Brazil - The political economy of low economic growth (2014)

Brazilian economic growth has been disappointing of late. At the end of Lula II, the seven-year real GDP growth had crept up to 4%. By 2015, seven-year growth will have declined to its multi-decade average of 2.6%. Put differently, under Lula I and II (2003-10), real GDP growth averaged 4%, significantly higher than the 2.3% registered under Cardoso I and II (1995-2002). (This does not mean that the Lula governments can take all the credit. After all, it was the Cardoso reforms that laid the foundation for subsequent accelerated economic growth, helped by rising commodity prices and moderate-to-low global interest rates.)

If current forecasts are correct, economic growth will average around 2% under Dilma I (2011-14). Admittedly, Brazil is not the only EM to experience a broader decline in trend growth. India, Russia, Turkey, even China, have seen lower growth in recent years, compared to the 2003-10 period. Nonetheless, real GDP growth of 2% is very low even by EM standards. This raises the question why the government has not taken more aggressive measures to lift economic growth. 

Source: IMF

The government did, of course, react to slowing growth. However, the Dilma government has focused more on demand than supply side measures. This has proven to be a mistake, for it resulted in higher inflation and larger (quasi) fiscal deficits, while it failed to prevent a decline in the economic growth rate. It is tempting to argue that, absent these measures, economic growth would have been even weaker still. However, higher inflation points to supply side constraints rather than a lack of demand. Under Dilma I, inflation has been 120bps higher (6% vs 4.8%) and real GDP growth has been 250bps (2.1% vs 4.6%) lower than under Lula II.

While the demand-side-oriented policy response to the global financial crisis in 2008-09 was completely appropriate, the continuation of relatively loose monetary and fiscal policies, including quasi-fiscal expansion through public-sector bank lending, failed to address the real problem: growing supply-side constraints. Basically, Brazil’s output gap closed quickly post-crisis due to a tight labour market and insufficient investment. If anything, the gradual erosion of the macroeconomic policy regime (higher inflation, larger fiscal deficits) may have helped undermine policy credibility in the eyes of the (real economy) private sector. While tax cuts and energy price reductions, for instance, were meant to make the economy more competitive, they were largely interpreted as lacking credibility and as unsustainable over the medium term given their fiscal costs. In this context, the government investment programme (PAC-2) and concession sales, which have been slow to take off mainly due to squabbles over rates of return, has thus far proven too little too late.

So what are the chances that Brazil will see a policy shift over the next year? In the past, severe financial crises spurred reform efforts. Hyper-inflation led to plano real under then FM Cardoso, admittedly after repeated failures to defeat inflation over the previous decade. The banking crisis in the mid-nineties led to large-scale bank restructuring and regulatory reform. The financial crisis of 1998-99 led to the adoption of the Fiscal Responsibility Law. Last but not least, the balance-of-payments crisis of 2002 led the Lula government to convert to fiscal discipline and an orthodox monetary policy. 

Today Brazil is not at risk of an imminent crisis. In the worst-case scenario, it will be stuck with a 2.5% growth rate. Unfortunately, low economic growth appears to be a politically stable equilibrium in the short-term. Unemployment is at record-lows, real incomes continue to rise and a large number of people continue to move into an expanding middle class. This has allowed the president to maintain a dominant lead in the polls and this makes a meaningful shift in policy before the October elections extremely unlikely. 

The relevant question to ask is how sustainable this equilibrium is over the medium term. If real GDP growth continues to trend lower, an uptick in unemployment looks quite possible given continued labour force growth. A sustained slowdown in income growth might also affect government popularity. Equally important, dissatisfaction with public services and an inadequate infrastructure is on the rise. Dilma’s approval ratings hit all-time lows during last year’s protests. This might give the next government sufficient political incentives to more aggressively focus on supply-side-oriented reforms and infrastructure investment (including concessions).

In short- to medium-term, a variety of supply side reforms (e.g. labour market, minimum wage, foreign trade) and an acceleration of public investment and concessions sales would help raise the growth potential and might also help address public discontent. Sooner rather than later, however, the government will have to slow down the growth of current expenditure (mainly transfers) to below the rate of GDP growth in order to increase domestic savings and the economy’s capacity to finance higher domestic investment. Politically, this appears unpalatable, not least becase inter-temporal trade-offs are typically solved in favour of limiting near-term political costs rather than long-term economic benefits. In Brazil, as in most democracies with competitive elections, short-term political expediency tends to outweigh longer-term economic rationality. 

A more orthodox policy might go some way in restoring confidence. (Presidential candidate Eduardo Campos has talked about the need for a more orthodox monetary and fiscal policy.) Broader structural reforms aimed at raising total factor productivity are also highly desirable. But unless the adjustment takes place in the context of slowing down the growth of current expenditure, it is likely to negatively impact public investment. This makes the government understandably reluctant to do what is necessary to live up to its recently re-affirmed commitment to fiscal discipline. Sooner or later, the government will have to accept that it needs to slow down the growth of current expenditure if domestic savings and investment are to rise sustainably. 

One might think that such a policy shift may become less costly in political terms once income growth slows, unemployment rises and public dissatisfaction with a poor infrastructure increases. Unfortunately, the government will likely seek avoid such an adjustment and the concomitant political costs by allowing the fiscal deficit to widen. In other words, there is for now a way for the government to have its cake and eat it. In terms of fostering higher long-term growth, this is a sub-optimal policy and it will likely be insufficient to lift real GDP growth above 3%. A credible, longer-term fiscal adjustment aimed at raising government savings (aka limiting the growth of current expenditure) and flanked by accompanying supply side reforms is necessary to raise domestic investment, increase productivity and lift the growth potential back to where it was during Lula I and II.

A few thoughts on EM government debt (2014)

The global financial crisis has not resulted in a general increase in EM government debt, unlike in the advanced economies. EM government debt is generally lower than in advanced economies. After all, empirical evidence suggests that emerging economies tend to suffer from so-called debt intolerance (Reinhart & Rogoff 2003). Estimates as what is a safe level of government debt typically range from 25-40% of GDP for EM, and much higher for advanced economies. Most major EM are in good shape.

Declining sovereign foreign-currency (FCY) mismatches have helped the top-tier EM avoid systemic financial crises in the past ten years. Typically, local-currency (LCY) as opposed to FCY debt affords governments with greater financing flexibility in terms of relying on the central bank as a lender-of-last resort or in terms of raising LCY liquidity through taxation. Moreover, reduced FCY debt makes government debt levels far less susceptible to sharp upward increases in the event of a balance-of-payments shock and currency depreciation.

EM total (public and private) net external debt varies greatly. Sovereign debt crises are often triggered and/ or exacerbated by the existence of contingent liabilities that governments are forced to assume (e.g. banking sector rescue). Today the EM’s total net external debt position is relatively solid. The 2008 crisis has demonstrated this already. Given restrictions on the size of FCY risks the systemically important banking sector can run, the overall FCY position is quite manageable. Combined manageable overall FCY mismatches, EM have little “fear of floating” these days in part due to the sovereign’s ability to provide FCY liquidity to the private sector and in part because “sudden stops” are self-correcting if exchange rates are allowed to depreciate. Tellingly, China and Russia, the two EM with the least flexible currency regimes, run the largest net FCY position.

External financing requirements are overall manageable and much smaller than a decade ago. More sustainable current account positions combined with larger FX reserves has translated into very manageable external financing requirements (EFR). Both the probability and the impact of a sudden stop are significantly smaller than before. Turkey, no question, is the EM most susceptible to a sudden stop. Luckily, the public sector’s net FCY exposure is close to zero, even though its FCY debt as a share of GDP remains relatively substantial at 20% of GDP. An important risk mitigant is a well-hedged banking sector. Thanks to well-hedged sovereign and banking sector balance sheets, Turkey can withstand even significant currency depreciation without running the risk of experiencing a systemic financial crisis as it used to do in the old days (e.g. 2000-01). Large EFR continue to make it susceptible to a sharp economic slowdown in the event of a sudden stop.

Non-resident holdings of EM domestic LCY government debt have increased dramatically. Low US interest rates and reduced EM sovereign FCY issuance have led foreign investors to pile into domestic LCY bonds. While this effectively transfers FCY risk from the issuer to the investor, a large share of foreign domestic bond holdings may nonetheless represent a vulnerability. Foreign holdings have proven quite stable during the 2013 tapering scare. Foreign holdings of domestic bonds are typically concentrated in longer-term, fixed-rate bonds. While this might raise volatility on this part of the interest rate curve in the event of heavy foreign selling, it also limits government refinancing risks. Short-term debt is largely held by residents and they are arguably far more likely to roll-over their debt than foreigners, even in times of market stress.

Government re-financing risks are very manageable. Given solid total external financing requirements and, even more so, the very small share of short-term FCY government debt, FCY refinancing risks have ceased to be an issue for EM. What about overall (basically: LCY) government refinancing risks? It is naturally unfair to compare the financing requirements of advanced economies to those of emerging economies. The former typically benefit from a deep and diverse investor base, often including foreign official investors in addition to a large number of non-bank investors. As far as the EM are concerned, Brazil and India, the two emerging economies with the highest government debt, have the largest gross financing requirements. India benefits from a captive investor base, while Brazil has not experienced liquidity problem with the exception of the 2002 crisis, when the prospect of Lula winning the elections and repudiating debt spooked even domestic investors. Since then, the structure of Brazilian government debt has improved dramatically. A relatively low share of foreign holdings might also be regarded as a mitigating factor in the case of Brazil. Less than 20% of domestic debt securities are in the hand of non-residents investors. In short, liquidity and foreign-currency risks attaching to government debt look quite manageable, even in Brazil and India.

Source: IMF

Cyclically-adjusted primary balances have moved from surplus into deficit over the past few years. Commentary is often focused on this fact. The intuition seems to be that a primary deficit is equivalent to a Ponzi scheme. While in absolute terms debt does increase ad infinitum, the financially relevant metric is the debt-to-GDP ratio. As long as this ratio does not increase indefinitely, government debt is sustainable. What matters therefore is the so-called the interest-rate/ growth differential. 

A favourable interest rate/ growth differential affords most EM to run a primary deficit. The IMF provides estimates of the interest-rate/ growth differentials for the EM. Brazil is the only country with a positive differential due to a combination of high domestic interest rates and low trend growth. Assuming the IMF forecasts are correct, all EM can afford to run (varying degrees!) of primary deficits without seeing their debt-to-GDP ratio indefinitely. In some cases the forecast primary deficit exceeds the interest rate/ growth differential, but the difference is small. 

In the baseline scenario, the adjustment in the CAPB required to stabilise government debt falls within the margin of error (0.1-0.2% of GDP). In the case of Russia, the uncertainty attaching to the CABP forecast is especially significant given the dependence on energy-related revenues. What but if the IMF is too sanguine about the interest rate/ growth differential? This could be the case of if the IMF growth projections are too optimistic and/ or the IMF is too bearish on interest rates. The IMF growth projections appear reasonable. Only Indonesia and Mexico are projected to experience faster growth in 2014-19 than during the boom years of 2002-07. The Brazil projection may appear optimistic. But Brazil should manage to grow 2% a year over the medium-term.

In a downside scenario, government debt dynamics do not appear overwhelmingly unsustainable. If differential moves by 100 bps against the EM, most of them would need to improve their CABP. Brazil, Russia and South Africa would need to make the largest fiscal adjustment in the order of 0.5% of GDP (and sustain it) in order to stabilise debt at current levels. All said, the deterioration of the CAPB should not be too much of a concern assuming (moderate) growth projections and interest-rate projections are more or less correct. Naturally, it would be desirable for the EM to improve their CABPs in order to increase their policy flexibility and widen their fiscal space, including the capacity to react to adverse shocks.

EM government debt would be manageable, even if government were to assume significant banking sector related contingent liabilities. Two words of caution are in order, though. Calculating the CABP is as at least much an art as a science. Moreover, discretionary policy measures can quickly lead to changes in the CABP, while contingent liabilities often materialise rapidly and unexpectedly. Especially the latter can quickly add to the government burden, raise interest rates and interest payments and thereby undermine medium-term solvency, absent a broader fiscal adjustment. In addition to wars, banking sector bail-outs have historically proven a major source of contingent liabilities. Assuming, heroically, that EM governments are forced to recapitalise their banking sectors with funds equivalent to 15% of total bank lending, government debt ratios would increase, but not to an extent where it would irredeemably undermine government solvency. Luckily, EM with large banking sectors tend to have low to medium debt levels and vice versa.

All things considered, government liquidity and solvency risks, including contingent liabilities, appear very manageable in the top-tier EM. The risk arising from contingent liabilities is also manageable. Last but not least, even if EM growth were to underperform and/ or EM interest rates were to rise more than currently expected, the fiscal adjustment required to stabilise the debt-to-GDP ratio looks politically and economically feasible. High nominal/ real GDP growth and limited FCY mismatches, which allow EM to devalue their currencies in order to boost economic growth, would make such an adjustment easier to implement than in economies with a lower growth potential where currency depreciation is not a policy option (e.g. euro area).

China’s rise - trade expectations & naval expansion (2014)

China’s export-oriented industrialisation strategy has proven highly successful in terms of economic growth and development. Economic openness is a critical ingredient of late development. The division of labour allows economies to specialise and take advantage of their respective comparative advantage. Economic openness offers late developers access to advanced technology, even if in the case of China high-technology sales are restricted. From a national and economic security standpoint, however, China’s growing integration and especially a sharply increased dependence on strategic commodity imports have created sensitivities and vulnerabilities. China is the world’s largest exporter of goods. Economically, gross exports overestimate the importance of foreign trade for economic growth, or at least value-added. The value-added may well be less significant that what gross exports to GDP imply. 

Chinese foreign trade as a share of GDP has been declining. Moreover, Chinese foreign trade as a share of GDP is not extremely high, but China’s dependence on commodity imports and its reliance on trade-processing-related job creation over the past few decades alerts makes foreign trade, access to foreign markets and control of sea lines of communication a very important issue. Processing trade is by its very nature very employment intensive. Local value-added has been increased over the past few years and over time, China will become a major source of final demand in its own right. While this will make China more important to other countries and makes political support for a trade embargo less compelling, it will not impact China’s perceived vulnerability significantly. Strategically, the dependence on foreign trade combined with concerns about future access to necessary markets creates considerable incentives to build a navy powerful enough to secure sea lines of communication.

China’s vulnerability to a disruption of international trade is nonetheless significant. Seaborne trade is critical to China’s continued economic development. China is a net commodity importers, 90% of its trade is seaborne as well as 80% of its energy imports, most of which need to pass through the Strait of Malacca. China’s desire to gain control or at the very least be in a position to deter threats to sea lines of communication is eminently understandable. This helps explain significant Chinese efforts to diversify the sources of its commodity and energy exports, including sources that do not depend on seaborne transportation such as Central Asia and Russia. China is becoming increasingly dependent on the imports of natural resources and food stuffs. China is a net manufacturing exporter and a net commodity importer. The dependence is on food and commodity imports is economically and politically more important than a dependence on overseas markets for manufacturing exports. China’s dependence on commodity imports renders it potentially vulnerable, politically and militarily, to outside pressure. It also represents a potential threat to domestic political and economic stability.

Arguably, China’s position is not all that different from Germany’s in the early 1900s and Japan’s in the 1930s. The breakdown of a relatively open world trading system and the emergence of economic blocs was one reason. In an environment where managed trade and political power and domination, the emergence of trade blocs (Ottawa), it is not surprising that aggressive states like Germany and Japan enjoyed significant support among industry. Once again, none of this is to deny that there existed very important qualitative differences between British Commonwealth, Germany’s Lebensraum and Japan’s Greater Asia Co-Prosperity Sphere. In fundamental economic terms, the differences were far less pronounced, if they existed at all. The causes behind Japan’s imperial drive are no doubt complex. Once again, strategic imperative featured nonetheless prominently. Gaining control of resource-rich Manchuria or, under increasing pressure, ensuring access to vitally important natural resource of South-East Asia underpinned Japan’s politico-military expansion, whatever other motives and causes might have played a role. German leaders had good reason to worry about the dependability of outside suppliers. In the decade and a half before the war, dependence on trade for vital goods increased dramatically, driven by phenomenal growth in both population and industrial size. Domestic oil production, for example, had gone up 140 percent from 1900 to 1913, but still accounted for only ten percent of total German oil needs. The state went from being a net exporter of iron ore as late as 1897 to relying on outsiders for close to 30 percent of its needs by 1913, despite domestic production increases of 120 percent. By 1913, over 57 percent of Germany's imports were in the form of raw materials, versus 44 percent in 1903 and 41 percent in 1893. All this was occurring at a time when Germany's ratio of trade to GNP was rising to new heights: from 32 percent in 1900, to 36 percent in 1910, to almost 40 percent in 1913 (Copeland 1996).

Naturally, the factors behind German and Japanese expansionism in the thirties and forties are complex – as are the reasons behind China’s naval modernisation programme. At some level, increasing naval capabilities are simply a reflection of economic growth and bureaucratic interests vying for financial resources. Strategically, however, it shows that rising powers are concerned about their dependence on strategic commodity imports. The breakdown of the international economic and financial system during the inter-war period led Japan to aggressively expand its sphere of economic influence. Its move into South-East Asia was in part driven by concerns about maintaining access to raw material. Similarly, the US oil embargo strengthened the case of the faction supporting the strike against Pearl Harbor.

Strategically, Germany was afraid of encirclement. This is today often derided as a phoney justification for German expansionism. But this is too facile. No doubt, German diplomacy made major mistakes and German Flottenpolitik was one such egregious strategic mistake in that it antagonised Britain and yielded zero military-political return given its inability to effectively challenge the British navy (Kennedy 1976). Imperial Germany had good reason to fear a naval blockade, as wide-spread starvation during the 1917-18 on the back of naval blockade demonstrated. Seeking to improve its imposition by forcing Britain into a naval race was politically and strategically disastrous. But this does not remove the underlying concern. The fact that Japan’s and Germany’s strategies failed disastrously should give Chinese policy-maker reason for pause. After their complete defeat in WWII, the two countries simply had no other option but to rely on the US for foreign market access and the protection of sea lines. The existence of a common enemy and a military alliance provided both countries with reassurance. Last but not least, neither country was in a position to challenge the US. China, by comparison, does have the potential to challenge the US over the longer term as well as locally in the shorter term. China and the US do not face common security threat. It is no surprise that China (Chinese planners and strategists) would be concerned about China’s maritime vulnerabilities.

Source: WTO     *excl. Hong Kong

Washington is strongly committed to the freedom of navigation and interested in maintaining a strong economic foothold in the region, and hence political stability. However, in a conflict situation, all bets might be off. Britain’s naval blockade helped bring Germany to its knees. Geo-politics and geo-economic logic leads China to build a navy. (Germany) Moreover, as China becomes economically more powerful, it will quite naturally seek to strengthen its ability to secure its trade routes. China has a strong interest in staying economically integrated. It also has an interest in mitigating its dependence on strategic commodity imports by diversification or protection. It will therefore be very interesting to see how the shale gas revolution will impact China’s reliance on energy imports. A growing economy and rising per capita incomes will nonetheless translate into significant commodity dependence, at a time when, interestingly, the US may be moving towards greater self-sufficiency. It therefore has a strong interest in mitigating or managing this dependence. Domestic political stability depends on it. China’s economic prosperity depends on it. So do ultimately its international influence and power. Political and military is built on economic prosperity and China’s economic prosperity is heavily dependent on trade and, more specifically, natural resource imports. 

Not surprisingly, China is pursuing a two-pronged strategy of protecting its sea lines of communication and of diversifying its sources of imports geographically, including seaborne and land-based (Central Asia, Russia, Africa). It is equally logical for China’s naval build-up to run head-on into the security interests of many of its neighbours and by extension the US. Military competition, unlike economic competition, if it cannot be avoided is a zero-sum game. From Beijing’s point of view, it makes perfect sense to pursue a strategy aimed at achieving economic security. Following MacMahon, sea power is meant to preserve commercial, political and military aces (in that order). China appears to fit this logic perfectly. China is not building its naval power in order to exert diplomatic and political influence in far-flung corners of the world, but in order to protect its commercial interests. The building of ports Sri Lanka and Pakistan is not as such a naval military strategy, though ports are dual-use, but part and parcel of securing trade routes, commercial access and diversification.

Source: CFR

Paradoxically, China’s naval expansion and territorial-maritime claims is bound to weaken China’s strategic position. Even though China may well succeed in pushing the US navy out of the East and South China Seas, beyond the so-called first island chain, strategically, this would not alter China’s position substantially as far as protecting its sea lines of communication is concerned. If anything, a more assertive Chinese stance will lead most countries in the region to move closer to the US. This is what Edward Luttwak (2012) calls the “logic of strategy”. Virtually all the countries making up the first island chain have an interesting in opposing China’s claims and in countering its strengthening naval capabilities, whether or not they join a formal alliance. As these countries control choke points that China would find it possible break through, China’s naval modernisation will have little to show for in strategic terms. It may help China gain control over its “near maritime abroad” and perhaps the natural resources that fall within the so-called nine-dash line. But this is a heavy price to pay for what no doubt will be perceived by Beijing as a strategic-maritime encirclement. The ghost of Tirpitz may end up haunting China. Germany’s imperial fleet proved pretty much useless in military terms and was extremely costly in diplomatic terms.

Beijing’s geo-political position is not great in the first place. The Philippines, Vietnam, Brunei, Malaysia have competing maritime claims in the South China Sea. Japan and China have competing claims in the East China Sea. Importantly, Myanmar’s decision to open to the outside world seems to be at least in part driven by concerns about becoming overly reliant on China, economically. Moreover, the US has close allies in Japan and Korea, Singapore, Australia and New Zealand, Thailand. India is also pulling closer to the US and naval competition is accelerating with both countries pursuing aircraft carrier programmes. Sino-Russian relations have historically been difficult and the two countries even went to war with each other in the sixties. While Moscow is keen, it is concerned about rising Chinese influence in Russia’s demographically Far East. In spite of energy co-operation, Russia regards China as more of a potential competitor than ally. In short, China has no major ally in the region. Laos and Cambodia are relatively insignificant countries. North Korea is more of a liability than an asset whose main use is to prevent the emergence of a unified Korea allied with the US.

China should therefore strenuously seek to avoid conflict with its neighbours and settle outstanding disagreements through negotiations in order to avoid countervailing alliances. It is far from obvious that the benefit of successfully asserting maritime claims outweighs the costs of antagonising its already suspicious neighbours and driving them into an anti-China alliance out. Beijing’s more assertive behaviour does bring about exactly the opposite. Instead of “speaking softly and carrying a big stick” (Teddy Roosevelt), it does almost the opposite. After all, what looks like aggressive posturing to its neighbours looks like a rational and logical step to reduce its vulnerability or at least raise the costs of imposing a naval blockade on China. This is the nature of a “security dilemma”. 

By contrast, the US has the advantage of being an off-shore balancer. China has territorial and maritime claims. The US has established a track record of relatively free trade and freedom of navigation. China has not. China’s more assertive diplomatic stance risks antagonising its neighbours, while its growing naval capabilities raises concerns. It is not easy being a rising power. This will make it attractive to many countries in the region. As an off-shore balancer and no territorial claims and committed to upholding the freedom of navigation, the US is perceived as less threatening than a rapidly rising, more assertive China. China has relatively few friends and zero allies. North Korea is useful in so far as it helps maintain a buffer between the China and future potentially US-allied, unified Korea. By contrast, China has a volatile friendly in North Korea and has garnered goodwill in Cambodia and Laos.

The risk of outright military conflict may be somewhat mitigated by confidence-building measures and strategic re-assurance, but it is far from obvious that it will suffice to overcome the logic of strategic competition itself. Some analysts have argued that a policy mix of reassurance and resolve may help manage rising security competition (O'Hanlon & Steinberg 2014). More likely than not, such policies may help mitigate competition and help manage some risks associated with (e.g. accidents), but it is unlikely to overcome the underlying logic represented by the security dilemma. China wants project power outwards, leading many of its neighbours to feel threatened. Moreover, the US is also very unlikely to concede East and South-East Asia to China’s sphere of influence. The need to reassure allies has led the Obama administration to pivot to Asia. This is of course not the way Beijing sees it.

China was for a long time focussed on Taiwan. Recently Chinese claims have become more extensive and have been asserted in a more forceful manner. China seems to claim most of the South and East China Sea and its expanding military capabilities are increasingly representing a threat to US naval assets operating in the Taiwan Strait and within the so-called First Island Chain (Japan, Taiwan). Ballistic anti-ship missiles even have the capability of striking US assets beyond the First and potentially second island china (Guam). This threat remains manageable from the US perspective, as China seems to lack the ability to locate and zoom in on a moving target thousands of miles at sea. Moreover, the US navy will have available tactical counter-measures. Nonetheless, China’s naval modernisation has begun to present a threat to the US navy. This contrasts sharply with the unchallenged control of the sea the US navy enjoyed until very recently. The other dimension of China’s naval build-up is to do with Taiwan and China’s long-standing claims to sovereignty there. Using nationalist rhetoric disguises the longer-term strategic objectives China is, consciously or unconsciously, pursuing.

In recent years, China is increasingly making its presence felt in the East and South China Sea. China is actively pursuing a policy of what military strategists call anti-access/ area denial. The US responds by adopting the Air Sea Battle concept that seeks to strike deep on land-based threats. The US seeks to maintain escalation dominance. Military planners are prone to see military relations as a zero-sum game. Strategists have to take into account the political purpose that military might is meant to achieve. It is important to distinguish between military competition and nuclear. A strong case can be made that nuclear weapons are deterrent instruments, much less so, if at all, coercive tool. This is all the more true in the case of two countries possess a nuclear deterrent. The existence of a nuclear deterrent may reduce the risk of an all-out war. This does not mean that military competition or an arms race cannot or is not taking place. The best China can hope to achieve in the short- to medium-term is turn the seas within the first island chain into an area of “mutually assured denial” (Holmes) for itself and its neighbours, including the US.

The risk is that China inadvertently enters into a naval race with the US and thereby antagonises its neighbours fearful of China’s territorial claims and concerned about China’s broader ambitions. A comparison with Imperial Germany seems to suggest itself. Wilhelmine Flottenpolitik did a great deal of damage to British-German relations and ultimately led London to reinforce its presence and meet the challenge head-on. The situation is however somewhat different in the sense that the German navy potentially threatened Britain directly rather than its overseas possessions or allies. Nonetheless, the outcome was relatively predictable. Diplomatically, it was a catastrophe. Militarily, it was a disaster. Famously, the German navy saw very short-lived naval action before retreating to its home port. A military strategy without a political-diplomatic strategy is not helpful and in many cases decidedly harmful. China may run the same risk. Rising naval power is one thing. Rising naval power combined with intensifying territorial and maritime disputes with its neighbours is likely to provoke a strong reaction from its neighbours, who will feel much less threatened by an off-shore balancer like the US than the rising hegemonic power in Asia. It is no coincidence that India is accelerating its naval build-up, including indigenous aircraft carriers. Japan’s launching is to be seen in the same light.

China, inadvertently or not, aims to shift the balance of military power in the surrounding seas in its favour, or at least acquire the ability to turn the seas into a no-go zone for the US and other countries. Its rather extensive maritime claims strongly suggest this. Moreover, the string of pearls strategy aimed at securing trade routes linking China to the region sitting on large, cheap energy, the Middle East, will bring China directly in competition with India. In addition to having unresolved border conflicts, China’s construction of port facilities around India littoral will lead India to respond. The fielding of an indigenous aircraft carrier and naval expansion show how seriously India takes China’s growing presence in the India Ocean and Arab Sea.

Meanwhile, Washington is responding to the perceived rise in Chinese power and capabilities in the political and military sphere by strengthening relations with its regional partners and allies (e.g. Australia, India, Japan) and increasing its military posture in the region, while treading cautiously in areas of more direct concern to Beijing (e.g. Taiwan). The TPP is squarely intended to exclude China by integrating the economies of Washington’s major allies and partner on both sides of the Pacific. No wonder, China feels this is another initiative directed against it.

Henry Kissinger (2011) dedicates the last chapter of this book to a brief comparison of the rise Imperial Germany after 1871 and that of China today. An important question is whether it is China’s intentions or its capabilities matter. It is clear that military planners are predominantly occupied with capabilities rather than intentions. In other words, military planners will tend to be offensive realists. Political leaders may or may not be defensive realists, but they have greater flexibility in terms of their world view. (It is therefore imperative that politician remain firmly in charge and ensure that military strategy remains subservient to a country’s overarching political strategy. After all, war is the continuation of politics by other means, not vice versa. Capabilities matter far more than intentions, at least as long as states have failed to build security communities (Deutsch 1957, Schroeder 2004, Wendt 1992). Socialisation may change things, but socialisation requires a context conducive to creating trust. A common threat or enemy may help alter perceptions more permanently (e.g. France-Germany after 1945) and it may have facilitated agreement or softened competition between Britain and the US post-WWI.

Barring a major accident, Chinese economic power and military capabilities will continue to increase and geopolitical competition in East and South-East Asia is bound to intensify. China’s increasing economic interdependence increases China’s interest in securing its seaborne lines of communication. Its economic rise affords it to expand its naval capabilities. While China remains many years away before it is in a position to reach naval parity, its expanding capabilities, combined with greater assertiveness in terms of maritime claims, have already begun to raise concerns among many of its neighbours as well as the US. China, as the rising power, is a less favourable position than the US as the off-shore balancer with no territorial claims and proven commitment to freedom of navigation. In military terms, China’s increasing capabilities and threat asymmetry will lead to intensifying military and naval competition in East Asia. The existence of nuclear weapons will limit the risk of war, but it does not prevent conventional military competition. Economic and financial interdependence will raise the costs of military conflict, but it will not render it impossible. After all, interdependence did not prevent the outbreak of WWI. It is crucial that political considerations outweigh purely military considerations. This is what distinguishes the responsibilities of the political and military leaderships. Sound strategy makes it absolutely imperative that politics prevails over military necessity. After all, to extend Clausewitz: war (and military competition) is simply the continuation of politics by other means. It was the rise of Athens and the fear that this inspired in Sparta that made war inevitable. The rise of China certainly inspires fear in a number of countries and will lead to military, political and diplomatic competition and instability. War is not inevitable, whatever the rise and decline school may argue (Organiski 1980, Gilpin 1981, Kennedy 1987).