Why China Will Find It Hard to Exercise Leverage Over the ASEAN Region

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John Lee is an expert on China’s political economy, Southeast Asian foreign policy and security, and U.S.-China relations. As a scholar at the Hudson Institute in Washington, he advises the Japanese and U.S. governments on strategic and economic issues. Lee is the author of Will China Fail?

For more than a decade, Lee has questioned the viability of China’s so-called market socialism model, arguing that without significant political reform, the country cannot sustain its economic and peaceful rise. He has predicted that its flawed and dysfunctional system will unravel at some stage, and this will have consequences for the world and especially its ASEAN neighbors, which have become dependent on its market and largesse.

Lee spoke with Knowledge@Wharton about China’s impact on its Southeast Asian neighbors. The following is an edited version of the interview.

Knowledge@Wharton: Is China going through the collapse that has been long predicted by experts like yourself?

John Lee: It depends on what you mean by collapse. If you’re talking about an American-style Lehmann Brothers collapse, that won’t happen because China still has adequate control of its financial system [and] guaranteed liquidity in the system. It’s still a pretty closed banking system so all those factors mean it’s got a resilience that a Western financial system doesn’t have.

If you’re talking about a Japanese-style stagnation, a structural tapering down, then I very strongly believe that is what China is going through now. The reason why I say that is, as we all know, the problem with the Chinese economy is too much debt [and] over-capacity. The cost of managing debt, using more and more natural resources to ensure that defaults don’t occur, is precisely what happened in Japan. We are seeing very clear signs of that occurring in China now.

Knowledge@Wharton: And what are the consequences for some of China’s nearest neighbors, like Japan, South Korea and ASEAN?

Lee: China will be more desperate to find new ways to generate growth. One obvious way is through export, which has become less important to China over the last five years or so. But as the domestic economy slows … China will implement policies that will aid its exporters. This will range from currency depreciation policies, increase [in] taxes and better subsidies for local producers for exporting. You’ll probably find that China will increase aspects of its domestic consumption market, to reserve these for [its] domestic firms. So I think we’re moving towards … a mercantile mind set for the Chinese, as they become more worried about trying to generate growth.

“One immediate consequence is that it will [be] harder and harder for the Chinese to throw money at foreign governments in an attempt to achieve political objectives.”

Knowledge@Wharton: How will that play out in details with, say, Cambodia, which has in recent times developed a deeper relationship, economically and politically, with China?

Lee: One way that it may play out is [in the area where] China has used its development aid to seduce a lot of these governments. When you look at where they get their money from — they get it from their foreign exchange reserves — we’re now seeing that China is using tens of billions of its foreign reserves to maintain stability in its currency. One immediate consequence is that it will [be] harder and harder for the Chinese to throw money at foreign governments in an attempt to achieve political objectives. There are also more subtle ways that may affect the capacity of China to exercise leverage.

China has always proffered the argument that its economic growth and growing domestic market will be the major source of opportunities for its neighbors, including Indochina, [but] as the Chinese economy slows, the narrative that China could use its domestic market as a carrot for other countries becomes less persuasive. China will still be [an] important source for every country, but it may not be as dominant a market as many people believed 15 years ago.

Knowledge@Wharton: But China would be hard pressed to let go some of those leverages it has gained?

Lee: China has found it relatively easy to exercise leverage through financial means for developing countries like Cambodia [and] Laos. But it has found it to be harder when it comes to more developed or larger countries like Indonesia, Singapore, even Malaysia … In their rhetoric, [these countries] have taken a very soft view on China, but if you look at what they have been doing behind the scenes, they have actually moved a lot closer to America.

China’s capacity to use economics to exercise leverage in more developed and successful societies in Southeast Asia has always been limited. And if you look at the numbers, what these countries need are two things. The first is capital, and the major source of capital into most of Southeast Asia outside of Indochina countries has been European countries, Japan, South Korea and America, not China — China is not even [in] the top five in any of these countries.

The second thing these countries need [is] export markets, and the dominant export markets are still America [and] Europe. Trade with China is largely processed trade, or intermediate trade, so the bottom line is that China still lacks a lot of the formal or actual economic levers to change the political and strategic trajectory of these countries. In the recent past, China has used the prospect of its future economic power for current leverage, but that becomes more difficult as China slows down.

“Whereas countries were before trying to remain neutral between the Chinese and the Americans, now, almost every major country is either hedging or balancing with the Americans.”

Knowledge@Wharton: What about Thailand? It has become more reliant on China in recent years. Its tourism industry, for instance, is geared towards the Chinese market.

Lee: Thailand is a rare case in Southeast Asia. It is different than the other maritime countries like Singapore, Malaysia and Indonesia. First, China has never been the big bad guy for [Thailand] historically, unlike countries like Vietnam or even Singapore in more recent times. Secondly, because of [recent] political developments in Thailand, its relationship with the West is strained, so China has taken opportunities to move closer to Thailand. The third thing is, Thailand is less interested in what happens in the maritime region in Southeast Asia, compared to Malaysia, Indonesia, Singapore, Vietnam. Thailand isn’t as worried about China’s behavior in the South China Sea as these other countries.

So when you look at all these factors, it is true that Thailand is much more willing to move closer to China, not just economically but even politically. And I would also note that there is significant concern within the United States about Thailand’s trajectory towards China. There are active debates, not so much openly in government, but in the think-tank community in America, as to whether the alliance with Thailand can be sustained over the next decade or so because of Thailand’s move towards China.

Knowledge@Wharton: At the same time, China’s play in the South China Sea has driven countries like Vietnam closer to the U.S. Do you think China has overplayed its hand in the South China Sea dispute?

Lee: I think China has overreached. If you go back a few years when China was trying to convince the region of its peaceful rise, when China was undertaking its rapid military build-up, it justified it by saying that it was about Taiwan — preventing Taiwanese independence. Now, given that the South China Sea is, in its own words, a core or essential interest, no one believes any more that China’s military build-up is about Taiwan’s straits.

So if you look at what China has done in the last five years, [they] have systematically exacerbated things in the East China Sea; the Taiwan Strait has never been good; and [now there is tension] in the South China Sea. When you look at the end result, whereas countries were before trying to remain neutral between the Chinese and the Americans, now, almost every major country is either hedging or balancing with the Americans. Japan has gone further with the Americans. Singapore, behind the scenes, [and] Malaysia [have] gone further with the Americans. Indonesia is hedging against China. Vietnam is looking towards America once again. And Australia has gone closer to America. Now this doesn’t look like a great strategy to me … so I do think they have overreached.

Knowledge@Wharton: So much of that power play has been funded by years of double-digit growth, what happens now during the current downturn?

Lee: I think it’s under-appreciated that there will be a huge impact. If you look at the last 15 years up to 2013, China’s fiscal revenue has gone up about 20% a year on average. If you look at 2014, it grew about 7% to 8%. If you look at 2015, it’s about 6% to 7%. So you’ve gone from an average of 20% to 6% to 8% growth. Now, the PLA’s [People’s Liberation Army] budget has grown about 10% to 15% each year during that period, so it’s pretty obvious that it will be harder and harder for China to sustain those sorts of increases in military spending, particularly when you consider that more and more of the fiscal budget is being used to stimulate the economy or bail out either banks or indebted state-owned enterprises or local government entities. You’re [going] to get more pressure on the public purse.

“The problem for China now is that a lot of countries have suspicions about the political motivations of China in allowing billions of dollars of capital into their countries.”

Knowledge@Wharton: What about funding for its AIIB [Asian Infrastructure Investment Bank]?

Lee: The funding for China’s infrastructure bank was to come from its foreign exchange reserves. Now it still has about $3.2 trillion, but that’s gone down by something like $800 billion over the last year or so, largely to support its currency. China still has a war chest, but it can’t allocate too much towards speculative projects, compared to a few years ago. Second, if you look at China’s rationale behind the Asian infrastructure bank, it’s essentially a way of trying to export excess capacity, that is, [to] find markets for its infrastructure companies because the Chinese domestic market has become too saturated.

The problem for China now is that a lot of countries have suspicions about the political motivations of China in allowing billions of dollars of capital into their countries, so countries will still want some of the money China is offering to build infrastructure, but I think they will be more wary about the consequences.

So the bottom line, to answer your question, is that [the] infrastructure bank will still go ahead. China will still fund some projects, but I don’t think it will be a game-changer in the region. Actually, if we look at the numbers, China’s infrastructure bank — [the amount] being talked about is $100 billion. Compared [with] the Asian Development Bank, which has a little bit more than that and the World Bank, which has about four times more than that, when you look at the infrastructure needs of the region — which needs a trillion — [the AIIB is] a small drop in the ocean. It’s significant, but it’s not a game-changer.

Knowledge@Wharton: How long do you think the Chinese currency will continue to fall?

Lee: The Chinese currency is falling at the moment because … of the capital flight out of the country. Investors and firms are losing confidence, at least [in] the short-, medium-term future of the Chinese economy. It’s not because China has been trying to depreciate its currency to help exporters, it’s actually more because of market forces. The problem for China is that [if] their currency falls too much, then imports become too expensive into China, which increases the cost of living … It has all sorts of negative consequences for the local economy, so the Chinese government has been using its foreign exchange reserves to buy Chinese currency to ensure that it’s not too volatile. That’s where we are at the moment.

In terms of a regional impact, other countries in the region are quite export-dependent. This ranges from advanced economies like Japan and South Korea to middle-income countries like Thailand and Malaysia — and these countries have suffered in terms of their share of exports, particularly to advanced economies. So it will be irresistible for those countries to depreciate their own currencies, and you’ve seen Japan doing that, for example.

What we may be seeing now is a currency war emerging in Asia. If that happens, that’s particularly bad for the developing economies, because if they depreciate their currencies, investors won’t invest in their countries because their currencies are worth less. And so these countries are stuck between China and exports … and trying to encourage foreign direct investment into their countries, which they desperately need. My summary is that the advanced economies like Japan and Singapore are better able to tolerate a currency war than the developing and undeveloped countries.

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