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Alan Kohler is one of Australia’s most experienced commentators and journalists. Alan is the founder of Eureka Report, Australia’s most successful investment newsletter, and Business Spectator, a 24-hour free business news and commentary website. He also hosts Inside Business, a half-hour Sunday programme on the ABC, is the finance presenter on the ABC News - and producer of the nightly graph (or two).
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China's new leaders jump into the fire

Stratfor7 Nov 2012, 4:26 PM

The politicians assuming China's fifth generation of leadership tomorrow face far greater economic challenges than their predecessors, and a raft of unfixed political problems.

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Chinese President Hu Jintao and Prime Minister Wen Jiabao, the core of China's 'fourth generation of leaders', will transfer control of the Communist Party of China on Thursday to Xi Jinping, Li Keqiang and five other members of the incoming fifth generation. The China that they will hand over is in some ways different from but in many ways remarkably similar to the one they inherited, in part because many of the Hu-Wen administration's core mandates remain unfulfilled.

The gaps between rich and poor, town and countryside and, in many cases, between coast and interior are starker than ever before and still growing. Domestic consumption is rising but not fast enough to offset the rapid – and probably terminal – decline in external demand that set in after successive financial crises rocked US and European consumers. Worse for Beijing, the proxy economy it created through two years of intensive, state-led investment is now crumbling under its own weight, dogged by overcapacity, waste and trenchant corruption at almost every level of governance. Despite Wen's persistent calls for "reform," the pillars of political and economic control in China have not kept pace with social change. Internationally, a more confident and assertive military, along with China's ballooning appetite for foreign natural resources, is steadily undermining Beijing's long-held foreign policy of cooperation and inoffensiveness.

Recent anecdotes and rumours suggest there is mounting anger within the Communist Party over the Hu-Wen administration's failure to uphold its mandate – handed down indirectly from Deng Xiaoping – to rebalance the economy away from over-reliance on exports and investment and toward domestic consumption and greater equity between China's diverse regions.

Certainly, when the fourth generation leaders assumed power in 2002, they did not intend to leave so many fundamental problems unfixed. Nor could they have anticipated the ways in which 9/11, two US-led wars in the Middle East and financial crises in the United States and Europe would fundamentally alter the international system and China's place in it.

The view from 2002

In 2002, China had a gross domestic product of $1.45 trillion, smaller than that of the United Kingdom, and an average per capita GDP of just over $1,100. It produced almost three-quarters of the oil it consumed domestically and was a small natural gas exporter. The country had undergone a period of political, social and economic uncertainty in the late 1990s, but by the early 2000s it looked stronger than ever, with booming stock markets in Shenzhen and Shanghai, a reformed and recapitalised state-owned sector and incredible urbanisation and economic growth rates, especially along the industrialised coast. China's military, which former President Jiang Zemin had brought back firmly under the Party's wing in 1998, was just beginning a modernisation drive that continues today. China was growing quickly, but it was not yet the global economic, diplomatic and resource giant it is today.

The China that Hu and Wen inherited was starting to shift out of the first phase of a process that began in earnest in 1992, when Deng made his famous "Southern Tour" to the boom towns of the Pearl River Delta. That tour ended the decade of political and economic transition that had culminated in the 1989 Tiananmen incident and set the country on a new path guided by three core principles: economic pragmatism, international cooperation and the absolute primacy of the Party.

The first phase, lasting until 2002 and presided over by Jiang and Premier Zhu Rongji, was essentially one of capital accumulation. In post-Mao China, where the promise of economic prosperity (rather than political ideology) formed the basis of Party legitimacy, ensuring long-term social stability required better integrating the country's vast, poor hinterland into a modern, internationally oriented economy. But as Deng saw, size, geography and distance made linking inland China to the coast difficult.

Developing the interior meant laying entirely new road, rail and waterway infrastructure. That, in turn, meant amassing capital – which Beijing did by transforming coastal provinces, with their direct access to global shipping lanes and enormous pools of cheap labour, into "workshops of the world" – and channelling that capital into the state's main organs of economic policy, state-owned banks and enterprises. Jiang and Zhu oversaw this process as well as its consequences: a growing wealth gap between the relatively urban coast and mostly rural interior, multifaceted social discontent and mounting pressure from outside China's borders to comply with the interests of a US-led international system.

In many ways, the mid-2000s appeared to be a high time for the Party and China as a whole. Anxiety and social discontent over rising inequality by no means disappeared, but public sentiment was boosted by the sense – at home and internationally – that China had finally arrived on the world stage. This was embodied in preparations for high-profile events such as the 2008 Beijing Olympics and the 2010 Shanghai World Expo, but it was also apparent in Beijing's rising diplomatic clout and rapidly improving military – especially naval – capabilities. Throughout this period, Beijing benefited enormously from Washington's focus on the Middle East. Tensions between the two countries had risen sharply following the United States' 1999 bombing of a Chinese Embassy in Belgrade and the 2001 EP-3 incident over Hainan Island. But after 9/11, with the United States suddenly distracted elsewhere, the People's Liberation Army and Navy gained enough room to expand without risking international backlash.

However, under the surface of rising headline growth rates loomed a number of problems. Increasingly entrenched coastal business interests constrained the Party's ability to shift focus and funding toward developing the interior, while the Party leadership's half-hearted calls for reform to weed out corruption, constrained at every turn by extensive bureaucratic patronage networks, had little practical impact. And despite the Hu-Wen administration's goal of rebalancing the economy, low value-added exports and state-led investment continued to overshadow domestic consumption as drivers of growth. The 2008-09 financial crisis did not create China's fundamental problems; it exposed them. It exposed how uneven the country's growth patterns had become, how heavily economic growth depended on the state's ability to channel the savings of ordinary Chinese into sustaining the manufacturing and construction booms that sucked up resources and employment, and ultimately how unprepared China's economic structure was to absorb even a fraction of the goods and materials it produced.

New scale

When the 2008-09 financial crisis struck, China was the world's third-largest economy. A year later, riding the wave of Beijing's multitrillion-yuan stimulus package, it overtook Japan to become the second largest. In seven years, China's GDP had nearly quadrupled to more than $5 trillion, while the average worker's salary more than doubled. (In some major cities, per capita GDP rose fourfold between 2002 and 2008.) In 2009, the country imported well over half its daily oil consumption and had begun importing natural gas and coal. Two years later, when Beijing put the brakes on stimulus to avoid overheating, China was the world's largest energy producer and consumer, and Chinese demand drove global markets for minerals and raw materials.

The fifth generation leaders inherit a country whose problems, while qualitatively similar to those faced by their predecessors, are – like the economy itself – of a vastly different scale. In 2002, corruption, graft, inefficiency and inequality were pervasive. But they were manageable so long as the fundamentals of China's economy – and its role as unobtrusive supplier of low-cost goods to the world – remained intact.

Back then, low wages and input costs in coastal Chinese manufacturing boom towns made them natural complements to global, especially Western, consumers. Moreover, when Hu and Wen took office, they did not have to contend with a 300 million-strong and globally connected urban middle class (social media such as Weibo did not exist until 2009). And in 2002, with the world's attention settled on the Middle East, China's naval modernisation and moves in the South and East China seas drew minimal attention at best.

By contrast, Xi Jinping, Li Keqiang and the incoming Politburo Standing Committee face not only a slowing economy but also the end of an economic cycle built on low-cost, export-oriented coastal manufacturing. At home, they will be challenged by new levels of social unrest both in the Han core and in China's peripheral buffer regions, while abroad they must navigate rising tensions over territorial disputes and resource acquisition. On the eve of the leadership transition, at the tail end of a year rocked by political scandal and intrigue, the pressure to reform is enormous. But as with so many other problems left unaddressed by the fourth generation, China's new leaders will inherit a political system that is, in many ways, structurally incapable of changing itself.

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