Subject: ESI and Smadja & Smadja: Highlights: The Future of China Conference
From: Clyde Prestowitz <[email-masked]>
To: [email-masked]
Date: Mon, 18 Aug 2014 13:06:56 -0400

Dear Friends,

Attached, please find the first in a new series of Highlightsreports being published
by Smadja & Smadja Strategic Advisory, Switzerland, and The Economic Strategy Institute
of Washington D.C. This initial edition is based on our own analysis about the development
taking place in China and some of the elements that emerged during the discussion
at the 5th Future China Global Forum in Singapore that Smadja & Smadja produces 
for Business China.

The Highlights reports will summarize some of our own analysis on global developments
as well as other views, and points of discussion emerging from global affairs events
that we hold or from bilateral meetings and conferences in which we are involved
 in the course of the year.

Because these events are attended by many of the world's top government, business,
academic, labor, media, and public society leaders, the Highlights will include 
many ideas and comments with a major potential impact on global businesses and geopolitical
landscape.

We hope that you will find this series useful and interesting and look forward to
your comments.

Sincerely,

Claude Smadja, President, Smadja & Smadja

Yael Smadja, President, Smadja & Smadja U.S.A.

Clyde Prestowitz, President, The Economic Strategy Institute
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THE FUTURE OF CHINA:

HIGHLIGHTS OF THE 5TH ANNUAL CONFERENCE IN SINGAPORE
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THE POWER OF XI

The announcement at the end of July that Zhou Yongkang, former member of the Stranding
Committee of the Politburo and former all powerful head of the security services,
the police and the courts is more than President Xi Jinping going one or two notches
higher in his fight against corruption and against competing centers of influence.
It illustrates in a spectacular and unprecedented way the extent to which President
Xi's rapid accumulation of power represents a significant structural shift from 
the previously prevailing model of collective rule by the top political elite to
 something approaching the old Mao model. Today Xi is in fact holding all the key
levers of power in his hands -  combining the role of Head of the Party, Head of
 State, head of nine crucial committees, and head of the Central Military Commission.

Xi is today constrained neither by his two predecessors nor by the members of the
Standing Committee of the Politburo, and is much less reliant on the bureaucracy
 than were his predecessors. Rather, he is increasingly more reliant on a close 
circle of advisors.

ANTI-CORRUPTION CAMPAIGN

XI's anti-corruption campaign is killing two birds with one stone:  It responds 
to the frustration of the public with the pervasive corruption among party and government
officialdom. It also gains him popularity, legitimacy, and justification for going
after the networks of his predecessors that are, or could become, an obstacle to
 removing the vested interests that oppose the reforms he deems necessary to rebalance
China's economy and thereby ensure its healthy growth.

TWO GOALS

Xi's two major goals are: 1)Restore the power of the center and ensure the sustainability
of the Party's rule. 2) Restore China to its historical position of prominence of
the world stage.

This marks a departure from the line of Deng Xiaoping who urged : "observe calmly,
secure our position, cope with affairs calmly, hide our capacities, bide our time,
maintain a low profile, and never claim leadership."

Two schools of thought now contend in Beijing - one advocating the low profile approach,
the other saying that this low profile has encouraged Japan and other Asian countries
to push their claims in the North and South China Sea, and arguing that it is now
time to show a more assertive posture. Xi seems clearly to be leaning toward this
latter approach: What he is now basically saying to the US is rather something like:"
We still have to catch up with you in many domains but from now on we intend to 
deal with you on an equal footing basis.

BEIJING AND U.S.

In fact the "new model of great powers relationship" that President Xi Jinping proposed
to President Obama during the Sunnylands Summit in October 2013 is implicitly based
on that notion. It assumes that the growing economic interdependence between the
 US and China, and the fact that the Interests of China will keep expanding as it
power rises in the same way as happened in the past with the US, now create the 
basis for a relationship among equals.

Beijings initiatives to launch a US$ 100 billion special Fund to fight financial
 crises and an Asia Infrastructure Investment Bank are a signal that it intends 
now to create counterweights to the U.S. dominance in the IMF and the World Bank
 as well as to that of Japan in the existing Asia Development Bank.

Xi's admonition to Asian countries during the last ASEAN Summit that "it is DISADVANTAGEOUS
to the common security of the region for military alliances with third parties -
 I.e. the US - to be strengthened" is in line with the policy of raising Beijing
 to a more prominent role in the region. It is in the same context that one has 
to consider the remarkable outburst of Lieutenant General Wang Guanzhong during 
the Shangri-La Dialogue last June against the speeches of Prime Minister Abe of 
Japan and US Secretary of Defense Hagel accusing both of them to have coordinated
to create threats and intimidation to China.

The proponents of this approach see the US as a super power in decline, or at least
as a super power which is not ready for the time being to pay the price or has lost
the will to act as a super power. So the time is right in their view for Beijing
 to push the envelope as much as it can to further its interests and positions on
the international scene.

OPPONENTS LYING LOW

Xi is undoubtedly confronting powerful vested interests which, while lying low now,
are certainly biding their time, until an opportunity to regain some of the lost
 ground presents itself. Such an opportunity might present itself if the current
 economic slowdown goes beyond a critical point or some of the reforms that Xi is
trying to engineer go badly. If economic growth gets down to 4.5-5% per year, as
 some respected Chinese and foreign economists expect (which will not be in itself
a bad thing) then the government will be threading a much finer line. Another opportunity
for adverse forces could be created by a serious natural disaster affecting China
and badly handled by the government or by an international crisis that would create
an opening for vested interests to strike back.

So it boils down to a single question: While Xi Jinping is the most powerful Chinese
leader since Mao, is his grip on power already beyond the risk of a backlash or 
not and how far are we from a fully stabilized power landscape in Beijing? In that
respect it is worth noting that while the 3rd Plenum of the Party had endorsed a
 "decisive role" for the market in the functioning of the economy, business leaders
in the private sector are almost unanimous in stating that they have not yet seen
any sign of concrete policy changes when it comes to allocation of credit, of resources
or in the opening up of sectors until now reserved solely to SOEs. The squaring 
of the circle exercise of enhancing the role and scope of the private sector while
keeping the role of SOEs unchanged in the overall economy will definitely remain
 a "work in progress" for some time to come and nobody really knows at this stage
where Xi is planning - or will be able - to land on that matter.

REBALANCING - POSSIBLY FALLING

China's high nominal GDP growth rate is not necessarily a good sign. It arises from
an eventually unsustainable system that has already taken China's total debt to 
about 250 percent of GDP while continuing on a path to much higher levels. Much 
of this debt has been contracted in the course of building enormous excess capacity
in the real estate, manufacturing, and infra-structure sectors. Since excess capacity
does not generate income for the paying off of debt, the debt load will eventually
be shifted to some sector capable of paying.

Regardless of how it is paid, a shift in the structure and direction of the economy
would entail at least a temporary slow-down of the Chinese economic growth rate 
to something like 3-6 5 GDP growth. Such a reduced growth rate would actually be
 a positive sign. However, because it would be seen negatively by many, and because
it would be costly to vested interests, there will be enormous opposition to taking
the steps necessary to achieve the temporarily slower growth rate. Indeed, the recent
official articulation of the goal of a 7.5 % growth rate which was hailed by many
investors, is actually a negative sign indicating that the vested interests are 
presently still holding a strong hand in the power struggle.

The household sector has already been financially repressed to such an extent that
China's consumption as a percent of GDP is around only 40 percent, an extremely 
low level by international comparison. So this is not the ideal sector for carrying
the debt load. The private sector small and medium companies are China's most dynamic.
It is desirable to keep them that way and not to saddle them with debt payment responsibilities.
The ideal candidates for paying the debt are the State Owned Enterprises (SOEs) 
which are not so dynamic and which have plenty of assets. Ideally they would carry
most of the debt load. But they, of course, are in the hands of the elite party 
and government officials. Thus rebalancing would strike at their wealth and power
and is being fiercely resisted.

To break achieve rebalancing, Xi must break this stranglehold of the elite. His 
anti-corruption campaign is aimed at doing just that. But, of course, it is also
 creating powerful enemies who, as noted above, are awaiting the right moment to
 retaliate. Achievement of rebalancing and long term healthy economic growth means
immense and perhaps dramatic conflict among the top Chinese party, government, and
business leaders.

WHERE IS THE ARMY

This in turn raises the question of whose side the People's Liberation Army (PLA)
will take. It is important to remember that the PLA is the instrument of the party
and owes its allegiance to the party and not to the state or the people.

In order to carry the PLA with him, Xi may have to satisfy many of its wishes, which
probably means a more aggressively nationalistic foreign policy, especially in the
South China Sea and the western Pacific.

The statement that : "China will not start any hostilities but neither will it shrink
from handling hostilities" was made loudly and continually at the conference.

The notion of the decline of the US as a superpower was very much en vogue at the
conference although several key leaders including Singapore Prime Minister Lee Hsien
Long cautioned that the US may not be dead yet.

Likewise, they noted that while the economic interdependence between China and its
Asian neighbors keeps increasing, new concerns in all Asian capitals about Beijing's
behavior cannot but have an impact on the way these capitals will assess the future
of their relationship with the mainland and the kind of guarantees and counter-weights
they will looking for, to avoid the too close embrace of a giant too assertive for
comfort.

A CRUCIAL MOMENT FOR CHINA

This is obviously a crucial moment in China, during which a number of shifts are
 occurring, with major implications for the country itself as well as for the global
economic and geopolitical balance. While trying to decipher the developments it 
is important for decision-makers and China watchers to think outside the usual obsolete
templates of "moderates" and "hard-liners" "reformists" and "conservatives" which
serve only to blur the picture and distort judgment. The present reality in Beijing
is too complex to be encapsulated in simplistic labels. This is the start of a new
ball game in dealing with China. It will keep us on our toes for years to come.
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