about China’s cyber activities against U.S. civilian and government targets. Public evidence shows that these activities are not the actions of lone hackers, but rather part of a Chinese state-sponsored program. Chinese cyber espionage harms both U.S. economic and military security.

A third alarming trend is China’s continued theft of American IP. As a recent report by the independent Commission on the Theft of American Intellectual Property asserts, “China is the world’s largest source of IP theft.”  More alarmingly, the Chinese government actually encourages the theft of U.S. IP. Such activities not only harm U.S. economic competitiveness, but ultimately put U.S. citizens out of work.

To dissuade China from continuing such behavior, President Obama should articulate three points to his counterpart. First, the president must make clear that the United States is firmly committed to supporting its allies in East Asia. Should China continue to pressure Japan or the Philippines over disputed maritime claims, it will be met with increased U.S. support for these long-time allies. Obama should also emphasize that the U.S. military will continue its forward presence in the Asia Pacific to minimize escalation by all sides.

Second, the president should stress that Washington will not stand by idly as Beijing-supported hackers continue to exploit U.S. civilian and military knowledge. China should be made absolutely aware that such behavior will not be tolerated. Should China ignore this warning, then the United States will have no choice but to develop the means to defend and eliminate this cyber threat.

Third, Obama should convey to President Xi that if China continues to support the theft of U.S. IP, the United States will be forced to respond. Such responses could include, at a minimum, strengthening U.S. legislation prohibiting the import of Chinese products containing stolen U.S. IP, and preventing known Chinese firms involved in IP theft from investing or operating in the United States.

Some argue that China is not an enemy, so don’t treat it like one. This is true, but only to an extent. Although China is not an enemy, its behavior often reflects malicious intent. If China does not wish to be seen as an enemy, it must refrain from such activities. Others maintain that Beijing is likely to ignore such warnings as it has so many times in the past. This may be true, but the point is not simply to persuade China to change its behavior. Rather, it is to stress that if China doesn’t cease such behavior, it alone will bear the blame for any future downturn in the relationship.

This weekend, President Obama has an excellent opportunity to express U.S. concerns about China’s behavior to his Chinese counterpart. All indications are that he will do just that. However, it remains to be seen whether China’s president will hear Obama’s warnings, or allow China to continue to push the relationship towards animosity and distrust.

Daniel M. Hartnett is a member of the Truman National Security Project’s Defense Council, www.trumanproject.org, and a research scientist in the China Studies Division at CNA. The views here are his own.

Some Friday China links:

Nicaragua has granted a Chinese company a 100-year concession to build an alternative to the Panama Canal. At a cost of US$40 billion, the new canal will have a higher capacity than the Panama Canal, allowing ships to transverse it that are twice as large as the biggest ones the Panama Canal will be able to handle after a current expansion is finished.

When the ranking of the world’s top supercomputers is released later this month, China is likely to top the list owing to a new machine unveiled last week at China's National University of Defense Technology, the Wall Street Journal reports. China briefly held that distinction in 2010, but the new machine, the Tianhe-2, or Milkyway-2, is likely to hold the top ranking until at least 2015 the report says.

On Friday millions of high school seniors in China will sit for the dreaded gaokao, the nationwide college entrance exam. Unlike the SATs in America, entrance to college in China is based almost entirely on gaokao scores, Bloomberg Businessweek reports in an interesting piece on the tests. Interestingly, the tests are seen as one the factors causing the spike in Chinese students going abroad for college. As China Daily reports, “In Beijing, 72,736 students signed up for the gaokao in 2013. However, the figure was 126,000 in 2006.” The same source outlines the grim jobs market recent college graduates face.

Fareed Zakari opines at the Washington Post that China is the not the world’s other superpower. Zakari writes, “China is the world’s second-largest economy and, because of its size, will one day become the largest…. But power is defined along many dimensions, and by most political, military, strategic and cultural measures, China is a great but not global power.” For a similar argument, which Zakari cites himself in the article, see George Washington University Professor David Shambaugh’s most recent book.

At the same time, as fears of an EU-China trade war grow, the People’s Daily insists that the EU must accept it is a declining power. “The change of the times and the shifts of power have failed to change the condescending attitude of some Europeans,” the paper said the Financial Times reported. Interestingly, the editorial doesn’t appear to be in the English-language edition of the newspaper.

In “The Wonk With the Ear of Chinese President Xi Jinping,” the Wall Street Journal’s Jeremy Page provides a probing profile of Wang Huning, head of the Communist Party's secretive Central Policy Research Office. Wang, a Politburo member and top adviser and speechwriter to Jiang Zemin, Hu Jintao, and now Xi Jinping, is described by one of Page’s sources as "Karl Rove and Henry Kissinger rolled into one,” owing to his strong influence on both China’s domestic and foreign policy.

Reuters reports that Chinese new leaders are content to allow growth to slip below 7 percent before instituting a stimulus package, which Premier Li Keqiang has been a particularly strong opponent of.

What did we miss? Want to share an important article with other readers? Please submit your links in the comment box below!

As Chinese President Xi Jinping concludes his trip to Latin America and the Caribbean (LAC), including Mexico, it is worth probing the trip for what it can reveal about Beijing’s future in the region and beyond.

Mr. Xi visited Trinidad and Tobago, Costa Rica, and Mexico – countries that are important in their own way. Trinidad and Tobago is a pearl in the Caribbean for its steady economic development and oil and gas reserves, which have made the country a regional petroleum hub. Costa Rica is one of the world’s oldest democracies, a key player in renewable energy, and is considered a success story in a troubled neighborhood. Mexico has the second largest economy in Latin America with an attractive oil industry that could be improved and opened through reforms. Taken together, these countries offer what China is looking for: a stable and reliable source of energy to fuel its own economy.

Beyond securing resources, Mr. Xi may also be using this trip as a PR opportunity to improve China’s image in the developing world. While Beijing emphasizes its “peaceful rise” in geopolitics, it is also trying to fight the perception that China’s size and stature in the world economy are crowding out other emerging countries, and dominating its smaller partners. With this Latin American tour, Mr. Xi was hoping to demonstrate that states of any size or condition can have a harmonious relationship with China.  

Despite these good intentions, China’s economic ties with Latin America are complicated by the fact that their economies are not entirely complementary. While Chinese trade and investment with Latin American countries have grown rapidly over the past several years, the rise in Sino-LAC business has also been accompanied by significant competition between both sides. China’s demand for commodities has benefitted Latin American countries and firms that export resources ranging from soy beans to oil. On the other hand, the sheer scale and competitiveness of Chinese industry has put pressure on manufacturers across Latin America.

Mexico in particular has been bearing the brunt of Chinese manufacturing competitiveness both in its primary export market, the U.S., and at home. Added to that is the pressure of a large trade deficit in which Mexico imported Chinese goods valued at US$57 billion while only exporting US$5.7 billion to China itself last year.

Despite a chill in relations between China and Mexico in recent years, both countries have new leaders in Xi Jinping and Enrique Peña Nieto who have signaled their intention to reset relations. With Mr. Peña Nieto’s visit to China in April and Mr. Xi’s trip to Mexico about to end, both sides appear to be interested in finding areas where they can cooperate for both sides’ benefits and downplaying competition. For instance, if Mr. Peña Nieto is able to make needed reforms in Mexico’s oil industry, China could become a big investor and consumer in that field. Additionally, both leaders have signed agreements in mining and infrastructure, agreed to China purchasing US$1 billion worth of Mexican goods, and opened the Chinese market to Mexican pork and tequila.

Still, while Chinese investment in the infrastructure and industries that focus on the extraction of natural resources and pledges to import more from other countries are good, but they cannot completely paper over the difficulties Mexico has encountered in competing with Chinese manufacturing. For example, while it is true that Mexico has regained competitiveness and market share vis-à-vis China as a result of exogenous factors, this trend alone might not guarantee long-term survival. In 2003, both countries made two million cars per year – today, China produces 20 million while Mexico only makes 2.5 million. Additionally, Latin American countries’ hopes of moving into high-end manufacturing could be dashed by China’s desire to do the same.

This does not mean that the good intentions between China and Latin America are doomed to be overshadowed by zero-sum competition for market share. Chinese cooperation gives LAC countries the opportunity to address other sources of growth and development, such as improving domestic governance and strengthening regional integration. Rather than looking inward, initiatives like the Pacific Alliance could leverage Latin America’s proximity to the United States or ties to Europe as a new base from which to assemble and export Chinese goods. Alternatively, LAC countries could become part of a broader value chain where their trade with China in finished goods declines relative to trade in intermediate goods. In other words, Latin American states could join countries like Taiwan and South Korea in supplying China with components for the production of finished products.

While competition between China and Latin America will not go away anytime soon, Xi Jinping’s visit to the region and a greater willingness to cooperate from both sides show that economic rivalry can be managed to a certain extent. Whether Mr. Xi’s visit is the prelude to a new era of enhanced ties or a rehash of Beijing’s previous policies to secure more sources of energy in the region will depend not just on good will, but also on how leaders can develop creative solutions that extend benefits to as many parties as possible. As Sino-Latin American relations continue to evolve, many in the Americas should expect more developments to come from across the Pacific.

Sebastian Sarmiento-Saher is an editorial assistant at The Diplomat.

Here are some Thursday (mostly) China links:

China’s state-run newspaper, the Global Times, has released an online game called “Recover the Diaoyu Islands.” In the game, the player is on a PLA mission to reassert sovereignty over the Diaoyu/Senkakus Islands. South China Morning Post has the story; here’s a link to the game (h/t Sinocism, which has a new Linked In page).

Former Ebay China Executive, Wang Jianshuo, has a thoughtful piece on why U.S. Tech companies are destined to fail in China. According to Wang, companies like Google can dominate small countries like the Netherlands because the market isn’t big enough to make it economical to establish a meaningful domestic competitor. If it were economical though, a Dutch company could make a better search engine for Dutch people than Google. This problem doesn’t exist in China, which has over half all online users. Hence why Baidu thrives.

After Presidents Xi Jinping and Enrique Pena Nieto announced they will pursue a strategic partnership, Mexico announced that is now formally recognizes a “one China policy” and considers Tibet and Taiwan to be “an inalienable part of Chinese territory. Beyond BRICS notes that Pena Nieto’s processor, Felipe Calderón, hosted the Dalai Lama at the Presidential Palace in 2011.

China will overtake Canada and Mexico to become the United States' largest export market by 2022, according to a new report, Xinhua News Agency reports.

A day before the Xi-Obama summit begins, three lawmakers from both parties in the House of Representatives will jointly release a bill that would allow individual hackers from foreign countries (China, for instance) to be “punished” for hacking, according to Reuters. Not many details have been released yet on how these punishments would be meted out.

South Korea “effectively accepted” North Korea’s proposal to hold working level talks between government officials over restarting inter-Korean economic projects like Mt. Kumgang and the Kaesong Industrial Complex. Seoul responded positively an hour after Pyongyang made the offer, Yonhap reports. Earlier, South Korea had rejected North Korean calls for talks to be held privately between businessmen and non-governmental sources.  

What did we miss? Want to share an important article with other readers? Please submit your links in the comment box below!

Non-performing loans (NPLs) are the blood pressure of an economy – high blood pressure doesn’t make a heart attack inevitable, but it certainly signals problems. Similarly, even though China’s level of NPLs doesn’t spell doom in and of itself, it can signal potential problems – such as the popping of a credit bubble.

At this point, China’s figures on bad loans aren’t particularly good, but they’re not at emergency levels either. In 2012, for instance, China’s NPLs rose by 64.7 billion yuan (US$10.4 billion) to reach a total of 492.9 billion yuan ($80 billion), though the ratio of bad loans to good ones stayed steady at 0.95 percent. More recently, at the end of last March, NPLs totaled 524.3 billion yuan ($84.8 billion), which was up more than 20 percent year-on-year, and 33.9 billion yuan from the start of 2012, China Daily reported, citing China Business News.

Bad loans are coming from a range of industries, but particularly the shipping, chemical, wind power, construction, and photovoltaic industries that are centered in China’s manufacturing powerhouse – the Yangtze River Delta.

What is causing NPLs now? On a very basic level, a period of expanded credit (S&P says loans grew 60 percent in 2009-2010) has turned into soured loans as growth has slowed.  Much of the credit issued was distributed inefficiently in already overinvested sectors, and the expected returns have not materialized.   

The ratios don’t look bad—certainly nothing compared to the 40 percent NPL ratio in the 1990s—and Chinese bank officials believe that the loan situation to be under control. Still the large size of the NPLs should elicit attention, and there are a few additional factors that should heighten our concern.

First, analysts question the accuracy of NPL figures, since they can come “from falsified statistics from local banks, for whom non-performing loans can result in official sanctions,” according to News China Magazine. Reporting discrepancies are a common problem in China, in everything from agricultural production to growth figures, especially when there are counterincentives to accurate reporting. 

Although the ratio is low now, it looks as if we are at the bottom of a rather steep hill. Interestingly enough, the ratio of NPLs, a commonly-used indicator, may stay low (or even decrease) because of the sheer volume of new loans issued. This is not a sign of fewer bad loans, but perhaps a sign of more bad loans to come in the future. 

For example, Forbes reported that in January, “China’s banks extended 1.07 trillion yuan in loans marking the highest monthly total in the last three years.”  Banking analyst Jim Antos told the Financial Times that the “absolute volume” of NPLs increased 15 percent last year, matching the 15 percent increase in banks’ overall loans. Furthermore, loans that should have turned bad a long time ago have been allowed to limp along with government-approved rollovers. The Financial Times noted that the rolled-over local government loans have either been restructured or refinanced through the issuance of bonds.  

Common sense says slowing growth (believed by most analysts to be inevitable for China) will hinder the ability of borrowers to repay loans.  A large percentage of loans have been issued through local government financing vehicles (a type of shadow banking) to local developers. The loans use land and property prices as collateral, which means that falling real estate prices could have a very detrimental effect on the ability of the borrowers to repay these loans. As Standard and Poor’s credit analyst Kim Eng Tan warns in the China Daily,  “We believe a number of these local government financing platforms will still default,” though he notes that “the systemically important commercial banks are unlikely to be destabilized by these NPLs.”

An interesting new development is the recent launch of the first local government-backed asset management company (AMC) in Jiangsu province.  The AMC is supervised by a triumvirate of local government financial supervisors, and comes in response to a new Ministry of Finance and China Banking Regulatory Commission allowing local AMCs. The AMC in Jiangsu was established largely to clean up bad loans in the photovoltaic and steel sectors, including Suntech Power, in which it is heavily involved. Suntech owes banks 7.9 billion yuan (appx. US$1.3 billion), but is a government priority thanks to its 10,000 employees and 400 suppliers. Analysts expect that Zhejiang, Shanghai, and Guangdong could be next in establishing AMCs. These local AMCs, however, will not have the kind of financial backing that central government AMCs enjoy, and one questions how useful they will be. 

In short, the question is not if the entire banking system is at risk. At this point, that does not seem to be the case. Rather, it’s what the cost of cleaning up this mess will be, and the structural inefficiencies and issues that allow this problem to continue to worsen.

In a 2011 article, Michael Pettis discussed how NPLs are resolved at the expense of household income, because banks are allowed higher profits through a wide difference in lending and deposit interest rates (which are both artificially low). This hurts depositing households and essentially grants loan forgiveness to borrowers due to the lower-than-natural interest rate. Despite some regulators expecting that another NPL crisis could be cleaned up quickly and without too much pain, Pettis notes the cost is not only limited to the level of cash needed to bail out banks. Instead, “the combination of implicit debt forgiveness and the wide spread between the lending and deposit rate has been a very large transfer of wealth from household depositors to banks and borrowers. This transfer is, effectively, a large hidden tax on household income, and it is this transfer that cleaned up the last banking mess.”  With the central government trying desperately to increase household income to bolster the economy and reduce China’s reliance on exports, this is a powerful point about the true costs and dangers of NPLs.

One of the key sources of NPLs are state-owned enterprises (SOEs): the government directs the banks to lend to SOEs no matter how inefficient or non-profitable they are. NPLs will continue in this sector until the larger issue of these anachronisms is resolved. 

One very large and general problem, which I will just briefly touch on, is the perverse incentives at the local level.  Since revenue sharing reforms in 1994, local governments have been strapped for cash, and have thus promoted breakneck growth, spurred on by loans. Anxious to attract developers and business, they have set up financing options that are now a significant source of NPLs.  This is a major political and economic issue in China.

At this time, the level of NPLs is being monitored carefully, though there are many directions from which more bad loans could come in the near future. China’s debt issue, and its ability to service this debt as growth naturally slows, will be a key area to watch in the next year. 

Every week, The Diplomat’s editorial team scours the web to find the best material on all things China. From Beijing’s relations with its neighbors and growing military might, to a rapidly evolving economy and amazing arts and culture, we present a diverse grouping of articles for your reading pleasure.

Here are our top picks for this week. What did we miss? Want to share an important article with other readers? Please submit your links in the comment box below!

Just when Hollywood’s luck in China seemed to be improving, the Global Times warns Hollywood and foreign film makers to expect another chilling summer in China as the “domestic movie protection month” that was established last year is set to have a repeat performance. On the other hand, Deadline reports that Superman: Man of Steel will hit theaters in China on June 20, about a week after its release in the U.S. and many other markets around the world.

Michael Pettis has a new article in McKinsey Quarterly examining who will be the winners and losers of China’s transition from an investment to a consumption driven economy. Meanwhile, Dealbook recounts some of the vexing challenges foreign investors face in China under the current system. The European Union is also going forward with sanctions against China’s solar panels, albeit, significantly watered down ones initially. The New York Times has the story.

The U.S. and China plan to step up their cooperation on climate change, with Xie Zhenhua, vice-minister of the National Development and Reform Commission, telling reporters last Friday that “Climate change will become a new highlight of the Sino-U.S. bilateral relationship.”

Archbishop Desmond Tutu and Chen Guangcheng pen a joint op-ed arguing that Xi Jinping’s Chinese Dream “cannot become a reality without social and political reform.” Veteran American China watcher, Robert Lawrence Kuhn, is the latest voice to weigh in on what Xi's Dream actual is.

Over at Tea Leaf Nation, Ashley Sun gives a history of the constitutionalism debate in the People’s Republic of China.

Venezuela state-owned oil producer, Petroleos de Venezuela SA, signed a US$4.02 billion loan agreement this week with China’s Development Bank Corp to increase production at a heavy oil joint venture in Venezuela’s Orinoco belt, Bloomberg News reports. During President Xi Jinping’s visit to Costa Rica, China also announced it would be floating that country US$1.5 billion to upgrade an oil refinery in the major shipping port of Limón. The loan, which is mostly financed by credit from the CDB, will allow the refinery to increase its production from 18,000 barrels of crude a day to 65,000 barrels of crude oil a day. Costa Rica itself doesn’t produce oil but is a shipping hub for countries that do.