ECONOMICS AND SECURITY 078 ESCTER 05 E rev 1 Original: English NAT O   Pa rl i a me n t a ry  As s e mb l y SUB-COMMITTEE ON TRANSATLANTIC ECONOMIC RELATIONS VISIT TO LONDON, UNITED KINGDOM SECRETARIAT REPORT 9 & 10 MARCH 2005 International Secretariat 19 April 2005 * This  Secretariat  Report  is  presented  for  information  only  and  does  not  necessarily represent the official view of the Assembly. Assembly documents are available on its website, http://www.nato-pa.int

078 ESCTER 05 E rev 1 i TABLE OF CONTENTS I. THE CHINESE LEADERSHIP................................................................................................. 1 II. THE ECONOMY ..................................................................................................................... 2 III. NATIONAL SECURITY AND DIPLOMACY............................................................................ 5 IV. ENVIRONMENT AND ENERGY............................................................................................ 6 V. MEETING WITH TIJDAN THIAM OF THE COMMISSION FOR AFRICA................................ 7

078 ESCTER 05 E rev 1 1 1. On 9^th and 10^th March, members of the Sub-Committee on Transatlantic Economic Relations   visited   London   to   discuss   China's   Economic   Emergence   and   to   gather information   for   a   sub-committee   report   on   the   implications   of   China’s   Economic Emergence for Europe and the United States. 2. Sub-Committee  members  met  with  senior  British  government  officials,  members  of the  Treasury  Select Committee who are also producing a report on China, UK business representatives  and  university  professors.    This  short  report  will  highlight  several  of  the key themes discussed over the course of the visit.  These ideas are developed more fully in the Draft Committee Report can be found at http://natopa.ibicenter.net/default.asp?SHORTCUT=674 I. THE CHINESE LEADERSHIP 3. The  new  leadership  of  China  was  strongly  marked  by  the  Cultural  Revolution  and places a strong priority on stability. Most of the top leaders have had scientific training and unlike the previous leadership generation, they have not had a great deal of international experience.  Their  scientific  background  informs  their  tendency to apply scientific models and rational approaches to government policy making. They are not ideological. They are also  somewhat  more  socially  oriented  than  the  previous  leaders  who  were  very  market oriented. Last year, for example, the government announced the first increase in poverty in 30 years.  This was a conscious decision to focus attention on social justice matters, a set  of issues that was not a priority in the early year of the economic boom. This social orientation also informed a recent decision to raise domestic agricultural prices.   4. Unlike Indonesia or many African states, corruption is not a problem among the top cadres of the Chinese state. Yet corruption is a central national problem at lower and at provincial  levels  of  government,  and  has  begun  to  seriously  impinge  upon  the  country’s capacity  to  deal  with  a  range  of  challenges  including  environment  and  disease  control. The SARs outbreak, for example, was hidden by low-level officials who saw no upside to reporting the pandemic. 5. All  this  suggests  that  the  Chinese  state  is  neither  as  strong  nor  as  compact  as  is often assumed. It remains highly opaque and the lack of alteration among the ruling elites makes the system highly susceptible to corruption.  The top leadership remains terrified of social chaos, or economic upheaval that might trigger a challenge to one party rule. For this reason the Communist Party will brook no real opposition.  Civil liberties are thus very seriously  curtailed  whenever  movements  appear  to  be  evolving  toward  some  form  of opposition.  That  said,  the  area  of  human  liberty  in  China  has  expanded  significantly. British  officials  do  not  believe  that  the  Communist  Party  hegemony  is  sustainable  given the rapid changes it is undergoing socially and economically. 6. The  new  generation  of  Chinese  leaders,  while  dedicated  to  continued  economic development, is also paying greater attention to social fairness and development. These were  issues  that  the  previous  generation  had  essentially  put  on  the  back  burner  for  the sake  of  economic  expansion.  Still,  continued  Communist  Party  supremacy  remains  the core aspiration of the authorities that see in economic development the primary means for

078 ESCTER 05 E rev 1 2 achieving this.  There is no longer a place for Communist ideology in contemporary China. If anything, consumerism has become the new creed. II. THE ECONOMY 7. Chinese leaders are very aware that they preside over a developing country fraught with  transitional  problems  including  a  swiftly  widening  wealth  gap  despite  a  massive reduction in poverty stemming from China’s stunning economic growth. 8. The   government   is   currently   very   worried   about   overheating,   and   has   taken administrative   measures   to   slow   the   economy   down.   Several   sectors— cement,  steel,  automobiles  and  property— government  is  struggling  to  rein  these  trends  in  with  limited  success.  China’s  sheer expanse is part of the problem, and cooperation between central and provincial authorities is  not  as  close  as  is  often  thought.    Officials in the provinces, to take one example, are hardly eager to sign on to policies designed to slow down growth and property speculation. Provincial  governments,  in  fact,  are  part  of  the  problem  and  have  been  borrowing  huge amounts of capital from state banks to engage in speculative investments. 9. China has opened its economy up to an extraordinary degree.  It has taken its WTO commitments  very  seriously  although  implementation  has  been  uneven.  International investors  have  generally  been  very  pleased  with  the  government’s  approach,  although there remain areas of dispute.  Some trade barriers have been raised despite the overall movement to lower impediments to trade. The financial services sector remains one area of concern, with foreign banks confronting barriers to expansion.  Under WTO rules, this market will have to be opened up within two years.  There are also some problems in the automobile   and   construction   sectors.   Compliance   with   intellectual   property   rules represents   yet   another   ongoing   challenge.   Although   the   Central   government   has introduced   strong   intellectual   property   protection   legislation,   implementation   is   very uneven across the country.   According to one speaker, the EU itself has launched some 80 anti-dumping cases against China, but this does not reflect how far China has come in opening its market to imports. The rapidity of change is in large measure due to the fact that when the Chinese leadership is united in a decision, they are positioned to move very fast  to  implement  it  at  least  formally.  Democracies  can  sometimes  take  longer  as  has been  evident  in  India  where  even  small  decisions  are  liable  to  long  drawn  out  debate. According to the speaker, this hardly suggests that centralized technocratic governance is superior  to  the  give  and  take  of  democratic  politics,  particularly  because  the  Chinese Communist Party also has the power to implement poor policies in an efficient manner. 10.    China  is  not  only  an  importer  of  capital.  It  is  increasingly  investing  capital  abroad, most notably in raw materials. The rational has certainly a great deal to do with strategic concerns  about  secure  access  to  vital  production  inputs.  The  problem  is  that  Chinese investors  are  paying  very  high  prices  for  these  assets  at  a  moment  when  raw  material prices are extremely high. A fall in global prices could make these investments look like very bad deals, and so they are one source of uncertainty in China’s economic landscape. Some  Chinese  investments  are  generating  tension  with  the  West.    China’s  energy investments in Africa, for example, have put some Western energy firms in a dilemma, as they  are  increasingly  competing  against  Chinese  firms  willing  to  pay  top  dollar  for

078 ESCTER 05 E rev 1 3 exploration rights. These firms also have business interests in China and find themselves in  an  uncomfortable  position  as  a  result.    Chinese  oil  deals  with  Iran  and  Sudan  have generated  some  anger  in  the  US,  and  some  have  argued  that  China’s  views  in  the  UN Security Council are increasingly conditioned by this asset purchase strategy.    11.    Enforcement of court judgments in China remains quite difficult.  There is no doubt that  business  is  still  dependant  on  political  consultations.    The  Chinese  economy  also confronts several long-term risks.  The growing gap between rich and poor is generating mounting  social  tension  in  China  and  the  lack  of  democratic  politics  gives  the  state  few means   to   vent   this   pressure.   (Editors   note   -   The   apparently   officially   sanctioned anti-Japanese  protests  of  recent  weeks  might  be  understood  as  an  effort  to  vent  this pressure). This problem partly explains the governments renewed focus on social matters. 12.    Geographical divisions in China are also apparent; Eastern China is in the midst of a rapid  economic  expansion  while  the  West  is  more  impoverished  although  parts  of  the West  are  now  undergoing  an  initial  stage  of  economic  development.  Large  areas  of the country,  however,  remain  thoroughly  undeveloped  and  there  are  regions  of  the  country where hunger and lack of water remain a serious concern. 13.    Unemployment is also a problem. Authorities have closed or privatised an enormous number of state owned enterprises and many Chinese have lost their jobs as a result. The hope is that rapid private sector expansion will take up slack in the labour market, but it must expand at a very fast clip to do so.  Some estimate that there are 150-200 million Chinese  who  are  effectively  surplus  labour— underemployed and easily persuaded to move to the country’s urban centres to find work. There are no accurate figures on the level of unemployment, but it is clear that millions of Chinese are effectively underemployed. 14.    China has made huge strides in its education system over the last twenty years.  The government  has  reformed  the  university  system  and  its  top  universities  are  globally competitive  in  science  and  mathematics.    Education  is  recognized  as vital to moving up the  production  scale  and  securing  greater  future  prosperity.  The  sheer  size  of  the educational system is stunning. There are more students of the English language in China than there are British subjects living in the United Kingdom. The government has recently invested  significant  resources  into  the  university  system  with  the  expectation  that  highly trained  technocrats  are  needed  to  keep  China  growing.  The  soft  sciences  continue  to suffer under the burden of political restrictions 15.    The banking sector is also very vulnerable because of a pattern of high risk lending. Chinese  banks  hold  considerable  non-performing  loans  on  their  books  including  many loans  to  failing  state  owned  concerns.    Some  have  estimated that non-performing loans are the equivalent of 30-40% of GDP. An economic downturn could well trigger a serious financial  crisis  because  of  this  debt  overhang.  Chinese  regulators  are  well  aware  of  the problem  and  are  looking  to  western  experts  to  provide  expertise  and  support  for  bank reform. Privatisation is one solution, although the largest banks are likely to remain in state hands, at least until some of these loans are written off.  Foreign Banks are not interested in purchasing large banks burdened with bad debt; they are focusing more on the smaller and  healthier  institutions  that  are  being  put  on  the  market.    China’s  banking  sector  also lacks  adequate  capital  and  expertise.  Accounting  standards  in  the  corporate  sector

078 ESCTER 05 E rev 1 4 generally remain inadequate as do economic statistics and both make the task of bankers all the more difficult. This adds a further degree of economic risk. Raising the presence of foreign banks in China would help on both fronts. 16.    China’s  monetary  authorities  continue  to  tie  the  Reminbi  to  the  dollar  and  have derived some commercial benefits from the dollar’s recent decline. They are not prepared to  move  with  haste  to  a  free-floating  currency.  The  Chinese  also  lack  the  transparent institutions  needed  to  manage  open  capital  market  fully.  The  People’s  Bank  of  China holds some US$ 400 billion of foreign exchange reserves.  A revaluation would result in a massive write down of these assets. This would lead to a capital adequacy crisis across China’s  banking  sector.    Moreover,  an  additional  US$  190  billion  is  held  by  enterprises and households in deposit accounts at Chinese commercial banks.  A sudden revaluation could thus precipitate a genuine financial crisis in China with important potential spill over effects.   17.    China has very rapidly emerged as a global economic power. It recently overtook the United Kingdom to become the world’s fourth largest exporter, and since 2003 has been the third largest importer.  It now accounts for 25% of the world’s steel imports and 8% of the world’s energy imports. This could rise to 25% by 2020. In both 2003 and 2004 China was the world’s leading destination for Foreign Direct Investment (FDI).   18.    It  is  thus  not  surprising  that  China’s  trade  surplus  of    $25  billion  is  only  3%  of  its overall trade. China’s very large trade surplus with the US, however, is posing diplomatic problems.  That  surplus  can  be  attributed  in  part  to  relocation  of  US  manufacturing  to Chinese cities as well as America’s overall macro-economic posture.  The domestic value added content of Chinese exports to the US is very low at 20% while the corresponding value  added  content  of  US  exports  to  China  is  very  high.    According  to  one  economist, who spoke to the Sub-Committee, if one looked at the trade balance in these terms then the US would enjoy close to a ten billion dollar surplus with China.  This also suggests that an appreciation of the Renmimbi would not be very likely to have an strong effect on the general trade balance between the US and China. Accordingly a ten percent appreciation would  only  have  a  2%  impact  on  reducing  exports  to  the  US.  This  same  problem  has cropped up before in disputes between the United State and Japan over the value of the Yen.    Yen  appreciation  has  never  significantly  reduced  the  Japanese  surplus  with  the United States.  The core reason in both cases is the saving- investment imbalance in US.   China  has  effectively  been  lending  capital  to  the  United States  and  allowed  it  to  keep interest  rates  lower  than  it  otherwise  would  have,  given  its  serious  budget  problems.    It should also be noted that China has large trade deficits with Taiwan, Korea and several other Asian states. It is importing both sophisticated components and capital goods from these countries.   19.    China confronts other long-term financial difficulties.  Because of its one child policy, China is an aging society and needs to devise a sustainable pension system— poses a serious financial and organizational challenge.  The burden now is falling almost entirely on families, but with so many one-child families, this is not a sustainable long-term solution. 20.    As suggested above, last year authorities put up the prices of all agricultural products by 30%. This was designed to slow migration into China’s ever more crowded urban areas

078 ESCTER 05 E rev 1 5 and  essentially  affect  a  wealth  transfer  to  the  countryside.  For  the  moment  the  gambit appears to be working; the farming sector has begun to absorb some of the excess labour that has been flowing into the cities.  It has also stimulated a domestic economy which has been relatively moribound compared to the explosive growth of the trading sector. This is providing a backstop for the manufacturing sector.    III. NATIONAL SECURITY AND DIPLOMACY 21.    On  the  international  Front,  China’s  relations  with  Taiwan  poses  one  of  its  most intractable problems. The National People’s Congress has recently passed a law that will allow the use of military force if Taiwan declares independence.  China has thus made it very  clear  that  were  Taiwan  to  renounce its “One China” policy, the mainland would not rule  out  military  action  as  part  of  its  response.  According  to  several  speakers,  Taiwan remains a highly emotive issue in Chinese politics, and no leader of China could be seen to be weak on the matter. The real question in the eyes of many is whether the new policy reflects a genuine military shift, or is simply rhetorical. China would certainly stand to lose a  great  deal  both  economically  and  diplomatically  were  war  to  break  out  in  the  Taiwan Straits. 22.    The  new  law  has  also  provoked  European  reassessment  of  a  recent  decision  to abandon   a   long-standing   arms   embargo   imposed   after   the   Tiananmen   crackdown.   Various  speakers  to  the  Sub-Committee  differed  on  the  possible  effect  of  the  embargo, with  some  suggesting  that  the  issue  was  more  symbolic  than  of  strategic  consequence. British officials have been consulting closely with the United States on the matter, and at the  time  of  the  visit,  asserted  that  they  did  not  judge  that  switching  to  a  new  code  of conduct  would  result  in  any  rise  of  arms  sales.  (Editor’s  note— pean governments have subsequently begun to back away from support of an immediate end to the embargo.) British officials are also firm in their position that China will have to make more progress on the International Convention for Civil and Political Rights to see through any  change  in  the  embargo.  Russia  continues  to  be  the  most  important  supplier  to  the Chinese military. But several members cautioned that the Chinese are also dedicated to modernizing their military and suggested that caution was also needed. China’s relations with its neighbours were also discussed. Several points came out of the discussions: 23.    According   to   one   analyst   the   Sub-Committee   met,   China   has   also   effectively undermined the international economic embargo of Burma. China sees Burma as a client state  through  which  it  enjoys  access  to  warm  water  ports.  The  Chinese  are  upgrading those ports that are also slated to be part of the Chinese energy network. 24.    China  sees  North  Korea  as  both  a  buffer  state  and  a  potential  area  of  dynamic growth  if  its  leaders  are  willing  to  open  the  country  up  further.  One  economist  that  the Sub-Committee  met  suggested  that  North  Korea  is  changing  very  rapidly  and  could eventually  become  a  key  Asian  manufacturing  centre.  Chinese  officials  do  not  welcome any  discussion  of  regime  change  and  this  is  a  source  of  tension  with  the  American Administration.  China is currently supplying most of the energy and a great deal of food to this isolated country.

078 ESCTER 05 E rev 1 6 25.    China  is  also  playing  a  very  active  role  in  Central  Asia.  It  is  participating  in  the Shanghai   Cooperation   Organization   with   Russia   and   four   Central   Asian   Republics: Kazakhstan,  Kyrgystan,  Tajikistan  and  Uzbekistan.  This  group  was  set  up  in  2001  to advance confidence building and arms control measures. The Chinese see the Shanghai grouping as one of several means to resist growing separatist movements it confronts in its own western regions. For China, Central Asia is an important potential energy partner and  Chinese  firms  are  very  active  in  Kazakhstan’s  oil  and  gas  sectors  where  they  are investing heavily. 26.    Chinese  relations  with  Russia  have  improved  substantially  in  recent  years.    Both sides see their relationship as being a major strategic asset and one means to resist US influence. 27.    In  Asia  itself  the  Chinese  are  increasingly  active  in  promoting  regional  economic integration.    Trade  in  the  region  is  exploding,  and  China  has  become  the  preferred location for final manufacturing for many of the region’s producers.  The problem is that the  country  is  so  big  and  so  dynamic  that  it  is  almost  invariably  seen  as  a  threat  in  the region.     IV. ENVIRONMENT AND ENERGY 28.    China is also burdened by serious environmental problems due to the dizzying pace of industrialisation and inadequate environmental infrastructure and regulations. The core problem is that China is rapidly becoming a mass consumer society, but it lacks the basic infrastructure for coping with the waste this level of development generates. As a result, very little waste is properly treated in China. Some improvements have been registered in showcase cities like Beijing, but provincial cities have seen little or no improvement. Again, the  top  priority  remains  economic growth and the environment was long relegated to an afterthought. 29.    This   is   beginning   to   change.   Chinese   officials   have   adopted   the   rhetoric   of environmental  protection,  pledged  funds  for  environmental  projects,  passed  relevant legislation and even signed up to Kyoto.  But implementation and enforcement has been very  patchy  at  best.    As  a  developing  country,  China  has  no  obligation  to  meet  its emissions quotas until 2012. Yet it is presently the largest producer of ozone in the world. To  their  credit,  Chinese  officials  are  reaching  out  to  the  international  community  for support  in  these  areas  and  the  World  Bank  has  developed  a  number  of  environment related  projects  with  the  government.  The  West  has  a  very  strong  interest  in  China becoming a more efficient energy user and generally more environmentally conscious and this is one of many justifications for a policy of engagement. 30.    China’s energy needs are daunting.  On the one hand, the government is intent on using   cleaner   fuels   including   gas   from   its   Western   provinces   and   Central   Asian neighbours.  Yet  coal  will  continue  to  play  a  central  role  in  meeting  the  country’s  ever mounting energy requirements. At the same time automobile use is growing at a very fast pace.    During  SARS  crisis,  the  government  essentially  conceded  to  broader  use  of automobiles. This led to a surge in sales that has only augmented traffic, environmental and long-term energy challenges.

078 ESCTER 05 E rev 1 7 31.    Northern China’s very serious water problems are not evident in Beijing but the effect is  profound  and  there  are  also  rising  energy  shortages  in  the  region,  which  are  also affecting life in the capital city. Within 50km of Beijing, there are millions receiving food aid because of persistent drought conditions. Energy shortages are also evident and are likely to  place  a  limit  on  Chinese  economic  growth.  Already  many  firms  need  to  purchase auxiliary  power  sources  because  of  rising  power  shortages.  The  problem  became  fully visible last summer when authorities in Beijing were faced with a choice of either switching off the air conditioning or the factories.  Air conditioning won out. 32.    One speaker at London University suggested that there are three time horizons with which  one  should  reflect  on  China’s  energy  challenge.  There  is  a  one-year  perspective; here whether the year will be very hot or cold is crucial. The medium term perspective of 4-6  years  hinges  on  China’s  capacity  to  build  new  generating  capacities.  The  long-term perspective is conditioned by securing access to energy. 33.    Energy  markets  have  undergone  a  radical  transformation  in  China.  In  the  early 1990s, the growth rate of energy consumption stood at about 9% and then it fell to 6%.   For the last three years, energy demand has risen up to 15% per annum.  This has vastly exceeded  the  expectations  of  authorities.  The  elasticity  coefficient  of  energy  demand  is also very large.  In Western countries that coefficient has been less than one.  In China last year, it was 2. In other words, China needed two additional increments of energy to drive  an  additional  increment  of  growth.    The  problem  has  become  serious  and  China’s State   Council   has   had   to   rewrite   its   energy   plans   several   times   to   account   for unanticipated leaps in energy demand.  There is little doubt that if China continues to grow at its current pace, it will confront serious energy constraints in the near term because of the lack of energy infrastructure capable of supporting that growth. 34.    Currently  foreign  imports  account  for  one  third  of  China’s  overall  energy  supply although there is substantial oil smuggling as well, and these imports do not appear on the books.  These  imports  are  effectively  tipping  the  balance  of  global  oil  markets.  China needs to intensify efforts to produce more of its own energy in order to encourage energy conservation. It uses a great deal of coal and, if anything, this will increase over time. V. MEETING WITH TIJDAN THIAM OF THE COMMISSION FOR AFRICA 35.    The  Delegation  had  an  opportunity  to  meet  with  Tijdane  Thiam,  a  member  of  the British Africa Commission. He spoke to the Sub-Committee the day before the launch of the Commission’s report, which was designed to provide a road map for Western relations with Africa at a moment when the UK is to hold the Presidency of both the G8 and the EU.   The Commission is chaired by the British Prime Minister Tony Blair and includes several eminent Africans, as well as prominent members from G8 countries.   36.    Thiam  discussed  the  work  of  the  Commission,  the  myriad  consultations  that  have provided the background for the report, its focus on governance and human development. Two  critical  themes  in  the  Commission’s  work  have  been  the  ultimate  responsibility Africans  bear  in  shaping  their  own  destiny  and  the  need  for  the  West  to  provide  an international context to make this possible.  More specifically, the developed world needs

078 ESCTER 05 E rev 1 8 to  open  up  its  markets  to  Africa  and  not  distort  agricultural  markets  through  export subsidies.   Western   companies   should   also   ensure   that   their   own   policies   are   not contributing to regional insecurity.  At the same time African leaders need to endeavour to ensure good governance and reduced corruption. 37.    On the security front, the African Union has played a very important role in regional peace  building,  and  the  West  needs  to  support  its  work.  Security  remains  one  of  the critical  problems  in  Africa,  and  a  genuine  roadblock  to  economic  development.  Foreign investors will not invest in countries at war, and are not even likely to invest in countries in regions  where  fighting  has  broken  out.  There  are  thus  very  high  economic  stakes  in settling  the  problem  of  African  insecurity  but  at  the  same  time,  trade  and  economic integration are keys to stability. 38.    Corruption  also  represents  a  serious  impediment  to  positive  change  in  Africa.  In “non-linear  traditional  societies”,  one  might  make  the  case  that  using  the  exchange  of favours  as  a  tool  for  political  organization  might  work.  The  problem  is  that  this  utterly breaks down in a globally integrated setting. Tribalism is part of Africa’s problem but there are ways to transcend this, in part, through education.