Bridge the Gap

The "Nuclear Option" : Increasing Global Economic Instability and the Realities of US-China Relations

The past week was noteworthy as the subprime mortgage market continues to melt down and wreak havoc on financial institutions and stock markets worldwide.  People are understandably nervous as the longtime US housing bubble begins to unravel.  In addition to the instability introduced into the financial system, let's not forget the impact it is having on people's lives.  Although one could argue that those who can no longer pay back their interest only ARMs were asking for financial trouble when they signed the mortgage papers, it is still not pleasant to have your house foreclosed.

Getting back to the larger picture, the Chinese government is starting to hint at taking a hard line stance in its economic relations with the US with comments this past week introducing what is now being called the "nuclear option." An economist from the Chinese Academy of Sciences, the pre-eminent think tank in China, and one from the government's Development Research Centre stated in relatively clear terms that the PRC should and will likely use its more than $900 B stockpile of US bonds to counter any move by the US Congress to try to compel China to allow the yuan to appreciate more aggressively.  This comes a week after Treasury Secretary Paulson made an unscheduled and unsuccessful trip to Beijing to try to advance the dialogue on exchange rate reform.

Hard-nosed diplomacy is nothing new and the US and China both take this tack at times, but one really has to wonder what Beijing is thinking here.  China is adamant about not being seen to be giving in to US pressure in the bilateral economic relationship, so they turn around and try to pressure the US in a way that is extremely counterproductive.  By making these threats, Congress will likely be more not less likely to push for legislation.  In spite of the fact that President Bush has said he will veto any such bills, China's threats serve to isolate Bush even more.  This does not serve Beijing's interests in a number of ways:

• With the election coming up in the US next year, the Democrats leading candidate Senator Hillary Clinton has already come out strongly against the US being held hostage economically by other countries.  These recent economic threats embolden and validate her strategy;
• Moreover, if China did in fact move to sell off some of its US treasuries it would have a strong negative impact on the US economy, likely sending it into recession.  This in turn would further increase the likelihood of the Democratic Party winning in 2008, all of whose candidates are distinctly less friendly towards Beijing than the Bush Administration;
• Equally important is that as China's largest trading partner a US recession would cause major problems in the Chinese economy right at the time that the country is trying to show its strength and progress to the world via the Olympics.

China has made great strides on the international diplomatic stage over the last decade and particularly in the last few years.  Let's hope that the higher ups in the government understand that trying to apply economic leverage at this juncture will cause serious damage to China-US relations and empower factions in the US that are less tolerant of Beijing's economic, diplomatic and military policies. In addition, any action to sell off US treasuries would increase economic instability at home and abroad at a time when domestic inflation is creeping up, there are large bubbles in the housing and stock markets, and the country is preparing for its Olympic coming out party.

And Now for A Little Fun...

Thanks to Foreign Policy for alerting me to a fun little quiz.  Test your global knowledge by typing in as many countries as you can think of in a ten minute timeframe.  I got 104 and then kicked myself when I saw some of the names I forgot.  Have fun!

192 UN Member States Quiz

China's Anti-satellite Missile Test

A well-balanced analysis of the repercussions of the PLA's successful January 11th anti-satellite missile test came out today from the folks over at the Power and Interest News Report.  Giuseppe Abruzza, an academic from La Sapienza University in Rome, argues persuasively that although China is investing heavily and making rapid progress in its space program, it still lags far behind the US and Russia.  Moreover, additional tests in the coming years will easily be monitored and allow time for the US to come up with improved counter-measures to protect observational and weapons-guidance satellites.

The tone of the analysis probably will not quiet any of the concerned brass in the Pentagon, but it is one of the more thoughtful pieces I have seen since the test.   China and the US are what I like to call "friendly competitors," with an emphasis on the competitors.  Whether or not one believes the "peaceful rise" rhetoric from Beijing, from a military standpoint the US retains a monumental advantage compared to the PRC.  Unless China significantly improves its ability to develop native technology, the gap between it and the US in the ability to project hard power will not close nearly as quickly as it is closing the GDP gap.

Download pinr_chinas_asat_test_and_its_impact_on_the_united_states.pdf   

Grad School Days

I just uploaded a group of papers from my days at Johns Hopkins SAIS.  These were on my old personal website and people seemed to enjoy them.  If you have some time, you can check out some ramblings on politics, economics, and defense issues related to China, India, Japan, Korea, and Mexico by following the links in the Grad School Days section on the right side of the page.

WSJ on Japan's Nuclear Options

Insightful article from today's WSJ on Japan's nuclear options, arguing that any major change to the status quo will take time due to constitutional issues and lack of political consensus.

Download testing_japans_resolve_wsj_11606.pdf

From If to When

I was sitting on a boat in Halong Bay when North Korea announced they had tested a nuclear device and set off the latest global diplomatic crisis. And the first thing that came to mind when I logged on back in Hanoi and saw the news was “Oh Shit.” I won’t pretend to do a detailed analysis here, but we now have a more forceful stance from a North Korea that is still in economic crisis; an increasingly concerned China that is extremely unhappy and has just lost a huge amount of face in the international arena courtesy of one of its supposedly closest allies (this at a time when the PRC is trying to prove that it can and should play in the first tier of the international diplomacy game); Japan has a new Prime Minister that is more nationalistic than Koizumi (and the papers were immediately debating whether Japan will now go nuclear, too); South Korea is still afraid to provoke its neighbor, whether out of national brotherhood or being scared shitless that Seoul will get leveled I am not sure.

So what does it all mean? I don’t know. Still, I can’t help but feeling that we have moved from the time of if to when there will be conflict in East Asia. Between a nuclear North Korea, a reflexively nationalist China, a Japan that is increasingly less willing to leave its security guarantees to the US, the Taiwan problem looming in the wings, I am very pessimistic about the stability of this part of the world. It may not be today or tomorrow, but within the next 10 years the probability of conflict in the region feels as if it has moved from somewhere around 25% to 50+% in a very short period of time.

Like I said, this is not a hard core analysis. Things may cool down soon.  But when I bring up Japan to educated, successful Chinese , and they immediately speak about how all Chinese hate the Japanese (in the tone that they will always be mortal enemies), I have to wonder how long it will be before nationalism, economics, old axes to grind, and military calculations stir up the pot enough to cause armed conflict…

Barnett-Oksenberg Lecture - Current State of US-China Relations

Wednesday night in Shanghai a cross section of the city’s political, business, and academic elite gathered for the third annual Barnett-Oksenberg Lecture at the Jinjiang Hotel. Billed as an unofficial "State of US-China Relations," this year’s main speaker was Ken Lieberthal, the professor from the University of Michigan and former Clinton National Security Council staff member. Professor Huang Renwei from the Shanghai Academy of Social Sciences provided commentary and also took part in the Q&A that followed the main session.

Lieberthal’s speech focused on current US perceptions of the cross-Pacific relationship. Much of it was textbook stuff, but there were some interesting insights as well. Lieberthal highlighted five areas that are driving US perceptions/concerns about China:

1) China has become a domestic issue in the US, especially due to the major impact it continues to have on the manufacturing sector.

2) There is strong uncertainty about the future development of China, which makes US policymakers and citizens in general, nervous. Lieberthal pointed out that of all the major developed and developing countries on the globe, China has the widest range of possible outcomes over the next ten to twenty years, and there is little clarity about where in this range the PRC will wind up.

3) There is concern in the US that the emerging "China model" or "Beijing consensus" is a threat to the democratic, free market development path that the US model offers. Although Huang pointed out that the "Beijing consensus" is a fabrication of US, not Chinese academics, the fact that China is taking a more aggressive diplomatic role across the globe is making more and more people within the DC establishment concerned about its intentions.

4) Along these lines, there is concern over the unclear intentions China has for its increased regional role. China has appeared to be happy at the rise of regional diplomatic groups such as the Shanghai Co-operation Organization, which do not have the US as members.

5) Within the US there is a major disagreement between hardliners and the center about the long term nature of US-China relations. Although this is nothing new, Lieberthal pointed out that the lack of transparency from China’s military buildup only gives firepower to the hardliners in the US, which in turn reinforces the hardliners in the PRC.

Lieberthal also highlighted the fact that 2006 will be a problematic year for the US-China relationship because of the midterm elections upcoming. He pointed out that given the strong possibility that China will be labeled a currency manipulator by the Treasury Department and that there is a strong possibility that Congress will gain final approval over CFIUS decisions, there will be a lot to test the relationship in the next nine months.

While summing up, Lieberthal had some constructive recommendations, including bringing China into the G8, establishing an integrated energy discussion forum so that the US and China could cooperate more rather than compete for energy resources across the globe, and forming a systematic impediments group to look at structural problems in the Chinese and US economies that are detrimental to the bilateral relationship.

The Rise of KPO

Just back from an India trip and laid up with the flu.  Not so bad though, given that Shanghai is beset by tourists and most everyone who lives here is out of town for Chinese New Year.  BTW, 新年快乐 (Happy New Year) to all of you.

The trip was interesting and I was in Bangalore most of the time.  Most of the major technology companies have set up shop there by now.  But I have to say that I was particularly impressed that Siemens and D Link had facilities in Goa, near the beaches I visited last weekend - nothing like being able to go to the beach after a day at the office!

Bangalore is still a sleepy town, but over the course of time it and the rest of the tech centers in India are just going to become more important players in board rooms across the world.  Much has already been written about outsourcing, but this usually refers to business process outsourcing, or BPO.  BPO  is the outsourcing of basic business functions, e.g., support call centers or medical transcription services.  This is a huge industry and India will continue to  lead its aggressive growth.

The other emerging area of outsourcing is knowledge process outsourcing, or KPO.  It is KPO that should be setting off alarm bells in Washington and London (for it is English speaking countries that will be most affected).  KPO involves areas such as financial modeling and writing research reports for Wall Street, doing biotechnology research,  or building advanced databases that can be used, e.g., in managing the hiring process for an HR department - in short advanced business functions that require strong expertise and process knowledge in an area.  India is already the leader in KPO, and as the industry grows ferociously during the next five years, amazingly, India will only become more dominant in KPO. 

Now I don't think that the Bush administration should throw up protectionist barriers to combat this issue; indeed, I think that if they did it would be futile.  However, they need to  understand that every business function that can be done remotely will likely get outsourced within the next decade.  What to do?  The answer is not simple, but has to focus around two areas: 1) aggressively supporting research and services that are geography dependent, much in the same way that the US has to help manufacturers that are geography dependent as it faces the China threat; and 2) fund as much as possible advanced research areas such as nanotechnology and energy research that by their natures cannot be easily outsourced.  Now the US is already doing this (as is the UK) with nanotechnology initiatives.  In addition, in the State of the Union speech earlier, Mr Bush pledged more support for clean energy research.  Now one can argue about definitions - I for one have a problem with nuclear energy being classified as clean, although I do think it is a valid path to develop energy supply - but I do not believe that we can overfund these areas. 

India is well placed with outsourcing picking up steam - and this is a good thing as it is helping thousands if not millions of Indians lead wealthier, more productive lives.  At the same time, the US and other English speaking countries have to move aggressively to provide training and research funding for areas that cannot be outsourced, if they are to retain their dominance in research and development and the service industries.

The Economist's World in 2006 is Out

Simply a must read...  http://www.economist.com/theworldin/?d=2006

Bush's Visit to China

While President Bush's visit to Asia was all over the international press, it was pretty hard to find significant coverage in China.  Most people I know seemed aware of the visit to Beijing, but nobody seemed too interested.  President Bush's open statement to China's leaders to move toward greater political representation and support greater freedom of expression, especially religious freedom, surely played well to the President's core constituents.  However, his speech at the Great Hall of the People fell on deaf ears.  Washington has struck a bargain with Beijing and now the PRC and the US are economically intertwined in a way that is not easy to unravel.  This is most likely a good thing, but after continuing to encourage this economic interdependence, prodding and pushing Hu and Wen on some of their most sensitive issues are not constructive.  Hu is trying to further consolidate his power, as highlighted in this Economist piece, and will not do anything to jeopardize his standing in the early days of his rule.

The US strategy of encouraging political openness through economic development is a long term strategy that may not work in all circumstances.  China will continue along its chosen development path and at this point will likely offer only minor concessions and pay lip service to the US President or Congress on economic issues.  To be sure, China should move toward increased flexibility in the yuan, but mainly this will benefit China, by decreasing inflationary pressures and encouraging improved capital allocation.  It will not have a significant impact on the US current account problem.  As such, President Bush would do well to  focus his energies in the bilateral relationship on continuing to encourage Beijing in its diplomatic role as a regional leader that has the ability to increase the stability of East Asia.  Otherwise, President Bush may find that during the last three years of his presidency, China's leaders turn an increasingly deaf ear to his administration as they wait for elections in 2008.