China Rising

As the most populous nation on earth, and the world’s second-largest economy, China is increasingly becoming both a concern and an opportunity for investors. (As an example of China’s influence on the global economy, a recent analysis by The Economist tied more than 10% of American multinational corporate revenue to China.)

A 4,000-year-old culture has begun to reassert itself on the world stage, and investors should arm themselves with a bit of knowledge of the powerful forces at play there. My goal is to lay a foundation for that understanding.

The concept of a “peaceful rise” is, perhaps, the triumph of hope over experience. During the last hundred years, the rise of great powers has been anything but peaceful: Historically, when a great power rises, there has been an elevated risk of territorial expansion, imperial aggression, and even the looming threat of world war. 

In the case of China, the goal of this peaceful rise is to avoid the fate that has seized other emergent powers, such as the Empire of Japan during the Second World War, and Germany during World War I and World War II.

China has already begun to develop its own blue-water navy, capable of operating in vast expanses of open ocean. The South China Sea, which borders China’s east coast to the south, is crowded with islands. Maintaining security in those shipping lanes is of paramount importance to the Chinese leadership.

More than half of global merchant tonnage, and four-fifths of the oil burned in China, pass through the South China Sea. Clearly, the defense of those shipping lanes is critical not just to China’s economic development, but also to Chinese national security.

An especially important strategic concern in the South China Sea is the security of the Strait of Malacca, a narrow, 500-mile passage between the Malay Peninsula and the island of Sumatra, which serves as the primary point of entry for cargo bound for East Asia.

Whenever I fly into Singapore, I always watch from the window. As the plane begins its descent, you get a bird's-eye view of the strait below, which looks like an endless ribbon of deep blue water, crowded with thousands of cargo ships.

Straights of Malacca from the air, January 2013 Strait of Malacca on January 21, 2013. (leogaggl/Flickr)

There are good reasons to be hopeful that China’s rise will be a peaceful one, avoiding the aggression and the terrible conflicts that have followed other rising powers. Of course, a “peaceful rise” must entail the absence of war, but what, beyond avoiding military catastrophe, would success in China look like? Let’s take a look at the long-term risks and opportunities in today’s China.

Roadmap for a Successful Rise

One way to think about the challenges of China’s emergence as a great power is to look at the best-case scenario for a rising China.

First, in geopolitics, a stable China must seek to limit its territorial ambition. The Chinese government must find ways to resolve their current regional-territorial disputes, including the long-simmering conflict with Japan over the disputed Senkaku Islands in the East China Sea. On the other side, the US pivot to Asia should not be designed and perceived as a way to contain China.

Second, on the economic front, China and its regional trading partners must improve trade and financial integration, and increase foreign direct investment among all parties. The US may need to allow China to join the trade-liberalizing Trans Pacific Partnership (TPP), as excluding China may signal that the US pivot to Asia is to counter the rise of China.

Third, China needs to successfully implement its transition from credit-fueled, resource-intensive, highly polluting, capital-intensive growth based on too many investments in real estate, infrastructure, and industrial capacity to labor-intensive, environmentally friendly growth based on consumption and the rise of services.

So far, the reforms needed to achieve this rebalancing have been postponed as President Xi is busy with consolidating his power, cracking down on corruption, and dealing with foreign policy and security issues. But the longer China kicks the can down the road and postpones reforms, the greater is the risk of a hard landing as bad assets, bad investments, and bad debts are mounting.

Ultimately, one would hope to see an easing of diplomatic tension, which would help to create a broader peace and prosperity in Asia. The APEC summit that took place while I was in Beijing in early November is an opportunity to start a dialogue on economic and geopolitical security in Asia.

I recently read an intriguing new book by reporter and analyst Robert Kaplan, which addresses the topic of China’s rise. In Asia’s Cauldron, Kaplan makes a compelling case for a kind of geographic determinism in Asia with respect to a rising China.

The backbone of Kaplan’s argument is that a rising China will seek to dominate the South China Sea in a manner similar to the way that the United States sought to dominate the Caribbean in the 19th and early 20th centuries. (In practice, Teddy Roosevelt’s policy of “Speak softly and carry a big stick” often meant fighting wars, changing the regimes of Caribbean governments, and militarily overseeing trade.)

But geography doesn’t need to be destiny, the way Kaplan mechanistically implies. The Pacific stance of the US, the existence of other important powers—such as Japan, other allies of the US, and India—that will resist Chinese expansionism may lead to a more cooperative outcome for the geopolitical balance of Asia.

I mentioned the Strait of Malacca earlier, and China’s build-up of a blue-water navy to ensure its access to shipping lanes there and elsewhere. As a matter of international law, the Chinese have no territorial rights to the strait. (The strait lies hundreds of miles to the south of mainland China, on the far side of Thailand, Cambodia, and Vietnam, between the island nations of Malaysia and Indonesia.) However, the waterway is clearly vital to China’s national interests and crucial to its economy.
 


 

In addition to those questions posed by the region’s geography, there is also the issue of China’s ideology. Or, perhaps more accurately stated, China’s absence of a Soviet-style grand ideology. The current Chinese leadership doesn’t seem interested in philosophical debate about economic philosophy: Their focus lies on pragmatic questions of competition for power and influence. While this may be something of a negative insight, it may prove to be a useful conceptual lens for investors to view China’s rising economic power.

The Role of the United States

In the short to medium term, the United States is almost certain to maintain its naval superiority in the Pacific region. (The US now has 10 aircraft carriers in its fleet. China has only one—and it’s an obsolete, secondhand vessel at that.)

Over the longer term, however, China will continue to make steady advances in ballistic missiles and other military technologies, potentially allowing its navy to one day pose a significant strategic challenge to the US in the Asia-Pacific region.

Diplomatically, the West has a delicate balancing act to maintain in its relations with China.

If Beijing perceives that China has become the target of a US containment policy, similar to the policy by which the West sought to isolate the Soviet Union during the Cold War, the Chinese would likely interpret this policy as an act of aggression. It is equally dangerous for the West to assume a posture of mechanical appeasement, deferring to too many of China’s economic and diplomatic demands.

The Chinese leadership, if it were to meet with such a permissive policy, might be inclined to stretch toward evermore territorial ambitions. So, the US and its allies in Asia need to find a right balance between cooperation and competition with China and avoid both containment and unconditional appeasement.

What’s in the Air?

Beijing is ringed by coal-fired power plants and heavy industry—unseen sources of the smog that choke China’s capital. Coal, quite literally, fuels China’s industrial growth—accounting for nearly 70% of its total energy production.

When you drive around the city of Beijing, you can see people on the street wearing surgical masks, or with scarves covering their nose and mouth to try to reduce the pollution they are forced to inhale. The situation is so severe that the Chinese government continually monitors the count of particles in the air. On some days, when the particle count is particularly high, cars are banned from the city.

When the number rises above 100, it’s considered dangerous. When I was in Beijing, the readings were at 300. However, my hosts assured me that things weren’t so bad—since the particulate count had recently risen as alarmingly high as 550. Paradoxically, the carbon emissions that have fueled China’s ascent may prove to be one of the biggest challenges to China’s peaceful rise.

Some Beijing residents have attempted to fight back against the pollution by installing air filtration systems in their homes and offices, but this option is only available to those with the financial means to do so. Similarly, the city’s priciest private schools have air filtration systems and covered gyms, allowing students to play without being exposed to the outside air, although most schools can’t afford such accommodations.

Chinese officials often talk about the need to stress quality over quantity when it comes to economic growth—but when you’re on the ground in China, you don’t see much of a shift in the country’s development strategy. Air, water, and land are all polluted, with serious risks to the safety of the food chain. Health costs from environmental damage could seriously strain the Chinese budget for decades to come. (Perhaps this isn’t surprising: It’s easier for an official from the Ministry of Commerce to make a speech than it is to reduce carbon emissions in a rapidly developing economy.)

In any case, the pollution is now so severe that it’s creating a political backlash by a rising middle class against the Chinese leadership, for obvious reasons.

The challenges of pollution within China are, of course, not limited to Beijing. The pollution in Shanghai is steadily getting worse. Expatriates working for multinational corporations are becoming increasingly less willing to live in these cities, even though their companies are offering progressively higher salaries to do so. Expats who remain are, understandably, sending their families back home.

The problems of pollution are no longer just a domestic issue for the Chinese. When I visited Korea, on my way to China, there were Korean officials who complained that air pollution from China was being carried into Seoul by the wind. Some studies now suggest that Chinese pollution is traveling as far as Hawaii and even California.

China is the world’s largest source of carbon emissions. If there is a silver lining to this toxic cloud, it may be that China’s pollution crisis has forced it to search for green alternatives to its coal addiction.

Several independent reports in the last few years, including studies done by the United Nations, Pew Research, and Bloomberg, have cited China’s investment in green energy as the largest in the world.

Chinese government officials have begun to tout green energy as part of their economic strategy. While the environmental results of China’s green-energy policy remain to be seen, Chinese investment in renewable energy is simply a fact, and one that investors should consider.

Recent studies show global investment in renewable energy production nearing a quarter of a trillion dollars annually. China seems poised to remain a world leader in that space—driven by political necessity, perhaps, more than deep environmental conviction.

My Final Thoughts

In addition to being the world’s second-largest overall economy, China is the largest economy in Asia. From the perspective of investors, the size and scope of the Chinese economy mean great potential for both risk and opportunity: the risk is more short term as China needs to rebalance its economy and avoid a hard landing; while the opportunity is medium and long term as China will—in a few years—become the largest economy in the world and the largest market. A rising China is, perhaps, the key center of gravity in developing Asia, which is now the fastest-growing region of the world.

Under such circumstances, it’s reasonable to assume that China will assert itself defensively—for example, to maintain the security of vital international shipping lanes in the region.

Without the ability to defend its trade routes, it would be possible for a regional rival to strangle China’s economic growth, which is a proposition that neither the Chinese leadership nor the broader population would be willing to accept. China will continue to project its power in the region in a way that is consistent with its national interest. And we will continue to watch their progress.

As I project forward to the future of Asia in 10 or 20 years, I envision a China that will continue to stretch its economic and international trading power. A China that will assert itself more broadly in the political sphere. A China that will exert increasing influence in its own geographic region. A China that will continue to project its geopolitical power, as it rises to address the challenges of a great world power in 21st-century Asia.

And, ultimately, a China that will open a door to long-term opportunities for astute investors.