China's Weaknesses

The Wall Street Journal pointed out some uncomfortable truths about China's oil vulnerabilities. China became the biggest importer of crude oil from Saudi Arabia in 2009, surpassing the US. Most of China's crude comes from Saudi Arabia:

The Middle East provides 2.9 million barrels of oil a day to China, more than half its total imports, and Saudi Arabia alone accounts for about 1.1 million barrels a day.

Chinese officials say they want to boost trade with Saudi Arabia by about 50% to $60 billion by 2015, further increasing Beijing's dependence on the kingdom.

China realizes its vulnerability, and has been doing what it can, mostly increased military spending and overt political alliances with Saudi Arabia, to decrease its vulnerability by gaining power. China's aircraft carrier program is aimed directly at gaining naval power and dominance over the Gulf, to assure the oil keeps flowing.

"Asia has been something of a bystander in the Middle East and importantly, in the case of China, an increasingly anxious bystander," said Andrew Shearer, director of studies at Australia's Lowy Institute for International Policy.

That anxiety comes from the economic implications of possible major disruption to energy supplies coming through the Persian Gulf's Strait of Hormuz and Beijing's unease that the calls for democratic change sweeping across the Middle East will set an unwelcome precedent at home. According to Mr. Shearer, the U.S. still has the military capability to intervene if the flow of oil from the region was threatened.
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In an extreme scenario, U.S. troops could seize control of oil installations in the region, leaving China and most of Asia dependent on the goodwill of Washington to guarantee their supplies. In such circumstances, "the oil would follow the gray naval ships" of U.S. forces in the Persian Gulf, Mr. Shearer said.

China may be racing to catch up. It has increased defense spending by almost 13% and is developing its own aircraft carriers. But its ability to project power beyond the South China Sea remains limited. Beijing sent one of its latest and most powerful warships, the Xuzhou, to help evacuate its nationals from the fighting raging in Libya, but this effort was dwarfed by the rapid U.S. navy buildup off the North African coast. "China has naval aspirations but they're still a long way from realizing that," said Mr. Shearer.

China remains hobbled by a fiscal system that is a mess. As the WSJ reports:

More important, the banks were relieved of their bad loans by what Messrs. Howie and Walter accurately describe as "accounting legerdemain."
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In 1998, the People's Bank of China—the state's central bank—reduced the Big Four's reserve requirement. This freed up reserves for the banks to acquire a special-purpose treasury bond issued by the Ministry of Finance. The loan proceeds were then used to recapitalize the banks. Beijing also created asset-management companies to buy the nonperforming loans from the banks at face value. In exchange, these repositories of toxic credit issued notes to the banks. (When these notes became due in 2009, they were extended for another decade.)

For the financial magicians' next trick, in 2005, other nonperforming loans were put into a "co-managed account" with the Ministry of Finance, which in return issued IOUs to the banks that were to be repaid through a combination of loan recoveries, bank dividends, sale of bank shares and tax receipts from the banks. To make matters even more convoluted, in 2009 the banks started acquiring large stakes in the asset-management companies that were still sitting on nonperforming loans from the previous decade.

As noted in the article (the review of "Red Capitalism" by Carl E. Walter and Frasier J.T. Howie), what this has done is given Chinese banks a guaranteed spread, between borrowing costs (artificially low) and what they charge for borrowing (high), but at the cost of artificially low rates on Chinese consumer bank accounts, aka "financial repression." Chinese have to save, save, and save, because they get in effect negative real returns on savings accounts. This accounts for all sorts of destructive bubbles in real estate, and the like. Empty apartments in Shanghai and elsewhere that Chinese families have purchased as investments, desperate for returns. Household deposits have financed the industrial banking system and export driven economy. Making Chinese domestic consumer consumption a joke (and a bad one on Western companies betting on it).

Bad loans are routinely hidden, and the various local, provincial, and special district liabilities for bad loans, often connected to White Elephant projects like high speed trains that will never recoup their investment costs, is probably on several orders of magnitude larger than the US state/local/county levels of indebtedness.

China is a formidable country with many advantages, but they are not world-beating supermen with no flaws. Their interior remains dirt poor and functionally illiterate. They have massive ethnic/racial/religious tension and separatism. [Tibet and XianXing Uighurs and Hui Muslims on the coast.] China has huge gaps between rich and poor, massive gender imbalance (roughly 30-40 million young men will never marry.) China is hideously vulnerable not just on its own sake for oil, but cheap Chinese goods rapidly increase in price if oil increases, by trans-Pacific transportation alone. Let alone cost of production. And as noted, its financial system is a shaky house of cards continually propped up, driven by insolvent State Owned Enterprises that must be continued to keep employment up (and the social safety net which is tied directly to employment, including schooling and welfare.)

China has been lucky, propping up its broken financial system. Betting on luck forever is not a wise move. It may well be that Japan's earthquake exposes China's weakness, as Japanese companies pull back from Chinese investment to focus on reconstruction at home and Japanese led export growth (to pay for reconstruction). Japan is highly indebted, aging, and with very little growth domestically. The only way for Japan to reasonably pay for reconstruction is export-led economic growth, in direct competition with China.