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Sino-Indian Relations: Realists and Rivals

Introduction

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The two most populous nations in the world, China and India share a disputed border, are both on the rise economically and politically, and both possess fearsome nuclear arsenals. Their rapidly changing economic and diplomatic positions have put not only their relationships in the wider world in flux, but they have also created a shifting engagement with each other. While China and India’s ever-closer economic ties have created a degree of optimism that their developing relationship will be harmonious and productive, territorial disputes, competition for spheres of influence within South Asia, and increasing friction over water rights will continue to significantly challenge their relationship.

Historical Ties

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Throughout ancient times, the link between India and China has been limited; theHimalaya formed a formidable natural barrier between the two civilizations. The most significant Indian contribution to Chinese culture was the transmission of Buddhism into China during China’s Age of Division 220-618 CE. Although the exact time and manner of Buddhism’s spread to China is still debated, it is likely that it made its way to China over the Silk Road, following merchants engaging in trade between the empires. Chinese scholars and monks also travelled to India to study Buddhism and to translate its scriptures. The most famous of these monks was Xuanzang, whose travels to and seventeen year stay in India were fictionally immortalized in the Chinese story, “Journey to the West”, considered one of the four great classics of Chinese literature.

In the modern era, with India colonized by the British, exports of opium to the Chinese mainland eventually led to the two Opium Wars of 1839-1842 and 1856-1860 between Britain and the Qing Dynasty of the time, though the involvement of what we now think of as India was incredibly limited, as it was a colony of Britain at the time. The post-Second World War period was a time of dramatic change for both countries. India was granted its independence from Britain in August 1947. The process of India’s independence was complicated by its separation from Pakistan which the British enacted immediately before granting independence to both nations as separate entities. Violence followed between the two new countries. Indeed, more than six decades after their separation, India and Pakistan remain at odds on many issues. Similarly, in China, violence ensued until the People’s Republic of China was founded in 1949 as Chiang Kai-shek’s Nationalists, and Mao Zedong’s Communists fought for control of the country. This meant that two giant new nations, both with extensive territories and massive populations, both recovering from differing forms of colonialism and struggling to find their place in the new world order, were created within a very short space of time. Despite their very long histories as civilizations, China and India are thus relatively new nation states. Their early dealings with each other have reflected their struggles to adjust to their relatively new country status and their efforts to find their place in the post WWII international order.

One early contribution that the Sino-Indian bilateral relationship made to wider international relations was the 1954 agreement in which was stated the “five principles of peaceful coexistence”. These principles were agreed as part of a treaty relating to Indian trade with Tibet, over which China had regained suzerainty. The five principles became both the founding principles of the Non-Aligned Movement (NAM) – a grouping of countries that sought to distance themselves from the Cold War by refusing to align with either superpower – and the cornerstone of China’s foreign policy, at least rhetorically. The five principles were: mutual respect for territorial integrity and national sovereignty; mutual non-aggression; mutual non-interference in the other’s internal affairs; equality and mutual benefit; and peaceful coexistence. At the heart of these principles is the agreement not to infringe the sovereignty of another country. Yet, despite their mutual commitment to these principles, within just a few years China and India were at war with each other.

The 1962 Border War

Following the 1959 Tibetan uprising – which was repressed by the Chinese military and resulted in the Dalai Lama’s fleeing into exile in India – there were several skirmishes between Chinese and Indian troops along the border. The border had never been successfully demarcated between the nations of China and India. An agreement reached in 1913 over the border between British India and Tibet – at the time conducting affairs as a pseudo-independent nation following the breakup of the Qing Dynasty – has been consistently rejected by the PRC, despite the apparent presence of Chinese representatives at the negotiations. China refuses to acknowledge any agreement made with the Tibetan authorities as it declines to recognize that Tibet had any level of suzerainty in this period of history. Interestingly, China’s refusal to recognize this agreement has some validity as it was, in fact, in breach of the Anglo-Russian Entente. Signed in 1907, but annulled in 1922, it stated that all dealings with Tibet must be conducted through the Chinese authorities in Beijing.

In October 1962 China invaded Aksai Chin and Arunchal Pradesh, the two largest portions of disputed territory over which it claimed sovereignty, but which were occupied by the Indians at the time. The simultaneous invasions were over a thousand of miles apart. The war lasted precisely one month, with the Chinese winning a military victory and successfully occupying much of the disputed areas. However, once military superiority had been established, a ceasefire was called and the Chinese unilaterally withdrew from all the territory they had gained in the offensive. While China’s real reasons for unilaterally withdrawing and ending hostilities are still debated, it is likely that a key reason for their retreat was the prospect of US involvement in the conflict, which raised concerns in China of an unwanted and unnecessary war with the superpower. Premier Zhou Enlai insisted that the withdrawal was a signal of good faith and that China had always wished to resolve the dispute peacefully.

The casualties in the war were relatively small, with an estimated 2000 Indians and more than 700 Chinese troops thought to have been killed. However, the consequences for the relationship and the region as a whole were extensive. While the Chinese succeeded in demonstrating their military superiority over their Indian rivals, the invasion harmed their international image and fed the belief in the West that China was a belligerent power intent on using aggressive means to expand its territory and influence. The lesson learned by India was that its military was woefully underprepared and wholly inadequate for purposes of self-defense. It therefore set about wholesale modernization of its military capabilities.

Territorial Issues

 

Territorial disputes are probably the greatest issue of difficulty between China and India. The disputes involve ten separate portions of territory, though several of these are tiny. There are two particularly significant areas: the more than 60,000 square km – around three quarters – of what India, and most other countries in the world, consider to be the state of Arunachal Pradesh; and the 37,000 square km Chinese-administered Aksai Chin, to the west of Nepal. It was these two areas over which the 1962 war was fought. At the time the Arunachal Pradesh was sparsely populated, but is now home to around one million Indian citizens. Since the 1962 war there have been many skirmishes along the disputed area, most notably in 1967 and 1987.

Given the size of the larger territories under dispute, it is politically difficult for either country to concede the territory to the other. This is especially true in the case of Arunachal Pradesh, which would be tantamount to the the Indian government effectively giving away the majority of an established Indian state. The other major disputed area, Aksai Chin, is considered by India to be a part of Kashmir and therefore complicates the matter further, given that India is already contesting Kashmir with Pakistan. Certainly, no solution to the current impasse appears imminent and the failure of the two great powers to resolve this remains a constant thorn in the side of diplomatic relations of the two. With that noted there has been some limited success in reaching agreement over the Indian state of Sikkim; initially claimed by both India and China but effectively operating as an independent state, Sikkim voted to join the Indian Federation in 1975. China originally refused to recognize this and continued to display Sikkim as a separate state on maps produced in the PRC. In 2004, it finally accepted it as an Indian state, although it did so with little fanfare.

As with most territorial disputes around the world the problem is exacerbated by nationalists on either side, who are prone to react to even the slightest provocation. Though nationalist responses in China are not as prominent as those that are directed against Japan or the US from time to time, India has emerged as a target for outpourings of nationalist sentiment, particularly over the issue of the disputed territory. Simon Shen, an academic who specializes in Chinese online nationalism, has identified that China’s online nationalists have turned their attention to India in recent years and use the government’s reaction to any perceived provocation as something of a litmus test. India also has its share of hotheaded protesters who make themselves heard whenever China acts in ways considered to infringe on India’s sovereignty over these areas.

Tibet

For historical, religious, cultural and geographical reasons, India continues to play a role in the Tibet issue. Homeland to the Tibetan people, and located on the high plateau of the north-eastern Himalaya, Tibet was unified in the 7th century, but then fractured into various territories which have since been controlled at various times by Tibetans, theDaniel J. Rao / Shutterstock.com Mongols and the Chinese. Tibet has been part of the People’s Republic of China since 1951, though full control by Beijing was only established following a military advance into the region in 1959. While China’s sovereignty over Tibet is accepted by the international community, its continued rule there remains controversial with the Dalai Lama continuing to campaign internationally for the Tibetan people to be allowed greater autonomy. Though China insists that the Tibet issue is a purely domestic matter in which no other country must interfere, India is inescapably intertwined in the problem. This is, primarily due to the fact that when the PLA rolled into Tibet in 1959, the Dalai Lama fled to India where he was given asylum, and allowed to establish the Tibetan “government in exile” – in the northern Indian town of Dharamsala. There have certainly been times since 1959 when the Indian government has wished it could bring an end to its own involvement in order to ease its strained relationship with China over this issue, but the Dalai Lama’s successful international promotion of the Tibetan cause has made this an impossibility, at least while he remains alive. For its part, China continues to raise this matter with Indian leaders, particularly whenever Tibetan refugees flee across the border to seek asylum there.

Competition for Water Resources

Tibet is also relevant to Sino-Indian relations as it is the source of the Brahmaputra River which provides significant water and power resources for Bangladesh and India. To take advantage of Tibet’s vast hydro power, China is planning a series of dams on the various transnational rivers that originate there. One of its proposed mega-dam projects is on the Brahmaputra, where it does a big U-turn in the world’s deepest canyon before entering India, close to one of the borders disputed by the two countries. This bend on the Brahmaputra is considered to be one of the world’s largest concentrations of river energy on earth. This mega-dam at the Brahmaputra is just one of what is estimated to be as many 28 dams on the Brahmaputra that are either planned, completed or under discussion by China. While China denies it, some Indian scientists also fear that China might also be planning to divert 200 billion cubic meters of water a year from the Brahmaputra to the Yellow River and other Chinese rivers.

China’s damming of the Brahmaputra puts control of a key source of Indian water into Chinese hands. More than 185 million people in north-eastern India and Bangladesh depend on the Brahmaputra. In the Indian state of Assam, 80 per cent agriculture relies on water from the river. Damming also affects a river’s ecosystem, altering silt and nutrient flows that risk impacting India’s downstream fertility and fisheries. Additionally, India derives significant power from its own hydroelectric projects on the river and its tributaries. The efficacy of these dams could be affected if China significantly alters the river’s flow volumes

Competition for Influence

As large and now rising nations, China and India have competed for and will continue to compete for influence in Asia and abroad. One keen area of competition is in Nepal and Myanmar. There is a difference in motive for the two of these countries. Nepal is considered to be a buffer state between the two powers, so that influence and access within Nepal is a strategic priority for both China and India. In any potential conflict between the two countries, Nepal would have clear tactical importance. Myanmar, on the other hand, is important to both countries as a source of natural resources, particularly natural gas. To seek influence in Nepal and Myanmar, China and India provide both countries with badly needed infrastructural investment; both Nepal and Myanmar have some of the worst infrastructure in the world. China in particular has been focused on building crucial road links throughout Nepal and into China, boosting trade and enhancing ties between the two countries.

While Nepal and Myanmar are important considerations, the relationship with Pakistan is potentially explosive. China has been Pakistan’s long term ally, while Pakistan remains India’s greatest foe, a consequence of the fact that most Indians opposed Pakistan’s separation from India before independence. During the Sino-Indian 1962 border war, Pakistan saw an opportunity to develop a strategic relationship with a large neighbor that would help to balance against what it perceived as the threat of Indian invasion. For its part, China sees its relationship with Pakistan as a way to offset what it believes to be a US strategy to contain China, which the US employs by forming strategic partnerships with significant powers surrounding China, revolving around the axis of Japan, Australia and India. There is unquestionably some truth in this analysis of US intentions, and India’s position within this alliance system is very important. The continuance of friendly relations with Pakistan is one way China works to counter this US strategy, though this has been complicated over recent years by the US-Pakistan alliance that formed in the wake of the 9/11 attacks. China’s engagement with Pakistan involves it in India’s most prickly international issue, Kashmir, which in turn causes further friction with India at both the government and the societal levels.

China and India are also now beginning to come into direct competition for influence and access to resources in Africa. China’s engagement with Africa has increased significantly in the last two decades as it looks to Africa both as a source of raw materials and as a market for its goods. India’s foray into Africa is still in its early stages, but it is already clear that both countries are pursuing differing strategies within the region. India’s investment strategy has been led by the private sector, where China’s incursion into Africa has been led by large SOEs and government ODA seeking access to Africa’s raw materials such as its oil and timber. Indian multinational companies are seeking to penetrate African markets by exploiting the comparative advantage of a significant Indian diaspora on the continent, as well as the ability of its nationals to speak English. That said, as competition for the continent increases, India’s government seems increasingly willing to engage to secure its competitive position. In 2011 for instance, Manmohan Singh, India’s Prime Minister, announced a three year aid package to Africa worth $5 billion. While significant, it is still dwarfed by Chinese aid that currently tops $20 billion per annum. As the China and India continue their rapid development, this competition for access to Africa’s resources and markets is likely to increase in the future though, for now at least, China appears better placed to take advantage.

Bilateral Trade

Though bilateral trade is not as large as one might expect given the sizes of the two nations, it offers one of the best chances to promote a cooperative coexistence between the two Asian giants. China is already India’s largest trading partner and in 2011 bilateral trade topped $74 billion, though this fell back slightly in 2012 to $66 billion. The 2012 reduction in trade was driven almost entirely by a 20% drop in Indian exports to China, with the trade deficit now $29 billion. Total bilateral trade is projected to reach $100 billion by 2015 with potential for even faster growth after that.

China does not offer India economic complementarity in the way that it does to some ofjbor / Shutterstock.com its richer neighbors to the east, such as Japan and South Korea. India, whose population is expected to surpass China’s within two decades, also competes to be a hub for low-cost manufacture out-sourcing. However, India provides China with raw materials; ore and slag, for instance, account for more than a quarter of all Indian exports to China. India also exports $1.5 billion dollars of cotton to China annually, providing a crucial source of supply to China’s critical textile industry, which is the world’s largest and responsible for a quarter of all Chinese exports. In contrast, Chinese exports to India are predominantly in manufactured goods, in particular electrical machinery which represents around a third of total Chinese exports to India. The fact that India exports raw materials to China and China returns finished goods reflects a slightly imbalanced relationship; indeed, India ran a trade deficit of around $20 billion with China in 2010. Nevertheless, deeper economic ties with China remain in India’s long term interests. Overall, India is developing its own economy in different ways to China. Specifically, India has focused on information technology and services. China’s rapidly growing IT market, which already boasts the greatest number of internet users in the world, offers opportunity for India’s leading IT firms. For instance, Infosys Technologies, an Indian IT firm, set up a Chinese subsidiary as far back as 2004. While its Chinese subsidiary still derives the majority of its income from outside of China, the Chinese domestic market now accounts for one third of its profits; this is projected to grow in the coming years. By 2014, Infosys predicts its Chinese subsidiary will employ 10,000 people, triple what it does today. The Tata Group, through Tata Consultancy Services (TCS), has also established a significant presence in China. It exports IT services to the Chinese banking sector, with Bank of China among its most notable clients. Its workforce in China is expected to quadruple over the next three years, taking the total number of its employees to over 5000. Following in TCS’ wake is India’s Wipro Technologies which has plans to center its Asian operations in China’s western city of Chengdu, in order to focus on growing its Asian market, and to diversify away from the US and Europe. India’s other great success story in China has been Mahindra & Mahindra, a manufacturer of tractors. Mahindra & Mahindra has established two joint venture tractor manufacturing companies in China which, combined, account for more than 30,000 employees and produce more than 30,000 tractors each year, many of which are exported to Europe or India. Indian IT firms are also seeking Chinese investment. By June 2009, the total Chinese investment in IT in India reached almost $30 billion. Much of this came from the Chinese giant Huawei.

Like many foreign companies working in China, Indian firms have also complained of barriers to their entering and expanding within the Chinese market. These barriers are increasingly being raised at the highest political levels. Complaints from the Indian side are met with calls from China for a bilateral Free Trade Agreement (FTA). Although India has been reluctant to agree to this until its trade deficit with China has been tackled, such an agreement, if signed, would represent the largest free trade area in the world measured in size of populace.

The BRICS Nations

Another area of promising cooperation between China and India is their involvement with the BRICS nations – Brazil, Russia, India, China and South Africa. The name originally came from an economist working for Goldman Sachs, who coined the term ‘BRIC’ in 2001 (South Africa was not included in either the original thesis or the initial gatherings of the countries) when writing about the shift in global power balances from the large developed western countries to the large developing ones. Initially not a formal structure, the four BRIC countries sought to capitalize on the success of the term by launching annual summits in 2009, where the countries meet to discuss their positions in the global order and to call for greater equity within it. South Africa was invited to join at the end of 2010 and attended its first summit in 2011. Both Brazil and India seek to exploit the status of the alliance in order to promote their aspirations for permanent membership of the UNSC, though declarations from the BRICS summits do not go as far as to directly call for this. Questions have been raised about the continued relevance of the grouping with varying degrees of economic growth; in 2012, only India and China surpassed GDP growth of 5% with South Africa as low as 2.8%.

Future Trends

Of the potentially disruptive issues that remain in the Sino-Indian bilateral relationship, the territorial dispute is probably the thorniest. There is seemingly some room for maneuver on China’s part in the disagreement over Arunachal Pradesh; certainly it seems impossible that the Chinese would try to make good their claims on an area that is widely recognized internationally as Indian territory and which is populated by more than one million Indian citizens. However, other disputes seem more intractable, particularly where Kashmir comes into the equation. Acts of insensitivity on either side are likely to continue to provoke minor spats, but the prospect of armed conflict between the two is highly remote. Indeed, informal talks on this very issue were held in Beijing in December 2012, though without any significant movement. The last formal negotiation on the matter took place in January of the same year.

The Tibet issue seems likely to continue to be an irritant as long as the Dalai Lama survives. It is probably China’s own calculation on this issue as a whole, not just with India, that the Dalai Lama’s death will help to remove Tibet from the intense international focus that it has been under for the last few decades. From India’s perspective, the trouble the Dalai Lama has caused has likely overwhelmed any soft power that it may have accrued as a result of it providing the Tibetan leader with asylum. There is probably understanding at the highest political level in the bilateral relationship that there is little that can be done in the short term over this issue.

China’s water disputes with its neighbors will likely be a growing problem, particularly given the unprecedented level of its dam building. Tension over water rights with India will be no exception. What is unclear is what its downstream neighbors can do about China’s hydro ambitions. It will likely be an increasing source of acrimony between China and India, especially as India plays catch-up to China’s water projects. India might voice these concerns more vocally on the world stage. It might also gain influence and leverage with other countries that are similarly vulnerable to China’s hydro ambitions to place economic and other pressures against the country.

It is in the economic ties that the greatest reasons for optimism lie. The different directions that the two economies have taken in their development mean that the potential for bilateral growth is significant. For both countries economic development is key and will continue to be so. They share much in common in terms of the continued need to raise large sections of their population out of poverty, a problem that is particularly pronounced in India. The incentive to stay focused on trade rather than to get tied down by territorial disputes or regional competition should remain at the forefront of the minds of policymakers on both sides of the Himalaya.

The election of Narendra Modi as India’s new prime minister in 2014 brought some new-found optimism given his pragmatic approach to international relations and prioritisation of economic cooperation. Modi was already popular in elite circles in China thanks to his careful diplomacy when serving as a regional leader in Gujurat, during which time he made numerous trips to Beijing. Nevertheless, the many thorny issues in the relationship cannot simply be washed away and the presence of Tibet’s prime minister-in-exile at Modi’s swearing in ceremony indicated that he would not simply roll over and acquiesce to all of Beijing’s demands.

Taiwan: Strait Talking

Introduction

More than sixty years after the establishment of the People’s Republic of China when Chiang Kai-shek’s nationalists fled to the island, Taiwan remains at the core of domestic and foreign policy decisions for Beijing. Despite enjoying de facto independence, having never been directly ruled by the CCP, Taiwan is considered by Beijing to be an inalienable part of its territory and the goal of ‘reunification’ is one of its highest priorities. This is resisted in Taiwan where most people favor retention of the status quo; that is, neither a declaration of de jure independence – a move that would almost certainly provoke an angry reaction from the mainland – nor a move to accept CCP rule over the island. The issue is a sensitive one in China at both the political and societal levels and any suggestion of support for an independent Taiwan ordinarily sparks heated responses from China, which accuses its protagonists of trying to ‘split’ China. It is a complex, emotional, and seemingly intractable problem.

Chinese Annexation and Japanese Colonialism

Taiwan was formerly known as Formosa in the West

Known as the island of Formosa in its past, Taiwan’s history over the past two hundred years has been complex. The largest island of the Formosa island chain located off the southeastern coast of mainland China, it was originally the home of aborigines and the occasional Chinese migrant, refugee, and pirate. Neither Western nor Asian powers showed any sincere interest in acquiring the island until the late seventeenth century, when China brought Taiwan under its authority in order to quell pirates using the island as a base of operations. China largely left the island untouched until the Qing Dynasty was forced to cede the island to Japan after its loss in the First Sino-Japanese War of 1894-5. Qing subjects were given a two-year grace period to sell their property and move to mainland China if they so wished, but very few Taiwanese saw this as feasible and most remained under Japanese rule. An 1895 effort by pro-Qing Taiwanese officials to challenge impending Japanese rule was quickly put down by Japanese forces.

During Japan’s fifty-year control of Taiwan, the occupying government imposed harsh rule on the island, showing no tolerance of dissent, and limiting lucrative jobs and business contracts to Japanese living on the island. Aboriginals and Chinese were treated as second-class citizens. Despite this harsh rule, the Japanese helped to develop Taiwan’s economy and brought with them technology that was unseen on the Chinese mainland. They also helped to enlarge Taiwan’s railroad and other transportation networks, built a widespread sanitation system, and developed the public school system. Rice and sugarcane production also increased greatly under Japanese occupation. Thus, by the end of the World War II the island of Taiwan was much better off than mainland China. That it was largely saved from the ravages of the Japanese occupation that were meted out on the mainland certainly helped in this, but it is an uncomfortable truth for those on both sides of the strait that Taiwan owed its position of relative economic strength to its former occupiers.

The Republic of China

Japanese rule over Taiwan came to an end after they surrendered to the Allies at the end of World War II in 1945. At this time the approximately 300,000 Japanese living in Taiwan were repatriated back to Japan. After Japan’s surrender Taiwan once again fell formally under Chinese rule, which was by this time under by the Chinese Nationalist Party or Kuomintang (KMT), with China now formally called the Republic of China (ROC). Celebration of the island’s return to Chinese rule was short lived. Tension soon built between the locals on the island and their new government. The source of this tension was two-fold. Firstly the KMT government questioned Taiwanese loyalties after their having been subject to fifty years of Japanese rule. The KMT thus continued Japan’s policy of treating the Taiwanese as second-class citizens. Secondly, as the KMT was fighting a civil war with the Communists in China, they took every resource available on the island to support their war efforts.

These tensions culminated in the 228 Massacre of 1947, so called because it occurred on February 28th. What started off as police harassing an old woman who was peddling cigarettes turned into island-wide riots in which local residents attacked mainland immigrants and their property. KMT leader Chiang Kai-shek and Taiwan governor Chen Yi responded by bringing in military reinforcements to restore order to the island. The result was the execution of as many as 4,000 Taiwanese. The 228 Massacre was the start of the nearly four-decade White Terror in which the KMT established a dictatorship over the island and suppressed any organized dissent.

The Chiang Kai-shek Memorial Monument in modern day Taipei

In 1949, Chiang Kai-shek was forced to flee to Taiwan after Mao Zedong and the Communists took control over all of mainland China and founded the People’s Republic of China (PRC). Eventually, 2 million people, most of them soldiers, KMT party members, intellectuals and business elite where evacuated to Taiwan. These refugees brought with them many national Chinese art treasures, as well as gold in foreign currency reserves. Most people on the island believed this would be the end of the KMT as Mao amassed an invasion force in the Chinese province of Fujian, directly across the Taiwan Strait from the island. In addition, the US, the KMT’s largest provider of funds and material, announced it would take no further steps to support Chiang in his fight against the Communists. It appeared that it was simply a matter of time before the PRC would gain control of the island.

The situation changed quickly in 1950, however, when communist North Korean soldiers crossed the attacked the US ally South Korea. US President Harry Truman, fearing communist attempts to take over all of Asia, reversed his policy on Taiwan and sent the US Naval Seventh Fleet into the Taiwan Strait to protect the island from Chinese invasion. This led to a political and military stalemate that is still basically in effect today. Because of the Cold War, most Western nations and the United Nations regarded Taiwan’s Republic of China as the sole legitimate government of China until the 1970s, when the most nations began switching their recognition to the PRC, a response to a thaw in relations with the US that saw it achieve mutual diplomatic recognition by 1978. Initially, Taiwan held the seat on the United Nations Security Council under its formal name of the Republic of China, recognized as the sole legitimate government of all of China. In November 1971, the seat was transferred to the PRC, since which time Taiwan has had no formal representation at the UN despite some sporadic attempts to achieve this.

Taiwan’s accelerated economic growth since World War II has transformed it from a largely agrarian island into an industrialized, developed society. The IMF categorizes it as an ‘advanced’ economy, and the World Bank considers it to be a ‘high income’ economy. One of the strengths of its economy is its advanced technology industry, which plays a significant role in the global economy. Although most of this manufacturing is now outsourced to mainland China, Taiwanese companies still control the production of a large portion of the world’s consumer electronics.

Political Reform

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The Sun Yat-sen Memorial in Taipei

Chiang Kai-shek died in April 1975, just over a year before the death of his old foe, Mao Zedong. Chiang’s son, Chiang Ching-kuo, took over. The younger Chiang slowly instituted political reform, allowing more native Taiwanese to enter into the bureaucracy and tolerating limited dissent. One example of the latter was the Tangwai. While the KMT did not allow any opposition parties to develop before 1987, it did allow for candidates to run for office independently. Thus some independent activists and politicians founded the Tangwai. The Tangwai, whose name literally translates as “outside the party”, was a loose coalition of people whose main commonality was opposition to the KMT’s dictatorship. The KMT did occasionally persecute its members, namely in response to a 1979 protest held in the southern port city of Kaohsiung. Nevertheless, KMT leaders largely tolerated the organization.

The Democratic Progressive Party (DPP), the island’s first enduring opposition party, was founded in 1986, a year before such parties officially became legal. The DPP’s makeup was similar to that of the Tangwai in that members were united predominantly in their opposition to the KMT. In fact, the DPP was made up largely of former KMT members. However, within a few years of its founding, the party had established itself as a pro-Taiwanese independence party that promoted a Taiwanese cultural and national identity.

Chiang Ching-kuo died in 1988 and was replaced by his hand-picked successor Lee Teng-hui, the first native Taiwanese to become ROC president and KMT chairman. Lee continued with Chiang Ching-kuo’s reforms, working within the KMT and with activists to open up more government positions to competitive election. For example, the National Assembly and Legislative Yuan, the government’s two legislative bodies, had their first general elections in the early 1990s, and Taipei, the island’s capital, had its first competitive mayoral elections in 1994, which was won by the DPP candidate Chen Shui-bian.

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Taiwan’s current president is the KMT’s Ma Ying-jeou

Taiwan’s democratic reforms continued through the early 1990s and culminated with the island’s first ever direct presidential election, held in 1996. Interestingly, in a world where dictatorial parties tend to get punished in free elections, the KMT’s Lee Teng-hui won what was widely considered to be a fair election. China reacted angrily to the possibility of elections in Taiwan and engaged in military exercises in the Taiwan Strait in a naked attempt to intimidate politicians and voters on the island. The move backfired as it led to the US intervening by sending its aircraft carrier into the area as a warning to the Chinese. The move also appeared to harden both the determination to democratize as well as the opposition to any suggestion of ‘reunification’ with the mainland. Four years later, taking advantage of a split KMT ticket, DPP candidate Chen Shui-bian was elected and succeeded Lee, becoming the first non-KMT president of Taiwan and marking the first change in government brought about by democratic elections anywhere in the Chinese speaking world.

Despite grand hopes that the new ruling party brought with them into office, Chen’s eight years as president were largely disappointing. There were many causes of this disappointment. For example, Chen came to power during a global economic downturn. As Taiwan has an export-based economy, the slump in demand significantly harmed many Taiwanese livelihoods. Additionally, China refused to deal with Chen, declaring him to be a Taiwanese separatist with whom they could not deal. While economic ties between the two sides continued to strengthen, political ties significantly worsened. Another problem lay in people’s expectations of Chen himself. Chen, as president, actually had relatively little power to keep his campaign promises. The power his predecessors enjoyed were largely due to martial law and other temporary revisions the government put in place during the KMT’s dictatorship. As the country instituted democratic reform, many of these presidential powers were taken away and given back to the legislature, where the writers of the constitution originally allocated them. This left Chen mostly powerless to enact some of the reforms he promised. Lastly, many in Chen’s administration, and ultimately Chen himself, were accused of corruption. After Chen’s terms as president ended, he was indicted on charges of bribery and is now in prison serving a 19 year sentence, though he maintains that the trial was politically motivated.

The teahouses of Jiufen

The KMT took back the presidency in 2008 with the election of Ma Ying-jeou, showing the resilience of this once dictatorial party. Ma has moved to improve relations with the mainland, recognizing the futility of antagonizing Beijing and the enormous potential of cross-straits trade, though he has always stopped short of advocating imminent reunification. The KMT remains rhetorically committed to the goal of reunifying with the mainland, though insists that this cannot be under the rule of the CCP. Though this had previously been an unacceptable stance to Beijing it has become the lesser of two evils in contrast to the pro-independence stance taken by many in the DPP. Ma was re-elected in January 2012 with more than 51% of the vote on an impressive turnout of over 74%.

Relations with China

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Taiwan’s army is focused almost entirely on one possible aggressor

Despite having a mature and stable government, a thriving economy, and an active civil society, Taiwan’s status in the international community remains in limbo. The reason for this is the position of China. Beijing insistence that Taiwan is a part of China that must eventually come under Beijing’s rule, whether peacefully or by force, remains a stumbling block for Taiwan in many of its dealings with the international community. Though Taiwan has never made a formal declaration of independence, partly because of the KMT’s stance that Taiwan is part of one China but also because of the fear of serious reprisals from Beijing if it did so, Taiwan maintains its de facto independence. In other words, Taiwan is independent for all practical means and purposes. It maintains set geographical boundaries, a government to rule over lands within those boundaries and this government and its state are recognized by its population. The international realm is not so clear. Other states do recognize Taiwan’s passport but most do no conduct formal bilateral relations with the island, although many maintain links in an unofficial capacity. There are 23 states that maintain diplomatic relations with Taipei instead of Beijing, a reduction from 71 in 1969, the most significant among them being Guatemala, the Dominican Republic and the Vatican. A practice of the PRC and Taiwan competing for diplomatic recognition among states seems to have come to an end; according to a document released by Wikileaks, Panama made moves to switch its recognition to the Beijing but was asked to remain with Taipei in order not to cause diplomatic embarrassment at a time when cross-straits relations were improving. Taiwan is therefore not able to enjoy de jure independence, which means it is not independent according to law. This means that Taiwan cannot join many international organizations that require statehood for membership. These organizations include the UN and the Organization for Economic Co-operation and Development (OECD). Additionally, when joining in other international events and organizations, Taiwan must join under some alternate name, such as its official Olympic title of Chinese Taipei.

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The US continues to supply F16s to Taiwan, despite objections from China

The status of Taiwan cannot be ignored in any aspect of China’s international relations; it is impossible for any state in the international system to have diplomatic relations with Beijing without recognizing the PRC’s sovereignty over the island. This is especially pronounced in the relationship with the US, and in almost every high level political meeting it is incumbent on the representatives of the US to reiterate their support for the “one-China policy”. However, there is a nuance to this acceptance by the US in that it explicitly opposes any actions or statements that would “unilaterally alter Taiwan’s status”. This applies to both Taiwan and the PRC, meaning that Taiwan has an insurance policy in its relationship with the US that ought to deter China from making the first move in any conflict. The special relationship that exists between the US and Taiwan is at the root of this sensitivity, but it is more serious than a linguistic exercise in diplomacy. The US has, on several occasions, demonstrated its willingness to defend Taiwan should it be subject to an unprovoked attack from the PRC. This was evidenced in the 1996 deployment of warships to the Taiwan Strait in response to PRC missile testing in the region. Additionally, the US has continued to meet its legal obligation to provide Taiwan with defensive arms which provokes strongly worded protests from Beijing on each occasion. Since 1990, according to a US Congressional report, Taiwan has requested major purchases in every calendar year except for 2006 and 2009. One of the most recent purchases, agreed in January 2010, included 114 PAC-3 defense missiles and 60 Black Hawk helicopters in a deal worth almost $6.4 billion; one of the largest ever agreed. In September 2011, the US reached a decision to refurbish Taiwan’s fleet of F-16s, fitting them with AESA radars (a form of stealth technology) but stopping short of approving the sale of new planes, but going far enough to anger China. While there are now some calls among American academics to rethink this alliance, it is unlikely to alter in the near future. The involvement of the US seems to assure that the future will be one of an easy maintenance of the status quo. While far from a perfect a solution, this is probably the best option for all concerned.

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China Airlines, Taiwan’s national carrier, now flies direct to the mainland

The period of Chen Shui-bian’s presidency was certainly a low point in cross-straits relations, but the recovery since Ma’s election in 2008 has been impressive and encouraging. Political gestures have been important in this process, most notably the historic visit to the mainland by then-chairman of the KMT, Lien Chan, in 2008. Following Lien’s trip Beijing relaxed rules on Taiwan residents visiting the mainland and on mainlanders visiting Taiwan. The result was a dramatic increase in grassroots exchanges across the strait, with up to 3000 mainland tourists visiting the island every day. Direct flights were permanently established in the same year as Lien’s visit and have expanded consistently ever since, with a total of 558 weekly direct flights between the island and one of 41 cities on the mainland. Taiwanese investment in the mainland is thought to be greater than from any other territory, though the exact figures are obscured by a tendency for the investment to be channeled through tax havens such as the British Virgin Islands. More than one million Taiwan residents – around 5% of the population – now live on the mainland.

Future Trends

Taipei 101 was the tallest building in the world for a time

While maintaining such an unconventional status within the international arena does present some symbolic challenges for the Taiwanese, the situation across the Strait right now remains stable and even mutually-beneficial for both sides. By some measurements, Taiwan is the number one source of FDI into China, providing valuable capital and knowledge from Taiwan’s world-class IT industries. In turn, these economic ties have allowed Taiwanese companies to remain cost-effective even as the island has shifted away from a labor-intensive to a knowledge-intensive economy. These economic ties have also gone some way in tempering Beijing’s saber rattling towards the island. One example of this was seen in 1996 when local officials in Fujian province, an important destination for Taiwanese capital, encouraged Beijing to show restraint during missile tests in the Strait, lest they scare off investors from the island. While CCP leaders say that economic factors would not deter an attack on the island if warranted, the prospect of the flight of Taiwanese capital from China certainly raises the potential cost for any Chinese action.

Although most states in the world continue to pay lip service to China’s ‘one China’ policy, they also maintain informal relations with Taiwan in their day-to-day affairs, particularly in the economic sphere. The US, in particular the US Congress, is Taiwan’s most ardent and powerful supporter. The involvement of the US and the potential for a conflict between to the world’s two greatest powers means that the cost of China acting unilaterally with regard to Taiwan is high, though the complexities of the forces competing for influence in China over this issue mean that it cannot entirely be ruled out. Oddly, one of the most potent sources of political tension in the region – the dispute between China and Japan over the Diaoyu/Senkaku islands – has provided an opportunity for improved relations between China and Taiwan, since both share a rhetorical position on the matter. Nevertheless, the most likely future path for Taiwan and its relationship with the mainland is one of an uneasy maintenance of the status quo; it is in neither side’s interests to act unilaterally and the scope for common ground is too narrow to allow an agreement to be reached in the foreseeable future. Taiwan will not gain the independence that some of its people seek, but it is unlikely to be swallowed whole by China any time soon.

What’s Holding the Chinese Consumer Back?

Introduction

Both Western and Chinese commentators have documented the real increase in Chineseshutterstock_113568136 living standards and consumption levels. Since market opening in 1978, GDP growth averaged 10.2%. Per capita income has risen from $400 in 1978 to $5,414 in 2011, the most recent year for which data is available. Per capita income is to exceed $8000 by 2020. Chinese citizens now have access to a wider range and a higher quality of consumer goods and services than ever before, and many now enjoy a better quality of life than they did during the Maoist era. Yet these benefits are far from equally distributed. The increasing marketization of the Chinese economy has had the consequence that Chinese citizens can no longer be as reliant on the Communist Party for education, healthcare and pensions. For the 400 million or so Chinese citizens who still earn $2 or less per day, this has meant that, in many ways, their life is less secure today than it was during the Mao era.

Since 1978, shifting levels of fixed investment (buildings, plant, machinery and infrastructure such as roads, railways systems, ports, etc), net export (export minus imports), government expenditure (social services, infrastructure) and domestic consumption (purchases by households) have driven China’s economy. Since 2001, China’s fixed investment has increased significantly. In 2011, China’s fixed investment rose to 48% GDP, while household consumption hovered at 35%, and savings remained close to 50% GDP. These figures are out of line with international norms. Generally, a country’s consumption comprises two thirds or more of GDP, and investment one third or less.

China is now increasingly recognizing the need to rebalance the economy. China’s 12th Five Year Plan has made boosting domestic consumption a priority. Indefinite high fixed investment rates puts an economy at risk in many ways. Each additional capital expenditure has an increasing chance of being wasteful because of the law of diminishing returns. Unneeded excess industrial capacity can undermine corporate profitability. High fixed investment can also be inflationary and risks creating asset bubbles. It also causes trade frictions as it depresses domestic import consumption and encourages exports.

China’s 12th Five Year Plan lays out a variety of economic tools to generate higher consumer spending, including improving the social welfare system, boosting wages, and increasing consumer goods imports. Increased outlay on social welfare is especially important as without more spending on education, healthcare, pensions and affordable housing, Chinese consumers will continue to save to provide for their future.

What Drives China’s Economy?

Interesting research by Andong Zhu and David Kotz has shown that since the 1978 launch of market reform, shifting levels of domestic consumption, fixed investment and export growth have driven China’s economy. Zhu and Kotz break these shifts into four time periods: 1978-1988, 1988-1991, 1991-2001 and 2001-2007. Between 1978-1988, domestic and government consumption were the strongest drivers of China’s economy, with household consumption accounting for roughly 50% of China’s GDP. Income inequality climbed. China’s Gini coefficient – a number between 0 and 1 where 0 corresponds with perfect equality and 1 corresponds with perfect inequality – worsened from approximately 0.29 in 1978 to 0.38 in 1988 (though it actually improved slightly immediately after the reforms of 1978 were introduced) .

Between 1988-1991, in an effort to control 18% inflation and the social discontent that was beginning to accompany it, Beijing temporarily cut government fixed investment spending. Household income grew more slowly as well, resulting in lower private consumption. Instead, average 7.1% GDP growth during this period was driven by government consumption and by an export surge. Exports increased 50% between 1988-1991, spurred in large part by the 1990 devaluation of the RMB.

shutterstock_41537107In 1992, Deng Xiaoping’s now famous southern tour cemented as the way forward the country’s experimentation with market reform. As a result, between 1991-2001 GDP growth averaged 10.3% and household income grew almost at pace, although rural income lagged, while urban income surged rapidly ahead. Overall, between 1991-2001, total private and public consumption accounted for 61.4% GDP and generated almost 85% GDP growth. An initial 1992-1993 surge in fixed investment of 30% caused the GDP growth rate to spike to 14.2%, but also rekindled inflation. As a result, Beijing reduce government fixed investment spending to 8.2% in 1994 and 6.3% in 1995. Yet, by 2001, fixed investment was back up to 34.7% GDP. Net exports played a relatively small role in economic growth between 1991-2001. While total exports reached 20.7% of GDP by 2001, imports also rose rapidly.

The 2001-2009 period saw China transition into the high fixed investment and export model that characterizes its economy today. After China’s 2001 entry into the WTO, exports grew at an average annual rate of 20.9% a year while imports increased at an average annual rate of 17.8%; by 2007, net exports accounted for 10.9% GDP. Between 2004 and 2009, China’s fixed investment accounted for approximately 41.2% GDP, while net exports were 8.6% GDP, government expenditure 14.7% GDP and private expenditure 35.5% GDP. The 2009 savings rate rose to 49.7% GDP. In 2011, China’s fixed investment increased further to 48% GDP, while household consumption hovered at 35%, and savings remained close to 50% GDP. These figures are out of line with international norms. Generally, a country’s consumption comprises two thirds or more of GDP, and investment one third or less.

An important factor that led to the high fixed investment was the privatization of many state-owned enterprises (SOE) starting in 1996. This resulted in SOEs shedding of approximately 50 million jobs, and handing back to the government their “iron bowl” responsibility of providing social services such as housing, healthcare, education and pensions for their workers. As a result, SOE profitability rose rapidly. SOEs put their profits into fixed investment. Rapid economic growth was a key political and therefore managerial objective. Low borrowing costs and minimal dividend payments supported the high fixed investment rate. In 2010, SOEs still distributed just 5-15% of profits. The government also directed their spending toward huge infrastructure projects, and less so to provision of social services.

The large unemployment caused by SOE privatization corresponded with a simultaneous expansion of the Chinese workforce. During the 1980s, China’s working age population increased 2.5% annually; coupled with high rural-to-urban migration, this has meant that since 1980, China’s overall urban labor force grew 4% annually. Work force productivity rose by over 9% annually. Production that had needed 100 people in 1990 required less than 20 people in 2009. The millions of newly unemployed, the labor force growth and rural-to-urban migration all have worked to push wages down. At the same time, the cost to households of housing, healthcare, education and pensions increased. Rising costs coupled with lower wages and greater economic uncertainty caused the Chinese savings rate to rise rapidly as Chinese consumers began saving for retirement, housing and medical expenses. Additionally, total taxes on labor income rose by 2.5% GDP, partly due to higher income tax payments, but mostly reflecting mandatory contributions to new pay-as-you-go pension system managed by the government sector that is being phased in across the country. Household interest payments also rose to about 1% GDP, as increased home ownership has led to an associated rise in mortgage related debt. High savings rates also reflected credit constraints and a greater incentive to save for business opportunities. Savings rate have also remained high as most of it large pool of depositors have no other place to rest their money.

Yet return on savings has remained low. Interest payments paid to these household savers have remained capped by the government, and have often been eroded because of inflation rates above the rate of interest. Households have thus not earned much interest income to supplement wages. Moreover, government capital controls and the lack of other investment and savings vehicles has meant that depositors have had few choices other than deposits in which to store their hard-earned money until enough accumulates so that they can purchase an investment asset such as a house or a car. By capping interests rates paid to depositors the government in effect has been quelling household consumption in favor of producers, many of which are state owned and benefit from the large savings rate by being able to access cheap loans. As a consequence, Chinese banks enjoy enormous reserves of cheap deposits. Moreover, by keeping is currency devalued, imports remain expensive and exports stay cheap, thereby discouraging the consumption of foreign goods, and encouraging the production of exports for foreign customers.

Government savings also increased during this period. Government revenue consistently exceeded government noninvestment expenditure. High government saving reflected a policy favoring government financed investment over government consumption. In large part, freedom from democratic pressures has enabled the Beijing to take a long-run view about the nature of its expenditure as it expects to remain in power for many years.

Private enterprise savings has also been high since 2000. This high savings rate can be explained in part by the imperfect credit market. Chinese bank lending and the Chinese equities market continues to favour SOEs, forcing private enterprises to rely on retained profit for future investment.

As a result of all these factors, GDP growth averaged 10.9% between 2001-2007 while the growth rate of household income was just 8.7% and rural income was only 3.4% per year. The ratio of consumption to household income also fell at a 2.2% per year. Income inequality also increased. By 2006, China’s Gini coefficient rose to 0.46 and in 2011, it had reached 0.48.

Despite China’s high fixed investment rates, overall capital expenditure has remained profitable. This is due to several factors including the fact that China started at such a low fixed investment base, particularly in terms of infrastructure; China experienced a rapid growth in its human capital over the same period; and China keeps shifting its production into new markets which opens up new investing opportunities. Moreover, China’s overall capital stock is still small relative to its population, and medium-sized relative to its economy. That said, it is hard to sustain such high fixed investment rates indefinitely without waste and bad investments. This risk increases as China’s capital stock accumulates. The modern “ghost” city of Kangbashi, Inner Mongolia has oft been cited as an example of excessive investment where local officials designed a city and infrastructure for 1.5 million residents, yet less than 150,000 people have come to fill it.

The constraints on consumption and the prioritization of fixed investment and exports has resulted in a significant imbalance in the structure of China’s GDP. Research by John Knight and Wei Wang show that these figures made China an outlier compared to other economies. Indeed, China’s investment ratio far exceeds that of other industrialized countries, and even that of Japan – 32% GDP 1960-1985- and Korea 30% 1970-1995 during their rapid growth periods.

In 2011, China’s fixed investment rose further to 48% GDP, while household consumption hovered at 35%, and savings remained close to 50% GDP. Part of the reason that fixed investment as a percentage of GDP rose after 2009 was because of the RMB 4 trillion or $586 billion 2008-2009 Chinese Economic Stimulus Plan that China launched in response to the breaking 2008 financial crisis. The government directed the majority of this stimulus into fixed investment. RMB 1.5-trillion was dedicated to infrastructure construction including railway, road, irrigation networks, and airports. RMB 1 trillion went to reconstruction works in regions hit by the 8-magnitude Sichuan earthquake. RMB 370 million went for rural development including building public amenities, resettling nomads, supporting agriculture works, and providing safe drinking water. RMB 370 million also went to technology advancement programs mainly targeted at upgrading industrial sector technology. The Chinese government allocated some RMB 210 billion to improving energy saving, cutting gas emission, and building environmental engineering projects. RMB 150 billion was allocated for educational, cultural and family planning purposes. Other funds were invested funding for social welfare plans, including the construction of low-cost housing, rehabilitation of slums, and other social safety net projects.

Rebalancing China’s domestic consumption is a key theme of China’s 12th Five Year Plan. Yet a key difficulty to boosting domestic consumption is the fact that Chinese citizens now face higher education, healthcare and pension costs due to the dismantling of educational and social security systems that existed under the planned economy. Premier Wen Jiabao recently recognized this challenging by noting that the government must increase spending on healthcare and social services to free up more Chinese disposable income.

Social Security: Education

China’s current educational system is undoubtedly in a better position now than it was during the Maoist era. This is specifically true during the Maoist era’s final years when the Cultural Revolution convulsed China. Launched between 1966-1976 the Cultural Revolution was to strengthen socialism in China by reducing capitalist, traditional and cultural elements from Chinese society, and to impose Maoist orthodoxy within the party. To achieve this end, in June 1966, middle schools and universities throughout the country were shut as students devoted all their time to Red Guard activities. The government sent many educated youth to the countryside in order to engage in manual labor. When schools and universities reopened in the early 1970s, students often won places at university not by being the most academically able, but by having good political credentials, and by being recommended by their work unit. As a result, by the late 1970s, the quality of Chinese university education declined sharply. In 1975, Deng Xiaoping reportedly complained to Mao Zedong that university graduates were not even able to read a book in their area of study by the time their university education was completed.

After the government launched market reform in 1978, renewed emphasis was placed on scientific training, and the overall quality of Chinese education began to improve. Since that time, China has undergone a major expansion in the quality and availability of education throughout the country. The number of university and doctoral degree graduates has risen fivefold between 1995 and 2005. Chinese government spending on education has risen approximately 20% per year since 1999, now reaching $100 billion annually. The results from this investment have been outstanding. The best Chinese students now lead the world in math, science and reading. There were 33 million Chinese in higher education in 2010, up from 12 million in 2000. 82.5% of all Chinese children now complete secondary education, up from 21.9% in 1990, and more children than ever are having the opportunity to gain a formal education. On average, Chinese students spend 40 when more days a year being educated than their US counterparts, although western educational analysts criticize the rote learning system employed in Chinese schools.

Much as with all social services, the quality of Chinese education varies greatly throughout China. There is still a large discrepancy between urban and rural education and between education standards in the eastern and western provinces, in terms of quality and quantity of education, including progression to higher education. It is indeed the cities, as opposed to rural areas, that receive the highest percentage of government spending, as well as having the highest quality of education at all levels. The exact numbers are hard to come by, as spending is split at various levels down the bureaucratic chain, but it has been suggested that spending per primary school child in Beijing and Shanghai was 18 times that of the poorest Chinese provinces.

J MARGOLIS 33Yet, those Chinese citizens migrating to China’s prosperous cities in search of better opportunity are often not allowed to take advantage of superior urban teaching for their children. The Mao-era Hukuo residential permit system means that local governments refuse school access without official documentation. This is a subject of huge contention for the almost 250 million migrant workers (a figure that is projected to grow to 400 million by 2025) who must leave their children behind in their towns and villages. For those that do choose to bring their children with them, many are forced to send their children to sub-standard private schools, which have no state funding. Fees can run as high as $165 year, the equivalent to several weeks’ wages. In 2011, local authorities closed several schools for the children of migrant workers, as they did not meet official safety standards, leaving an estimated 14,000 children without access to schooling. Notwithstanding the social injustice that this may present, needing to save for education costs reduces domestic consumption. Many Chinese senior-level middle schoolers must also pay tuition, as after completing the compulsory nine years of education, students who wish to continue on to senior-level middle school, must pay a small tuition fee. University students are also required to pay a part of their education. There is growing pressure within China for reform to this hukou system, though no significant changes have been enacted.

The Chinese government is taking increasing initiatives to reduce the gap in educational standards throughout the country. In 2011, the Chinese government announced a 20% increase in rural education spending. Yet, improving rural education and education availability generally will take time. Until then, being born in an urban environment gives the average Chinese child a far better chance at a decent education. Until then, migrant workers bringing their children with them to the city, and parents of those students wishing to pursue higher education will need to save in order to finance future education costs.

Social Security: Healthcare

Like education, China’s healthcare, today faces many challenges. After 1949, CCP created the Ministry of Public health to take charge of all healthcare activities in China. The new system provided healthcare in both rural and urban areas through a three-tiered system. The first level of healthcare comprised China’s “barefoot doctors” that practiced in the village medical centers. These doctors focused on hygiene, preventative health care, family planning in the treatment of common illnesses. The barefoot doctors were primarily farmers who received minimal medical and paramedical training to serve rural areas that urban-trained doctors could not reach. The next tier of healthcare was the township health centers that were primarily outpatient clinics, each with a capacity of serving up to 30,000 people. Assistant doctors were the primary healthcare providers at these clinics. These two rural collective healthcare tiers comprised the majority of China’s Communist healthcare. The third tier, county hospitals, treated only the sickest rural patients, and was staffed by senior doctors trained at medical schools.

In urban areas, neighborhood health centers delivered the first tier of healthcare. These were staffed by personnel with minimal training and focused predominantly on hygiene and preventative medicine. These urban caregivers sent sicker patients to district and municipal hospitals. Often, however, connected employees could get medical care directly from district or municipal hospitals, bypassing neighborhood medical clinics.

Overall, Mao’s Communist China provided a good basic medical care for its rapidly expanding population. Average life expectancy increased from 36 years in 1949 to 68 years in 1980. While this increase in life expectancy was also due to improved nutrition and other factors, the focus on hygiene, preventative medicine, and the nationwide eradication of epidemics such as cholera, plague, typhoid, and scarlet fever certainly contributed significantly to China’s improved longevity during this period.

The de-collectivization of agriculture in the 1980s, and the privatization of SOEs in the 1990s, caused fundamental changes in the way that healthcare was delivered throughout China. While in urban areas, most Chinese citizens with residential permits still have relatively inexpensive access to medical coverage for themselves and their families. Additionally, they have often also taken out some form of medical insurance. Nevertheless, an estimated 36% of the urban population finds healthcare costs prohibitively expensive. Workers that lose their jobs also lose their medical insurance coverage. Migrants relocating into China’s growing cities have no medical care coverage as they lack a residential permit. The government has recently tried to respond to this challenge by creating the Urban Employee Basic Medical Insurance System (UEBMI) to include the non-state owned sector and self-employed workers. In 2008, UEBMIs covered an estimated 200 million people.

Those citizens in China’s rural regions face even greater healthcare challenges. By 1984, for instance, only 40-45% of the rural population was covered by an organized cooperative medical system, down from 80-90% in 1979. The number of barefoot doctors decreased. Authorities monitored village water and sanitation supplies less frequently, while a still rapidly expanding population created greater waste treatment challenges. Moreover, the cost of even the most basic medical treatment increased, forcing citizens to save more to pay for medical care, and often to forgo medical treatment.

Partly spurred by the SARS epidemic scare, in 2003, the Government established the New Rural Co-operative Medical Care System (NRCMCS). NRCMCS costs about $7 per person annually, half of which the government provides. As of September 2007, 80% or approximately 685 million rural Chinese citizens had signed up for the new initiative. Like China’s old health delivery system, the care is tiered. The plan covers the cost of small hospitals or local clinics to 70-80% and county hospitals to 60%. Yet specialist hospitals in modern system cities are only reimbursed 30%.

Despite these efforts to provide greater coverage for all its citizens, China’s healthcare system still faces enormous challenges. As doctors are paid low wages, and as hospitals are responsible for covering a significant portion of their operating costs through revenue-generating services, over prescription of drugs and x-rays and other tests is rife. China’s new rural and urban health care initiatives still only cover a part of the drug and testing prescriptions, meaning most patients still face high out-of-pocket costs – some estimate as high as 60% of their total medical care. Additionally, most doctors still have minimal basic training. This is particularly true in rural areas. A 2001 study of 46 counties and 781 village doctors in 9 Western provinces found that 70% of the village doctors had no more than a high school education, and had received an average of only 20 months of medical training before beginning to practice. China’s healthcare system is also struggling to balance the delivery of Western versus traditional Chinese medicine. As China’s population begins to age rapidly in coming decades, even more strain will be placed on a medical system already struggling to cope with the citizens it is currently treating. Finally, like all countries today, China will need to find the right balance between spreading scarce medical resources as widely as possible versus providing each of its patients with the most advanced medical care available.

Social Security: Pension

As it has with education and healthcare, the Chinese government has taken real steps towards combating the ticking time bomb of the Chinese pension system, which is poised to come under enormous strain as China’s population rapidly ages over the coming decades. Currently, China has an estimated 160 million citizens over the age of 60. By 2050 that figure is likely to increase to almost 400 million, which will represent more than a quarter of the population. Part of the reason that the country is ageing so rapidly is that China’s “One Child Policy” has meant that fewer young people have been born since the 1980s. In 1975, there were six Chinese children for every one elder. By 2035, there will be two Chinese elders for every one child.

Before market reform in 1978, urban workers at China’s state owned enterprises received generous pensions upon retirement. Yet, these workers always constituted a minority of the total Chinese population. In the 1990s, the privatization of state owned enterprises has meant that these companies no longer fund their employees’ pensions. The government tried to launch a basic pension system for urban workers to replace the state owned enterprise funded system, yet as of 2007, just 65% of the urban workforce earned any benefit from the basic pension system. Coverage is highly concentrated among workers at SOEs that account for dwindling share of total employment. Much of the fast-growing private sector workforce, including China’s rural migrants, remains uncovered. Indeed, if urban employers made social welfare contributions on behalf of their migrant workers, their payrolls could rise by an estimated 35-40%.

Additionally, the basic pension systems inherited from SOEs have large unfunded pension liabilities. This means those workers contributing to the plan must do so at high rates, often causing workers to try to avoid payment. In addition, a lack of portability of the pension plan has meant that workers often need to choose between job mobility and losing their retirement savings. While private pension systems are beginning to take shape in China, in 2007, only 9.3 million employees contributed to “enterprise annuities”, or just 1.2% of the total Chinese workforce.

As for the countryside, in 2006, formal retirement protection was still virtually non-existent  Indeed, all told, just 31% of China’s total workforce is estimated to be earning a public pension benefit of any kind. Part of China’s challenge is that its population is ageing at a much earlier stage of economic and social development compared to developed countries. This means that China will have to support its elderly with a fraction of the per capita income and wealth of developed nations. Despite high savings rates, the majority of Chinese workers are not accumulating sufficient financial assets to support themselves in retirement.

Traditionally, the young have cared for you old in China. In the coming decades, the great majority of workers will have to continue to rely on their children for financial support. Indeed, in 2006, an estimated 56% of elders lived with their grown children or other relatives. Even those who do not reside with their children often depend on their extended family for financial support. The importance of this safety net was reinforced when the government passed a 1996 law obligating children to care for their ageing parents. By 2050, the average pension burden supported by each Chinese worker is estimated to quadruple from today’s levels.

Yet, as more workers migrate to cities in search of opportunity, as China’s birth rates decline, and as China’s population begins to rapidly age, this traditional informal safety net is facing new strains. Indeed, while multigenerational families are still the norm, there are less common than they were a generation ago. Older workers will also need to remain in the workforce longer. While in the countryside, 76% of men aged 60-64 and 38% men aged 65 or older continue to work, in the cities, older labor force participation is much smaller. Only 34% of men aged 60-64 and 13% work past the age of 65. This low urban elder work participation rate is a result of the fact that SOEs downsized its obsolete workforce in part by offering them early retirement.

The government will continue to be under enormous pressure to introduce initiatives to provide minimal Social Security for the ageing population, so the majority of worker disposable income is not funnelled into carrying for ageing parents future worker disposable income is not spent solely on the care of grandparents.

Trends

China’s domestic consumption was expected to have grown 15% through 2012, a rate shutterstock_102510107double that of China’s projected GDP. Indeed, in a recent speech in 2012, Premier Wen Jiabao confirmed the government support of this trend by noting that boosting domestic consumption will be crucial to China’s future as it rebalances its economy. China’s 12th Five Year Plan reinforced the importance of domestic consumption. Future growth in consumption will be driven not only by rising per capita income, but also by continued government domestic consumption subsidies. Recent subsidies have included programs for rural households to buy electric appliances and automobiles. The government will also support more paid vacation, expand consumer credit, and increase agricultural subsidies. Specifically, the VAT on cars and a number of other items has been reduced, and vouchers for certain durable good purchases by the rural sector have been provided.

The government is also taking steps to moderate the high household savings ratio and support consumer growth over time. The government’s 2011 spending on education increased 14.6%, on social security and unemployment 14.2%, on medical and healthcare 13% and on public housing spending 9.6%.

China’s central government is also developing policies to stimulate the growth of small and medium-size enterprises. These policies include providing guarantees on their borrowing, reducing small and medium-size enterprise taxes reductions and offering subsidies. Small and medium enterprises are typically a large share of total employment in other countries. Their expansion, especially in the retail and wholesale sectors currently dominated by SOEs, could significantly boost both employment and household income over time. The government is also considering the increase in dividend distributions from SOEs so that they might help finance higher government social spending and reduce the level of retained earnings in these enterprises that can be plowed back into investment. It also plans to raise the minimum wage.

The government is also considering raising interest rates on savings accounts. Market level interest rates could increase Chinese consumption. Chinese households are generally saving toward a goal such as a down payment on a house or the cost of potential medical emergency. Increasing disposable income by creating investment income in the form of bank interest could allow households to meet their savings objectives more quickly, and thus could encourage increased discretionary spending.

Political Articles

Defining the 21st Century: the Sino-US Relationship

Introduction

The Sino-US relationship is, without question, the most important bilateral relationship in the international system today, and is likely to define the twenty-first century. At stake will be whether China and the US can become “strategic partners”, as Bill Clinton argued they ought to be, or whether they will remain the “strategic rivals” as they were characterized by George W. Bush. In other words, can the two develop a working relationship that serves the core interest of both parties as well as the stability of the international system, or are they destined to clash over key interests? The answer will depend on careful management by both sides of the many tensions that exist between the two powers. In truth, given the complexity of the Sino-US relationship, it is unsatisfactory to characterize the relationship in such simplistic partner-rival terms; a productive and stable relationship between the world’s two greatest powers will surely have to encompass elements of both partnership and competition. A constructive Sino-US relationship will be one in which the partnership element is at the fore.

The Cold War and Normalization

After the end of the Second World War, the international system in general, and US bilateral relations in particular, came to be defined by the dichotomy between Communist and non-Communist nations. The People’s Republic of China (PRC) fell firmly into the Communist camp, while the US was at the head of those opposing communism. US relations with China were further complicated by the existence of the Republic of China (ROC) on Taiwan, which was an ally of the US and still recognized as the legitimate government of the whole of China by most countries in the non-Communist bloc. Additionally, the ROC held China’s UN Security Council seat. The two sides actually fought an armed conflict in the Korean War, which resulted in the deaths of nearly two hundred thousand Chinese soldiers and over thirty thousand Americans.

The first steps towards Sino-US reconciliation came somewhat out-of-the-blue in the early 1970s, although, with hindsight, there was clear motivation for wanting rapprochement on both sides. The US was mired in the Vietnam War and still feared the “domino effect” of communism toppling state after state across the world. The US leadership felt that they needed a breakthrough to split the most powerful country within that bloc (the USSR) from other significant players. This coincided with a Sino-Soviet rift of the 1960s that had, by the end of the decade, become a serious threat to the PRC’s own perception of its national security, exemplified by a series of border skirmishes that occurred between the two former allies at that time.

In the autumn of 1969, there existed no official channel of exchange between the People’s Republic of China and the United States, so that when Nixon wanted to indicate to China his willingness to create conduits of communication between the two countries, he had to relay the message through the Pakistani and Romanian leaders who then communicated with China. Having received no reply from China, Nixon tried again in December 1969. The US ambassador to Poland approached his Chinese counterpart at a function in Warsaw. This time China responded, albeit in a circuitous manner through the two countries’ respective ambassadors to Pakistan, indicating that the two respective ambassadors to Poland might meet in Warsaw in January 1970. In this meeting, the US expressed willingness to send an envoy to China. In a second meeting China communicated that if the Americans wished to upgrade their diplomatic relations with China, they would need to recognize that Taiwan was a part of China and to withdraw all US forces from the Taiwan area. Nixon again pushed to establish a direct channel of communication with Beijing so that the two countries could more effectively discuss Taiwan and other issues. However, events in Southeast Asia complicated the process, with the US deeply entrenched in the war in Vietnam and China involved in a power struggle with the Soviet Union involving both Cambodia and Vietnam.

An acceleration in the Sino-US reconciliation came in March 1971 when the US and Chinese ping pong teams met in Japan, during which the Chinese invited the American team to visit China. The visit of the American ping pong team to China received prominent coverage in Chinese media. During the visit, the American team met with Premier Zhou Enlai at the Great Hall of the People, where he declared that the Americans’ visit had “opened a new chapter in the history of the relations between the Chinese and the American people.” This “ping pong diplomacy” paved the way for Henry Kissinger’s clandestine visit to China in July 1971, which laid the groundwork for Nixon himself to make his historic visit to Beijing in February 1972. The famous image of Nixon walking down the steps of the plane with his hand extended came about because Kissinger had caused great offence by refusing to shake hands with Zhou Enlai on his own visit. Nixon’s gesture was appreciated by the Chinese who considered it a restoration of ‘face’. During the visit, President Nixon agreed to withdraw US forces from Taiwan, and to publicly recognize that there was only “one China” as Taiwan was part of Chinese territory. Although it paved the way for a normalization of diplomatic relations between China and the US, thus driving a wedge between the two major Communist powers of the Soviet Union and China, the ‘one-China’ concession was viewed as highly controversial, with many in the US as it was considered an abandonment of a long-term ally. This controversy, along with the disruption caused by the deaths of both Mao and Zhou Enlai in China, meant that it took a further seven years before diplomatic relations were finally established between the US and the PRC, causing the US to cut official ties with Taipei in the process. In order that agreement could be reached within the US, the Taiwan Relations Act was passed. Under the terms of the Act, the US allows Taiwan to be treated as a normal state in its relations in everything but name and, even more significantly, it legally obliges the US to “provide Taiwan with arms of a defensive character”. These provisions were essential to the acceptance of the switch of diplomatic recognition from Taipei to Beijing, allowing the two countries to formalize their diplomatic relations. Yet these provisions also created the greatest source of current tension between the two countries.

Taiwan

The status of Taiwan cannot be ignored in any aspect of China’s international relations; it is impossible for any state in the international system to have diplomatic relations with Beijing without recognizing the PRC’s sovereignty over the island. This is especially pronounced in the relationship with the US, and in almost every high level political meeting it is incumbent on the representatives of the US to reiterate their support for the “one-China policy”. The special relationship that exists between the US and Taiwan is at the root of this sensitivity, but it is more serious than a linguistic exercise in diplomacy. The US has, on several occasions, demonstrated its willingness to defend Taiwan should it be subject to an unprovoked attack from the PRC. This was evidenced in the 1996 deployment of warships to the Taiwan Strait in response to PRC missile testing in the region. Additionally, the US has continued to meet its legal obligation to provide Taiwan with defensive arms which provokes strongly worded protests from Beijing on each occasion. Since 1990, according to a US Congressional report, Taiwan has made major purchases in every calendar year except for 2006 and 2009. The most recent purchase, agreed in January 2010, included 114 PAC-3 defense missiles and 60 Black Hawk helicopters in a deal worth almost $6.4 billion; one of the largest ever agreed. In 2011, the US reached a decision to refurbish Taiwan’s fleet of F-16s, stopping short of approving the sale of new planes, but going far enough to anger China. While there are now some calls among American academics to rethink this alliance, it is unlikely to alter in the near future.

Belgrade Embassy Bombing and Hainan Spy Plane Incident

At both the political and popular levels, the reputation of the US in China has suffered greatly in recent years for a number of reasons. The most notable incidents were the bombing of the Chinese embassy in Belgrade by US forces in 1999, and the collision of a US spy plane with a Chinese fighter jet close to Chinese territory two years later. The embassy bombing, which resulted in the deaths of three Chinese staff, occurred during the action against Slobodan Milosevic’s regime. It was blamed by the US on outdated maps that failed to identify the building as the Chinese embassy, despite the fact that it had been in that location for three years. This version of events has never been fully accepted by the Chinese. The reaction in China was one of anger and outrage. Popular protests in Chinese cities culminated with an attack on the US embassy by a mob of protesters who threw stones and other projectiles, and tried to set fire to the building with the US ambassador still inside. A similar reaction occurred in 2001 when a US spy plane was intercepted by Chinese jets and ultimately collided with one of them, killing its pilot and causing the US plane to make an emergency landing on Hainan. Its 24 crew were captured and held by the Chinese authorities, who refused to release them until an apology was issued by the US government, though the eventual apology was deliberately ambiguous and designed to allow both sides to claim a moral victory.

Economic Interdependence

Trade relations and the growing level of economic interdependence that exists between both countries cannot be ignored in any assessment of the bilateral relationship. The level of trade is a cause of concern for some in the US, both because of its exceptionally high trade deficit with China and because of the belief that this deficit is caused in large part by the PRC’s policy of maintaining a debased RMB. The high level of trade dependence, while viewed by some as a sign of US weakness, is in fact seen by many as a reason for optimism. Some scholars argue that high levels of economic interdependence lead to stable and peaceful relations between states due to the resulting greater levels of bilateral interaction and the increased costs to both sides of conflict. There are concerns in the US that Chinese ownership of US debt puts the US in a position of weakness vis-à-vis China; in theory, if China decided to sell its debt and its other holdings of US currency en mass, it could trigger a collapse in the value of the dollar and an economic crisis in the US. However, the result of such an action would be catastrophic for China as well given that any collapse in the value of the dollar would diminish the value of their huge reserves, as well as triggering a global economic downturn that would unquestionably affect China detrimentally. Indeed, recent Chinese criticism aimed at the US about its debt ceiling management indicates that China understands fully how much it has invested in the prudent management of the US economy and its currency. Thus, it seems well argued that the economic relationship is mostly beneficial to the overall condition of the political relationship between the two states.

Human Rights

On the agenda at every high-level meeting between almost any Western nation and China is the issue of human rights and political reform. In no Chinese international relationship is this more prominent than with the US. While many in the US consider this to be an important issue that their leaders have a moral responsibility to tackle with China, the issue of human rights is perceived by the CCP leadership as, at best, an irritation and, at worst, a hypocritical infringement of China’s sovereignty. The annual report issued by the US State Department on China’s human rights record is frequently critical of the lack of, among other issues, freedom of religious expression, the failure to liberalize politically, and the practice of detention without trial. In 1998, in direct response to this criticism, China began to publish its own annual report on the US record on human rights. In 2004, for example, this report highlighted the abuses of Iraqi prisoners of war at Abu Ghraib. While this report is not taken seriously in the US, it is designed to reveal what many on the Chinese side view as double-standards from the US over this issue.

Perhaps the most prominent ongoing issue of human rights in China that concerns the US government and many of its citizens alike is the issue of Tibet. Although the US explicitly recognizes Tibet to be sovereign Chinese territory, it frequently expresses concern over apparent human rights abuses in the region. The position of the Dalai Lama, dismissed in Beijing as a “splittist”, is a constant thorn in Sino-US relations. Every US president since George Bush Senior has met with the Dalai Lama – though, with the exception of George W. Bush’s presentation of the Congressional Gold Medal to the Tibetan leader in 2007, these meetings are never in public – and, on each occasion, Beijing reacts with venomous language. In 2010, a Chinese official issued a veiled threat over President Obama’s planned meeting, calling it both “irrational and harmful” and warning that China “will take necessary measures to help them realize this (US mistake)”. However, such rhetoric has yet to sway any president from a planned meeting with the Dalai Lama, though the US continues to give limited publicity to such meetings; just a single photo of Obama’s meeting was released.

China’s Military Development

A key concern in the US regarding China’s increasing power in the international system pertains to its military development. There is a widespread perception that China’s rapidly developing military capacity and its year-on-year double-digit increase in expenditure has positioned it as a military rival to the US. Such views, however, are not accurate. While it is true that China’s military expenditure has grown by significant amounts in recent decades, it is important to put this into some kind of perspective. According to figures from the Stockholm International Peace Research Institute (SIPRI), the most widely-respected research organization that reports on such matters and one that uses educated estimates to include military spending that is not declared in official statistics, China’s military expenditure as a proportion of GDP has actually fallen from 2.5% in 1990 to 2.2% in 2009. For comparison, the figures for the US show military expenditures were at 4.7% of GDP in 2009. More significantly, despite the sharp increase in absolute terms, and even using the higher estimate provided by SIPRI, China’s military budget remains less than one fifth of that of the US, whose own expenditure exceeds the combined total of the next 17 largest military budgets. Similarly, apparent advances in military technology, while unquestionably real, appear to have been exaggerated. The reports of the testing of a new Chinese Stealth fighter earlier this year were, in some quarters, treated as proof that US superiority is being eroded. Yet this seems premature; conservative estimates suggest that even if the testing was successful, and there is no evidence in the public domain that it was, then it will likely be at least seven years until the technology is battle-ready. Given the consistent levels of investment in military technology in the US, it is improbable that its own arsenal would stand still over this period and, in any case, it already has in excess of 130 stealth fighters that are ready for military deployment.

Future Trends

As with most bilateral interaction in the international system, there are causes for both optimism and pessimism in the Sino-US relationship. There are signs of both the rivalry

Political Articles

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and partnership that Presidents Bush and Clinton identified. The economic interdependence has two principle benefits that ought to aid relations. Firstly, the increased mutual reliance on each other’s economies raises the cost of any potential conflict for both parties, which ought to at least alleviate some tensions. Secondly, the higher amount of interaction at a societal level that results from the natural course of trade should foster a greater understanding between the two peoples, and go some way towards mitigating the mistrust that has developed over recent decades. As demonstrated above, the oft-cited military build-up is not as great a threat to the balance of power as is sometimes suggested. Additionally, the number of contacts between the two militaries is reason for cautious optimism.

Nevertheless, there are other issues that may come to the fore which, if not handled sensitively on both sides, may cause Sino-US relations to deteriorate. For instance, as China’s involvement in, and financial contribution to, major international organizations such as the World Bank and IMF has increased, it has also jockeyed for more influence within the organizations still dominated by the US and Europe; in 2008, Justin Yifu Lin, a Chinese citizen who was born in Taiwan but defected to the PRC, was appointed as Vice-President at the World bank. The US has been reluctant to weaken its positions of prominence and this has caused resentment in China. In some cases, this resentment has contributed to China’s decision to work outside of existing frameworks. For example, the Shanghai Cooperation Organization, in which China plays the leading role, has been termed as a potential competitor to NATO. China decided to work within the G77 instead of joining a G9 so that its interests would not be overwhelmed by the other Western-oriented members. China’s creation of rival international frameworks not only frustrates a US accustomed to global control, but it also creates concerns about China’s ultimate aims and intentions.

Similarly, as China’s economy expands, it will be a fiercer competitor with the US for natural resources and basic commodities around the globe. This affects the Sino-US relationship in three ways. Firstly, as natural resources are finite, there may become a time when there will not be enough resources to go around and China’s acquisition of resources may be at the expense of the US. Secondly, rising global demand, much of which has been driven by China’s booming economy, has sent global prices for commodities to record levels. In April 2011, the IMF raised its global inflation forecast from 3.7% to 4.5% due to these commodity price gains. Similarly, the IMF revised its 2011 US inflation forecast to 2.2% in 2011 up from 1% in 2010 due to higher food and energy prices. If inflation continues to increase, the US may feel pressured to raise interest rates to curb its rise, thus putting at risk the already weak Western recoveries. Finally, China’s eagerness to secure supplies of natural resources has led it to form alliances with countries which Western powers have tried to ostracize. Such Chinese alliances directly conflict with US policies in the region, and can inflame citizen passions on both sides. Mia Farrow, for instance, led protests against Beijing’s “genocide Olympics”, so-called because of China’s continued support of the Sudanese regime despite its actions in Darfur. The Chinese reject such claims out of hand, and viewed Western attempts to meddle with the Olympics as insulting and an attack on its national honor. China maintains that it does not interfere in internal affairs of other countries. This position stems from China’s own experiences of occupation and meddling in its affairs by Western powers during the late 1800s and early 1900s, as well as the brief, but unsuccessful, period in the early years of the PRC when Maoist policies were exported to other countries. It is certainly observable that the no-strings attached approach to infrastructure investment in Africa has had some significant benefits for China in terms of promoting itself there.

Yet despite these many issues of concern between the two countries, some form of which will undoubtedly remain between the two powers as the US adjusts to a more vocal and powerful China in the international arena, outright conflict between the two powers is highly unlikely. Instead, current and future issues between the two countries will continue to be resolved, or at least mitigated, through negotiation and diplomacy.

The wildcards in this prediction are Taiwan and the ongoing dispute over the Diaoyu/Senkaku islands with Japan. The special relationship that exists between the US and Taiwan, and the US’s own legal obligations to defend the island should it be attacked, render the possibility of military conflict between China and the US over Taiwan a possibility, however unlikely. Vigilance on both sides – and in Taiwan – is essential in order to avoid a conflict that would be to nobody’s benefit. Similarly, the US is committed to defending Japan, its closest ally in Asia, should it be attacked. The simmering tensions over the Diaoyu/Senkaku islands that boiled over in 2012 continue to cause concern for US policy-makers. The US will continue to push for diplomatic resolution on this issue but an outside chance of a low-level military conflict cannot be ruled out.

Economics

Sino-US Trade: Mutual Benefit, Mutual Problems

Introduction

TheChinaFile

The US has run a trade deficit with China since 1973. The deficit increased from $10 billion in 1990 to $266 billion in 2008. It dropped to $227 billion in 2009, and then grew to $295 billion in 2011 but dropped again in 2012 to $262 billion. The Sino-US trade deficit consistently accounts for more than 40% of the US’ overall deficit in its global trade.

Some in the US argue that this large deficit with China is caused by the competitive advantages China gains from practices such as keeping its currency artificially depreciated, having lax environmental and health and safety legislation, poorly protecting intellectual property rights, not comprehensively implementing WTO obligations, and widely employing industrial policies and discriminatory government procurement practices which work to subsidize and protect domestic Chinese firms at the expense of their foreign competitors. Critics argue that these practices have in turn caused the US to unfairly lose manufacturing and other jobs to China.

Others have argued that Chinese economic policies, which have enabled China’s GDP to grow 9% annually over the last two decades, have provided many advantages to the United States. For instance, China’s rapid economic growth has generated significant demand for US exports. For the last 10 years, China has been the US’ fastest growing export market. In the future, this market is expected to further expand as China’s domestic demand develops, as the living standards of its citizens improve, and as a sizable Chinese middle class emerges.

US consumers have also benefited from cheap Chinese imports, both because they increase US consumer purchasing power, and because they act to keep inflation low. US firms have profited from China’s competitive workforce, either by using China as a low-cost assembler of its manufacturing components or as a source of inexpensive components to be assembled in the United States. As importantly, by purchasing US treasury securities – nearly $1.2 trillion as of September 2012 – China helps keep US interest rates low, which in turn spurs domestic US economic activity.

Since the financial crisis of 2008, trade relations between the US and China have come under greater scrutiny by government and business leaders from both countries. Some members of the US Congress have recently ratcheted up their complaints about what they consider to be China’s distorted trade policies, given the US’s persistently slow US GDP growth and high unemployment. This trade friction is likely to intensify as the current sovereign debt crisis faced by Western countries places a new spotlight on US debt levels.

US Exports to China

The US exported $90 billion of merchandise to China in 2012, down from $104 billion in 2011 but still more than 30% higher than 2009 levels. US exports to China account for around 7% of total US exports, up from to 2.1% in 2000. The largest exports to China included oilseeds and grains, waste and scrap, semiconductors and electronic components, aircraft and parts, and resins and synthetic rubber and fibers. It is expected that US exports to China should continue to grow rapidly in the future. This export growth will be driven by factors such as the continuing modernization of Chinese infrastructure, by increasing domestic demand from its growing numbers of middle-class and affluent consumers, by the growth of its transportation industries, particularly its rising need for airplanes, trucks and cars, and by its increased imports of food products.

China’s Exports to the US

Yet, despite the success the US has made in increasing exports to China over the last decade, Chinese exports to the US still dwarf US sales to China. In 2012 China’s exports to the US were worth $351 billion, which was down from $399 billion from the previous year. The top 2010 Chinese exports to the US were apparel, manufactured goods such as toys and games, computers and communications equipment and parts, and audio and video equipment. The mix of Chinese exports to the US is shifting. Throughout the 1980s and 1990s, the majority of US imports from China were low-value, labor-intensive products such as textiles and toys. Increasingly, however, more of US imports from China are comprised of advanced technology products, reflecting China’s growing international competitiveness in the assembly and manufacture of high-technology.

Skewed Accounting of International Trade

TheChinaFile

One of the principal drivers of the US trade deficit with China is the worldwide increase in global production sharing, from which China has benefited enormously. Many products that used to be entirely made in such places as Japan, Taiwan and Hong Kong, are now being made or assembled in China as those countries have shifted all or parts of their production to China in order to take advantage of its low-cost labor. For instance, the US International Trade Commission estimated that in 2002, 99% of computer exports to the US from China were sold by foreign firms manufacturing in China. Taiwan, a world leader in information technology manufacturing, now produces over 90% of its information hardware equipment in China. Similarly, many US technology companies outsource their manufacturing to Taiwan, which in turn outsources this production to its facilities in China. Yet, these exports, even if they are commissioned by US firms, are credited against China when calculating the US trade deficit as China is the place from which the products were shipped to the US. To illustrate this, it is worth considering that while US imports of computer equipment from China rose 620.5% between 2000 and 2010, the total value of US imports of computers worldwide rose only 41.9%.

Similarly, China now has more than 40% of all international processing or assembling trade. The iPod, for example, is assembled in China by the Taiwanese firm Foxconn, from parts produced globally. A 2005 study by the University of California estimated that it costs approximately $144 to make each iPod unit, yet only about $4 of the total cost is generated by the Chinese workers who assemble it. Yet, when China ships the iPod to the US, it increases the Sino-US trade deficit by the full $144 cost of the unit, not by the $4 of value that China earned assembling the different components. In similar fashion, the iPhone trade has increased the US-Sino 2009 deficit by $1.9 billion. Yet, if the trade were measured through value added in China, the US trade deficit would have decreased by $48 million. Likewise, each unit of the iPad 2 increases the deficit by approximately $250. On the day of its release, the iPad 2 was estimated to have contributed $130 million to the Sino-US trade shortfall.

As shown with the Apple example, international trade data struggles to accurately account for component processing. In its trade numbers, China is credited with the full value of the finished exported goods, regardless of the origin of the component parts. For example, if Japan supplies the original components to China and then China does nothing but assembles the components and then ships the finished product to the US, Japan’s US trade balance is unaffected, but the US’s trade deficit with China increases by the full cost of the finished good. This distorts trade data, giving a skewed impression of the total value of the goods originating from China. As China’s trade has increasingly shifted away from the production of textiles and other primary products to the manufacture and assembly of technology goods, this skewing has increased.

The services trade is also equally difficult to quantify. Most trade data does not take account of the value added to a product by services, such as IT, financial, or management consultancy services. As the largest supplier of these services worldwide, the US generates income by effectively employing its advantage of human capital. The incomplete accounting of these services in world trade data means that the overall US deficit appears larger than it is in actuality.

An Undervalued RMB?

TheChinaFile

Another important driver of the trade imbalance between the US and China is Beijing’s pegging of the RMB to the dollar at what is deemed by many to be a substantially discounted rate. While many agree that the RMB is undervalued, few concur on the actual level of distortion with estimates ranging from 15% to as much as 50%. The depreciated currency increases the competitiveness of Chinese exports, leading many US companies to import from China over domestic or other international suppliers. China’s currency has not always been undervalued. In the early 1980s, for instance, it was greatly overvalued, with 1.5 RMB per USD, a rate set to allow China more easily import the goods it needed to develop its economy. There have been numerous revaluations of the RMB-dollar exchange rate since the 1980s. Between 1994 and 2005, the rate remained stable at around 8.3 RMB per USD. Though generally resistant to international pressure, particularly regarding key domestic interests, the CCP has since allowed the RMB to appreciate, albeit very gradually. The most significant appreciation occurred between 2005 and 2008 when the rate shifted from 8.27 RMB to 6.81 RMB per USD, an appreciation in value of the Chinese currency of almost 18%. However, it remained at or around that rate for another two years, before a further gradual appreciation was allowed to begin in 2010. By June 2012, it was valued at 6.36 RMB to the USD. China is able to maintain this low rate of exchange through vast purchases of US treasuries, which helps keep the dollar strong; as of November 2011, China held approximately $1.3 trillion dollars in reserves, equating to around 40% of its enormous foreign reserves.

This implicit subsidy to Chinese exporters has meant that US manufacturers have struggled to compete against Chinese products, causing US manufacturing industries to suffer and US unemployment to increase. Some estimates have put the number of additional US unemployed because of China’s devalued exchange rate at 2.4 million between the years of 2001 and 2008. Yet, what is often forgotten in debates on US unemployment figures is that the average US citizen has benefited from cheaper consumer products and, consequently, a greater disposable income. Recent estimates suggest that the average American household is $625 per year better off as a result of low-cost Chinese trade.

Beijing insists that its foreign exchange policy is vital to domestic economic security; the stability of its society and its monopoly on power is very much dependent on its ability to provide economic prosperity to its people. Additionally, an appreciation in the RMB also means that its US dollar holdings will buy less in its own currency. For example, an appreciation of the RMB by 41% would result in a value of $672 billion effectively being wiped off China’s US securities’ holdings in terms of what those holdings would be able to purchase if converted into its domestic currency.

Implications of China’s Large US Dollar Holdings

Some US analysts contend that China’s holdings of US debt give it a potentially powerful tool which it can use as leverage against the United States. Yet, China’s economic reliance on the US economy as an export market and its substantial holdings of US securities means that any effort to sell large volumes of dollars would likely hurt China as much as it would damage the US. A large sell-off of dollars would cause the currency to sharply depreciate against global currencies, diminishing the value of China’s remaining dollar holdings. Additionally, as long as China continues to pursue a depreciated currency policy, it has no choice but to purchase US dollars, thus making the likelihood of a large Chinese sell-off of the currency highly unlikely.

China has its own concerns about its large US dollar holdings. It fears that high levels of US debt, and the potential implementation of expansionary monetary policies by the US government could spark inflation in the United States which would result in a sharp depreciation of the dollar. To offset this risk, China has argued for the creation of an alternative reserve currency, such as through the International Monetary Fund’s special drawing rights system. Yet, most expect that the creation of an alternative reserve currency is not likely not to occur in the near future. In the absence of such a solution, China has sought to diversify its foreign currency reserves, notably through purchases of Japanese yen and Euros.

China and the World Trade Organization

TheChinaFile

China became a WTO member in December 2001. US policymakers supported China’s accession as they believed WTO membership would spur deeper market reforms, encourage the rule of law, diminish the government’s role within the Chinese economy, further assimilate China into the world economy, and enable the United States to use the WTO dispute resolution mechanism to resolve trade disputes between the two countries. In the first years after China’s accession to the WTO, it made great strides in opening its economy to both trade and FDI. Its ratio of imports to GDP – a common measure of how open an economy is – has now surpassed 30%, which is twice the level of the United States and three times that of Japan.

Yet, by 2008, government and business officials had begun to note that Chinese efforts to liberalize its markets appeared to have slowed. With the tougher global economic environment many argue that China relies more on state intervention in markets to gain China a competitive advantage. This has caused some friction between the two within the WTO. As of January 2013, the United States has brought 16 trade complaints against China whereas China has brought 8 cases against the US. Of these 24 disputes, 5 were raised in 2012 making it the most fractious year to date.

A key area of WTO complaints by the US has been the violation of intellectual property rights within China, and the US has brought two cases against China over this issue. The US International Trade Commission estimated that US firms with significant intellectual property interests lost $48.2 billion in sales, royalties and license fees in 2009 because of international property rights violations in China. The International Intellectual Property Alliance estimated that business software piracy in China alone cost US forms $3.4 billion in lost trade in 2009. However, these figures have been questioned by some economists who point out that the calculations are based on an assumption that genuine products would be purchased if all counterfeit goods were eliminated. Given that the price in China for a counterfeit DVD is usually around $1.50, compared with in excess of $12 for an authorized version, it is highly unlikely that an elimination of counterfeit products would have no impact on the overall sales figures of these products. It may not be possible to give a wholly accurate figure for the losses that the widespread IPR-infringements cause. US critics feel that, even when IPR enforcement is in place, fines and punishments for IPR infringements are often not sufficiently punitive to deter Chinese companies from piracy. Some estimates suggest that between 15% and 20% of all products made in China are counterfeit, equal to about 8% of China’s total annual domestic product. Under pressure from the US, in late 2010, China launched a six month campaign against IPR abuse and counterfeit goods.

Future Trends

Although it is understandable that Beijing is somewhat protectionist in its exchange rate policy, a revaluation of the RMB is essential if current imbalances are to be eased. China cannot continue to purchase US securities indefinitely – indeed it has already shown that would prefer to diversify away from its overwhelming reliance on the dollar – and the US cannot continue to get deeper and deeper into debt to foreign creditors. To resolve the situation, China needs to stimulate domestic consumption and allow its exchange rate to appreciate. A key to increasing Chinese domestic consumption will be shoring up its healthcare and pension systems that were largely dismantled when the Chinese privatized large sections of its state-owned industries. A stronger currency will decrease the international competitiveness of Chinese products, but will reduce pressure on the US, China’s largest trading partner. This will lead to greater global economic stability, which is ultimately in China’s interests. Thus while China’s manipulation of the RMB is expected to continue, in the long-run, a slow appreciation of the RMB would be expected as a more balanced trade environment is in the interests of both China and the US. In fact, between September 2010 and December 2012, China allowed the RMB to appreciate 7.4% against the dollar. Though China needs to take action on this issue, 2012 Presidential Candidate Mitt Romney’s vow to declare China a “currency manipulator” on his first day in office had he win the election, is not the sort of tactic that should be employed. Such a move would have made it politically more difficult for the Chinese to act in the way that the US would like them to do.

At the same time, in order to reduce its trade deficit, the US needs to stimulate domestic manufacturing and become more internationally competitive. Investment in infrastructure, education and the creation of a national industrial policy with taxes and other incentives to spur the development of strategic industries would enhance the ability of the US to continue to design and produce products that would be in demand internationally. The challenge for the US is that the increasingly divergent views of its two main political parties has made it progressively more difficult for it to take the necessary legislative steps to invest in economic competitiveness.

While both the US and China have benefited substantially through closer economic ties, the trade imbalance has increasingly become a political concern. To date, no concrete plan has been formulated to bring the deficit back into balance. However, some steps have been taken to increase economic cooperation between the two nations. The annual US-China Strategic and Economic Dialogue (S&ED), established in April 2009, is intended as a forum to discuss “long-term strategic challenges”. However, in the 2011 session there was no consensus as to the future of the trade imbalance between the two countries and it received mixed reviews from American business leaders and government officials.

The issue of the amount of US sovereign debt held by China is of huge political significance. On a positive note, China’s extension of credit has helped decrease US inflation and, hence, to maintain domestic economic stability. Yet US indebtedness to China is seen by many American thinkers to be a real risk; China and the US only formally resumed diplomatic relations in 1979, having been at ideological loggerheads since the founding of the PRC in 1949. Even today, the US and China disagree on many international issues. There are numerous domestic political ramifications of your largest creditor also being traditionally perceived as an ideological competitor. The amount of US debt held by China means that it would be incredibly difficult to offload all at once, and would trigger a huge devaluation in its remaining holdings. Such a situation is unlikely and would be particularly unwise, but shows the extent of the economic power China holds over the US. Yet China is increasingly using that economic power it holds over the US as leverage over contentious political issues, such as Taiwan and its human rights record. This trend should be expected to continue.

The reality is that the fates of the economies of China and the US are closely entwined, each reliant on the health of the other. China has been recording a substantial trade surplus with the US over the past 20 years and there has been a considerable decline in the US manufacturing sector. We have seen, however, that China’s trade surplus with the US is more a product of the system of trade-data collection than of a mercantilist strategy to undermine US manufacturers. The imbalance is, of course, a concern for both countries, but it is in neither country’s interests for the other’s economy to fail. The deficit must be addressed through mutual cooperation and dialogue in order for both countries to prosper and will, in turn, lead to a more balanced and secure global economy.