In the run-up to Beijing’s leadership transition next fall, China’s leaders are indulging in self-congratulation, as well as some serious soul-searching. They are congratulating themselves — with good reason — for having kept their economy on a high growth path through the buffeting of the Great Recession, but they are increasingly nervous about the formula. At the National People’s Congress in March, Premier Wen Jiabao recited a long list of economic accomplishments but admitted that “we are keenly aware that we still have a serious problem in that our development is not yet well balanced, coordinated or sustainable.”
Wen’s caution is justified. The nine men on the Politburo have a lot on their plate. They alone make the big trade-off decisions between employment growth and price stability, between tolerating civil activity and suppressing it, and between a foreign policy of low-key “peaceful rise” and the assertion of Chinese territorial integrity with the ever more muscular People’s Liberation Army.
These are decisions with a narrow tolerance for error, for each year the Politburo and the Communist Party must deal with the unintended consequences of their past policy successes. Rapid growth induces both jarring income inequality and rising expectations. Each year brings a more connected, better educated, increasingly assertive population. And the momentum of Chinese nationalism, enabled by the Party propaganda machine and reflected by the PLA, makes China’s foreign policy increasingly brittle, with less room for compromise and diplomatic maneuver. Premier Wen could be right — Beijing’s formula may not be sustainable.
The potential impact of a China risk event — economic, political or military — is huge. “China tail risk is massive and not properly discounted,” says Laurence Zuriff, managing partner of Granite Capital International Group, a New York–based hedge fund. “Investors and policymakers alike have underestimated China’s economic potential and also the risks of betting on that growth.”
Institutional investors, hedge funds and especially global macro traders are becoming closer students of China country risk — both the upside and the downside. They are beginning to think systematically about plausible scenarios of China risk events and devising early-warning systems to make those events “tradable.” It’s not an easy task. “Even if the decision-making process in Beijing is becoming more open, if various bureaucratic and nongovernmental interests are now engaged and if top Chinese officials feel an increasing need to appeal for mass support, then the system may be even less predictable than it once seemed,” says Aaron Friedberg, professor at Princeton University’s Woodrow Wilson School of Public and International Affairs.
The first main China risk concerns economic growth. The outlook for real growth in 2011 and 2012 ranges between 7.5 and 10 percent, enviable by any standard. However, investment and exports account for three quarters of GDP — not unusual for a fast-growing emerging market but clearly not sustainable for the world’s second-biggest economy. Something has to give. If growth falls much below 7 or 8 percent, China can’t absorb new entrants to the job market, a harrowing prospect considering the estimated 100 million migrants from the countryside to the country’s urban and eastern manufacturing centers. Growth at the upper end of the range fuels inflation — currently running at a rate of 6.5 percent — which China’s leaders traditionally fear as a source of social instability.
The debate in China over this core economic trade-off is surprisingly open. The Politburo may deliberate in secret, but the National People’s Conference witnessed a vociferous debate, and both the economic ministries and the People’s Bank of China telegraph what they are going to do in speeches and press releases.
The second risk concerns domestic security. Here the range of outcomes extends from incremental tolerance and accommodation of civil society to increased surveillance and repression. China’s leaders are used to a background noise level of riots and civil unrest, but they monitor the trends extremely closely. In my only peek at the agenda of a Politburo meeting, some years back, the focus was overwhelmingly on domestic instability. Everything else — from macroeconomic conduct to foreign policy — took a backseat.
The leadership was stunned by the public outrage over the Wenzhou bullet train wreck in July and alarmed by the massive street demonstrations against pollution at a chemicals plant in Dalian in August; in both cases citizens were enabled and emboldened by China’s Weibo microblogging site. “The Chinese leadership has never been more confident about their ability to manage the outside world given what they perceive as their growing power and incipient U.S. decline, particularly in Asia,” says Bonnie Glaser, a China expert at the Center for Strategic and International Studies in Washington. “But they have also never been as nervous about their domestic stability. They are increasingly cowed by their own population.”
The third big risk revolves around China’s place in the world and involves a complex brew of nationalism, great-power ambitions and assertions of territorial sovereignty. The outcomes range from a smoothly orchestrated “peaceful rise,” as the Chinese call it, with an amicable handling of border disputes and the hot-button issue of Taiwan, to a more assertive and possibly bellicose foreign policy.
This risk is fairly easy to track as well: Just listen to what the Foreign Ministry, the PLA and China’s political leaders say publicly. They are very precise, if uncompromising, regarding their territorial claims in the South China Sea, and there is an exquisitely tuned set of phrases reserved solely for Taiwan. The Politburo may debate foreign policy choices in absolute secrecy, but its members are very skilled at diplomatic and military signaling.
Although it’s clear that Beijing has a master plan for the expansion of the PLA, I doubt there is a corresponding plan to use the PLA for aggressive territorial moves. Yes, China’s leaders have an awareness of their growing power, a deep sense of historical grievance and a persistent paranoia that the U.S. intends to contain China and subvert Communist Party rule. But Chinese security policymaking is more obsessed with internal threats than with external enemies, as well as riven by factional feuds and bureaucratic infighting. Inside the vermilion walls of the Zhongnanhai leadership compound in Beijing, the Politburo members are as conflicted as the leaders of any fractious liberal democracy. Moreover, the cautious engineers who sit on the Party’s standing committee know how high the economic costs of security clashes on China’s periphery could be. Xi Jinping, President Hu Jintao’s anointed successor, made his name as a provincial Party star by successfully attracting high levels of investment, especially during his tenure as governor of Fujian, which is tightly linked to the Taiwanese economy.
Unfortunately, three structural factors are at work that increase the odds of China’s blundering into a clash on its borders — most likely its maritime borders in the Western Pacific or somewhere around Taiwan — despite the innate caution of the Politburo. In the shadowboxing over leadership succession in Beijing, advocating concessions on China’s territorial claims or taking a soft line on Taiwan separatism would be a career-limiting move by ambitious Party members and military officers. The fifth-generation Politburo leaders in Beijing have no military credentials and sit uneasily atop a PLA they neither understand nor, in my view, fully control, although Xi has stronger PLA ties than his peers have. And judging from the tone of their blogs, most Chinese citizens are very nationalistic when it comes to these territorial disputes, especially the neuralgic question of Taiwan. China’s Internet lights up with strident rhetoric every time a border dispute takes place, and any signs of compromise by Beijing are harshly criticized by the netizens.
The most unpleasant scenario for investors is a cocktail of these three risks that combines slow growth (or what one could call stagflation with Chinese characteristics), serious domestic unrest and a border clash of some kind. In that cocktail there are three security risk events that could sap economic growth and fan civil unrest. It is a useful discipline to consider what plausible circumstances might entangle China in these security events, what their probability is, what signals might warn of such impeding events and how they would roil financial markets.
• A type-A event would be a collision of ships or planes along one of China’s disputed sea borders. On April Fools’ Day in 2001, a Chinese F8 jet smashed into a U.S. EP-3 spy plane. In September 2010 a Chinese fishing trawler rammed a Japanese coast guard vessel. The increasing radius of Chinese military maneuvers puts the PLA in ever-closer proximity to the ships and planes of China’s neighbors and to U.S. forces in the Pacific. Near misses and accidental collisions are increasingly likely. The world would probably see some video of such an event quickly.
• A type-B event would be a larger clash over one of China’s contested borders — either planned or the result of a type-A event escalating out of control. A type-B event would involve larger numbers of PLA troops or ships, though in relatively small formations. There would be some shooting and some casualties or prisoners. It would almost certainly be posted and heavily viewed on YouTube.
• A type-C event would involve threats and possible military actions to keep Taiwan from formally declaring independence from the Chinese motherland. These actions could range from missile salvos (the PLA has 2,000 aimed at Taiwan) to the nightmare of a Normandy-style amphibious assault.
What would we watch for early warning, what probability could we assign to these risk events, and what would be the likely impact on markets? How would these events feed back into China’s economic growth and domestic political environment?
There are three potential signals of an impending A, B or C event: anxious policy debate in Beijing, military mobilization and anomalous movements in financial and commodity markets.
Policy decision making in China is now genuinely more inclusive, at least inside the Politburo and related ministries in Beijing. Neither Hu nor Xi would be able to make a unilateral call to press Taiwan the way Mao Zedong browbeat the Politburo to take Chinese troops into Korea in October 1950. This increases the odds that evidence of a type-B or type-C debate would leak out. In the government you have intelligence sources, but anyone can draw on the rich trove of open-source reporting on Beijing palace politics — everything from news reports to blogs to the buzzing Hong Kong or Shanghai rumor mills.
Military movements in advance of a type-B and perhaps a type-C event could be concealed to some degree from both governments and public observers, but not of large units and not for long. China is so integrated in the world economy that the same Fujian province ports, highways and airports that would be used to stage an invasion of Taiwan are also being used to ship furniture to California and fly integrated circuits to Japan.
Any one of these security events could move financial markets, among other reasons because China is the world’s largest net creditor. China’s net international investment position (IIP) was $1.8 trillion at the end of 2010, with $4.1 trillion of assets and $2.3 trillion of liabilities. There are two striking aspects to China’s IIP.
• China’s claims on the outside world are much more liquid and short-dated than foreigners’ claims on China. Sixty percent of China’s IIP liabilities are composed of foreign direct investment while only 8 percent of China’s IIP assets consist of FDI abroad. Foreign direct investment is inherently immobile and wouldn’t react to a security crisis, at least not in the short run.
• The Chinese state controls most of the IIP: $2.9 trillion of the $4.1 trillion in assets (or 70 percent) is foreign exchange reserves held by the PBOC and the State Administration of Foreign Exchange. According to the U.S. Treasury, the Chinese government held $1.16 trillion of Treasury debt at the end of 2010, or a third of the total held by foreign governments.
Because of its IIP liquidity profile, Beijing would not have to worry about being squeezed by global financial markets in the event of a crisis. On the other hand, the leadership is responsible for safeguarding the assets of the IIP, which are widely viewed as “the people’s wealth.” China’s IIP thus serves as a strong anchor against foreign policy adventurism, but it could also force Beijing to adopt some defensive financial measures if the leadership found itself entangled in a security event. China has been slowly diversifying its assets away from the dollar by buying more instruments denominated in euros and some Asian currencies, as well as real assets and energy resources. If China was headed for a big type-B or type-C event, the prudent state bankers in Beijing would probably scramble to accelerate this diversification process. As a London-based macro trader mused to me, “If the Communist Party was going to put this much on the line over a disputed border, they would be foolish not to protect their balance sheet.” The sheer size of Beijing’s dollar exposure, which amounts to about 60 percent of foreign exchange reserves, suggests that the authorities couldn’t diverge too rapidly from their ongoing diversification glide path without setting off early-warning indicators in the fixed-income markets.
An unfolding risk event would also be likely to trigger some capital flight from the personal accounts of Chinese families to perceived safe locations like Singapore and Switzerland; this would probably light up the compliance screens of international financial institutions such as HSBC Holdings, Oversea-Chinese Banking Corp. and other banks favored by wealthy Chinese families, including some of the current 115 Chinese billionaires, all of whom have accounts overseas and can quickly transfer assets.
Similarly, the PLA and state-owned enterprises would try to stockpile oil and other commodities to have a buffer should a security event interfere with the shipping lanes. In the case of a type-C incident, the PLA and some selected SOEs, particularly the big petroleum companies, would need to stockpile several months’ worth of energy and food imports, as tensions with Taiwan could result in a partial shutdown of some key shipping lanes.
In sum, several asset markets might begin to behave unusually, at least from the perspective of those outside Beijing’s inner circles. As a result, private financial market participants may well be in a position to pick up early-warning indicators of a type-A, B or C event sooner than governments. “There are dozens of sophisticated quantitative and high frequency traders out there minutely combing markets, looking for asset prices and market movements that deviate from the mean,” says Thomas McGlade, a Greenwich, Connecticut–based portfolio manager at Prologue Capital. “They’ve got rooms full of Ph.D. programmers and powerful computers looking for any kind of pattern you want, including a China risk event.”
In addition to looking for early-warning signs, managing China tail risk requires some sense of the magnitude of market movements and the probability of such an event actually taking place.
Of the roughly 18 major military incidents in the South China Sea over the past two decades, all qualify as type-A events and four — including the 1996 gun battle between Chinese and Philippines naval ships at Capones Island — qualify as bona fide type-B events. As the scale of Chinese sea and air patrols grows, the odds of another type-A accident within the next decade verge on statistical certainty. As Beijing’s thirst for energy security increases, and with some fairly expansive estimates floating around Beijing of the oil and gas reserves under the disputed border areas in both the East and South China Seas, I’d put the odds of another type-B sea-border clash within the next decade at better than even.
Beijing appears to have convinced the Taiwanese that formal separation is a bad idea, not least because of the implied hit to Taiwanese pocketbooks. Unless things go very wrong indeed, I place the odds of Beijing threatening force against Taiwan in a type-C event over the next decade in very low single digits.
Still, that risk has some alarming upticks. In October 2012, Xi and Li Keqiang will almost certainly be anointed as the fifth-generation Politburo leaders at the 18th National Congress of the Communist Party of China. Beijing will take a relatively hard line on territorial and national reunification questions before and after that transition. The tone of this party line will be set in January when Taiwan’s president, Ma Ying-jeou, faces off against Tsai Ing-wen, whose political party is pressing for greater independence from China. If Madame Tsai adopts strident separatist rhetoric during the campaign or wins the election, the risk of a type-C clash will go way up.
How much market risk-off would these China events cause? Recent history gives us some clues.
A type-A event would be a mere blip in financial markets, with a negative effect probably no more than one standard deviation of daily volatility as soon as the event occurred. But it would take time to sort out what actually happened, and it would take time for both sides to escalate or de-escalate the incident, so the long-term effect on assets would depend upon how bad the situation got and for how long. As one global macro trader observes, “Markets may take a few anxious days trying to decide whether what they just saw was an A, B or C event.”
That could be a tricky call. There is a military truism that the first reports from combat are always wrong. This is why the U.S. Pacific Command (and groggy leaders in Washington) were careful not to leap to conclusions about the EP-3 incident in 2001. In contrast, history suggests that Beijing may leap to accusations of foreign perfidy, as it did in 2001. China’s propaganda apparatus attempted to seize the moral high ground from the get-go in the EP-3 incident, putting out the line that “your spy plane intruding into our waters collided with our jet and killed our brave pilot.” This was their story, and they stuck to it even as evidence emerged that their jet collided with the EP-3 over international waters. We did finally manage to install a crisis hotline between the Chinese National Defense Ministry and the Pentagon to deal with such events more easily the next time, after two years of haggling and a final top-level negotiation in 2007 during a visit to Beijing by my then-boss former Defense secretary Robert Gates.
In sum, the effects of a type-A security event on China’s growth would be minimal, but the feedback into domestic politics could be dicey. If history repeats itself, a hard-line official position will elicit a hard-line popular position that could in turn further reduce the room for official maneuver, even if the new crisis hotline is buzzing.
“The problem with trying to trade this China risk is that today’s financial markets quickly shrug off these A- and B-type events,” says Prologue’s McGlade. “The Arab Spring’s initial risk-off movement took place on Thursday and Friday and snapped back by Monday. If you had gone short late Friday, you’d have been killed over the weekend.”
By the same token, a type-B incident would cause a modest risk-off event across all globally traded assets, with a more focused but still limited hit to the pairwise country equity markets. As with type-A incidents, any really big effects would take place weeks or months after the event if the situation escalated and the diplomatic shoving got rough.
For example, if there is another South China Sea–type encounter, history suggests there would be an equity sell-off of modest proportions at the Shanghai Stock Exchange and a larger sell-off at the exchange of the other country involved — most likely Vietnam, the Philippines or Malaysia. There would be some negative spillover for all of the Association of Southeast Asian Nations markets as emerging-markets traders took out their maps and tried to figure out which claims lay where. According to a New York–based macro trader, “This summer everybody and his brother is long the ADXY [an index based on Asian currencies including the renminbi but excluding the yen]. A South China Sea crisis would hammer that index immediately.”
Because the U.S. would not be involved in most type-B incidents, short-dated Treasuries would kick up in a typical risk-off flight to quality. Unless this incident took place very close to the Malacca or Lombok tanker routes, demand by Northeast Asian consumers (China itself, plus Japan, South Korea and Taiwan) would continue unabated, so there wouldn’t be a significant long-term demand shock. But the inflammatory effect on China’s domestic debate would be far more dramatic than that of a type-A event. There would almost certainly be video images flickering around China’s social media and a chorus of nationalistic rhetoric even before the official propaganda machine kicked in. This would make the Politburo and the security apparatus extremely nervous, and for good reason. Governments from the Qin Dynasty onward have been challenged and sometimes toppled for “appeasing” foreigners.
A type-C conflict would be a major risk-off event. Equity markets in China, Hong Kong, Taiwan and the U.S. would all take big hits as soon as a Taiwan Strait crisis began to unfold. Nervous investors would almost certainly have had several weeks of rumor, soft warnings and official threats that something was in the works. Two thirds of the losses at the Taiwan Stock Exchange during the so-called third Taiwan Strait crisis of 1995–’96 took place in reaction to statements by China; only a third of the losses occurred in direct response to the PLA missile salvos.
Among the most vigilant observers of a looming type-C event would be the 500,000 or so Taiwanese living on the mainland — almost 5 percent of the total population of the island nation. They would closely follow the escalation of political rhetoric that would precede the use of military force, and they have their own close links with Chinese elites. They would likely vote with both their feet and their bank accounts in advance of a type-C crunch, possibly kicking off the usual cascade of risk asset sales (including equities) and gold or Swiss franc hedges.
Because China is the largest single holder of U.S. Treasury debt, the negative effects on U.S. fixed-income markets, particularly those for government and agency debt, could well be more significant than those on China. The net effect on Treasury prices is very hard to predict, but there would certainly be huge volatility across the whole yield curve.
A type-C event would disrupt air and sea transportation in the Western Pacific, initially for reasons of risk but over the longer term because of a perceived demand shock. Insurance rates would soar; commercial shippers and air carriers would divert from the area. Many commodities would plunge as the shock of reduced demand was priced into the market segments with large Chinese consumption, including oil, coal and most metals. As noted earlier, there would almost certainly be some Chinese stockpiles of these commodities before a type-C event; this would likely have driven ex-ante prices to high levels, exacerbating the postevent price plunge.
So the effects of trade disruption on economic growth would be dramatically negative given China’s high trade dependency. Far from being a trade-off between 7 percent and 10 percent growth, China’s GDP would almost certainly contract for some period of time. The impact on civil discourse would be equally dramatic and even more worrisome for the Politburo, which would likely be caught between an outpouring of popular nationalism against provocations by Taiwanese independence-seekers and criticism of Beijing’s leaders for having let the situation get so far out of control.
As scholar Jing Huang wrote in a book with the scary title If China Attacks Taiwan, “Even if China ‘won’ the war, a recession — not just at home but in the entire Asia-Pacific region — and the resultant hostile international environment would prove devastating for China. Ironically, the more successful Beijing’s war turns out to be, the more hostile its external environment will become.”
In the long run, I don’t believe that Aaron Friedberg’s projected rivalry between China and its neighbors, including the U.S., is inevitable or automatic. Unlike most of my former colleagues in the intelligence and defense world, I don’t view China primarily through a national security lens. I spent years working in and traveling through China, made a lot of money there in business and have always found it a congenial place. I have many friends in Chinese business, academic and government circles, including some in the PLA and even a spy or two. I have long argued that the rest of the world’s reaction to China’s growing power will be conditional rather than automatically negative. It depends primarily on how Beijing’s fifth-generation leaders decide to use China’s growing power in the international system.
They could well make some strikingly positive choices, decisions that would reduce or even eliminate the risk of type-A, type-B and type-C events, thus flattening China tail risk and making it even more attractive for foreign investors. For example, Beijing could adopt rules for PLA naval and aeronautical patrols to reduce the risk of an accidental type-A collision, and it could practice crisis management procedures and the use of that handy Pentagon hotline. To forestall type-B clashes, Beijing, Hanoi and Manila could reach a three-way deal for resource exploitation in parts of the South China Sea by invoking United Nations procedures and with the mediation of a neutral third party, thereby reducing the risk of a type-B event. Or Xi Jinping and his colleagues in Beijing could decide in 2013 to take the initiative and negotiate a political deal with Taiwan (probably with Ma, probably not with Tsai) that involved military de-escalation such as dismantling some of those 2,000 ballistic missiles, confidence-building measures and some political guarantees that would pave the way for a Hong Kong–type administrative agreement. All of these positive events would have substantial risk-on effects in financial markets.
As Granite’s Zuriff wisely observes, most investors’ China tail risk is already high and will automatically expand over the coming decade as China’s weight in global markets continues to grow. That’s all the more reason to think the risk scenarios through and get it right. • •
James Shinn (email@example.com) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He currently serves on the advisory boards of Oxford Analytica and CQS, a London-based hedge fund.