Gordon G. Chang's Blog, page 20

China’s Incredible Shrinking Economy

How big is the Chinese economy? Beijing’s National Bureau of Statistics reported that the country’s gross domestic product totaled $8.28 trillion last year.

Perhaps. Christopher Balding, an associate professor at the HSBC Business School at Peking University, thinks it’s more than a trillion dollars smaller. GDP numbers are supposed to show changes in a country’s output without regard to inflation or deflation. In an August 14th paper, Balding persuasively argues that the NBS grossly understates and underweights housing costs in adjusting nominal GDP for inflation to arrive at real GDP.

Balding builds on the work of Standard Chartered Bank’s Stephen Green, who was among the first to advance the notion that China inadequately adjusts its GDP for inflation. Green believes the country’s economy expanded only 5.5 percent last year—not the claimed 7.8 percent—once properly adjusted for inflation. “If there was an index for suspicion about China’s official statistics, it would be off the charts, or to use the technical American term, ‘crazy bad,’” the widely followed economist has written. Even Li Keqiang, before he became China’s economic czar this March, confided to American officials that his country’s statistics were unreliable, or “man-made” as he put it.

What are the consequences of the large downward adjustment in Beijing’s numbers? China’s official statisticians must be at least slightly embarrassed because Balding’s paper is devastating, exposing the obvious manipulation. Yet apart from the loss of their “face,” not much would seem to be at stake. After all, even with Balding’s correction, China retains its distinction of having the world’s second-largest economy, comfortably ahead of third-place Japan.

Yet the Green-Balding argument reveals China’s critical weakness.  When assessing a country’s economic condition, one of the leading indicators is its debt-to-GDP ratio, which measures a country’s ability to manage its indebtedness. With regard to China, there is wide disagreement as to the amount of debt that exists. Furthermore, there are questions as to what debt should be counted for this purpose. Yet putting these disagreements aside for the moment, China’s ratio, and its economic stability, appears substantially weaker when its GDP is adjusted downward.

This adjustment is important because the Chinese central government has been essentially buying economic output—in other words, creating GDP—with massive amounts of state spending. Premier Li has been trying to convince the global financial community that Beijing is no longer engaged in this practice, but this month he has, without announcement, begun implementing an “unofficial economic stimulus” by forcing state banks to lend to provincial governments.

China can continue creating growth in this manner as long as it is able to service the debt that is incurring, but concern is growing that the country’s “hidden obligations” threaten to overwhelm the country’s economy and trigger a crisis.

Beijing says its debt-to-GDP ratio at the end of 2012 was about 40 percent. That is considered manageable, but the real number is undoubtedly higher because Beijing excludes substantial obligations—and because it is inflating its GDP by understating inflation. Some believe the ratio, properly calculated, is actually north of 200 percent (America’s, by comparison, was a scary 102.9 percent at the end of last year). If Balding is correct, then the ratio is worse, and China is on the edge of a monumental debt crisis.

Clearly, China’s inadequate adjustment of GDP for inflation produces artificially inflated numbers, but there are undoubtedly other problems that result in the overstatement of GDP, such as the exaggeration of industrial production. If we knew what China’s economic output really was, we would better understand that the country is headed into a debt crisis from which it may not recover this decade.

 

Photo Credit: saiko3p / Shutterstock.com

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Does China Need a Jinping the Great?

“The Chinese,” wrote Garnet Wolseley, “are the most remarkable race on earth, and I have always thought, and still believe them to be, the coming rulers of the world. They only want a Chinese Peter the Great or Napoleon to make them so.”

Yes, the Chinese are indeed remarkable, and on Friday Tom Holland, the South China Morning Post columnist, argued that Wolseley, a 19th-century British field marshal, was farsighted. Yet Wolseley’s words, from 1903, have been proven wrong. China, as Holland should know, got its fair share of larger-than-life figures in the 20th century. There was, most notably, the willful Chiang Kai-shek and then the charismatic Mao Zedong. Neither was lacking in ambition or strength, and yet both ultimately failed the Chinese people.

Wolseley was correct that the Chinese needed leadership, but they did not need a Chinese Napoleon. What they needed then—as they still do today—is a system that allows them to lead themselves. The Communist Party of China, however, insists it has a historical obligation to rule.

The party chose a new general secretary last November, Xi Jinping, the first one to be born after that organization came to power in 1949. “He has ambition to be a great leader, someone like Mao Zedong,” said Bo Zhiyue of the National University of Singapore early this year. “He wants to change things.”

Xi’s changes have been noticeable. Chinese officials no longer talk about “harmony,” the theme of Xi’s predecessor, Hu Jintao. They now lavishly praise Xi’s “China Dream.” Beijing is big on show campaigns, like the one against displays of official extravagance. Disturbingly, Xi has been responsible for a resurgence of Maoist imagery. Cadres these days are fond of talking about the “mass line,” for instance. The crackdown on human rights has intensified, and the atmosphere at this moment is even worse than it was during the dismal years over which Hu presided. And Xi has played to the military, allowing flag officers to engage in a series of provocations against China’s neighbors to the south and east, especially India, the Philippines, and Japan.

Xi’s accession last year triggered the usual wave of hope and optimism, but now much of that has turned to disappointment and even despair. His defenders, such as Kenneth Lieberthal of the Brookings Institution, make the case that Xi is just shoring up his defenses on his “left”—Maoist—flank so that he can go out and implement real reform later.

That very well may be the case, that to move “right” in China a new leader must first pander to the “left.” That was the same excuse made for Hu Jintao, who never quite executed the pivot to progress. Many Chinese now call his ten-year tenure “the lost decade.” In any event, one has to wonder about a political system that requires a new leader to endorse Maoism, implement campaigns of repression, and commit acts of aggression just so that he can sponsor what most everyone views as progress. These unwelcome acts suggest that today China’s current system is incapable of reforming itself.

China’s leaders going back to Deng Xiaoping have made the case that the country could—and should—pursue economic reform before political reform. Now, they are pursuing neither. Why? Economic reforms, initiated at the end of 1978 by Deng, have enriched state institutions, and these institutions have been able to translate economic success into political power. They have then used newfound clout to block further economic reforms that would undermine their role in society. So economic reform has stalled ever since Deng’s reign ended in the1990s.

Entrenched interests are now so powerful that they have appeared to capture the Politburo Standing Committee, the apex of Chinese political power. Because the political system has become comfortable with the status quo, reform looks dead in the water.

And that brings us full circle. The Communist Party developed its collective system largely as a reaction to Mao, responsible for the Great Leap Forward and other calamities, and Mikhail Gorbachev, whom Chinese leaders blame for the fall of the Soviet Union. So Wolseley was right that China lacked the right kind of leadership but wrong to suggest the country had to have a great leader. What China needs is not a Jintao the Magnificent or a Jinping the Great but a new political system, one where 1.4 billion Chinese make decisions for themselves.

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Soliciting China—a Failed Policy

When he visited Washington in February of last year, then Chinese Vice President Xi Jinping talked about “a new type of relationship between major countries in the 21st century.” Since then, he has been elevated to general secretary of the Communist Party and this formulation has been shortened to “a new type of great-power relationship.”

American analysts still wonder what the phrase means. In a short piece in the first (July-August) issue of the Asan Forum, Peking University’s Wang Jisi states that the concept envisions a future where China and the US avoid “the same old disastrous road of great power rivalry that lead to catastrophe.”

As no one is in favor of catastrophic outcomes, Wang, one of China’s most visible foreign policy specialists, finds no argument on that score. Yet he is unable to articulate anything useful beyond that basic proposition. Again, unfortunately, we are left without a guide as to what Chinese leaders ultimately want.

Wang tells us the phrase entails “really new elements and new work” that will avoid antagonism and “push” China and the US toward cooperation, and he refers to Zhou Enlai’s 1955 exhortation to “seek common ground while reserving differences.” He then writes this: “The key to developing a truly new model of great power relations between the United States and China is an expansion of their common economic and security interests, which now go far beyond East Asia.”

Do Wang’s words mean anything? To his credit, he first notes that the US and China have kept the peace for more than four decades and then acknowledges that the avoidance of war is nothing new. Yet he fails to state that Washington, during that time, has desperately tried to find common ground and has gone out of its way to assist Chinese development, both economic and political.

The truth is that Sino-US relations have recently deteriorated—especially in the last three years—and this is an indictment of the general American approach of seeking cooperation with China in the post–Cold War period. As secretary of state, Hillary Clinton in February 2009 famously talked about downgrading human rights in America’s conversations with China. In November of that year, Jeffrey Bader, then the top East Asia hand on the National Security Council, talked about China’s assent as central to everything Washington was trying to accomplish.

These signals of cooperation from the Obama administration were immediately rebuffed. And it’s not hard to figure out why. Beijing officials believed Clinton had just performed a rhetorical “kowtow,” as one analyst based in the Chinese capital wrote at the time. Not surprisingly, Chinese policymakers immediately pressed their advantage by harassing unarmed Navy ships in international waters. And in the same month as Bader told a Washington audience how essential China’s cooperation was, already arrogant Chinese officials decided to use this veto that the American official had effectively handed them. Around the same time, China’s leader Hu Jintao consistently brushed off President Obama during their summit in Beijing.

So perhaps the path to better relations with China lies in being less solicitous. That would signal to Beijing that America knows it is holding the stronger hand and would be willing to play it. The ruthlessly pragmatic Communist Party of China has always respected strength and scorned weakness.

This is not to say American leaders need to go back to Reagan’s “we win, they lose” formulation—this decade is not yet the zero-sum world of the 1980s—but we should make sure our norms and values prevail and those of the Communist Party do not. The world we want is where citizens engage in robust debate, oceans and skies are open for commerce, and nations contribute to the maintenance of the rules-based international system. The one-party state in China, unfortunately, undermines all these fundamental notions.

We do not know what Xi Jinping contemplates when he talks about the “new type of great-power relationship,” and, judging from Wang Jisi’s vague comments, he doesn’t either. Yet we do not need authoritarian Beijing’s guidance in shaping the international system. The West’s postwar ideals of free markets and free societies have proven to be successful and enduring, and they remain popular across cultures and continents.

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China Eyes a Forward Base in the Atlantic

Last Tuesday, the US House of Representatives unanimously voted to block the Air Force from reducing its presence at Lajes Field. Congress did the right thing in freezing, at least for the moment, the American withdrawal from the Portuguese base on Terceira, one of the Azores.

Lajes, formally called Air Base No. 4, is the second-largest employer on the economically depressed island in the Atlantic Ocean. The Air Force had planned to send home 400 of the 650 military personnel and civilian employees as well as 500 family members. The transfers would have devastated the economy of Terceira and put many of the base’s 790 Portuguese workers out on the street.

Representative Devin Nunes, Republican of California, talks about the base as a logistical hub and as a spot needed for the fight against al-Qaeda in the Islamic Maghreb, and he’s right.  Nonetheless, Lajes’s strategic role has been diminished over time, and the Pentagon’s proposed cuts reflect that fact.

The Chinese, however, view Lajes differently. In June of last year, then Premier Wen Jiabao stopped there, adding thousands of miles to his journey back home from South America, so that he could say hello to local officials and tour the remote island. And at the end of last month, Huang Songfu, China’s ambassador to Portugal, went to out-of-the-way Terceira, calling on President Vasco Cordeiro, the head of the Regional Government of the Azores, to talk about Chinese tourism to the island and Azorean dairy exports.

What was almost certainly on Huang’s mind was China taking over Lajes, something Beijing has, according to Washington insiders, apparently discussed with Portuguese authorities. Lisbon officials don’t want to invite the Chinese in, but they have quietly indicated they will have no choice if the US Air Force decides to leave the base.

It’s not hard to see why Beijing wants Lajes. Chinese planes taking off from the 10,865-foot runway on the northeast edge of Terceira could patrol the Atlantic and potentially disrupt air and sea traffic between the US and Europe. Beijing could also affect access to the nearby Mediterranean Sea, or even target the American mainland.

Phasing out Lajes, which the Pentagon ultimately contemplates, would be budget cutting of the worst sort. Just think how much more costly it would be to defend against Chinese troublemaking in the Atlantic. In the long run, it would be far less expensive to maintain personnel at Lajes to keep it out of Beijing’s hands. 

In the meantime, the Senate takes up the National Defense Authorization Act for Fiscal Year 2014 sometime after Labor Day, which means the Lajes issue has not been resolved and cuts could still be made.

The Chinese military, of course, would like that very much.

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Global Narrative About the Chinese Economy Darkens

Last week, the global narrative on China’s economy changed. On Thursday, the New York Times’s Paul Krugman told us China’s economy was hitting “its Great Wall,” and others raced to pen similarly dire forecasts. As Stratfor’s George Friedman writes this week, “We have gone from China the omnipotent, the belief that there was nothing the Chinese couldn’t work out, to the realization that China no longer works.”

China’s economy has shown signs of not working since the fall of 2011, but most economists and analysts chose to ignore them. Now, just about everyone is commenting on Chinese economic weakness. Expert opinion never seemed more synchronized.

Of course, pessimistic observers today could be wrong. Friedman, however, makes one crucial observation as to why the change in global discourse matters: “The admission that a crisis exists is a critical moment, because this is when most others start to change their behavior in reaction to the crisis.”

Precisely. As pessimism grows about Beijing’s ability to create growth, two things will surely happen.

First, outsiders will commit fewer funds to China. Foreign direct investment in the first half of this year increased by only 4.9 percent over the same period in 2012. The number would have been even worse were it not for a simply unbelievable jump in foreign direct investment last month of 20.1 percent. Before the release of the official numbers, observers thought FDI in June would slump. Even if the suspicious June number is accurate, inward investment will tend to fall off in future months when talk about China darkens, as it surely will.

Second, participants in the Chinese economy will take their money out of the country. The process is already underway. Last month, Chinese banks sold a net $6.7 billion of foreign currency, a sign of capital outflow. Undoubtedly, the amount of capital flight is higher if smuggled cash, often stuffed into shipping containers leaving the country, is considered. Beijing has erected sturdy-looking restrictions on currency movements, but the crafty, greedy, and desperate have always been able to move money in and out of the country, almost at will.

Liquidity is already tight in China—Beijing has somehow managed to create the anomalous situation of too much credit and not enough liquidity—so outbound capital flows can aggravate the sense of crisis in the country. Therefore, today’s pessimism could become a self-fulfilling prophesy.

Ultimately, it is confidence that holds economies together. At the moment, most observers still believe that, despite everything, Chinese technocrats will be able to muddle through. China is “too government to fail,” Andrew Wang, a New Jersey financial adviser, said last month.

If everyone thinks this way, then there is some chance Beijing will be able to pull through this rough patch. Yet if the economy continues to underperform expectations—a safe bet in my book because of crushing debt and political paralysis, to name just two factors—then the next break in confidence could herald a historic collapse in China.

In the meantime, follow the money flows in and out of the country. That, rather than expert opinion, will be the best predictor of China’s future.

 

Photo Credit: Hung Chung Chih / Shutterstock.com

 

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South Korea Abandons Its Prisoners of War

Sixty years after the armistice that ended the fighting in the Korean War, there could be as many as 500 South Korean soldiers held captive by the Democratic People’s Republic of Korea. Seoul, incredibly, is doing little to obtain their release.

There were some 80,000 unaccounted South Korean combatants when the armistice was signed on July 27, 1953. Pyongyang returned only 8,300 of them, however, in the prisoner exchange. The fate of the missing was of little interest to the South Korean public until 1994, when the first prisoner of war escaped to the South. Even then, the issue was not considered important to a nation determined to establish good relations with the horrific North Korea. Kim Dae Jung, the dissident-turned-president of South Korea, did not even mention the plight of the prisoners of war during his historic summit in 2000 in Pyongyang with Kim Jong Il.

In 2007, the administration of Roh Moo-hyun, Kim Dae Jung’s immediate successor, talked to the North Koreans about the POWs, and Roh’s successor, Lee Myung-bak, did the same. The last time both Koreas discussed the prisoners was February 2011, toward the end of Lee’s term.

“Time is chasing us,” said General Lee Sang-chul, now in charge of getting the prisoners back, to the Washington Post. And that observation is correct—Korean War veterans are at least in their 80s.

What is not correct is the one-star general’s assessment that Seoul does not have much leverage over the Kim regime. At the moment, the North Koreans want some 123 South Korean businesses to reopen their factories in the Kaesong Industrial Complex, just six miles north of the Demilitarized Zone dividing the two Koreas. Before Kim Jong Un arbitrarily closed Kaesong in early April, approximately 53,000 North Korean workers earned an average wage of $134 a month—and Pyongyang skimmed off 45 percent of the hard-earned cash.

The North also hopes the South will reopen the Mount Kumgang tourist resort as well as hand over substantial amounts of aid. There are so many levers the South can employ to move Pyongyang.

Park Geun-hye, inaugurated as president in February, has called her North Korea policy “trustpolitik.” It’s not clear what the term means—her advisers are figuring that out as they go along—but Seoul needs to say this: “The South cannot trust the North until Pyongyang fully accounts for prisoners of war.” In September 2002, Kim Jong Il, as he attempted to reconcile with Tokyo, admitted that Pyongyang had kidnapped Japanese citizens. Now it is the turn of his son, Kim Jong Un, to help end the Korean War by releasing all the South Koreans his state has wrongfully imprisoned for six decades.

Justice demands this. So should the South Korean people.

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Talking to a China in Disarray

The Obama administration is nothing if not persistent when it comes to wooing the Chinese. Beginning Wednesday, American officials are hosting their Beijing counterparts for the fifth round of the US-China Strategic and Economic Dialogue in Washington. 

The large get-together—hundreds of officials on each side have attended previous sessions—comes a month after the “shirtsleeves summit” between President Obama and Xi Jinping, China’s newly installed supremo. That event, despite high hopes on the American side, proved to be a bust. At the time, then National Security Adviser Tom Donilon, in his post-summit press briefing, put his best face on what happened, but he inadvertently revealed how bad things went when he spent almost all his time telling us what Obama said to Xi, omitting what Xi told Obama.

The failure of the informal gathering in June should have been a warning. The thinking behind last month’s event was that the formality of past summits made meaningful conversation difficult. Administration officials believed the relaxed setting—in Rancho Mirage, California, at the Annenberg estate—would help Obama and Xi put relations on a better path. 

Since Nixon’s visit to Beijing in 1972, the US has talked to China in every conceivable format, formal and informal, bilateral and multilateral, secret and announced. During the previous administration, the number of ongoing bilateral forums reached 50. Today, there are more than 90 of them.

Yet as we continued to talk in all settings, relations became even more strained. And as we held seemingly never-ending discussions, Beijing’s behavior deteriorated.

We need to ask ourselves why. The problem for the administration is that China’s external policies are now being driven by internal trends. For one thing, the Chinese economy has hit an inflection point and is evidently on a long downward slide. This has consequences because, without prosperity, the Communist Party’s only remaining basis of legitimacy is nationalism. Militant nationalism, unfortunately, is now the defining feature of Beijing’s approach to the world.

Moreover, despite what most observers believe, China’s political system is fraying. The divisions caused by the leadership transition to Xi Jinping, which was formally completed in March, have not yet healed. For instance, the failure to bring the divisive Bo Xilai, China’s most charismatic politician, to trial indicates the party’s factions remain at odds. 

In a divided political environment, the People’s Liberation Army looks like it is the most powerful group in Beijing, certainly more influential than Xi’s so-called Princeling faction, which is by no means unified. China now has a leader who, although acceptable to most party bosses, has no identifiable political base of his own. 

In any event, Xi leads a political system where influence is widely spread across party and government units as well as the military. It’s no wonder that, with power so diffuse, Chinese policy lacks coherence. China, in short, is now in disarray.

In this situation, talking to Chinese officials, by itself, will produce little of value. We need to spend less time on dialogue and more on imposing costs for increasingly unacceptable behavior, like harassment of American ships, cyber hacking of our companies, proliferation of weapons to rogues, and aggression against US allies, to name just the most dangerous acts.

Last year, China’s merchandise trade surplus against the US—$315.1 billion—was an astounding 136.3 percent of its overall surplus. That gives the Chinese at least 315.1 billion reasons to act responsibly, but only if they think we have the will to use our power. It’s been a long time since they have respected an American administration. It’s time to change their perception of us. 

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America Versus China in Africa

“I want everybody playing in Africa,” President Obama said on Saturday in Pretoria, South Africa, during his just-concluded three-nation tour of the continent. “The more, the merrier.”

The American leader made no direct reference to anyone as he spoke those words, but everyone knew whom he was talking about. After all, his visit, as the journalist Peter Bergen put it, was just about one thing. “There is a one-word subtext to President Obama’s trip to Africa: China.”

According to the US Government Accountability Office, China surpassed America as Africa’s largest trading partner in 2009. Three years later, Chinese two-way trade with African nations amounted to $198 billion, about double ours. And the future looks bright for the Chinese. Projections put China’s African trade at $325 billion just two years from now. It was only $11 billion in 2000.

Nobody believes America can grow its trade with Africa as fast as China will. Yet China has just about hit high tide on the continent, and there are three principal reasons why, despite the prevailing skepticism, America could regain its lead from the Chinese over the next several years.

First, China’s economy, after 35 years of virtually uninterrupted growth, is exhausted. The series of Chinese liquidity crises in June is only the most visible result of the country’s long-term down cycle. Manufacturing, the source of China’s decades-long ascent, is already in distress. On Monday, the HSBC Purchasing Managers’ Index showed continued contraction of the factory sector last month, the largest portion of the Chinese economy. This widely followed indicator is in line with China’s disastrous import and export performance in May. According to official numbers, exports increased by just 1.0 percent from the same month last year. More important, imports, a sign of domestic demand, fell 0.3 percent. This year, commodity prices have been tumbling across the board because of falling Chinese requirements.

Chinese enterprises have signed up resource-extraction deals across Africa, but technocrats in Beijing have undoubtedly overestimated their country’s needs over the long-term. So look for the Chinese to begin dumping excess commodities on global markets—and reneging on their overly ambitious deals on the continent. China’s Africa trade numbers should fall accordingly.

Second, American business is realizing that Africa is, as President Obama put it, “a continent full of promise and possibility.” After all, the president took about 500 business figures with him to Africa, home to six of the ten fastest-growing economies on the planet, including the top three: South Sudan, Libya, and Sierra Leone. Africa is, at least from the perspective of economic growth, the new East Asia.

The president’s new $16 billion “Power Africa” initiative, announced in Cape Town on Sunday, and his “Trade Africa” plan, released on Monday in the Tanzanian city Dar es Salaam, mean that companies like General Electric and Texas-based Anadarko Petroleum will be doing much more business there.

Third, Africa is reevaluating its new best friend. “So China takes our primary goods and sells us manufactured ones,” wrote Lamido Sanusi, governor of the Central Bank of Nigeria, in a much-discussed piece in the Financial Times in March. “This was also the essence of colonialism.” (Read more about this in “The New Imperialism,” March/April 2011.)

Not surprisingly, Xi Jinping was on the defensive during his March trip to the continent and ended up admitting that Sanusi was on target. “China frankly faces up to the new circumstances and new problems in Sino-African relations,” he said in a speech in Dar es Salaam. “China has and will continue to work alongside African countries to take practical measures to appropriately solve problems in trade and economic cooperation so that African countries gain more from that cooperation.” Xi can deliver applause line likes this only so many times before African policymakers hold him to them.

China has had a great run in Africa since the turn of the millennium, but now the economics of its relationship with the continent will begin to adjust. 

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China’s Coming Cash Crash?

Today you could not tell the Chinese banking system is entering a new phase in its month-long liquidity crisis, at least from the Chinese stock market. Shares ended down 0.4 percent, but the big story is that trading was only “choppy,” not volatile. 

Yesterday shares went on a “bungee jump.” First, the widely followed Shanghai Composite Index fell almost 6 percent—to its lowest level in more than four years—and then, in the last 90 minutes of trading, it skyrocketed to close near its opening, down only 0.2 percent for the day.

The reason for the last-minute recovery? Government-related entities went on a buying binge, indicating that central government technocrats were supporting the market. This is at least the second time they did this in the last two weeks. On June 13th, Central Huijin Investment Co., a holding company for Beijing’s investments, bought 363 million yuan of stock of the so-called Big Four banks, according to Reuters’s calculations.

Chinese leaders have to be worried. Stocks also fell across the board Monday, with the Shanghai Composite off 5.3 percent. “We are down almost 20 percent in two weeks,” said Hao Hong of Bank of Communications International. “It’s ferocious.”

The ferocious fall is just the latest result of China’s liquidity crunch. On Thursday, overnight rates hit 30 percent, and, as a result, the credit market froze. Banks defaulted on their interbank obligations, and Bank of China, one of the Big Four, had to issue a statement to deny it had failed to meet its obligations.

The virtually universal opinion in the analyst community is that the near-disaster of last week is actually a good sign. Why? Observers believe the People’s Bank of China, the central bank, is heroic, insisting on reform by refusing to inject liquidity in substantial quantities. This is, we are told, designed to force banks to back away from their reckless affliction with dangerous banking practices. “The central bank wants to accelerate reform,” said Zhu Haibin of JPMorgan Chase to the New York Times, in a typical comment. “They want to give the market a lesson: you need to manage your risk and not rely on the central bank.”

This narrative is what everyone wants to hear, but it makes no sense. If this were true, it means the PBOC engineered the month-long credit crunch, but government officials by their nature never set out to start panics. If the events of last Thursday were the result of conscious policy, China’s central bankers are nothing short of reckless. On the contrary, they are, like their counterparts across the world, cautious.

Anne Stevenson-Yang, of J Capital Research in Beijing, has proposed a much more believable storyline. The crisis, she says, began on May 5th when the State Administration of Foreign Exchange issued a rule cracking down on fake export invoices. That caused $40 billion to flow out of the banking system, and this led to a series of crises in June.

This month, for instance, there have been two failed central government bill auctions, two spikes in short-term interest rates, and two waves of defaults in the interbank markets. In the last couple days, banks have suspended lending. Smaller banks are reportedly borrowing from loan sharks and online microfinance sites.

In this crisis, Beijing’s technocrats have no good options. Everything they could do to remedy the situation carries extremely negative consequences. For example, if the central bank injects substantially more liquidity, the fresh funds would end up in imprudent investments, as we have seen with the recent explosive growth of wealth management products. This would make the eventual crisis even bigger than it will already be.

The problem is that China does not really have a liquidity crisis; it has a debt crisis, and the debt crisis is the result of a slowdown in the economy. Despite claims from China’s National Bureau of Statistics that the economy is growing 7.7 percent, growth is more like 3 to 4 percent. And if you strip out economically useless production, the growth rate might even be 0 percent. Slow growth means borrowers will not be able to service their debts, and highly leveraged businesses and government entities will default in domino-like fashion.

What follows the ongoing liquidity crunch? Stevenson-Yang believes there will be a “severe contraction.” That’s probably the best possible scenario, as China could otherwise be facing catastrophic failure. Look for the property market to crash, money to flee stocks, the renminbi to decline in value, and money to leave the country. We could, within six months, see China’s “Lehman moment,” the beginning of a broad-based economic failure.

Almost everything we know about the mighty Chinese economy could become obsolete overnight.

Beijing Drivers Vent Their Anger

On Monday morning, hundreds of people silently walked by abandoned cars and empty buses on a Beijing expressway. Bloggers on Weibo, China’s Twitter-like service, posted photos of the phenomenon and immediately compared the images of the “drone-like” people to scenes in AMC’s The Walking Dead.

Had zombies invaded the Chinese capital? No, residents were frustrated by traffic moving at the rate of “millimeters per minute.” So they simply turned off their ignitions, locked their doors, and left their vehicles on the road.

It’s not news that Beijing has traffic. There are 5.2 million registered vehicles there, and the Chinese capital has to hold the record for commuter congestion. In 2010, a Beijing traffic jam took 12 days to unclog.

What’s surprising is that the Chinese people, even in their straitjacket capital city, are starting to think for themselves. As we saw Monday morning, they are taking control of their lives and acting on their own. That has to frighten China’s rulers, even if the issue this week was merely too many vehicles on the road during the morning rush hour.

How does one control 1.35 billion Chinese? The Communist Party at last count had 82.6 million members. It is governed by a Central Committee of 205. The Central Committee, in turn, is directed by the 25-member Politburo. The Politburo is ruled by the seven men sitting on the Standing Committee. The Standing Committee’s seven believe they have the right—and historical responsibility—to tell the rest of the Chinese people what to do and even what to think.

Since 1949, the system has worked for the Communists. Yet today their hold is tenuous. The fundamental problem for the party is that, from what we can tell, most Chinese do not believe that a one-party system is appropriate for their country’s modernizing society. They may not take active steps to oppose it—almost none of them do—but they do not like the form of governance either.

That means the party must use force to keep its system in place. With the possible exception of the North Korean regime during the days of Kim Il Sung, no ruling group in history has employed surveillance, censorship, imprisonment, and coercion better than the Communist Party does today. Yet no authoritarian system can be stable in a dynamic society, and China’s is one of the fastest-changing on earth.

A fast-changing, over-congested, and under-served society means discontent. No one knows the number of “mass incidents” in China. A Peking University professor, quoted by Joel Brinkley, puts the figure at “more than two hundred thousand a year.” Some of these disruptions are not merely demonstrations and disturbances—a few rise to the level of insurrections and revolts, like the uprising in Wukan that began in late 2011. This dissent gives us an indication of the restlessness in society and the inability of the political system to mediate conflict. 

The Communist Party no longer publishes figures for protests, and you can understand why. No ruler wants to encourage disobedience, and the Chinese people are beginning to lose their timidity. As New York Times columnist Nicholas Kristof has noted, the Chinese don’t take to the streets when they are angry. They do so when they think they can get away with it. “China has always operated to some degree on fear, and that fear is now eroding,” he wrote as far back as 2003. In 2009, I was talking to a prominent businessman in Shanghai, and he acknowledged the change in the preceding 20 years. “No one fears the government any more,” he noted.

An assertive populace is something the Communist Party cannot handle. Every day, the seven men of the Standing Committee must worry that one day the Chinese people will tell them they are able to think for themselves and make their own choices, free of the Leninist institution that presumes to be the infallible interpreter of history.

On Monday, several hundred fed-up residents of Beijing violated all the rules and left their cars parked on a highway. Suppose, instead of being aggravated over traffic, they were frustrated over the lack of say in their lives and they walked to the center of their city, demanding the right to govern themselves.