Supplement I

Comparative Trend-Line Analysis: Retrospective Research Anthology

Current Events Form Future Trends. 1591
Gerald

Celente, Founder and Director Trends Research Institute

Archived Research Abstracts

2001 2003 2004 Gordon Chang: Publishes first-hand account of the trending social sentiment in China and the future implications The RAND Corporation: Publishes an analysis of the fault lines in the Chinese economy Sovereign Advisers: Publishes research bulletin warning of the risks endemic to Chinas selective default on its external sovereign debt and refusal to repay bondholders A. Gary Shilling & Co.: Publishes research bulletin warning of risks to investors with exposure to Chinese corporate equities as demand for Chinas exports will be adversely impacted by the U.S. subprime meltdown and resultant global financial crisis Sovereign Advisers: Publishes research report surveying key global macroeconomic trend-lines and analyses the likely future impact on the Chinese economy Stratfor: Publishes report describing trend of local government officials ignoring the central governments dictates Risk Review Magazine: The Global Association of Risk Professionals, the industry association for financial risk analysts, publishes an article reassessing core risks associated with the maturation of the Chinese economy and warning of deteriorating trends

2008

This perspective is embodied in the Trend Research Institutes Globalnomic methodology of systemic risk analysis.

1591

RESEARCH ANTHOLOGY: RETROSPECTIVE REVIEW OF SELECTED ABSTRACTS Pre-2007 China Observers Identify Fault Lines in the Chinese Miracle
GORDON CHANG (2001)

Mr. Chang is a lawyer and a former partner with the Beijing office of Paul Weiss Rifkin. He is the author of a book entitled, The Coming Collapse of China (Random House, 2001). Mr. Chang has lived in China for many years and has also presented testimony before the United States Congress on matters pertaining to China.
Quite simply the best book I know about Chinas future. - Arthur Waldron Lauder Professor of International Relations, University of Pennsylvania; Director of Asian Studies, American Enterprise Institute

Mr. Changs perspective is the product of first-hand experience gained from living in China. His thesis is predicated upon numerous factors, including the following: The breadth as well as the intensity of discontent among the populace including both rural and urbanized populations which is underreported in the west and which the Communist Party, although able to muzzle such sentiment, has not been able to extinguish it. The Party is unwilling to undertake structural reforms necessary to ensure long-term stability. State-owned enterprises (SOEs) remain uneconomic, state-owned banks continue to be insolvent, and corruption remains endemic. In order to remain in power, the central government is pursuing fiscal stimulus on a massive scale. The monopoly on power enjoyed by the Communist Party has resulted in a loss of community with the Chinese people, leading to an increasing rift between the Party and the vast majority of the population, which is worsening as the Party withdraws from the lives of the masses.
We should die fighting, Mao said, and thats just what is going to happen. The Party knows how to suppress, but it no longer has the power to lead. Today the people no longer want Maos revolution or the party that administers it. And so the Peoples Republic is going to fall, just like its predecessor. 160 - Gordon Chang
The Coming Collapse of China authored by Gordon Chang and published by Random House (2001). Many of the same themes which appear in Mr. Changs book are echoed in a more recent book: see Red Capitalism: The Fragile Financial Foundation of Chinas Extraordinary Rise authored by Carl E. Walter and Fraser J.T. Howie and published by John Wiley & Sons (Asia) Pte. Ltd. (2011). Mr. Chang testified before the U.S.China Economic and Security Review Commission hearing on August 22, 2006. The following is the summary of his presentation: Chinas financial system is much weaker than it appears because there is too much debt. Chinese localities and enterprises are burdened by excessive financial obligations. As a result, many lenders, and especially Chinas larger banks, are in a precarious position. Furthermore, the central government is probably carrying more indebtedness than it admits to. A recent interview with Forbes columnist Gordon Chang on November 18, 2011 is accessible at: http://www.chrismartenson.com/blog/gordon-chang-reasons-chinas-imminent-bust/65040
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RAND CORPORATION (2003)

In 2003, the Rand Corporation published a research report entitled, Fault Lines in Chinas Economic Terrain, an assessment of the probability of Chinas continued economic growth. The report identifies specific challenges, potential adversities, and structural flaws endemic to Chinas economic model which may eventually result in destabilizing imbalances leading to an economic collapse. As summarized below, the authors identify eight specific areas of concern: (1) persistent and disguised unemployment, poverty and social unrest; (2) economic consequences of corruption; (3) HIV / AIDS and epidemic disease; (4) water resources and pollution; (5) energy consumption and prices; (6) fragility of the financial system and state-owned enterprises; (7) possible shrinkage of foreign direct investment; (8) Taiwan and other potential conflicts. The study attempts to model the effect on the Chinese economy of each adversity occurring separately or in clusters. The report also examines the likelihood of a future reversal of Chinas recent impressive growth rates. The authors present a countervailing perspective to what has been a generally prevailing consensus that Chinas economy will be able to sustain high rates of economic growth for the indefinite future.
China has astounded the world with a record of near double-digit growth for over two decades. () This analytically sophisticated assessment of eight fault lines in Chinas current economic circumstances highlights the dangers () an important corrective to the view that China can sustain an annual growth rate of 7% or more without risk of setbacks that could be socially or politically destabilizing. 161 - Richard Solomon Former Assistant Secretary of State for East Asian and Pacific Affairs

Most of the issues which the authors examine are those which China has confronted in the past and has thus far managed with sufficient success to sustain high rates of economic growth.162 The scope of the report considers whether, and by what extent, these adversities might worsen in the future, and the possible effects of such deterioration. The reports principal findings are summarized below. Key Findings:

The research described in this report was sponsored jointly by the Office of Net Assessment in the Department of Defense and the Smith Richardson Foundation. The research was conducted in RANDs National Defense Research Institute, a federally funded research and development center supported by the Office of the Secretary of Defense, the Joint Staff, the unified commands, and the defense agencies. The report is accessible on the world wide web at: http://www.rand.org/pubs/monograph_reports/MR1686.html 162 The following statement appears on the RAND Corporations website in reference to this report: China has confronted in the past two decades five of the eight fault lines that the authors consider (unemployment, corruption, water resources, HIV/AIDS, and financial fragility), and, nonetheless, it has sustained high rates of economic growth. Therefore, in assessing the potential effects of these fault lines on China's future economic performance, the authors focus on whether, why, and by how much their intensities may increase that is, on changes, rather than on the prevailing levels of each fault line. For the other three fault lines examined, which have not previously occurred or recurred oil price shocks, foreign-direct-investment shrinkage, and serious military conflicts-the authors consider the circumstances under which they might arise and their resulting economic effects
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 Persistent and disguised unemployment, poverty and social unrest. Open and disguised unemployment in China amounts to about 23 percent of the total labor force, or approximately 170 million. Recent and prospective increases in unemployment have been principally due to population increases in the 1980s. Chinas efforts to comply with its World Trade Organization (WTO) commitments may engender more unemployment. Rural poverty has led to increased income inequality between rural and urban areas, rural-to-urban migration, rising urban unemployment, and social unrest. Economic consequences of corruption. The authors utilize two recognized indices of corruption and their association with differing quintile positions in annual economic growth rates of the various countries included in the indices, in order to calibrate corruption in China and to link it to Chinas expected economic performance. Were corrupt practices in China to increase as a result of plausible though not demonstrable recent trends, the result would be to lower Chinas position in the quintile distribution linking economic growth with the prevalence of corrupt practices. HIV/AIDS and epidemic disease. Estimates by the United Nations and other sources place the prevalence of HIV/AIDS in China between 600,000 and 1.3 million, with an approximate annual rate of increase between 20 and 30 percent. To analyze the effects of possible further disease spread, several scenarios are simulated, which include varying estimates of the costs of therapy, the effects of disease on factor productivity, and the effects on per-capita output. The bottom-line estimate for the intermediate rather than pessimistic scenarios is a trajectory of annual deaths from HIV/AIDS in China between 1.7 and 2.7 million in the second decade of the 21st century, cumulating by 2020 to over 20 million casualties and associated with annual reductions in gross domestic product (GDP) growth Water resources and pollution. China is beset by a perennial mal-distribution of natural water supplies. The North China plain, with over a third of Chinas population and at least an equivalent share of its GDP, has only 7.5 percent of the naturally available water resources. Subsurface aquifers in North China are near exhaustion, and pollution discharges from industrial and other sources further aggravate the shortage of water for consumers and industry. By contrast, South China normally has an abundance of natural water supplies, sometimes leading to serious floods. The dilemma this poses for Chinas policymakers is whether to push for capital-intensive water-transfer projects from south to north, or to emphasize recycling as well as conservation of water supplies in the north, or to pursue a combination of these alternatives. This key allocation issue is further complicated by political considerations relating to the relative influence of provinces in the north and south. The report examines several different scenarios involving different combinations of water-transfer projects and recycling/conservation efforts intended to reduce the stringencies in water resource availability in the north. For various reasons, non-optimal policy decisions and resource allocations might be pursued. A plausible but adverse scenario would result in a reduction in Chinas annual GDP growth between 1.5 and 1.9 percent. Energy consumption and prices. Another risk posed for Chinas sustained high growth rate is the availability of oil and natural gas supplies at what might be sharply increased

world energy prices. Price changes constitute the main risk, rather than Chinas shift from being a net exporter of oil in the early 1990s to a situation in which nearly half of its oil and nearly a fifth of its natural gas consumption are derived from imports. To analyze this potential adversity, the report considers several scenarios in which there is a drastic contraction in global oil supplies by about 25 percent lasting for a decade. The several scenarios consider a range of plausible demand elasticities, together with allowance for increased energy efficiency, resulting in a conservative estimate of increased global oil prices by as much as threefold. Fragility of the financial system and state-owned enterprises. One of the salient indicators of the fragility of Chinas state-dominated financial institutions is the extraordinarily high rate of nonperforming loans (NPLs) on the balance sheets of the four major state banks. NPLs have risen and continue to rise as a result of accumulated policy lending from the state banks to loss-incurring state-owned enterprises. Estimates of total NPLs cover an enormous range, between 9 percent and 60 percent of Chinas GDP: The correct figure is more likely to be at the upper end of this range. Under various plausible circumstances, China could experience a panic run of withdrawals from the state banks, large-scale capital flight, a significant reduction in savings, and a sharp decline in capital formation. The ensuing financial crisis and credit squeeze could plausibly reduce total factor productivity, with an accompanying reduction in the annual rates of growth of capital stock and of employment that would collectively reduce annual GDP growth. Possible shrinkage of foreign direct investment. Analysts both within and outside China agree that FDI has been of considerable importance and has had leveraging effects for Chinas high rates of real economic growth, although there is considerable disagreement about the mechanisms that account for these leveraging effects. High rates of FDI may well continue in the future, but there are also not implausible circumstances under which this FDI might severely contract. These adverse circumstances include both possible internal developments (such as tensions accompanying the leadership succession, the possibility of internal financial crisis, inconvertibility of the renminbi, and slow implementation of Chinas WTO pledges), as well as possible external developments (such as improvements in the economic infrastructure and investment climate in other competing countries and regions in Eastern Europe, Russia, India, and elsewhere). To a greater extent than in the past, future FDI in China will depend critically on the comparative risk-adjusted, after-tax return on investment in China compared with that of other countries. Based on very rough assumptions and using three different methods, calculations suggest that a sustained reduction of $10 billion a year in FDI may be associated with an expected reduction in Chinas annual GDP growth of between 0.6 and 1.6 percent. Taiwan and other potential conflicts. The status quo in the perennially troubled relationship between China and Taiwan entails major benefits for the Peoples Republic of China (PRC), Taiwan, and the United States. However, there are also significant risks and tensions associated with the status quo. It is not inconceivable that these tensions might erupt into possible conflict between the PRC and Taiwan. The report considers one possible scenario involving escalation from what Beijing might view as provocation by Taiwan, a blockade imposed by the PRC in response, tangible though limited coercive force to effectuate the blockade, and the resulting effects on Chinas stock markets, exchange rates, and reallocations of

resources to military spending, with ensuing reductions in the rate of growth of the civil capital stock and in total factor productivity. Conclusions: There exist many important questions about Chinas future. This study considers only one of them; to attempt to identify the major challenges, fault lines, and potential adversities that confront China in its efforts to sustain a high rate of economic growth in the coming decades. Estimated Impact on Chinas Growth Arising from Separate Fault Lines 163

Separate Effects Diminishing Chinas Economic Performance Type of Setback Unemployment, poverty, social unrest Economic effects of corruption HIV/AIDS and epidemic disease Water resources and pollution Energy consumption and prices Fragility of the financial system and state-owned enterprises Possible shrinkage of foreign direct investment Taiwan and other potential conflicts (percentage/year) 0.30.8 0.5 1.82.2 1.51.9 1.21.4 0.51.0 0.61.6 1.01.3

The analysis of these fault lines underscores their scale and complexity, and it also suggests that their ramifications will extend into all levels of Chinas society, government, and party structure. This is especially true since deterioration of any specific adversity(ies) may reasonably be expected to produce a contagion effect among the various adversities, thereby further increasing the socio-economic and political effect.

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This analysis identifies possible outcomes which could ensue from each of the several adversities or fault lines, were they to occur separately on a one-at-a-time basis. The results shown in this table beg the question of how long each of these adverse effects would endure without inducing remedial efforts or, failing to induce them, having contagion effects on the other adversities.

Interdependencies Among Fault Lines

HIV/AIDS and epidemic disease Energy consumption and prices Fragility of the financial system and state-owned enterprises Economic effects of corruption Water resources and pollution Unemployment, poverty, and social unrest Possible shrinkage of foreign direct investment Taiwan and other potential conflicts

Consequence
Unemployment, poverty, and social unrest Economic effects of corruption HIV/AIDS and epidemic disease Water resources and pollution Energy consumption and prices Fragility of the financial system and state-owned enterprises Possible shrinkage of foreign direct investment Taiwan and other potential conflicts

NOTE: indicates where a fault line (cause/column heading) is likely to affect the occurrence and/or severity of another (consequence/row heading).

An important but debatable proposition can be inferred from this analysis: To mitigate the stresses engendered by these fault lines will demand an enormous and continuing array of consultations, negotiations, and transactions among Chinas central and provincial governments and the Communist Party apparatus. This demanding process is likely to preoccupy Chinas new collective leadership, predisposing it to avoid external distractions and to maintain equable relations with the United States.

SOVEREIGN ADVISERS (2004)

SA

SovereignAdvisers
Specialists in Risk Metrics Analytics

In early 2004 our firm published a research bulletin exposing the Chinese governments refusal to repay Chinas full faith and credit external sovereign debt in violation of settled international law.164 Our findings were subsequently published by the Global Association of Risk Professionals, an independent association of risk management practitioners around the world with 77,000 members from fields such as banking, investment management and academics.165 The information presented in the report was also cited in a subsequent article which appeared in EuroWeek Capital Markets magazine.166

The report examines the circumstances comprising the existence of an estimated $125 billion of defaulted sovereign debt of the Chinese government and the implications of Chinas refusal to honor repayment of external bond issues. The report presents a comparative analysis of the prevailing investment grade sovereign credit ratings published for China by the three primary Nationally Recognized Statistical Rating Organizations (NRSROs), i.e., Standard & Poors Ratings Service; Moodys Investors Service; and Fitch Ratings, whose published metrics and definitions state that the ratings are developed on the basis of an evaluation of an issuers willingness to repay debt and the ability to repay debt. The long-term foreign currency sovereign credit ratings published and distributed for China are demonstrably false in comparison to the facts and fail to conform to the primary agencies published metrics.167
The continuing refusal by the PRC to pay legally valid obligations of the Chinese Government, in violation of international law, represents a form of institutionalized behavior pattern of the PRC, suggesting the probability that such debt defaults may reasonably be expected to recur in the future. The exposure to litigation and the probability of adverse judgments act to create a substantially adverse risk profile for newly-issued as well as outstanding obligations of the Peoples Republic of China. 168 - Excerpt: Peoples Republic of China Sovereign Credit Rating Research Bulletin
Peoples Republic of China Sovereign Credit Rating Research Bulletin authored by Kevin OBrien and published by Sovereign Advisers, Inc. (January 20, 2004). The bulletin is accessible of the world wide web at: http://www.globalsecuritieswatch.org/Sovereign_Rating_Research_Bulletin/China.pdf See also: Restatement (Third) of the Foreign Relations Law of the United States, Section 712(2) and Creditors Claims in International Law. The International Lawyer (Volume 34, page 235, Spring 2000). 165 Credit Risk Sovereign Advisers Issues Downgrade Alert on PRC Bonds published by the Global Association of Risk Professionals and distributed electronically via the Risk eNews service (September 21, 2004), and redistributed by Fitch Ratings News. The article is available from Risk Center Financial Risk Management Media at: http://www.riskcenter.com/story.php?id=9418 166 U.S. Holders Claim on China for Pre-War Bonds by Adam Harper, Asia Editor, EuroWeek (April 08, 2005). 167 See the section of this report referencing Chinas selective default on its national debt for a comparative analysis of the published ratings for China and the truthful rating of Selective Default. 168 Id. at 6.
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Key Findings: Selective default by the Chinese government on various series of Chinas external sovereign debt and refusal to honor repayment of an estimated $125 billion or more of defaulted full faith and credit external sovereign debt in violation of international law. The fact pattern associated with the Chinese governments selective default implies a significant degree of repayment uncertainty as regards both outstanding and future-issued sovereign obligations, and which risk is not reflected in the sovereign credit rating classifications presently published and distributed for China by the three primary NRSROs. Emergence of a significant contingent liability in the form of defaulted sovereign debt and a material adverse effect on Chinas external payments position. The fact pattern associated with Chinas selective default may hinder the ability of the four asset management companies responsible for recovery or disposal of the state-owned banks non-performing loans to repay loan purchases through the issuance of sovereign-supported debt. Impaired ability of the Chinese government to implement monetary policy reforms as a result of Chinas inability to engage in the creation and sale of new international foreign currency sovereign debt, attributable to the existence of a disclosure obligation referencing the Chinese governments selective default and refusal to honor repayment of Chinas defaulted full faith and credit obligations. In addition, debt underwriters; clearing agents and paying agents face potential civil liability in connection with actions which have the effect of assisting China in shedding its foreign debt obligation.169

"It's a hot potato, a very complicated issue, said one Asian rating agency official. 170 - Statement appearing in article published by EuroWeek Capital Markets In addition, the pricing and marketability of new debt issues may be adversely affected and foreign participation in Chinese financial markets may be discouraged as well as a direct result of the PRCs posture with respect to refusal of payment of government obligations. 171 - Risk Center Financial Risk Management Media Company

See e.g., lender liability claims arising from the involuntary subordination of defaulted creditors claims as a result of exclusionary and non-proportional payments; underwriter due diligence liability pursuant to the SarbanesOxley Act of 2002 (Pub.L. 107-204, 116 Stat. 745, enacted July 30, 2002); and credit rating agency liability arising from the continuing publication and electronic distribution of knowingly false sovereign credit ratings for China pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173). 170 Id. at 8. A similar statement referencing the same issue appeared in another article published by the Financial Times: Its a sensitive issue for agencies, says one international banker. See Peoples Republic Called to Account authored by Richard Beales, Gillian Tett and Andrew Yeh, Financial Times (June 07, 2005). 171 Id. at 7.
169

A privately distributed version of the report (subsequently made public) included a discussion of additional non-disclosed / hidden risks to which foreign purchasers of newly-issued PRC sovereign bonds would be exposed, and which could reasonably be anticipated to adversely affect the secondary market prices of publicly listed and traded PRC sovereign bonds. The set of revised risk metrics associated with investment in both outstanding as well as newly-issued PRC sovereign bonds includes the following: Judicial Risk: Bond underwriters; clearing and paying agents; and investors in newly-issued PRC sovereign bonds face exposure to litigation by defaulted creditors for any such actions as may be interpreted as assisting China in shedding its foreign debt obligation. If successful, such litigation may include filing of court petitions to enjoin non-proportional and exclusionary payments to new creditors; interception of payments; seizure of proceeds from bond sales; et al.172 Legislative Risk: Risk of U.S. capital markets restrictions or trade sanctions including enactment of federal legislation prohibiting the offer; sale; and quotation of PRC sovereign debt obligations within the United States financial markets until China completes a full settlement of the defaulted debt with U.S. bondholders.173 Liquidity Risk: Risk of regulatory agency enforcement action imposed on dealers pursuant to existing (i.e., Sarbanes Oxley) and future federal financial markets reform legislation (e.g., Dodd-Frank), including increased disclosure requirements.174

For relevant authorities, see e.g., Elliott Associates, L.P., General Docket No. 2000/QR/92 (Court of Appeals of Brussels, 8th Chamber, Sept. 26, 2000); Republic of Nicaragua v. LNC Investments and Euroclear Bank SA (Injunction issued against paying agent by Belgian Commercial Court, Sept. 8, 2003); Red Mountain Finance, Inc. v. Democratic Republic of Congo and National Bank of Congo, Case No. CV00-0164R (C.D.Cal. May 29, 2001); Republic of Austria v. Maria V. Altmann, Docket No. 03-13 (United States Supreme Court, June 7, 2004). The U.S. Supreme Court decision enabling the 1976 U.S. Foreign Sovereign Immunities Act to be retroactively applied to fraudulent and deceptive commercial transactions perpetrated by foreign sovereign nations against United States citizens. The Court found that it was the intent of the United States Congress to apply the provisions of the Act to any such pre-enactment actions of foreign governments. As a result, the Peoples Republic of China is now subject to civil suits in U.S. Courts by United States citizens holding defaulted full faith and credit sovereign obligations of the Chinese Government. Holders of defaulted full faith and credit sovereign bonds of the Peoples Republic of China may now obtain a judicial order attaching interest payments on recently-issued and outstanding PRC sovereign obligations. In addition, participants in future PRC sovereign bond sales may face exposure to lender liability claims resulting from the involuntary subordination of the claims of existing creditors to whom China refuses repayment in violation of settled international law. The defaulted bonds were excluded from the 1979 U.S. China Claims Settlement Treaty and remain valid outstanding obligations of the Peoples Republic of China as the internationally recognized government of China. See the following two memorandums of law prepared by the U.S. law firm Stites & Harbison PLLC: http://www.globalsecuritieswatch.org/LegalBrief%5B1%5D.feb2202.pdf http://www.globalsecuritieswatch.org/may30_2003_memo.pdf See also the letter of notice provided to the underwriters counsel for the Peoples Republic of China: http://www.globalsecuritieswatch.org/Letter_from_Stites_&_Harbison_to_Sidley_Austin_Brown_&_Wood 173 See, e.g., the following: http://www.globalsecuritieswatch.org/joint_economic_committee_press_release.pdf http://www.uscc.gov/pressreleases/2004/04_06_15annualreport.pdf http://wwwc.house.gov/International_Relations/108/bian2021.htm 174 See, e.g., the actions of Morgan Stanley and Goldman Sachs in providing assistance to China in regard to the publication and distribution of demonstrably false sovereign credit ratings: http://www.globalsecuritieswatch.org/China_Denies_Seeking_Sovereign_Credit_Rating http://www2.goldmansachs.com/our_firm/investor_relations/financial_reports/annual_reports/2003/features/gl obalchina.html
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 Repayment Risk: Risk of future default accruing from the willingness to pay metric, e.g., as demonstrated by the failure of the PRC to honor its repayment obligation of the existing defaulted debt as well as the PRC's willingness to honor outstanding obligations in the event of future adverse economic conditions. International Setoff Risk: The vulnerability of the Peoples Republic of China to international setoff may adversely affect the PRC's balance of payments position and impair the PRC's ability to maintain its current level of external debt.175 Following publication of the report in 2004 describing the risks endemic to Chinas selective default on its external sovereign debt, there have been no international, publicly-offered sales of foreign currency PRC sovereign bonds in the United States. The PRCs final international foreign currency bond sale, occurring in 2004, was restricted from the United States financial markets and was offered and sold outside the U.S.

175

See, e.g., National Bank v. Republic of China, 348 u.s. 356 Statement by the United States Supreme Court affirming right of international setoff: We have a foreign government invoking our law but resisting a claim against it which fairly would curtail its recovery. It wants our law, like any other litigant, but it wants our law free from the claims of justice. (...) unjustly enforced by disregarding legitimate claims against the Republic of China. (...) the individual can set off all debts properly due him from the sovereign. The judgment of the Court of Appeals must be reversed and the case remanded to the District Court with directions to reinstate the counterclaims and for further proceedings not inconsistent with this opinion. Pravin Banker Associates v. Banco Popular del Peru aff'd 109 F.3d 850 (2d Cir. 1997), aff'g 895 F. Supp. 660 (S.D.N.Y. 1995) Decision by the Court of Appeals for the Second Circuit affirming claimant's right to receive full contractual value of defaulted sovereign debt: Peru's arguments to the United States Court for the Southern District of New York centered on the claim that Pravin had purchased the debt in the secondary market at a substantial discount and face value recovery was therefore not contemplated and would constitute unjust enrichment by enabling Pravin to reap a windfall profit from Peru's economic misfortune. The U.S. Court disregarded these arguments and asserted the following: (a) Pravin was within its full legal rights to seek a full-servicing of the debt it had acquired regardless of the price it had paid in the secondary market; (b) the U.S. has a strong interest in ensuring the enforceability of valid debts under contract law; and (c) that Pravin sought merely to enforce the terms of the debt agreement as written. The Court of Appeals for the Second Circuit concurred with the Court's findings and affirmed the decision of the S.D.N.Y.

2008 Risk Analysts Identify Emerging Trends Which Threaten the Chinese Miracle A. GARY SHILLING & CO.

Founded in 1978 by A. Gary Shilling, who later achieved widespread recognition as the investment manager who first Economic Consultants predicted the 2001 dot.com collapse. Dr. Shilling also accurately predicted the onset of Japans lost decade when virtually everyone else was as bullish on Japan as are many today in regard to China. A. Gary Shilling & Company is a research-focused, total return-oriented investment management company employing a three to five year horizon. The firms approach to investment management is guided by Dr. Shillings two long-standing principles:
A. Gary Shilling & Company, Inc.

Human nature changes very slowly over time, if at all. Therefore, history is relevant because human beings will react to similar circumstances in similar ways. The trick, however, is to find the relevant piece of history on which to draw parallels. In this sense, forecasting is an art, not a science. The objective of forecasting is to identify the significant but undiscounted aspects of the outlook. This is where the true opportunities for investors lie and where business can get the jump on competitors. A rehash of the consensus view, which is fully discounted in security markets and business plans, is of limited value.176 - Dr. Gary Shilling

In the immediate aftermath of the U.S. subprime crisis and global financial meltdown, Dr. Shilling issued a report entitled, Get Out of China ASAP warning of the risk to stock market investors exposed to Chinas export-dependent economy:
If you still own Chinese shares, sell. If you are daring, short-sell an exchange-traded fund of Chinese shares.177 - Dr. Gary Shilling

As the United States continues experiencing an economic slowdown and declining home values, Dr. Shilling sees diminishing prospects for Chinese growth. He states that he expects Europe and Japan to follow the U.S. downward as their housing prices collapse as well. As homeowner equity disappears, so too does the fuel for consumer spending. As consumer confidence evaporates, exportdependent economies around the world will suffer, and the effect will be especially pronounced in China, where 38% of its gross domestic product is derived from exports.
Without export growth and the foreign investment it brings, Chinas economy is in trouble.178 - Dr. Gary Shilling

176 177

http://www.agaryshilling.com/ http://www.forbes.com/forbes/2008/0519/150.html 178 Id. The prevailing economic situation in China bears eerie similarities to the dot.com implosion: On March 20, 2000, after the NASDAQ had lost more than 10 percent from its peak, financial magazine Barron's shocked the market with its cover story "Burning Up". Sean Parker stated: "During the next 12 months, scores of highflying Internet upstarts will have used up all their cash. If they can't scare up any more, they may be in for a savage shakeout. An exclusive survey of the likely losers." The article pointed out: "America's 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market." By 2001 the bubble was deflating at full speed. A majority of the dot-coms ceased trading after burning through their venture capital, many having never made a net profit. Investors often referred to these failed dot-coms as "dot-bombs." Source: http://en.wikipedia.org/wiki/Dot-com_bubble

Dr. Shilling dispels the fallacy of decoupling of Asian and western economies, and notes that the prospects for a long-term deterioration in U.S. consumer confidence and discretionary spending will continue to exert a sustained and adverse impact on the Chinese economy.
American consumers have been on a spending spree for a quarter-century, kidding themselves that paper gains on stocks and house prices are a form of saving. Theyre way overleveraged, but they never stopped as long as credit was available. Now its gone. Many of them owe more on their cars than the cars are worth. At the same time that lenders are tightening the purse strings, consumers are facing job cuts and high food and energy costs.179 - Dr. Gary Shilling

Dr. Shilling notes that part of the problem for China is related to personal income. Just 8% of the population earns enough to positively affect the domestic economy, and Chinese save nearly a third of their pay. He predicts that capital spending will decrease as the banks reduce lending activity and real estate will decline. He warns that the domestic situation in China could become ugly, and notes that it was inflation that helped spark the Tiananmen Square uprising in 1989.
Further declines in Chinese stocks will rile the 100 million Chinese who have invested in equities with the governments encouragement, and since most public companies are stateowned, those investors may blame the state for their price collapses.180 - Dr. Gary Shilling

Worse is Yet to Come by A. Gary Shilling. Forbes (September 29, 2008). Id. In an interview with Bloomberg (April 14, 2010), Dr. Shilling expressed a similar perspective as Hugh Hendry in regard to Chinas record excess capacity: You cant trust the [Chinese] numbers They have kickstarted their economy in the last year its a stop go economy, they can do it fast, they dont have to worry about EPA audits, they just let the bulldozers roll when they want to build a new road or whatever. The point is they build an awful lot of excess capacity and the question is how they are going to use it because American consumers arent buying their exports the way they used to and their domestic economy isnt that strong Chinese consumer spending is 36% of GDP and is a declining share over the last two decades. They dont have a big enough middle class. In China there were 110 million people with over $5k per capital income, enough to give them discretionary spending but that was only 8% of the population. In this country it is 80% of the population. Dr. Shilling was a speaker at Bloombergs 2011 China Investment Strategies Conference, where he stated that Chinas economy is in for a hard landing He also expressed doubts regarding the ability of the Chinese government to control the economy and described its monetary policy as very crude. Because of the amount of speculation on Chinas continued growth, Dr. Shilling foresees a Chinese hard landing leading to a global downturn. In an interview on Bloomberg TV (September 28, 2011), Dr. Shilling reiterated his view that China will experience a hard landing and stated that such event will have a profoundly adverse effect on commodity prices, especially copper which acts as an indicator of global industrial production. He noted that the U.S. Federal Reserve, using far more sophisticated financial policies than China has available, has on twelve occasions attempted in the post-WW II era to slow the U.S. economy without causing a recession. It only succeeded once. See interview and transcript at: http://www.zerohedge.com/news/prominent-deflationist-schilling-sees-deflation-china-hard-landing-and-800-sp
180 179

SOVEREIGN ADVISERS

SA

SovereignAdvisers
Specialists in Risk Metrics Analytics

In mid-2008 our firm published a research bulletin entitled Peoples Republic of China Economic Outlook and Sovereign Risk Review (June 19, 2008).181 The objective of the report was to undertake a forward looking evaluation of the primary economic fundamentals affecting the Chinese economy following the global financial crisis which began in mid2007. A central theme of the report is an assessment of the effect of the contraction of U.S. consumer credit on Chinas export-dependent economy. The report noted that the economic situation in China following the decline of U.S. consumer spending disproves the widely disseminated decoupling myth which had been largely promoted by Goldman Sachs in an attempt to prop up the China story fervently pitched by the sell-side of the industry. The report references a research note issued by then-Oppenheimer analyst Meredith Whitney, who warned:
The real harrowing days of the credit crisis are still ahead of us and will prove more widespread in effect than anything yet seen. Just as strained liquidity pushed so many small and mid-sized specialty finance companies to the brink, we believe it will do the same to the U.S. consumer. We believe losses will only accelerate further and far worse 182 than the most draconian estimates. - Meredith Whitney Former Oppenheimer Analyst

Another principal theme of the report examines the intransigence of inflation in China as a product of both global macroeconomic influences in conjunction with embedded inflationdrivers within the Chinese economy. Other aspects examined in the analysis include energy consumption related to manufacturing activity and Chinas reliance on imported petroleum; the effect of labor force demographics, energy and transportation costs on Chinas global competitiveness; the true extent of non-performing loans held by Chinas state institutions; Chinas increasing dependence on foreign borrowing and growing reliance on short-term debt; the escalating human and economic effects of Chinas environmental contamination; and recent trends in social unrest in China. The report predicted the potential societal impact from the emergence of social media. The report also references the introduction of concurrent House and Senate bills in the United States Congress addressing Chinas action of selective default and subsequent repudiation of its foreign sovereign debt, and the continued publication and

Id. at 1. Oppenheimer research note dated May 19, 2008: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=auq3s_xEc9BI Ms. Whitney also estimated that about $2 trillion of credit card lines will be removed by 2010, cutting the credit available to U.S. consumers by nearly half.
182 181

distribution by Standard & Poors; Moodys Investors Service and Fitch Ratings of an artificial sovereign credit rating for China.183 Key Findings: Chinas economy is dependent upon U.S. consumers. The report demonstrates the falsity of the decoupling myth as evidenced by the extent of dependency of the Chinese government on hard currency earnings derived from manufactured exports, supported largely by U.S. consumer spending. Even with wages growing at an annual rate of 20% in China, just 8% of the population earns sufficient income to exert a positive effect on the overall economy. China's export manufacturing sector accounts for approximately 38% of China's total gross domestic product and is the primary hard currency earnings producer for the Chinese government, making China especially vulnerable to the surge in crude oil prices and slowing demand for export products resulting from decreased U.S. consumer spending. Aggregate U.S. housing prices have declined by an estimated $2.5 trillion, representing approximately $25,000 per household. The downward trend in U.S. home values is expected to continue with many economists projecting a decline of 30% nationwide, reducing household spending by $300 billion. The contraction of U.S. consumer credit and the depth of the retreat in U.S. consumer spending resulted in a substantial decline in export manufacturing activity within China. As both the U.S. and the global economy enter a period of protracted stagflation and discretionary income declines further, this trend is expected to continue. Global and domestic macro trends threaten Chinas political stability. The report reveals that China continues to experience domestic wage and price inflation, attributable in part to the rising cost of imported consumer and industrial commodities.184 On average, Chinese families spend approximately 50% of their total household income on food. Continuing inflation in conjunction with reduced demand for export products, which has already resulted in a significant increase in urban unemployment, is expected to lead to an increased risk of political instability.185 The Paris-based Organisation for Economic Co-operation and Development

Senate Concurrent Resolution 78 and House Resolution 1179. Legislative initiatives continue in the United States Congress, with The China Debt Default Act of 2012 legislation expected to be introduced sometime next year. Specific provisions of the bill include requiring the U.S. Securities and Exchange Commission to examine the rating practices employed by Standard & Poors Ratings Service; Moodys Investors Service and Fitch Ratings with respect to Chinas selective default, and deliver a report to a special panel established by both houses of Congress in regard to the conformance of the sovereign credit rating classifications published and distributed for China by the three primary NRSROs with their published criteria; definitions and metrics. 184 According to a 2008 report by the United Nations Food and Agriculture Organization (FAO), global food prices have risen 65% from 2002. In 2007 alone, according to the FAOs world food index, dairy prices rose nearly 80% and grain rose 42%. 185 According to a June 12, 2008 report issued by Stephen Green, China economist for Standard Chartered Bank in Shanghai, There are other price pressures out there that are being severely repressed. There is a lot more bottled up inflation in this economy than meets the eye. Dwyfor Evans, a macro strategist at State Street Global Markets in Hong Kong, has stated that Chinas excessive money supply, if not absorbed by government bond issuance, will make its way to domestic credit, which has risen consistently over recent years. This opens up a potential monetary source of inflation. In regard to global food price trends, the prevailing fundamentals in most primary producer markets are causing many analysts to regard recent price spikes as merely the beginning of a much longer term trend. According to Jason Ward, an analyst with Northstar Commodity in Minneapolis, Minnesota, You know those complaints youve been hearing about high food prices? Theyve just begun. The transportation cost
183

(OECD) states that it expects wage and price inflation to erode Chinas export competitiveness.186 A sustained decrease in export sector earnings by the Chinese government will impede the ability of the central government to service its outstanding debt without further stimulating inflationary pressures by increasing the money supply. An emerging additional threat is the nascent emphasis on fair versus free trade policies by developed nations and the potential ramifications to Chinas mercantilist trade practices as a result of a transition by developed nations to a policy emphasis favoring fair trade. The rate of increase in Chinas domestic petroleum consumption is unsustainable. The report notes that Chinas export manufacturing sector is dependent upon petroleum imports in the face of declining domestic oil reserves. A net oil importer since 1993, China imports approximately 78% of its petroleum.187 With increasing demand and relatively flat domestic production since 1986, Chinas reliance on petroleum imports is expected to continue, subjecting the government to additional economic stress.188 Chinas reliance on imported oil doubled between 2004 and 2007, with approximately 60% derived from the volatile Middle East. Chinas diminished ability to maintain the global competitiveness of Chinese manufactured goods as it loses its labor force advantage. The report references the Asian Development Bank (ADB) Asian Development Outlook 2008 annual report, which reveals that China is losing its labor force advantage as it also faces the challenges presented by an aging population and a shortage of skilled and semi-skilled labor, resulting in degradation in the quality of industrial goods. The ADB findings are corroborated by a 2007 study conducted by Chinese

increment of agricultural products will be particularly acute for countries which are grain and animal protein importers, such as China. 186 Economic Outlook (June 2008). The OECD report states: Coupled with ongoing weakness in external demand, exports and the pace of market share gains are expected to slow markedly. Such an outcome increases the risk of political instability resulting from rising urban unemployment, among other factors as discussed in the report. 187 According to the U.S. Energy Information Administration, Chinas increase in oil demand represents a majority of the total global increase in demand over recent years. 188 Oil produced from Chinas overseas investments accounts for just 5% of Chinas total imported oil, with 95% being purchased on the open market at the prevailing rate. The vast majority of Chinas purchases of oil imports are denominated in U.S. dollars, creating an especially acute strain on the government since China faces the increasing allocation of its dollar reserves toward ever larger purchases of oil imports at the same time a declining dollar reduces the purchasing power of the governments dollar reserves. With declining domestic reserves, China is expected to continue to increase its degree of dependency on imports each year and since petroleum is consumed in both manufacturing and transportation of export products, Chinas export manufacturing sector will come under further duress if global petroleum prices continue upwards. In this regard, note the forecast by former Citigroup analyst Louise Yamada, who predicts oil rising to over $450 per barrel within a decade based largely upon fundamental demand. Ms. Yamada was the top-ranked market technician at Smith Barney for four years. Note also the following statement by Bo Lin, an energy specialist at the Asian Development Bank: More than a billion Chinese are joining the oil market. How can prices go down? According to APS Reviews publication Oil Market Trends (November 08, 2004), Chinas central government has no coherent energy strategy, with a Communist culture of secrecy continuing to blind Chinese consumers to the risks of their high consumption of gasoline, heating oil, coal and LPG. But, more important where oil is concerned, China is consuming too much gasoline relative to size of the nations per capita GDP. The report also states that the production from Chinas four largest oilfields is in decline, and that some estimates show Chinas current proven reserves becoming totally depleted by 2018. Chinas largest oil refiner, PetroChina, recently announced that it would issue up to 60 billion yuan worth of corporate bonds to raise cash, raising the question as to how long the central government can continue to underwrite Chinas consumer oil subsidy.

Academy of Social Sciences and referenced in an article published in the Beijing-based China Youth Daily. The report stated that not only coastal cities but also mainland areas are experiencing a decline in the number of young and middle-aged people entering the labor market.189 The year 2004 witnessed the first decrease in the growth rate of the population segment aged 15-59. The working-age population is estimated to stop growing altogether around 2011. Chinas demographic dividend is forecast to turn into a demographic liability in 2013.190 From 2021-onward, Chinas population is forecast to continue to decline, according to the report. The Pearl River Delta, a hub of labor-intensive industries, first faced a shortage of rural labor force in 2004, followed by the Yangtze River Delta. The phenomenon is spreading gradually from coastal areas to mainland provinces including Jiangxi, Anhui, Hunan, and Hubei. According to a survey by the Labor and Social Security Department of Hubei Province, the province runs short of 400,000 laborers annually. The rate of labor shortages in the provincial economic development zone has risen to 38%. Chinas diminished ability to maintain the global competitiveness of Chinese manufactured goods in the face of increasing transportation costs. The report examines the impact of increasing transportation costs and cites reference to the recent OECD study which predicts the erosion of China's competitive advantage in export manufacturing as rising labor and transportation costs begin causing the relocation of manufacturing industries away from China and closer to U.S. and European consumer markets.191 As predicted by the OECD, the effect of increasing domestic wage and price levels will decrease the competitiveness of Chinas export sector, causing further economic stress as a result of constrained Government revenues and the migration of labor-intensive manufacturing activities to low-wage venues located closer to enduser consumer markets in response to increasing transportation costs.192
EXAMPLES:

> Claude Hayes, president of the retail heating division at DESA LLC, is quoted as stating that My cost of getting a shipping container here from China just keeps going up-and I dont see any end in sight.193 His company joined the emerging trend of relocating manufacturing operations out of China and closer to consumer markets when it recently moved most of its production back to the U.S. where, according to the Wall Street Journal, Mr. Hayes says the company was lucky to have held onto its manufacturing machinery.194 The article

Commenting on the China Youth Daily article, Deng Xiaogang, a social science professor at the University of Massachusetts (Boston) stated, Chinas economic growth and foreign trade rely heavily on its labor-intensive products with the cheap labor. When the demographic structure changes entirely, the whole economic structure will encounter dramatic changes and the country will be running short of a labor force. China will be unlikely to properly adjust its economic structure in a short period of ten years. China is not optimistic in the future. 190 The phrase, demographic dividend is defined as the economic benefit produced when a decreasing birth rate alters the population age structure, so that fewer investments are needed to meet the consuming populations needs and labor resources are released for investment in economic development and family welfare. 191 Id. at 28. 192 Energy analyst Kevin Book states that the current oil market is operating at 96.5% of capacity and notes that retail gasoline and diesel prices are subsidized by many emerging economies, notably China where an increasing population is placing greater duress on the governments ability to subsidize consumer prices. 193 See article entitled, Stung by Soaring Transport Costs, Factories Bring Jobs Home Again, Wall Street Journal (June 13, 2008). 194 Id.
189

singled out China in particular as the venue in which the cost of doing business has grown steadily as workers there demand higher wages and the government enforces tougher environmental and other controls.195 > Edward Zaninelli, vice president of trans-Pacific westbound trade at Orient Overseas Container Lines, a major shipping line, acknowledged that he is aware of production moving out of China, but states that it wont be only transportation costs responsible for the trend, because other production costs continue to increase and that companies are beginning to realize that they can have better control over their production when it is closer to home. > Emerson, a U.S. manufacturer of electrical equipment, recently shifted a portion of its production operations out of Asia and into the U.S. and Mexico, citing logistics costs associated with transportation of finished goods. Other manufacturers are following suit as evidenced by the CIBC report which shows a significant decline in Chinas freight-intensive exports to the U.S. over just the past 12 months.196 The CIBC research report also reveals that oil prices have already driven up shipping costs so much that Chinese imports are now high-cost and losing market share, predicting that the expected continued rise in transportation costs will completely erode Chinas low-wage economic advantage and may also remove the single most important brake on domestic inflation over the last decade wage arbitration with China. > Bremen Castings Inc., a family-owned foundry Bremen Indiana, is witnessing a wave of customers bringing work back from China. According to J.B. Brown, the companys president, one customer (a pump manufacturer) which had been operating a metal casting plant in China called to reactivate production facilities in the U.S., stating that the cost of transport from overseas was the straw that broke the camels back and that they didnt see it going back down any time soon. Higher fuel costs are expected to slow the outsourcing of goods in the future according to Daniel Meckstroth, an economist at the manufacturers Alliance/MAPI, a public policy group in Arlington, Virginia. A prime example is Craftmaster Furniture in Taylorsville, North Carolina, which was bought two years ago by a Chinese manufacturer which intended to shift 40% of its production to China before the end of this year or early next year. With the planned move only half done, the shift has stopped cold. Were getting hit with increases up and down the system, states Roy Kalcain, the companys president. Its changing our whole equation for where we produce. As revealed in the OECD study, emerging economic trends and the underlying dynamics evidence the early stages of a major structural shift in global trade fundamentals, as the erosion of Chinas manufacturing cost advantage continues to accelerate.197 Many analysts now expect to see a reversal of the 30-year trend of offshore manufacturing by U.S. companies. For

195 196

Id. Defined as goods that carry a relatively high freight cost. 197 Id. at 28. China uses five times as much energy as the U.S. to produce a unit of GDP, and is therefore acutely vulnerable to increasing energy costs. A quarter of the 800 shoe factories in the Guangdong region have shut down in recent months, and several thousand textile shops are battling to stay afloat. Hong Kongs industry federation has warned that 10,000 firms operating in the South of China may soon go out of business. In an article entitled, Emerging Markets Face Inflation Meltdown, Daily Telegraph (June 13, 2008), Ambrose Evans-Pritchard writes that There is a dawning realization that China is facing a major storm as inflation (7.7 pc), the rising yuan (up 5pc

Workers riot at the Kai Da Toy Factory in Dongguan, China

example, in the recent CIBC research report cited above, CIBC World Markets chief economist Jeff Rubin states that the cost of shipping a standard 40-foot container from Asia to the East Coast has already tripled since 2000 and is expected to soon double yet again. This is going to cause a major re-think for people who have re-jigged their supply lines to China. CIBCs Mr. Rubin says, noting that Chinese steel exports to the U.S. dropped by 20% during the past 12 months. Manufacturers will seek venues (e.g., Mexico) which are located in closer proximity to consumer markets as transportation costs continue to increase, further reducing the incentive to manufacture export products in China.198 Richard Cookson, a strategist at HSBC, advises clients to slash their Asian exposure, stating, Inflation looks like a very real problem in Asia, and the risk is that investors will lose faith in the regions currencies. Although markets have fallen savagely from their peaks, theyre still looking pricey. Were lopping exposure even further, to zero.

this year), soaring oil prices, and an economic downturn in the key export markets of North America and Europe all combine to crush profit margins. 198 Mr. Rubin predicts that Mexico will be the biggest winner of all as increased transportation costs make China uncompetitive.

 Selective default by the Chinese government. The report identifies legislative initiatives in the United States Congress addressing the Chinese governments repudiation and selective default of Chinas full faith and credit national debt, including the governments discriminatory actions toward new creditors versus defaulted creditors, e.g., the practice of exclusionary payments to certain classes of bond investors. In response to the Chinese governments refusal to repay its binding sovereign obligations in contravention of international law, both houses of the legislative branch of the United States government have concurrently called for the reclassification of the Chinese governments sovereign credit rating into the proper category of Selective Default (see United States Senate Concurrent Resolution 78 and House Resolution 1179 introduced in the 110th Congress, second session). United States Securities and Exchange Commission Enforcement Brief Resolution of the United States Senate Resolution of the United States House of Representatives The prevailing sovereign credit rating classifications assigned to the long-term foreign currency obligations of the Chinese government contravene both the published metrics (e.g., evaluation of an issuers willingness to repay debt which it is lawfully obligated to repay) and published criteria (e.g., see comparative definitions of the prevailing credit rating classifications assigned to the Chinese government by the three primary NRSROs). An additional risk posed by Chinas repudiated debt is the threat of seizure by defaulted bondholders of discriminatory interest payments made by the Chinese government to holders of newly-issued Chinese government bonds. Failure of the PRC to acknowledge and effectively address the true extent of state institutions bad debt. The report delves into the lack of disclosure concerning the true extent of Chinese state-owned banks exposure to bad debts. Chinas financial system continues to generate non-performing loans (NPLs) in the state banking sector as evidenced by the audit results produced by government auditors Ernst & Young prior to being pressured by the Chinese government to retract its 2006 report which identified nearly $1 trillion in state institutions bad debts in the form of NPLs. Prior to his firms retraction, Jack Rodman, managing director of Ernst & Young, commented: I think the numbers will be a big surprise because China has been giving the impression [with its banks listing overseas] that the problem is behind us. China has not really resolved the issue - they have just moved it from one state enterprise to another. According to the report, Chinas current NPL level is equal to 40% of GDP, and was almost double the 2002 figure of $480 billion. The four major state-owned commercial banks accounted for $358 billion of bad loans nearly three times the officially reported figures.199 With the exception of China, every market covered in the 2004 report has witnessed a reduction in its levels of NPLs written before 1997, the report stated. Ernst & Young stated that its higher estimation of Chinese bad debt was based on access to broader information, including the rapid
199 The four largest commercial lending institutions are the Bank of China, Industrial and Commercial Bank of
China, China Construction Bank, and the Agricultural Bank of China. There are also three separate policy lending banks: the Long-Term Development and Credit Bank, Import-Export Bank, and the Agricultural Development Bank.

growth of loans in recent years and details of distressed debt companies (such as rural credit cooperatives) attached to major banks. These had been excluded from previous reports. Under pressure from Beijing, Ernst & Young withdrew the report, which had been labeled as damaging to the image of Chinas banking assets by the Peoples Bank of China, and promised that such an embarrassing situation will not happen again. At the time the report was withdrawn, Ernst & Young had a lucrative contract to audit the Industrial and Commercial Bank, Chinas largest lender. The incident revealed Beijings extreme sensitivity to any comment critical of its financial system.200 The continuation of speculative investment and increasing levels bad debts are the inevitable result of the Chinese governments fiscal policies designed to maintain disproportionate inflows of foreign investment and unsustainable economic growth rates. Previously, the Chinese central bank admitted that for the period of 2000-2001, politicallydirected bank lending accounted for 60% of bad loans, and according to the World Bank, approximately one-third of Chinas fixed asset investment in infrastructure in the 1990s was wasted. Although the government claims to have cleared in excess of $560 billion in bad debts since 1999 and injected fresh capital into the major state banks from the central banks foreign currency reserves, it is evident that much of this reduction has been through transfers to other state-owned disposal agencies and nullified by surges in new lending.

Kai Da Toy Factory in Dongguan, China

200 According to an article published by the Financial Times shortly before the Ernst & Young report was
withdrawn, the report was consistent with a number of other recent studies, including a report issued by the corporate consultancy firm, McKinsey & Company the same week as the Ernst & Young report. The McKinsey report stated that the core causes for the massive creation of NPLs had still not been effectively addressed.

Laid-off workers protested against their compensation in three Chinese provinces amid increasing factory closures and government concern about unrest

The growth of massive bad debts in Chinas banking system has exposed the fact that Chinas apparently strong economic performance rests on a fragile financial foundation. Chinas Ministry of Finance continues to guarantee hundreds of billions of dollars in bonds issued to the state banks at the time the bad assets were transferred. The governments reforms have merely addressed the symptoms of Chinas financial fragility. Although poor business practices are generally cited as the root cause for the growth in NPLs, the actual source is political. So long as the communist party relies on state-controlled banks to maintain an unreformed core of a command economy, Chinese banks may be expected to continue to engage in practices which generate more bad loans. Systemic economic waste, bank lending practices, political patronage, and the survival of a one-party state are inseparably intertwined in China. The communist party, aware that it is no longer able to secure the loyalty of its 70 million members via ideological indoctrination, employs material perks and careers in government and state-owned enterprises to engender loyalty. After 30 years of economic reform, the state continues to own 56 % of the fixed capital stock. The unreformed core of the economy is the base of political patronage. Government figures reveal that in 2003, 5.3 million party officials held executive positions in SOEs. The party continues to appoint approximately 80% of the chief executives in SOEs and approximately 56% of all senior corporate executives. Recent corporate governance reforms, which mimic Western-style practices yet fail in substance, have not cured the endemic defects

of Chinas economic foundation. Approximately 70% of large and mid-sized SOEs, ostensibly restructured into Western-style companies, continue to appoint members of party committees to the boards of directors. China has shed in excess of 30 million industrial jobs since the late 1990s, yet few party officials have suffered adverse consequences.201

Unemployed workers riot at closed Chinese factory

Chinas four largest state banks have originated an additional $225 billion in risky new loans (one-third in real estate), the nature of which the Chinese banking authorities attempted to obscure by classifying them as of special mention. The most serious speculative bubble is in real estate, where prices have risen largely on the basis of the prospect of yuan revaluation and the 2008 Beijing Olympic Games. Chinese central bank statistics published at the end of 2005 reported approximately $400 billion in property lending, representing 17% of GDP. The National Bureau of Statistics warned that unsold residential space across China had risen by nearly 25%. A collapse of the property bubble could have catastrophic consequences for the countrys fragile banking system.

201

Source: Chinas Bad Debt Mountain, The Australian (May 9, 2006).

 Increased foreign borrowing and growing reliance on short-term debt. The report notes that Chinas debt to the outside world rose again in 2007, with higher-risk, shortterm borrowing comprising a greater share of overall borrowing. Chinas outstanding foreign debt, excluding its repudiated debt, reached US$345.7 billion at the end of September, up 7% from the end of 2006. Of this amount, short-term debt (i.e., maturity of less than one year) accounted for 57.2 %. At the end of 2006, short-term debt stood at 56.9% of the total, according to data from the State Administration of Foreign Exchange. Including its repudiated debt, Chinas total obligation to foreign creditors totals US$605 billion. Since the mid-1990s, China has adopted a proactive fiscal policy, raising large amounts of debt for public investments to drive economic growth. Ministry of Finance data reveal that cumulative long term construction debt rose from 100 billion yuan ($12.2 billion) in 1998 to 990 billion yuan ($123.6 billion) by 2005, a tenfold increase in seven years. Beginning in 2005, Chinas Ministry of Finance began retiring the 18th issuance of national debts, marking the start of a five-year peak debt repayment period. Between 2005 and 2009, the Finance Ministrys annual debt repayment obligation will amount to approximately 400 billion yuan ($50 billion). The monetary impact on the Chinese domestic economy will be significant unless new national debt is issued during this period.202 To date, a relatively insignificant portion of Chinas overall national debt has been allocated to support social development and environmental preservation, which has contributed to serious imbalances.

Man holding a baby as he sits in front of a poster begging for work on a walkway bridge above a main road in Beijing (November 05, 2008)

202 Note that as interest rate liberalization has progressed, the Peoples Bank of China has liberalized, simplified or
eliminated 114 categories of interest rates under control since 1996. At present, 34 categories of interest rates remain subject to control by the Peoples Bank of China.

Much of the national debt has been apportioned to financing local infrastructure and real estate development projects and redundant industrial and commercial ventures that did not fit into a coordinated national plan. Thus, the high GDP growth rate has become a problem in itself, rather than an index that reflects balanced national growth. Furthermore, the national debt-to-GDP ratio does not include potential financial burdens such as contingent or implicit liabilities (e.g., the national debt that the central government lends to municipal governments for infrastructure construction; special national debt used for systemic bank reform including losses from the stateowned banks massive non-performing loan portfolios in their transition to commercial banks; approximately $60 billion borrowed from the World Bank, Asian Development Bank and various foreign governments which is excluded from the government budget; debt due to wagepayment arrears by local government and state-owned enterprises; losses due to government grain-price support and petroleum-price support; and a serious funding shortage in social security and health care obligations.

Civil disturbances are increasing throughout China

The vast majority of proceeds from the issuance of national debt have been used to finance local physical infrastructure, while the social infrastructure has been largely and critically neglected in the reform process toward a market economy during the past two decades. China presently exhibits the symptoms of a 19th century boom economy in the age of industrial revolution, including urban slums, migrant workers, working poor, rising unemployment, loss of health care and social security, unequal education opportunity for the young, substandard housing, wages declining relative to inflation, sweatshops, and loss of social benefits attributable to privatization. Income and wealth disparity is rampant and increasing at a rapid rate. The majority of the social welfare programs created in the early decades of the socialist revolution have been discarded. For China to achieve and function at the level of a modern socialist society, the nations social liability would exceed a tenfold increase relative to current levels.

Unemployed migrant workers in Changan returning home due to lack of jobs

For Chinas population, the deteriorating environment resulting from a shortsighted, frenzied rate of industrialization will require enormous sum of money and decades to restore. Economic loss from environmental degradation and industrial pollution is nearing crisis levels.203 According to central government statistics, Chinas short-term foreign debt (debt with a maturity of less than one year), in proportion to its total outstanding foreign debt, reached a record 57.5% by the end of March 2007, increasing markedly by $7 billion to $190.63 billion and representing an increase as a proportion of total debt by .65 of a percentage point in just three months. At the same time, Chinas total outstanding foreign debt increased by $8.57 billion to $331.56 billion, according to the State Administration of Foreign Exchange. During the fourth quarter of 2007, Chinas foreign borrowing increased by $27.9 billion, reaching $373.62 billion by yearend, with a majority of the increase comprising short-term debt which rose by $22.4 billion to a total of $220.1 billion over the same period. Overall for 2007, Chinas total foreign debt increased by $50.6 billion or 15.7%. For 2007, short-term debt accounted for $36.5 billion of the 12 month
203 Source: the World Bank, with particular reference to an environmental health risk assessment researched and
prepared by the World Bank, which was subsequently suppressed at the insistence of the Chinese government, which feared the consequences from Chinas population had the report been published as intended.

increase, marking an accelerated rate of accumulation of short-term debt in the fourth quarter. Chinas Ministry of Finance issued a total of 2.35 trillion yuan ($324.8 billion) in treasury bonds in 2007, representing an increase of 1.46 trillion yuan over 2006. According to a report issued by the ministry and published by Chinas state-owned Xinhua news service, at the end of 2007 Chinas aggregated domestic debt balance exceeded five trillion yuan for the first time, doubling the figure from the end of 2003. Also for 2007, Chinas total transaction volume of treasury bonds reached 19 trillion yuan, nearly 50% over that of 2003. Under the rules of international competition established by the World Trade Organization, of which China is a member, Chinese commercial banks are required to participate in the global credit derivatives markets.204 Dangerous levels of total liability-to-GDP, debt dependency ratio, and debt service ratio. The report reveals that the central government debt figures reported by the Chinese government reveal that borrowing by the central government has reached an unprecedented and dangerous level relative to international standards, as shown in the table below.205 National Debt Statistics Peoples Republic of China National Debt to GDP Ratio National Debt Dependency Ratio National Debt Service Ratio Exceeds 100%206 78%207 17.05% (est.)208

December 31, 2007. Source: State Treasury Department except as otherwise indicated.

204 China was admitted as a member of the World Trade Organization on December 11, 2001. 205 See, e.g., the preeminent essay and accompanying economic analysis authored by Ms. He Qinglian, one of the
most esteemed Chinese economic commentators, entitled China Continues to Borrow Despite Heavy Debt. In her essay, Ms. Qinglian states the following: There are several methods that corrupt officials use to turn national debt funded projects into bribery generators. The first one is to propose a project (including ghost projects) in order to get funding from the central government. The second is to transform the fund to their own with their authority over the use of the funds. From the above analysis, it is not difficult to see that the so called prosperity in China is completely built upon raising a large volume of national debt. Borrow new debt to repay the old one is one of its basic tactics to maintain economic operations. The tactic could be used for a while, but definitely not for the long term. Any conscientious scholar who understands Chinas fiscal system would not be optimistic about the economic situation of China. See also, the study by Professor Song Yongming at the Peoples University of China, in which Professor Yongming reports that after the economic reform, national debts were mostly used by corrupt officials in conspicuous consumption, and not in construction expenditure as most people expected. According to Henry C. K. Lius monograph entitled, Chinas Internal Debt Problem (published by Asia Times Online, 2006), there were frequent reports of corrupt officials converting projects funded by national debt into extensive bribery networks and fraud schemes. According to Mr. Liu, such corruption is rooted in the absence of a separate independent supervisory and auditing authority in project management. 206 Figure is inclusive of the Chinese governments total liability including both explicit and implicit liabilities as of November 2005, as estimated by the World Bank. 207 Figure represents the central governments fiscal expenditure only, and does not include local government fiscal expenditure. The current figure is extrapolated from the trend since 1998. The generally accepted safety range by international standards is below 25-35 %. 208 The generally accepted safety range by international standards is 8-10 %.

In each category, the present debt position of the Chinese government significantly exceeds the international normative values considered prudent, and the widening trend is accelerating rather than reversing. Of equal or even greater concern, the governments use of debt proceeds appears highly questionable and quite possibly counterproductive to sustained long term economic growth.

Increasing civil unrest threatens Chinas political stability

Indications of escalating social instability. The report describes Chinas uneven income distribution relative to urban versus rural populations, which appears to be fostering a sentiment of wage and wealth disparity and an increasing perception of deprivation by specific segments of the population, as evidenced by the increasing reported incidence and severity of public unrest and civil disturbance. In excess of 58,000 incidents of civil disobedience were publicly reported in 2003, representing an increase of 15% over reported incidents in 2002 and a sevenfold increase over the figure reported just a decade ago.209 The upward trend in the reported incidence of civil disturbance is expected to continue to rise as unemployment also rises. A 2006

209

In an article entitled, Civil Unrest Challenges Chinas Party Leadership (November 04, 2004), the Washington Post reports that civil protests in China are growing larger, more frequent, and more violent. The RAND Corporation also reports that such incidents are growing markedly in both size and in violence. During 2007, over 80,000 such incidents were reported, representing an increase of 38% over the previous five year period. The continued migration of a significant portion of the rural population into urban concentrations and the rapidly increasing speed and scale of communication capabilities among large population segments concentrated within urban environments materially increases both the potential for, as well as the magnitude of incidents of civil unrest, further threatening political stability.

World Bank study revealed that China requires an ever-increasing economic growth rate to generate an adequate level of employment. The study estimated that 25 million people would enter Chinas labor market in 2006, yet only 11 million would successfully secure a job.210 In order to prevent unemployment from rising further, the government continues to maintain inefficient state-owned enterprises (SOEs) which account for more than 70% of the primarily state bank-issued loans. The productivity of Chinas SOEs has fallen to just a quarter of Chinas total GDP over the past decade. The government is reluctant to engage in a fire sale privatization of the state sector, which has already shed in excess of 30 million jobs over the past 10 years, fearing such action would threaten social stability.

Workers who lost their jobs at China Top Industries, a factory in Changan, lined up this week for a government subsidy. Officials are trying to avoid worker unrest.

China is estimated to presently be consuming more than twice what its ecosystems can sustainably supply, according to a report co-published by the World Wildlife Fund and the China Council for International Cooperation on Environment and Development. The study states that if China were to emulate the United States, China would require the available capacity of the entire

210

An employment survey released by Chinas National Development and Reform Commission yielded the same figures as the World Bank estimate, indicating an increase of 1 million jobless over 2005.

planet.211 As social tensions resulting from Chinas vast income inequality, as well as tensions resulting from a myriad of other grievances including withholding of pension entitlements; land seizures, conversion, and forced relocation; substandard working conditions; relations between the Han ethnic majority and other ethnic groups; persistent government corruption including at the local level; and unemployment resulting from the transition from socialism to state-managed capitalism continue to escalate, the likelihood for coalescence of incidents of civil disturbance into large-scale organized opposition to the communist party also increases dramatically.212 A significant and prolonged decline in the trading price of Chinese equities may also be expected to exert an adverse effect on the attitude of many of the individual Chinese citizens who invested in response to the active encouragement of the central government.213 Political stability will become less certain and the potential for the failure of the communist party, and thereby the central government, will increase significantly as stated in a recent report prepared by the Central Committee for senior communist party officials, which warned that the life and death of the party is at stake.214

According to a separate study conducted by the World Bank, environmental degradation has passed a point where large segments of Chinas rural as well as urban populations are exposed to serious health risks, and is responsible for an estimated 400,000 premature deaths each year related to air pollution. 212 China is not a homogenous society; for example, there are between 200 and 300 languages spoken in China (depending upon the manner in which the data is interpreted). The risk of collapse of the communist party has prompted alarm at the highest levels of the government. He Zengke, executive director of the China Center for Comparative Politics and Economics in Beijing, recently stated we all know the importance and urgency of the problem. Pointedly, the most recent approach employed by the party to quell incidents of civil disturbance (i.e., offering concessions to demonstrators, referred to as buying stability) communicates the perception that protests are the most effective manner in which to seek redress from the government and the greater the number of people involved, the more effective such protests will be. 213 The Shanghai Composite stock market has experienced a total decline so far in 2008 of almost 38 percent, making China the third-worst-performing market in the world this year after Vietnam and Iceland. Since most of the publicly-listed shares on Chinas stock exchange are those of state-owned enterprises, investors may blame the state for a collapse in price. 214 A comparative review of the structural factors responsible for the collapse of the Soviet Union is revealing, including an enduring one-party political system; rigid governance; a general decline in the ability to govern; popular disenfranchisement with local officials; and the governments mounting isolation from the masses.
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STRATFOR GLOBAL INTELLIGENCE

Founded in 1996 by Dr. George Friedman, Startfor utilizes human intelligence and other sources combined with incisive analysis based on geopolitics to better understand international events and to reduce risks and identify opportunities in every region of the globe. Stratfor publishes exclusive analyses, forecasts, situational reports (SITREPS) and geopolitical monographs, and is the world leader in global intelligence pertaining to political, economic and military developments. The firms clients include corporations, media outlets and governments. Dr. Friedman and his staff of analysts provide frequent Executive Briefings to boards of directors of multinational corporations regarding future world developments. "Without peer in open-source intelligence. 215 - General Thomas Wilkerson, USMC (retired), CEO of United States Naval Institute I think you do a great job with what you produce. Keep up the great writing and analysis, its as good or better than a great deal of the classified intel briefings I used to get. 216 - Herb Riessen, Brigadier General (retired) As a subscriber paid up for the next few years, I find your thinking very refreshing and very rewarding for me personally. I have always thought the mainstream news media were a day late and a dollar short on most subtle issues. And of course elected political leaders were only interested in discussing issues in a way that would help their re-election chances. 217 - Ed Paules, SVP Capital Markets Stratfor issued a special report entitled, China, the Olympics and the Visa Mystery (July 29, 2008).218 An excerpt from the report appears below: Something extraordinary is happening in China, and we are not talking about the Olympics. () Something just isnt right. () Disrupting an integral part of the global economy for a full quarter because of an international exposition makes little sense. The Germans in 1936 didnt do

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Stratfor website: http://www.stratfor.com Dr. George Friedman is the author of two New York Times bestsellers: The Next Decade: Where Weve Beenand Where Were Going and The Next 100 Years: A Forecast for the 21st Century. Dr. Friedmans other books include Americas Secret War, The Future of War and The Intelligence Edge. He appears regularly as a geopolitical analyst and commentator on CNN, Fox News and NPR. 216 Id. 217 Id. at 57. 218 The report is accessible at: http://www.stratfor.com/weekly/china_olympics_and_visa_mystery

it, the Russians in 1980 didnt no one has. One doesnt simply shut down international business transactions for three months or more to stop a terrorist and particularly not China, which depends on foreign direct investment. () Chinas behavior has been erratic for several months now, if not for the past few years, with the implementation of new and often contradictory security and economic policies. These have all been brushed aside as somehow related to preparation for the Olympics. But they are in fact anomalous. Chinas behavior is not that of a country trying to show its best side for the international community, nor that of a nation simply concerned about potential terrorist or public relations threats to the Olympic games. In another two months, after the Olympics and Paralympics have ended, it will become clearer whether this was a spate of excessive paranoia or a reflection of a much more significant crisis facing the Chinese leadership and the evidence increasingly points toward the latter. () Mao Zedong built a China designed to be self-sufficient and massively redundant. Every province, every city, every factory was supposed to be a selfcontained unit, making the country capable of weathering nearly any military attack. Deng Xiaoping didnt get rid of these redundancies when he opened the economy to foreign investment. Instead, he and his successors encouraged local officials to work to attract foreign investment and technology so as to raise Chinas economic standard more rapidly. By the time Jiang Zemin was in power it had become clear that the regionally and locally driven economic policies threatened to throw China back into its old cycle of decentralization and, ultimately, competing centers of power. () Slapping restrictions on foreign businessmen may make little sense from a broader business continuity sense, but if the point is to begin breaking the backs of the local governments whose strength lies in their relations with foreign businesses then the moves may make more sense. If the central government has reached the point that it is willing to risk its international business role to rein in wayward local officials, however, then the Chinese leadership sees a major crisis looming or already under way. It is one thing to toss out a few local leaders and replace them, quite another to undermine the structure of the Chinese economy for the sake of regaining control over local officials. Stratfors observations appear to indicate an emerging fracture between local government officials and the central government.219

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Subsequent to the publication of this report, Stratfor published another report entitled, CHINA: The Shaky Structure of an Economic Miracle (April 26, 2010), which examines the sustainability of Chinas political economy and the endemic failure of the Chinese economic model to develop household consumption as a source of economic growth. The report describes how the Chinese economy remains dependent on revenues earned from exports and spending on fixed investment, and how the government has failed to implement the policies necessary to transition to a balanced economy with consumer-led growth. Stratfor demonstrates in the instances of Taiwan and South Korea that the shift from state-guided investment to balanced, consumption-driven economies occurred as a function of the process of democratization. In the instance of China, allowing greater domestic freedoms would pose a threat to the Chinese regimes unity and stability. The overall contribution to Chinas GDP derived from

UPDATE Announcement of New Publication available from Stratfor: China: Power and Perils China's rapid economic growth and emergence on the world stage in recent years appear as signs of a country that is growing ever more powerful, but this perceived strength belies an insecure government with a tenuous grasp on domestic stability. As China nears a 2012 leadership transition, it is faced with myriad challenges, both internal and external, and understanding these challenges is critical to being able to predict and prepare for the China of the next decade.

Chinas transition into global power-hood means we should all start learning Mandarin. Or so the mainstream media would have us believe. Look deeper, and youll see that this Asian giant is reaching a point of crisis. Chinas economic model prioritizes flow-through of money, or growth above profit. Like a Ponzi scheme, its exactly the kind of model that breaks down rapidly under crisis. - Stratfors description of the firms newest publication, China: Power and Perils

domestic household consumption has declined since the 1980s. The report also presents a discussion of regional disparities within China and describes how many of Chinas provinces are dependent upon monies from Beijing to subsidize social stability. Stratfors report includes a map of the economic profiles of Chinas various provinces, including each provinces degree of dependency on exports and fixed investment relative to consumption. Following a detailed analysis of the relevant dynamics, the report concludes: Despite the massive amount of public funds spent in 2009 and 2010 to boost domestic consumption, no amount of incentives or subsidies will enable Beijing to turn domestic household consumption into the engine of Chinas growth in the near term. As a result, Stratfor predicts that rising unemployment in the export sector in conjunction with declining government investment likely will create sociopolitical instability. The report including the map are accessible on the world wide web at: http://www.stratfor.com/memberships/160215/analysis/20100419_china_shaky_structure_economic_miracle

GLOBAL ASSOCIATION OF RISK PROFESSIONALS / RISK REVIEW MAGAZINE

Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle

A feature article published in Risk Review Magazine identified numerous emergent risks and developing trend-lines of deteriorating economic and social fundamentals the sustainability of the Chinese Miracle. 220 Contrary to the prevailing perception of China as a relatively benign credit risk, research by risk analytics firm Sovereign Advisers demonstrates that the country is experiencing troubling trends including escalating incidents of civil unrest; adverse labor demographics; severe environmental degradation; wage inflation; soaring transportation costs; failure to address state institutions bad debt; a transparently artificial sovereign credit rating; and the erosion of Beijings central authority that represent an ominous threat to its economic outlook. Looking toward the future, the myriad of emerging country risks endemic to China transcend and even exceed the threat posed by the economic contraction of Chinas primary export markets.
Today, thanks in part to its investment-grade sovereign credit rating, China is seen as a strong credit risk. But is this just a mirage? Kevin OBrien argues that political, social, environmental and economic trends including artificial ratings, massive amounts of non-performing loans in the state banking sector and the Chinese governments default on billions of dollars worth of credit sovereign debt make China very risky. In fact, the myth of Chinas ever-expanding economy belies sustainability issues that comprise the core of Chinas economic development. This article summarizes some of the key global and domestic trends impacting Chinas political economy and reveals why the so-called Chinese Miracle may be facing the very real threat of a dramatic reversal. - Excerpt: Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle.

Article Highlights:
True extent of non-performing commercial loans greater than acknowledged: The Chinese government has failed to acknowledge and effectively address the true extent of state institutions bad debt. Chinas politically-directed financial system continues to generate many non
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The article entitled, Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle by Kevin OBrien, Risk Review Magazine (October / November 2008) is accessible on the world wide web at: http://www.garpdigitallibrary.org/download/GRR/2089.pdf

performing loans (NPLs) in the state banking sector. According to a 2006 report by Ernst & Young (E&Y), Chinas NPL level was equal to 40% of its GDP and the four major state-owned commercial banks accounted for $358 billion of bad loans nearly three times the figures these banks officially reported. E&Y attributed its higher estimation of Chinas bad debt was based on access to broader information, including data on the rapid growth of loans in recent years and details of distressed debt companies (e.g., rural credit cooperatives) attached to major banks. The massive growth of bad loans in Chinas banking system underscores the fact that Chinas apparently strong economic performance rests on a fragile financial foundation. Chinese central bank statistics published at the end of 2005 reported approximately $400 billion in property lending, representing 17% of the countrys GDP. At the same time, Chinas National Bureau of Statistics warned that unsold residential space across China had risen by nearly 25%, suggesting that a collapse of the property bubble could have catastrophic consequences for the countrys fragile banking system.
Prior to being pressured by the Chinese government into retracting the report, E&Ys Jack Rodman (a managing director) said: I think the numbers will be a big surprise because China has been giving the impression [with its banks listing overseas] that the [NPL] problem is behind us. China has not really resolved the issue they have just moved it from one state enterprise to another.

- Excerpt: Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle

Chinas selective default and artificial sovereign credit rating: Following Chinas 1987 discriminatory settlement with defaulted bondholders in Great Britain which excluded from settlement any bonds held by non-U.K. citizens, the Chinese Communist Party continues to refuse to honor repayment of Chinas national debt to certain other nationalities of foreign bondholders, including United States citizens.221
Then in 2006, the Chinese Ministry of Finance issued an official communiqu addressed to the Embassy of the United States of America in China, in which the Chinese government formally repudiated Chinas defaulted full faith and credit sovereign debt and announced that it would not repay any debt held by American citizens. - Excerpt: Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle

The matter was the subject of a hearing conducted by the Subcommittee on Terrorism, Nonproliferation and Trade of the Committee on Foreign Relations of the United States Congress on July 17, 2008 and a Senate measure was introduced which labels Chinas investment-grade credit rating as artificial. In testimony before the Senate Banking Committee, SEC Chairman Christopher Cox acknowledged that wrongful actions by a credit rating agency may subject the agency to revocation of its SEC registration. Both the U.S. Congress and the SEC are reviewing evidence

Settled international law establishes the continuity of sovereign obligations among internationally-recognized successor governments. The certificates of the defaulted bonds state that the debt is intended to be a binding engagement upon the Republic of China and its successors.
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suggesting that the actions of Standard & Poors Ratings Service, Moodys Investors Service and Fitch Ratings were profit-motivated and intentionally designed to conceal the Chinese governments debt repudiation and establish an artificial sovereign ceiling in order to increase ratings revenue from expanded securities issuance by Chinese corporations. The issuer pay revenue model incentivizes the credit raters to publish and distribute a demonstrably false sovereign credit rating for sovereign ceiling convention and actively assist the Chinese government in shedding its foreign debt obligation free from a default penalty.222 Moodys Investors Service has even gone so far as to sponsor a conference encouraging Chinese domestic corporations to exploit Chinas investment-grade sovereign credit rating (assigned by Moodys) to issue bonds internationally, after being rated for a fee by Moodys.223 The publication of false sovereign credit ratings for the Asian region is not without precedent. During the Asian Crisis in 1997, the ratings assigned by Standard & Poors, Moodys and Fitch misstated the true credit risk of the governments of Thailand and Korea. Until very recently, the rating agencies have been exempt from regulation by the SEC and other regulatory agencies. The agencies claim to be publishers of information and claim that their ratings constitute free speech. The concurrent House and Senate resolutions also express the belief of the Congress that the selective default status of Chinas repudiated sovereign debt should be treated as a material fact of disclosure by the SEC, thereby subjecting the rating agencies to an enforcement action under the federal securities fraud statutes for publishing knowingly false ratings; more specifically, the resolutions note that the agencies have violated Rule 10b-5 and Section 10(b) of the Exchange Act, which prohibit disclosing materially incomplete statements (half-truths) and omissions of material facts.

Excerpt: Reassessing Chinas Sovereign Risk: Emerging Global and Domestic Trends Threaten the Chinese Miracle
The prevailing corporate culture at Standard & Poors, Moodys Investors Service and Fitch Ratings is exemplified by the following statement: Lets hope we are all wealthy and retired by the time this house of cards falters. Source: findings of a ten month investigation into the internal practices of the three primary NRSROs conducted by the Office of Inspections, Compliance and Examinations, the Division of Trading and Markets, and the Office of Economic Analysis of the United States Securities and Exchange Commission. The investigative findings were published by the SEC in a report entitled, Summary Report of Issues Identified in the Commission Staffs Examinations of Select Credit Rating Agencies (July 2008). The report is accessible at: http://www.sec.gov/news/studies/2008/craexamination070808.pdf The SEC subsequently conducted an examination of the internal practices of each NRSRO and published the results in a report entitled, 2011 Summary Report of Commission Staffs Examinations of Each Nationally Recognized Statistical Rating Organization (September 2011). Among findings of other wrongful practices at each of the firms, the examination revealed that one of the three primary NRSROs failed to follow its own methodology for developing credit ratings. The report is accessible at: http://www.sec.gov/news/studies/2011/2011_nrsro_section15e_examinations_summary_report.pdf Based upon the information obtained during the investigations, the SEC is reportedly considering filing civil fraud charges against the three primary NRSROs. Source: Raters Draw SEC Scrutiny, by Jean Eaglesham and Jeannette Neumann, Wall Street Journal (June 17, 2011). The article is accessible at: http://online.wsj.com/article/SB10001424052702303499204576389973019552548.html See also, SEC Could File Civil Fraud Charges Against Some Raters, by Matt Egan, Fox Business News (June 17, 2011). The article is accessible at: http://www.foxbusiness.com/industries/2011/06/17/sec-could-file-civil-fraudcharges-against-some-raters/ And: Raters May Face SEC Civil Fraud Charges, by Joseph Woelfel, The Street (June 17, 2011). The article is accessible at: http://www.thestreet.com/story/11156576/1/raters-may-face-sec-civil-fraud-charges.html 223 http://globalsecuritieswatch.org/Moody%27s-Promotion.pdf
222

Through their invocation of the First Amendment of the United States Constitution, the rating agencies have thus far escaped liability for their actions including the willful publication and distribution of knowingly false, misleading and injurious ratings, e.g., China. When considering why the rating agencies would deliberately falsify a countrys sovereign credit rating, it is important to understand that the entire ratings revenue stream derived from a specific country is dependent upon that countrys sovereign rating; this rating establishes a sovereign ceiling which constrains the ratings of domestic corporate and directly affects their ability to issue debt (for which a rating agency is commissioned and paid). A report released in July by the SEC Office of Compliance, Inspections and Examinations provides details on the abusive practices employed by the rating agencies and describes numerous instances involving conflicts of interest, intentional misapplication of rating methodologies and other self-serving practices intended to increase revenue for the agencies. Prior to seeking a legislative solution to the problem, the Chairman of the Joint Economic Committee of the United States Congress sought to initiate an investigation and enforcement action by the SEC.224 In response, the SEC not only disclaimed jurisdiction over the practices of the rating agencies, but also rejected the adoption of a proposed rule requiring the agencies to employ systematic procedures designed to ensure credible and reliable ratings. 225 China: summary of emerging risks: The following is a summary of emerging risks in regard to China: Dependency of the Chinese economy on export manufacturing in the face of rising transportation costs, increasing wages, adverse labor demographics, and the prospect of prolonged stagflation in Chinas primary export markets. The rate of increase of Chinas petroleum consumption and the dependency of Chinas export manufacturing sector on petroleum imports. Health risks from Chinas pervasive and severe environmental degradation.226

Global commodities price inflation and Chinas domestic consumer price inflation, particularly with regard to food and energy.227

See letter dated May 24, 2005 to William H. Donaldson, then-chairman of the SEC, from the Honorable Jim Saxton, then-chairman of the Joint Economic Committee: http://www.globalsecuritieswatch.org/Letter_from_Chairman_of_the_Joint_Economic_Committee_to_SEC_Reques ting_Investigation 225 See letter dated September 21, 2005 to Christopher Cox, then chairman of the SEC, from Sovereign Advisers:
http://www.globalsecuritieswatch.org/Letter_from_Sovereign_Advisors_to_SEC_Chairman_and_Associate_Director
224

Securities and Exchange Commission. 17 CFR Part 240. Release Nos. 33-8570; 34-51572; IC-26834; File No. S704-05. RIN 3235-AH28. See: http://www.globalsecuritieswatch.org/SEC_Conference_Brief.pdf 226 One-third of the Chinese mainland suffers from exposure to acid rain; one-half of the water of Chinas seven largest rivers is unusable; one-fourth of Chinas population lacks access to clean drinking water; and one-third of the urban population is breathing polluted air. In Beijing alone, between 70% and 80% of all deadly cancer cases are related to the environment. The deputy director of Chinas state environmental protection administration warned that growing environmental problems will create millions of environmental refugees. See The Chinese Miracle Will End Soon (interview with Chinas Deputy Minister of the Environment), Spiegel (March 07, 2005). 227 As previously noted, the United Nations FAO reports that global food prices have risen by 65% from 2002 to 2008. Food staples have risen by 50% in China over a twelve month period, adding to the potential for domestic

Social instability stemming from income inequality and wealth disparity.228 Population demographics and shrinking labor surplus.229

World Net Daily published an exclusive report on the topic of Chinas selective default and refusal to honor repayment of its full faith and credit sovereign debt as originally reported by Sovereign Advisers.230 The Senate measure labels Chinas present investment-grade credit rating as artificial and in testimony before the Senate Banking Committee, SEC Chairman Christopher Cox acknowledged that wrongful actions by a credit rating agency may subject the agency to revocation of its SEC registration.

- Excerpt: China Stiffing America for $100 Billion in Debt

This action will put all investors on notice that China has refused to honor its obligations in contravention of international law. - Excerpt: China Stiffing America for $100 Billion in Debt, referencing a published statement by United States Congressman Elton Gallegly in regard to House Resolution 1179 and Senate Concurrent Resolution 78

unrest and political instability. On average, Chinese families spend half their total household income on food, and the prevailing fundamentals in most primary producer markets cause many analysts to believe that recent price increases are merely the beginning of a much longer term trend. 228 Chinas wage and income inequality is responsible for the emergence of two Chinas, comprised of a small and relatively prosperous urban class and a vastly more populous rural poor class. As this situation continues to develop, perceptions of discontent and general disenfranchisement on behalf of a majority of the population may reasonably be expected to lead to an escalation of civil disturbances and the erosion of the communist partys centralized authority. In fact, this erosion already appears to be underway: see China, the Olympics and the Visa Mystery, Stratfor Geopolitical Intelligence Report (July 29, 2008). 229 Chinese factory managers have recently begin to complain of labor shortages, and wages have begun rising more rapidly than in the past. The countrys one child policy, introduced in 1979, has caused the growth of its labor supply to slow sharply. The growth of the working-age population is forecast to drop from an annual rate of 1.3% in 2005 to 0.1% by 2015. See The Great Fall, The Economist (September 05, 2008). 230 China Stiffing America for $100 Billion in Debt. World Net Daily (October 10, 2008). The World Net Daily exclusive is accessible on the world wide web at: http://www.wnd.com/?pageId=77687