China Risks and Implications for the Global Community

*Opinions expressed or implied herein are solely those of the author(s)/speaker(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).

Risk is all around us, and political risk, which is the focus of our firm at the Eurasia Group, is among the many risks that all societies face in a complex and uncertain world. We at Eurasia Group were very honored and challenged to be given an assignment to do a comprehensive overview of risk in China over the 10-year period from this year, 2006, through 2016. We decided to take a "bottom up" approach rather than a "top down" approach in trying to identify and analyze risk. We began with an analysis of the trends that we believe have been shaping China over the last 25 years, and projected those trends forward another 10 years. We then identified the risks we felt that those trends suggested, and because risk is something that can be mitigated, we tried to come up with some recommendations to China, the international community, and the international business community of ways to reduce to the probability or mitigate the consequences of those risks.

We put together a task force, which in turn convened a series of six day-long conferences on some of the key aspects of Chinese society. We identified a large number of trends, 22 in all, that we felt have shaped China over the last 25 years and will continue to shape China. Rather than discuss each of these 22 trends, let me identify a few broader generalizations that tie many of the trends together.

First of all, it is clear that China is a society in very rapid transition along many different dimensions. What is important is to realize that many of the risks in China center around the fact that this transition, as rapid and comprehensive as it has been, is in many ways incomplete. While China is greatly expanding the role of the private sector, there are still continuing biases in state policy towards the public sector, and some of the most important contradictions are those between a society that is becoming increasingly free and more open and an economy that is increasingly market-oriented, and a political system that remains relatively closed; still essentially an authoritarian system.

Another summary trend is that China's development strategy, although it has produced impressive rates of growth over the last quarter century, has been highly imbalanced in favor of raw economic growth, which has been valued over social welfare, equity, and environmental sustainability. Thus we see serious problems of environmental pollution in China, and the significant erosion of the social safety net, with China moving from one of the world's most egalitarian societies to an increasingly unequal society, as measured by the Gini Index of economic inequality.

At the same time, within that pro-growth strategy there have also been imbalances. The composition of growth has featured extensive reliance on investment, fueled by an extraordinarily high savings rate, and also by net exports. It has not been fueled significantly by domestic consumption, and the relatively imbalanced composition of growth is another area where the sustainability of China's development strategy has been called into question.

These are changes that have already occurred, but there are also some interesting changes in China that are either just beginning now, or else will start to take place in about 10 years. In our judgment, China is at the beginning of a major change in its pattern of foreign economic relations as significant as the fundamental change that began with the reform and opening policy of the late 1970s and early 1980s. At that point, the change was from a closed economy to one that avidly welcomed foreign direct investment as a way of gaining access to the technology, capital, management and markets that could help China achieve export-led growth. That policy will continue, but added to it is a new, parallel policy: a significant increase in China's outbound foreign investment in three areas. The first is the attempt to gain access to raw materials, especially energy; the second is growing Chinese investment in services and manufacturing in the third world; and the third is Chinese direct investment and merger and acquisition activities in advanced economies. This new foreign economic policy is introducing significant new challenges and risks.

A further transition that is going to take place, which is absolutely predictable unless there is an enormous public health catastrophe, is the demographic transition that China will face beginning around 2015. This transition is going to have two parts. The first is that there will be a rapid increase in the proportion of the Chinese population that is elderly. The other is that new entrants into the Chinese labor force will level off and begin to shrink. The bottom line is that China will at some point experience an absolute decline in its labor force as well as an aging of its population. It is very important, as Chinese leaders themselves know, that they anticipate and plan for this now, as the aging of the population is going to have fundamental consequences for the social safety net.

The last transition is that what Chinese would call their country's "comprehensive national power" is rapidly rising. Not only is China's domestic economy growing, but its resources are also growing on the international stage. In fact, I argue that China gives sign of becoming a new multi-dimensional major power, a power that is military, economic, diplomatic, and cultural. (Indeed, many analysts are talking about the rise of Chinese soft power, as well as its military and economic power.) China has the potential in this 10-year period of playing an increasing role in all these dimensions of international affairs, but at the same time is not yet fully accustomed to the challenges and responsibilities that come along with major power status.

From these trends, we then identified more than 20 risks in five categories: humanitarian risks threatening the physical well-being of individuals both inside and outside China; economic risks threatening the prosperity of the Chinese economy or the world economy; commercial risks threatening the profitability of foreign firms; political risks threatening the stability of the Chinese political system; and international risks threatening the balance of power or the stability of the international order.

In assessing risks it is very important to look at both probability and impact. It is important to assess how likely it is that something occurs, but equally important to try to estimate how significant the impact would be if it did occur. So the first order of analysis was to assess the risks we had identified in terms of both their probability and their impact. We then tried to conclude as to whether they were rising or falling in severity over time.

One conclusion stands out immediately, and that is that some of the risks that are commonly discussed in the press we regard as relatively unlikely, and some of the risks that do not get that much attention we think are the more serious risks.

Let us begin with the risks that, perhaps to our surprise, we found to be the most worrying: an environmental crisis and an epidemic of communicable disease. These are the most worrying in part because of the high probability that they will occur, and because they would have fundamentally serious consequences not only for China but for other parts of the world as well. Obviously our greatest concern would be some kind of an acute crisis, which could have consequences, especially in the case of disease, of global significance. But in addition to acute risks, there are also risks of a more chronic character. There are contagious diseases in China that are not acute, the most obvious of which is HIV/AIDS, which could have long-term economic and social consequences. The same is true of chronic environmental problems, such as air pollution and the generation of greenhouse gasses. Thus, humanitarian risks are at the top of our agenda.

With regard to the second cluster of risks, one of the surprises was that we put the risk of a major financial crisis down quite low. The risk of financial failure is gradually declining as the result of the attempt by the Chinese government to recapitalize banks and to bring in better management practices. The Chinese government also now has the resources to deal with the failure of a major bank if such a problem should occur. Instead, in the economic department we are much more concerned about the normal business cycle, with the possibility of more dramatic swings in the performance of the Chinese economy. The Chinese economy is vulnerable to imported inflation, largely as a result of the increased prices to which its own economic growth is contributing, and to the inflationary pressures of its global trade surplus. At the same time, China's economy is also susceptible to recession, even a hard landing, equally important because China is a highly-integrated economy vulnerable to a global economic downturn.

Of course China poses risks to the rest of the world and to herself, but as we did our study, we realized that threats from China have to be understood alongside threats to China. One of the biggest threats to China is what would happen if there were a significant slowdown in the international economy. Here the good news is that the risk of one danger, inflation, mitigates the risk of another, and the Chinese government increasingly has the fiscal and monetary tools to manage the economy. We believe that there is a high probability of a perturbation in the rate of Chinese economic growth over 10 years, but the severity of those cycles depends on specific circumstances.

Turning to the category of political risk, it is true that China faces chronic problems of corruption, the difficulty of implementing unpopular policies, and increasing signs of divisions of interest and orientation within the bureaucracy. Although the probability of an acute crisis of the collapse of the political system is relatively low, the worst case scenario would be an explosion of dissent if China begins to face serious humanitarian, economic or social problems, or if the leadership divides. Although the Chinese political system has become much more institutionalized over the 30 years since the death of Mao Zedong, we believe that management of the next succession, which has to be completed by 2012, is an area of concern.

In terms of international risks, as in the case of political dissent, we think that chronic tensions in China's relations with its neighbors and trading partners will simply be a fact of life. It would be unusual if countries at different levels of development, with different political and economic systems, did not have tensions. However, these tensions are not likely, we think, to explode into crisis, in large part because all of the major powers are increasingly constrained by their mutual economic interdependence.

The way that I put it is that the world is no longer multi-polar; it is multi-nodal. In other words, the various centers of powers are hubs, and it is very costly to break off the linkages between one hub or node and another. This will be a significant constraint on letting tensions between major nodes in the economy get out of hand. If there is a danger, it is the actions of smaller, third parties, which are outside the ability of major powers to control and might lead unintentionally to crisis. If the unlikely does occur and there is a major crisis, the consequences could be severe, and could even lead to a polarization of the international community between pro- and anti-China blocs. There is a "risk with a long tail," a low-probability of a risk that has a dangerous set of consequences, but in general we think these issues of crisis and polarization are relatively unlikely to occur.

The higher-probability risk is a gradual shift in the regional and global balance of power in China's favor as it rises as a multidimensional power. The key variable in determining the impact of this development is the dynamism and stability of the rest of the region, and the key to managing it is to maintain a stable and orderly Asia-Pacific region in which a rising power can be relatively smoothly absorbed.

The final set of risks we have identified is those affecting foreign firms and multinational corporations. As China grows, it will consume larger quantities of raw materials, even if there are improvements in the efficiency of energy use. How far prices will rise is another question. All we can say at this point is that China will contribute to an upward pressure on commodity prices and energy prices.

The other big risk is China's participation in a process of what we call value destruction, meaning that foreign firms are going to face more and more pressure on their profit margins over the coming 10 years. This value destruction will be the result of a variety of factors. First, overinvestment has created excess capacity, which drives margins down. Second, we anticipate an increase in the cost of labor, land and utilities. And third, Chinese actors are capturing foreign intellectual property, legally or illegally. All of this is part of a broader problem, a deliberate strategy by the Chinese government and Chinese firms to capture more of the value chain from their foreign competitors, driving down returns to their competitors from such areas as research and development, design, branding, and distribution. This is a major reason why Chinese are investing abroad.

Many of the other risks that I have mentioned could disrupt the supply and distribution chains of firms operating inside China. We could see a deterioration of the business climate at the margin as a result of rising economic nationalism. It is not surprising that we see signs of a backlash in China against globalization. Many countries that have been at the forefront of the first wave of globalization are now beginning to retreat or push back again. We see attempts to promote national champions and to restrict the market share of foreigners operating in China through such things as the anti-monopoly law to restrict foreign involvement in strategic sectors like banking. At the margin, another risk will be a deterioration of these aspects of the business climate.

Finally, one of the most intriguing set of risks is what I call "reputational risk." These are the risks to foreign forms of operating in China from stakeholders both in China and in their home countries. To illustrate, Japanese firms suffered some problems in the spring of last year when the anti-Japanese protests broke out, simply because they were Japanese. These are examples of the reputational risks that can arise because a foreign firm is operating inside China.

In summary then, the most severe domestic risks in our analysis are not political turmoil and not financial collapse. Instead, the most severe domestic risks are environmental problems and a public health pandemic. The most severe international risks, in our judgment, are not the military threat from China; instead, they are the more serious international risks of the growing competitiveness of Chinese firms, the impact of China's growth on international commodity prices, and the possibility of a gradual shift of the balance of power in China's favor as it rises in international power.

Let me turn next to assessment of the temporal dynamic. In general, we believe that the severity of the risks will increase over the next 10 years. The most difficult period for China since it launched its reform program lies ahead, and if it can get through this period, then the future becomes less risky. Why would we come to this assessment? In many cases it is because the underlying threats and vulnerabilities are becoming worse. The Chinese government has announced programs to try to deal with these problems, but they are going to be difficult to design; the problems are intractable, and many remedial measures are limited by remaining ideological constraints. They will be costly to undertake, and thus will be politically difficult to implement.

China has risks, but the world is full of risks, so what if anything is unique about China? Many of these risks are common to other developing economies and emerging markets. In fact, you could argue that because of the accumulation of resources by the Chinese government and the development of a more efficient economic management mechanism, the risks in China may be less than in other developing countries. However, while in some ways the risks associated with China are common to many other developing countries, in other ways China may be relatively unique.

First of all, we know that what creates risks and instability is dynamism; the very speed of China's growth generates a unique level of risk. Secondly, the nature of the transition from an extreme Leninist economy and political system to a much more market-oriented and integrated economy is also relatively unique for a country of China's level of development and size, and I think that is exacerbating risk. Third, no matter how you calculate risk in China, the world is far more exposed to it than for virtually any other country, because of the degree to which we are economically interdependent.

As for our recommendations, we begin by acknowledging that the Chinese government has identified virtually every one of the problems that we have identified, and we admire the way the new leadership has grasped the essence of the risks. But while applauding that fact, we make a few additional suggestions to China. First, identifying problems is easier than designing and implementing solutions. We believe it will require a greater growth of NGOs at the grassroots to implement policy. Second, although China has made great strides away from ideology towards pragmatism, there are ideological barriers to certain reforms, and China has to grasp the problem of dealing with transitional issues such as the reform of the banking system.

With regard to foreign governments and international organizations, our recommendations boil down to two points. First, China needs not financial assistance, but a sharing of experience and advice. Second, foreign governments will want to hedge against risks, including in the security area, but it is extremely important not to trigger the so-called security dilemma, in which what other countries see as defensive moves to counter the risks of a rising China are seen in Beijing as offensive moves that threaten China's security. Strategic hedging is going to have to be done with absolute transparency, and with constant reassurances that we welcome China's emergence as a responsible power.

With regard to foreign firms, a few recommendations stand out. China's attempt to promote national champions and move up the value chain is going to put competitive pressure on individual firms and whole societies. Staying ahead, keeping up, and redefining comparative advantage will be key for both firms and governments. Also, firms are going to have to pay more attention in their operations in China as to how to manage some of these risks. Just as governments hedge, companies will diversify.

Risk is omnipresent in life, and the risks are moderate relative to the reward. The rewards of doing business in China and developing relationships in China are enormous. We should be as objective as we can about the risks, try to develop strategies to mitigate them, and at the same time take advantage of the enormous opportunities that the growth of China presents to the international economy and individual firms.

Q: What are the political consequences of the upcoming shortage of tens of millions of women for China's political stability?

A: For a variety of reasons, there is what can be described as either a shortage of women or a surplus of males in China, which will be an increasing problem as that cohort becomes of marriageable age. There have been some rather alarmist forecasts, , which we ultimately rejected, that there will be a large number of young men who will be absorbed in the military and be a source of aggressive impulses on the part of the Chinese army. We did conclude, however, that there is a more reasonable probability that there will be an uptick in crime, much of it in human trafficking and sex commerce outside of China. Another possible area of impact is terrorism affecting China as its ethnic minority problems become more serious, Islamic radicalism spreads, and increasingly China is seen as a rich, secular, non-Islamic country on the same side as the U.S. and Japan.

Q: Do you see the possibility of a leadership crisis leading to a fundamental change of direction arising from internal debate? Or is the only thing that will lead to a leadership crisis something equally dramatic?

A: I am going to interpret your question as "causes and consequences of a leadership crisis." One cause could be a sharp division in leadership over how to deal with some other problem. While we can analyze these risks separately, one of the most worrying things about risk is how it cumulates. I think that the major consequences would be first, an inability to deal effectively and quickly with problems and issues as they emerge. The next is that when leadership is clearly divided, the chance of unrest at the grassroots also increases, because there is a greater sense of space. However, let me underscore the growing quality of the leadership in China. It has more and more policy tools to use and greater experience in using them, but it is a leadership that already seems to be dividing over how to handle problems. Therefore, despite the improvement in quality, we still put leadership crisis in a fairly prominent place in our chart.

Q: In September Japan will have a new prime minister. If you were the advisor, what advice would you give concerning Japan's policy toward China?

A: Obviously you have to start with Yasukuni Shrine. We have to understand that this has become the litmus test in China for the perceived orientation of the Japanese prime minister. My first recommendation would be that some other way be found for honoring the memory of those who sacrificed their lives in all innocence for their country. At the same time, it is important for China to understand that whatever interpretations are reached at the official level, in a pluralistic society there will always be other opinions. There are also issues such as dealing with some way of either postponing or dealing with disputed energy claims and territorial claims by joint development, rather than by unilateral action by either side.

Relationships improve not just when contentious issues are dealt with and removed from the agenda. They improve more fundamentally when common interests are identified and progress is made in addressing them. This is going to take a significant change of thinking on the Chinese side. They will have to realize that they are the winners in the international system, and that gives them much more in common with the U.S. and Japan than their continued self-identification as a Third World country orientation would lead them to believe. The sooner the Chinese understand that, I think the easier it will be to handle both China-Japan and China-U.S. relations.

Q: Is there any particular period or year when those risks will synchronize to be one big disastrous risk? For instance, in 2008, we have presidential elections in Taiwan and the U.S., as well as the Olympics in Beijing.

A: I think actually not. I think you could make an argument that 2008 is going to be relatively calm year, because the Olympics is going to be an opportunity for China to show off its best, and I think it will be very responsible that year. At this point one can only guess whether the American presidential election is going to focus on China; I suspect it will not that much. The 2008 Taiwan presidential election is hard to predict. Projecting the trends forward, the Taiwan election will lead to the election of a candidate with an interest in stabilizing cross-strait relations. Of all the years to pick, 2008 would not be the one that I would worry about.

Q: Regarding Taiwan in particular, can you tell us what the thinking is about the risks?

A: This was one of the most difficult decisions we had to make: Taiwan is not on our chart. There is however a Taiwan sub-risk in two categories: a "crisis triggered by others" and a "crisis triggered by China." The difference is whether Taiwan declares independence or whether Beijing seeks to secure its unification with the mainland by force. We put these as some of the lowest probability but highest severity risks, posing the threat of war between two nuclear powers, China and the U.S. In this time period China is unlikely to initiate a crisis over Taiwan. There would be too much to lose, too little to gain. The bigger near-term risk would be a declaration of independence by Taiwan. However, as the balance of power shifts in China's favor, the chance that others will defy China declines and the chance that China will trigger a crisis by its own assertion of its interests increases. I would conclude, however, that the risk of a war in Taiwan, as opposed to an increase in tensions, is very low.

Q: Can you touch upon the U.S. administration's China policy after the resignation of Robert Zoellick as U.S. Deputy Secretary of State? Might this resignation affect policy?

A: Deputy Secretary Zoellick did play a major role in developing the concept of the responsible stakeholder as the foundation of American policy, but I do not believe that his resignation will make that much difference in overall policy formulation. What worries me more is who will take over day-to-day management of U.S.-China relations at the highest level of the U.S. government, and how much attention it will get there.