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China to become world's largest retail market in 2018

China is on track to become the world's largest retail market in 2018, according to a report published by PricewaterhouseCoopers yesterday.

Over the next couple of years, China's retail sales volumes are expected to expand at an annual average rate of 8.7 per cent.

The report noted that retail industry sales volume in the Asia-Pacific region grew by and estimated 4.1 per cent in 2014 and said that this rate of expansion is expected to lift to 4.6 per cent in 2015.

(The Beijing News)

Chinese bank deposit insurance scheme imminent

The Chinese government will implement a bank deposit insurance scheme this year, says the Deputy Governor of the People’s Bank of China Pan Gongsheng.

Beijing published its draft guidelines on bank deposit insurance for consultation last year. The State Council reportedly passed the draft guideline. The new insurance will guarantee deposits up to 500,000 yuan. 

Mr Peng said the scheme will be implemented this year.

(China News Service)

Chinese mobile payment transactions grew 170 per cent last year

Chinese mobile payment transaction soared 170.25 per cent last year, according to the latest figures from the Chinese central bank.

The total value of mobile transactions was 22.59 trillion yuan, up 134.30 per cent from the year before.

(NetEase)

Chinese tourists buy a third of global tax-free goods in 2014

Chinese tourists accounted for nearly a third of global tax-free purchases in 2014- an increase of 18 per cent on the previous year reports Xinhua news. 

Citing statistics from Global Blue, a tourism shopping tax refund service provider, the report says Chinese tourists were the biggest spending group for the seventh consecutive year.

According to Global Blue, Russian, US, Indonesian and Japanese tourists were the next biggest spenders.

The biggest locations for tax refunds in order are Paris, London, Singapore, Milan and Rome with Chinese tourists preferring Paris overall.

Shoppers were most interested in buying fashion and clothing goods, followed by watches and jewellery.

(Xinhua)

‘One belt and one road’ strategy gets first investment interest

The Chinese government has reportedly approved a large investment plan regarding its "one belt and one road" strategy, according to Securities Journal. 

Beijing wants to spur its export sector and build better trade relationships with its neighbours through the new strategy. ‘One belt’ refers to the New Silk Road Economic Strategy, which will link China with Europe through Central and Western Asia and ‘one road’ refers to the 21st Century Maritime Silk Road, which will connect China with Southeast Asia countries. 

Many local governments are trying to jump on this infrastructure gravy train to spur their local economic growth. 

(Sina Finance)

China gives green light for SOE reform package: report

A contentious state-owned enterprise reform package has been approved and will be released following major party and government meetings in March reports the Economic Information Daily.

After numerous readings and alterations, the top-level policy documents intended to guide China's SOE reforms have now been approved by higher authorities, the newspaper reports quoting an unnamed 'authoritative source'.

The same source says that the policies will be announced following the annual plenary meetings of China's parliament in March.

Mixed ownership reforms will be further widened, likely increasing the scope for private and foreign firms to take stakes in certain state-owned firms, according to the report.

The report also says that the size of the stakes that private and foreign firms can take in SOEs operating in 'competitive sectors' will be further expanded so that the state will no longer necessarily have an 'absolute' controlling stake.

It's also noted that SOE reform was a key area of policy attention in the recently concluded round of local level political meetings. 

Finally, given that almost a third of the companies listed on China's two main stock exchanges have ties to the government, the article quotes a report that says this SOE reform package is likely to help boost China's A-share market in 2015.

President Xi Jinping announced an overhaul of how China's state-owned enterprises at the conclusion of a major meeting of the CPC in late 2013.

The State Council and both the central and local branches of the State-owned Assets Supervision and Administration Commission (SASAC) have since announced various trials and measures but no overarching central policy has yet been released.

(Economic Information Daily)

A Chinese official has set a March deadline for Australia to be a founding member of the Asian Infrastructure Investment Bank, a reporter for The Australian Financial Review said on Twitter.

Zhou Qiangwu told the Australian Aid Conference in Canberra on Friday that the new infrastructure lender would complement, not compete with other multilateral banks.

Mr Zhou is director of China’s Asia-Pacific Finance and Development Center and a senior adviser to the Chinese government on the AIIB.

Mr Zhou also called on the US and European countries to join the bank pointing out that, at 50 per cent, China’s proposed share of equity on the bank was too high and needed to be reduced, according to the the tweets. 

In December, Trade Minister Andrew Robb told The Australian it was now almost certain that Australia would join the China-led AIIB.

“It’s the wish of everyone in the cabinet, from the Prime Minister down,” he told the paper.

“Tony Abbott has said publicly that we shall not only join, but do so enthusiastically.”

In August, Australia gave China nine governance provisions it would like to see included in the new AIIB regime. Mr Robb told the paper China had picked up four of the nine fully, and adapted half of the other five.

Australia had baulked at becoming a founding member in October despite having been involved in talks on its structure and aims.

The United States has been urging caution on the bank. US Secretary of State John Kerry reportedly personally asked Prime Minister Tony Abbott not to take part in the AIIB last year.

The US views the AIIB as a rival to the World Bank and Asian Development Bank and fears China could use it strategically.

Australia’s first privately-owned Chinese bank is on its way, Reuters  reports.

According to the news service, Sydney-based investment management company Australia Capital Investment Group is planning to set up the bank to cater to the rising number of wealthy Chinese investing in Australia.

The new bank will raise up to $200 million ($US155.7 million) as early as next week and hopes to achieve a start-up asset book of $1bn, project manager Howard Ting told Reuters.

"Rather than being backed by a government enterprise it will be backed by private Chinese individuals which makes us the first in the Australian market," Ting said.

The company has yet to apply formally to the regulator.

In January, Chinese conglomerate Wanda pledged to invest $1bn for development in the Sydney CBD. Another Chinese company, Fosun, partnered with Sydney-based Propertylink to buy an office tower in North Sydney for $116.5mn.

The announcement of the proposed bank follows a move by the government this week to subject purchases of agricultural land of over $15 million to Foreign Investment Review Board scrutiny.

Details of the reforms to foreign investment in residential real estate are expected to be announced by the government is the coming weeks.

China's central bank has pledged to maintain a prudent monetary stance, but that may be getting harder to do as fairly weak credit data in January and a slowing economy prompt calls for more credit easing to spur growth. 

Analysts said that the central bank's tight grip on so-called shadow banking--just as capital is flowing out of the country--have left the world's second largest economy short of the credit it needs. 

On Friday, the People's Bank of China reported a rise in new bank loans in the economy. But overall credit--as measured by what is called total social financing--was weak compared with a year ago. The growth in broad money supply for the month was also at a record low and well below expectations. 

"Today's data suggest that current monetary policy is not easing," said Ma Xiaoping, economist at HSBC, suggesting more monetary easing is needed. 

New yuan bank loans by Chinese banks were 1.47 trillion yuan ($A310.5 billion) in January, up from 697.3bn yuan in December. Bank lending--held in check by the government's annual quotas--traditionally gets off to a fast start to the year as banks compete for good projects. 

Total social financing, a broader measurement of credit in the economy that includes nonbank lending, came to 2.05tn yuan in January, up from 1.69tn yuan in December but well below the 2.6tn yuan of January 2014. 

Economists said that nonbank financing--known as shadow banking--was roughly one-third its level in January 2014. That reflects ongoing efforts to put the squeeze on shadow banking, some of which is seen as loans to riskier parts of the economy. 

"We're seeing looser bank lending but a tightening on shadow banking," said Mark Williams, economist with Capital Economics. "I think policy makers are still focused on reining in overall credit," he added. 

The reining in of nonbank credit comes at a time when the economy is struggling. China's economic growth slowed to 7.4 per cent last year, the slowest pace in nearly a quarter of a century. 

Trade data has been disappointing and inflation slipped to a five-year low in January. Analysts are openly talking of possible deflation. 

China's central bank cut interest rates in November. This month it allowed banks to lend more by reducing the proportion of deposits they have to keep with the central bank--trimming what is called the reserve requirement ratio.

Analysts have said that data at this time of the year--just ahead of the Chinese Lunar New Year holiday--is often distorted. But they also said the central bank needs to be more flexible and that more monetary easing measures may be needed. 

"A cut in banks' reserve requirement ratio is not enough to support the cooling economic growth," said ANZ economist Zhou Hao. "The central bank may need another cut in either interest rates or banks' reserve requirement ratio in the first quarter." 

China's broadest measure of money supply, M2, expanded 10.8 per cent at the end of January compared with a year earlier. This was the lowest level on record and compared with a 12.2 per cent rise seen at the end of December. 

In recent months, the central bank has also had to grapple with growing strains as more Chinese and foreign companies move money overseas, amid less positive expectations for the economy's performance this year. China had net capital outflows of $US91bn in the fourth quarter of 2014. 

Reserve Bank of Australia governor Glenn Stevens has delivered a striking vote of confidence in the ability of the Chinese authorities to continue managing a high-growth economy.

In his testimony to the House of Representatives Economics Committee on Friday, Stevens commended the Chinese authorities for hitting their 2014 growth target of 7.5 per cent and said a target for 2015 of 7 per cent would be appropriate.

“They are by now … the largest trading economy in the world. An economy of that size growing at 7 per cent is still quite an impressive performance, if they can do that,” Stevens said.

It was impossible to say whether the target would be achieved, but Stevens said: “They have done a pretty good job of managing things thus far. I would say there are few countries that could better their track record of growth -- I cannot think of any.”

Growth anywhere between 6.5 per cent and 7.5 per cent would be a good result for a country China’s size. Stevens said the main challenge for China was not managing its growth but rather handling the financial excesses left by a period of double-digit growth. “So far, so good, but that will inevitably remain an open question.”

Stevens remains confident in the ability of the Chinese authorities to manage the financial system, including the so-called “shadow-banking” or unregulated sector where most of the problems are believed to lie. “As far as I can see, they are across the issues and are managing them fairly well.”

The bank’s confidence contrasts with a burst of pessimistic commentary about China’s outlook, which is drawing on a run of surprisingly weak economic reports over the past two months.

Diana Choyleva, the well-­regarded China analyst at British research group Lombard Street, put out a note last week discounting the official growth figures, saying they were inflated. She estimates China’s growth was only 4.4 per cent last year and only an annualised 1.7 per cent in the December quarter.

What is ­taking place in China is more than a simple ‘maturing’ of its growth to a more sustainable pace.

Steel production is a benchmark of industrial production, construction and infrastructure development. Over an eight-year period through to 2008, it averaged 20 per cent growth a year -- enough to quadruple in size. In 2014, growth was 1 per cent, according to the World Steel Association. Steel exports soared because domestic consumption of steel was falling.

Electricity consumption, which is also seen by many as an independent check on the official growth figures, rose by only 3.8 per cent in 2014 -- half the rate of the previous year and a fraction of the 20 per cent rate reached before the financial crisis.

The latest official manufacturing survey shows firms are reporting falling output (although growth in the number of firms means total output will still be rising) for the first time since late 2012. Heavy industry is suffering from excess capacity built during the credit boom that followed the financial crisis.

But Choyleva contends that the weakness is more widespread than that. Imports have been falling, with the January figures down by 19.9 per cent (exports were also 3 per cent lower). Much of this reflects the fall in the prices of major commodities like oil and iron ore. However, Choyleva notes that imports excluding raw materials also fell sharply, suggesting problems with demand.

The shake-out in China’s property market is continuing, with prices falling across the country, including in the major cities. There are hopes that this may be drawing to an end, with sales volume picking up in December, but there is a large overhang of unsold property. Excess capacity is plaguing both property markets and heavy industry.

The economy is not falling in a heap -- the latest car sales figures have been good and retail, which softened in the September quarter, has lifted since. And intra-regional trade is still showing good growth, as are China’s exports to emerging markets beyond Asia. But there are signs that all is not well. The financial sector seems to be facing a rising tide of trouble. Total lending in January was down 21 per cent from a year earlier, reflecting the clamps on shadow banking but also the reluctance of banks to lend to small and medium enterprises.

China’s foreign exchange reserves, which mesmerised the world as they rose towards $US4 trillion, are starting to be run down as capital flows out of the country, reflecting both a loss of confidence in the economy and expectations that the authorities will seek to devalue the yuan. Outflows reached $US100bn in the December quarter.

The World Bank’s latest review of the world economy provided a central forecast that China would achieve growth above 7 per cent this year but warned that “a sharper decline in growth could trigger a disorderly unwinding of financial vulnerabilities and would have considerable implications for the global economy”.

China now takes a third of Australia’s exports and, including its influence on demand from other countries in Asia, shapes close to half Australia’s trade, so there is a great deal at stake.

The RBA’s February monetary policy statement said the health of China’s property market was a risk facing the Australian economy, noting that conditions remained “subdued” despite attempts by the authorities to support construction activity.

The RBA has a dedicated team tracking the Chinese economy, including someone posted in Beijing. Stevens and his senior staff have regular personal contact with their counterparts at China’s central bank.

Stevens has at various times expressed frustration with the gloomy prophesies about China -- there were waves of pessimism about its outlook in late 2011 and late 2012 when growth appeared to falter before recovering. However, the weakness is increasingly evident in the numbers.

His optimism about the Chinese outlook before the economics committee on Friday may require some marking to market as the year unfolds.

This article originally appeared in the Australian Business Review.

A proposed Bitcoin producer has been ordered to stop seeking support on social media for a potential share market listing.

Bitcoin Group has been seeking expressions of interest from potential investors, mainly in China, on social media app Wechat, the Australian Securities and Investments Commission (ASIC) said.

But the company is yet to lodge with ASIC a prospectus, a document required from companies seeking investors.

"Any statements made about a potential offer may influence the investment decisions of consumers who will not have the benefit of all material information that would be included in a prospectus," ASIC Commissioner Jonh Price said.

A stop order has been placed on Bitcoin Group.

It’s the trillion dollar question about China’s economy.

The country is still investing, but are the returns anywhere near what they used to be?

With the economy expanding at its slowest pace in 24 years last year, and the IMF downgrading its forecast of Chinese GDP growth to 6.8 percent this year, it’s a question that keeps getting louder.

We’ve all the seen the photos of ghost cities without any residents, shopping malls without tenants or customers and the roads to nowhere. Anecdotes can serve as useful warnings. But they can also distract. Has the overall picture worsened so dramatically?    

Many keen China watchers say ‘yes’.

The rot is usually traced to the early days of the Global Financial Crisis. When growth started slowing sharply, the Chinese government told the state-owned banking system to open the credit taps. The aim was to boost the quantity of investment, its quality was less of a priority.  

In a sense, the policy response worked: output quickly stabilised.

But China bears believe that what the authorities delivered what was the economic equivalent of a sugar hit. And when its effects began wearing off, they responded by adding even more sugar.

A day of reckoning is fast approaching. A quick look at the macroeconomic data suggests that they could have a point.

The World Bank says that back in 2007 investment in fixed capital accounted for 39.1 percent of China’s GDP. In the same year, the economy grew at a breakneck rate of 14.2 percent.

In 2013, the investment share of GDP had risen to 47.3 percent, yet GDP growth had slowed to a more modest 7.7 percent.

So a crude number crunching exercise says that in 2007 it took $2.8 of investment to produce $1 additional dollar of output (39.1/14.2).  By 2013, this had risen to $6.2 (47.3/7.7). Investment seems to have lost its mojo.

But serious economists don’t take such calculations of the returns on investment too literally. For a start, a rising number of investment dollars doesn’t mean a collapse is inevitable. In 1989, the same calculation says it took $6.4 of investment to boost output by $1. In 1990, it took $6.7. Yet China’s economy then proceeded to more than double in size by 1997.

Another problem with such estimates is that they jump around from year to year. That’s because anything that slows GDP growth -- a slumping global economy for example -- will give the impression that China’s investment efficiency has worsened. In fact, fundamentally, nothing may have changed.   

Macroeconomics gives us a better measure. It’s called the marginal product of capital.  It shows how output responds to a one dollar increase in the capital stock. Remember, it’s investment that increases the capital stock.

To estimate it, you only need to know two things. The first is the share of GDP that is paid to owners of capital in forms such as profits. The second is the ratio of output to the capital stock.

Now multiply the two together and there’s your number.  

The data we need can be found in The University of Pennsylvania’s Penn World Tables. The catch is that the latest edition only extends until 2011.  Still, that’s three years after all the wasteful investment is supposed to have begun.

What this shows is that in 2007 a $1 dollar increase in China’s capital stock led to a $0.18 increase in output. In 2011, it was $0.16. 

A drop to be sure, but the 2011 figure isn’t low by historical standards. In fact, it was the average for China throughout the 1990s and 2000s. 

And get this. Repeat the exercise using US data and you’ll get $0.12.

If we close our eyes and take a deep breath, none of this is surprising.

With a population of 1.4 billion, capital in China remains scarce relative to labour. So the returns of investing in new capital are higher.

Now, what about 2012 until today?

Looking at the components of the marginal product of capital reveals a mixed bag.

The reason why the marginal product of capital is so much higher in China than in the US is because the capital share of GDP is bigger. 

Again, that shouldn’t surprise anyone. The capital share of GDP is just the flipside of the share of GDP that’s paid to labour in forms such as wages and wages in China have been held down by surplus workers from rural areas.

According to data from China’s National Bureau of Statistics, the real wages paid to these migrant workers leapt in 2010 and 2011. Since then though, they’ve started falling back more in line with the growth rate of overall output.

So, by that assessment, the capital share of GDP may have dropped slightly in recent years but it would remain well above that in the US.

The output to capital stock ratio has been on a downward trend since the mid-1990s. With extremely high rates of investment in 2012-2014, it’s likely that has continued.  

So, the best guess is that the marginal product of capital in China today is around 0.14-0.15.

To be clear, none of the above analysis gives China’s economy a clean bill of health in each of its many sectors. But at the aggregate level, the returns to investment haven’t collapsed, although they have come off the boil. And given that they remain around 20 per cent higher than in the US, you’d be brave to bet against China for a little while yet.

Professor James Laurenceson is deputy director of the Australia-China Relations Institute at the University of Technology, Sydney.

East Asia Forum

China’s new government fund for venture capital has real potential to significantly promote the country’s domestic entrepreneurship and innovation. But if access to the new funding is too easy, the projects main objective will be jeopardised.

On January 14, the State Council -- China’s chief policy body -- announced it will allocate 40 billion yuan (US$6.5 billion) to a new venture capital fund to support new start-ups and foster emerging industries. The announcement noted that the fund ‘comes at the right time’, but that ‘follow-up efforts are still required to ensure the fund works’. The government said the fund will come from the government’s existing budget designated for the expansion of emerging industries. Details on how it will be managed have yet to be announced. The government has referenced the possibility of including ‘social capital’ and will invite tenders from fund managers.

The goal is to promote innovation. But the success of the fund won’t simply depend on how widely new funding is spread. Instead, it depends on the ability to pick winners from among China’s fledgling start-ups, foster profitable businesses, and secure market returns to investors.

China’s economic strategy has recently faced challenges. Abundant labour from China’s rural hinterland has tapered off, entitling workers to demand better wages and conditions. The global financial crisis demonstrated that demand for China’s labour-intensive exports cannot be relied upon indefinitely. China is working hard for a ‘soft landing’ from its growth slowdown by improving its economic structure. The start-up venture fund is the latest concrete step toward climbing the value chain. The new fund will “help breed and foster sunrise industries for the future and promote [China’s] economy to evolve towards the medium and high ends”. Recent success stories such as Alibaba Group, Huawei and Lenovo signal bright possibilities for Chinese industry’s capacity for world-class innovation in competitive global markets.

China’s private small- and medium-sized enterprises (SMEs) are driving its economic growth, but they still struggle to access finance and investment. Yiping Huang wrote that China’s capital market is distorted against SMEs because of asymmetric liberalisation of China’s factor markets. Product markets have been completely liberalised, but the state deflates prices for factors of production such as capital, labour and land. The state-owned banks lend at below-market rates; as a result they don’t lend enough to meet demand. Lending is instead prioritised to asset-rich SOEs.

The government statement said SMEs -- especially start-ups -- have few or no assets to be mortgaged by banks, and must turn to other financial organisations, especially venture capital funds.

China’s venture capital market is small and has been constrained by a variety of restrictions in the past. According to research by Z-Ben capital consultancy, China has around 3,100 hedge funds with RMB388bn (US$62bn) under management, and another 2,500 private equity managers who oversee RMB1.2tn (US$192bn).

Government restrictions on the venture capital market are loosening. In late 2014, regulators allowed insurance companies to invest their huge pools of premiums into venture capital. Caixin recently reported that Anbang, a relatively small Chinese insurer, is making big forays into private equity, raising questions about whether regulators are keeping up. China’s ‘princelings’ are reportedly flocking into the nascent venture capital industry.

The danger is that such a significant increase in the supply of venture capital will ‘water down’ the performance expectations of investment recipients. Recipient firms might develop the same ailment as their larger state-owned cousins: inefficiency caused by easy access to government capital.

The solution to this risk is ‘mixed capital’. The government has recognised this, and refers to the possibility of raising ‘social capital’ (or really private capital) for the fund. ‘Mixed capital’ has already been discussed in relation to improving the performance of SOEs. Zhao Changwen from the Development Research Center of the State Council wrote that ‘mixed ownership’ can raise the performance of public capital. The idea is that public capital is invested in conjunction with social capital and private investors have a say in the management of assets. CASS economist He Fan noted that if private investors are sceptical over whether they have management control of their investment in ‘mixed capital’ assets, they are unlikely to invest in these ventures.

The same goes for venture capital. If the state is to have any hope in successfully achieving a ‘mixed capital’ fund with rates of return that attract private investors, investors will need to be confident that they will have a say in investment decisions. Investors will want fund managers who can create winning formulas for picking start-ups and innovative SMEs. They will need to support them to become profitable businesses in order to make a return on their investment.

If the government can’t attract ‘social capital’, the failed fund may well become yet another inefficient government subsidy program, rather than a real investor in the future of innovation in Chinese industry.

Patrick Williams is a visitor at Peking University as a 2014 Prime Minister’s Endeavour Award Postgraduate Scholar, and graduate student at the Australian National University.

This article first appeared on East Asia Forum and is reproduced here with permission.

BEIJING—China attracted $13.92 billion of foreign direct investment in January, up 29.4 per cent from a year earlier, the Ministry of Commerce said on Monday. 

The figure was above December's $13.32bn, which was 10.3 per cent higher than a year earlier. 

Chinese investments overseas reached $10.17bn in the first month of the year, up 40.6 per cent from a year ago, according to the ministry. 

It didn't say whether this included financial investments, which are normally calculated separately.

A senior official from the country’s top economic planning agency says the country's economy needs to grow by at least 6.5 per cent a year during the next five-year plan in order to meet the goal of doubling the average income if its citizens.

Xu Lin, the Director General of the Planning Department at the National Development and Reform Commission says growth of 6.5 per cent is the 'bottom line' for the next five-year plan period which starts in 2016.

Yi Gang, the deputy governor of the central bank in charge of the country’s $4 trillion foreign exchange reserves, says the potential growth rate for China’s economy could be as high as 7 per cent. However, he warns against the government picking industrial winners and advocates for allowing the market to play a greater role in allocating resources.

Both of them made these comments at a high-level finance forum in Beijing.

Imported Chinese berries are reportedly responsible for an outbreak of hepatitis A in both NSW and Victoria, according to the ABC.

Five people became sick after consuming Nanna’s frozen berries imported from China. Contaminated products have been recalled from supermarkets.

Victorian health authorities confirmed the linkage between the infectious outbreak and Chinese producers.

Chinese technology giant Huawei has appointed three high profile and titled British business executives to its newly created UK local board.

Lord Browne of Madingley, a former BP chief executive, has been hired as the chairman. Dame Helen Alexander, chairman of UBM and former president of the Confederation of British Industry and Sir Andrew Cahn, the former head of UK Trade & Investment, have also been lured to join Huawei’s board to bolster its profile.

It seems Huawei’s imperial chief executive Ren Zhengfei, a self-professed Maoist strategist, has a taste for British aristocrats (The tightrope China’s biggest business tycoon must walk, June 20). The creation of the British board is a clear indication that the Chinese tech giant is rolling out its Australian model across its global empire.

Huawei created its Australia board back in June 2011 -- the company’s first local board anywhere in the world. It recruited three prominent local directors from both sides of politics as well as a former fleet commander of the Australian navy, Admiral John Lord. The other two appointed at the time were ex foreign minister Alexander Downer and John Brumby, a former Victorian premier.

The board was empowered to make calls on decisions relating to government relations, marketing and sponsorship. Huawei’s headquarters also tasked the Australian board to produce a report on the feasibility of rolling out the Australian model globally.

However, the company has an image problem -- and a deadly one as well. It is seen by many Western intelligence agencies, including ASIO and the NSA, as a Trojan horse for Beijing. The US congressional committee has slammed it as a “national security threat” and Canberra has told it to stay away from the national broadband network.

The creation of a local board is part of a conscious effort by Huawei to improve its image and alleviate concerns over its opaque governance structure.

The Australian experiment has produced mixed results. Huawei clearly wanted to use its high-profile board to win a slice of the lucrative NBN contract. More importantly, if Huawei had won the NBN contract, it could have made it harder for the US to justify its exclusion of Huawei. The company already operates in Britain and New Zealand, two close US allies.

Britain, New Zealand, Australia, Canada and the US are all part of a closely-knit Anglophone intelligence community known as ‘Five Eyes’. Huawei’s chairman John Lord said it openly in an interview in 2013 that “if Huawei really booms here, one would hope, the people in the US would say Huawei is in every country in the world including all our traditional allies, it is serving them well and there is no concern”.

On this point, Huawei’s local board failed to live up to Ren’s expectations. Both Labor and the Coalition rejected Huawei’s bid. A senior telco executive with extensive government relations experience says the company should not have lobbied the government so publicly.

However, there are larger forces in operation when it comes to Huawei. Beijing and Washington are duelling over an ever escalating cyber-war. Americans are accusing the Chinese of waging a relentless and coordinated campaign of cyber theft and, at the same time, Beijing is telling its government agencies and banks to get rid of American-made gear for fear of cyber infiltration.

There is deep mistrust between the two countries. Companies like Huawei, Cisco and IBM are becoming collateral damage in the new digital cold war. We can hardly expect a local board to change that strategic dynamic (A China-US tech war will cost the world dearly, May 27).

But Huawei has learnt useful lessons about branding through its sponsorship of the Canberra Raiders. Mastering public and media relations are necessary skills that the company needs in order to become a fully-fledged global player. Creating a local board is clearly part of its international strategy and the Australian experiment laid the foundation.

However, it can never successfully resolve the most fundamental question about its alleged link with Beijing. Given the amorphous nature of relationship between the state and business in China, Huawei will always be viewed with suspicion. The Australian model can become more transparent but it can never put the security issue to rest.

East Asia Forum

The Chinese economy, one might think if one took most of the commentary on it seriously, is on a hiding to nowhere good. The growth rate is falling. Manufacturing is suffering over-capacity. The real estate bubble has burst, or is about to. The opportunity for productive infrastructure investment is running out. If you’re sitting in an economy like Australia which is dropping off the edge of the Chinese-driven commodity boom over the past decade or so, there mightn’t seem to be much cheer in the Chinese economic outlook. But China continues to grow at more than twice the rate of the world economy and, at this rate, will almost double its per capita income in the coming decade. So what’s the problem?

The prophets of Chinese economic doom worry about three big problems: the slow global recovery and the negative effects of previous stimulus policies that generated over-investment and capacity; a growth model that no longer attacks the burning problems of the day, such as over-investment and income inequality; and the challenge of steering a way through the middle-income trap by lifting the productivity of an already shrinking labour force. The last two problems are deeply structural and underline the challenge of maintaining higher growth potential (a rate around 7 per cent in the coming few years would be very satisfactory) through lifting productivity, as the supply of cheap labour dries up and the steam runs out of infrastructure investment.

So the real question about Chinese economic performance would seem to have very little to do with maintaining a growth rate that is as high as it used to be, the problem of a lower uptake of labour in the manufacturing sector or a slowdown in infrastructure investment. It has to do with the quality and efficiency with which growth is generated, how Chinese firms are learning to do more with less, and how the economy is able to re-structure towards higher productivity jobs across the board and especially in the expanding services sector.

Shanghai’s Mayor, Han Zhen, recently told the Financial Times that his government no longer uses GDP growth as a key performance indicator. "When I first became Shanghai mayor five or six years ago, we had a GDP performance review for local county and district chiefs. However, there is only one government department that still cares about the GDP figure, and that is the Bureau of Statistics," he said. "Do I care about GDP growth figure? Not really. I just need to look it at the end of year." It’s the ‘quality’ and ‘efficiency’ of growth that matters to Han in a part of China where incomes are already above US$14,500 a head. "[That] should be reflected in our contribution to innovation which includes institutional innovation such as the Shanghai Free Trade Zone", he said. The governor of the People’s Bank of China, Zhou Xiaochuan, is another senior official who has urged everyone to focus more on innovation and structural reform rather than on GDP growth per se.

How well then is China doing on the innovation front? It’s the effect of innovation on productivity that will ultimately determine whether the Chinese economy grinds to the halt that some predict or triumphs over the middle income trap.

What is little remarked in the commentary on the retreat of the old model of Chinese economic growth is the revolution that is taking place in Chinese corporate innovation in the new model. China is no longer an economy whose industrial growth is based on the absorption of a copious supply of cheap labour in low skilled manufacturing activities with the generous financial backing of the state, if ever it was. China is rapidly becoming a centre of innovative opportunity. It already ranks at the top of the world, alongside the United States and Japan, in terms of the number of patents and the ratio of patents to R&D expenditure. Zhongxing and Huawei are among the world’s top three companies for patent numbers. The internet is revolutionising finance, commerce and publishing.

Private firms are driving leading-edge innovation in manufacturing as well as the emergence of a world class IT driven services economy. Haier whitegoods manufacturer or Alibaba didn’t get to where they are today just by throwing lots of labour and capital together. And while the state may still be messing around in their patch in a way that requires continuous negotiation, there is now clearly space and a capacity in the Chinese political economy that allows intelligence and know-how to find productive expression. There is a fresh edge to management and innovation that could deliver China through the middle income trap at the same time as it effects a revolution in the standing of Chinese corporates on the global stage.

In this week’s lead essay, Yiping Huang points out that despite the difficulties that traditional manufacturing industries face, innovation is emerging as a game-changer in the Chinese economy. "The recently US-listed Alibaba is a case in point. Online shopping already accounts for more than 10 per cent of total retail sales and continues to grow at 40 per cent a year. China’s express postal and internet finance services are already world class. Manufacturers of large machinery equipment, electrical machines, cheap mobile phones and other products are rapidly catching up to global leaders." Zhang Ruimin, the chairman of Haier group, plans to transform Haier into a giant platform for innovation, destroying the traditional corporate structure and turning Haier into an incubator that transforms employees from executors of orders into innovators.

The paradox is that Chinese productivity was on the rise before 2008 and most studies reveal a slowdown in productivity after 2008. All this innovative activity in the private corporate sector in recent times has yet to reveal its impact on China’s aggregate productivity numbers. Important to that outcome, and success in traversing the challenge of the middle income trap, will be entrenching an economic and political environment that encourages creative freedom and investment in the human capital that is its seed -- without distracting Mr Zhang of Haier or Mr Ma of Alibaba from doing more with less.

Peter Drysdale is Editor of the East Asia Forum.

This article was first published by East Asia Forum and is reproduced here with permission.

Business in the Asian Century requires knowing more about what’s happening on the ground in Asia. A recent dispute in northern Myanmar makes this clear.

This stoush between Chinese logging companies and the Myanmar government is a messy knot of commercial, political and security drama. Chinese media reports claimed that the loggers had at least $US50m of equipment confiscated, that hundreds of Chinese citizens were detained and thousands fled back to China with the help of local militias.

The underlying quarrel reflects a problem that will undoubtedly return. Chinese companies do business in unsettled regions, where apparently mouth-watering profits are offered, but are left with no resort when local push comes to international shove.

In this case, the loggers claim that they bought legitimate licenses from a representative of the Kachin Independence Army. But their contact allegedly defected, and an outbreak of fighting trapped the loggers, who were forced to flee back to China.

The logging companies went to local authorities in China, pleading their case. They argued that their tax revenues alone justified a strong Chinese response.

But the logging companies will receive no such relief. In line with Beijing’s priority for getting its citizens out, a team of diplomats negotiated the release of the Chinese workers who were trapped. The investment, however, is lost.

The experience of these logging companies flies in the face of the image of an all-conquering China that vacuums up foreign resources at will.

Yet, while the local government cares about the logging companies, they are unable to change anything, as they can’t negotiate with the parties in Myanmar.

And while China’s Ministry of Foreign Affairs will negotiate with the Myanmar government, it has no clout within China itself, nor any stake in whether the logging companies get their money back.

So, the loss of overseas investment puts the Chinese government in a difficult position. They are constrained, geopolitically, as their personal ties and sympathies are undoubtedly with Myanmar’s long entrenched military leaders.

These are the same military leaders that have approved waves of major Chinese investment. Huge projects, including oil and gas pipelines across Myanmar, a deep-sea port facility in Rakhine State and handfuls of major mining, dam and agricultural investments.

The most contentious of those projects is the gigantic Myitsone hydroelectric dam, a $3.6bn project of the China Power Investment Corporation, to be built in conjunction with local Myanmar partners.

In September 2011 it was suspended on the order of Myanmar President Thein Sein. Facing a backlash from environmental and social activists in his country’s heartland, the issue of the Chinese dam on the Ayeyarwady River threatened to destabilise a new and tentative government.

The postponement of construction of the Myitsone dam was taken as a sign that Myanmar wanted some distance from the authorities in Beijing. It was supposed that a strategy of hedging against undue Chinese influence was part of Myanmar’s new foreign policy setting.

But Myanmar can’t hedge too aggressively. Many of the major projects that China has worked on are beyond local engineering capacity. Labour needs to be imported from across the border and the Chinese seek to manage the entire project cycle.

The construction of the pipelines from Kyaukpyu in Rakhine State to Ruili in Yunnan is an example. These projects require technical savvy that is not widely available in Myanmar. China’s ability to deliver such huge infrastructure to tight schedules is one of its major contributions to the Myanmar economy.

The implications of this dilemma are particularly apparent to local Myanmar governments. The armed conflicts that surge along the China-Myanmar border in the Kachin State are bad for business.

Both local governments and the rebel groups promise that they will support Chinese investment; but none can promise total peace and security in an area. It was this hard lesson that the Chinese logging companies have learned.

So what does this mean for Australians looking to do business in the region?

First, it tells us that picking winners will remain very hard. If Chinese businesses -- with their many local ties, close political links to Myanmar’s leaders, and extensive cross-border networks -- can’t pick winners in Myanmar, how can we expect Australian firms to do better?

Second, it tells us that we need to be choosing partners carefully. When dealing with far-flung regions, political nous matters much more than political clout. Partnerships, connections, and risk mitigation strategies become critical.

We can’t ignore Asia -- there is no alternative. Even places like Myanmar, where the risk of business is still high, should be given their due. But we also can’t engage with Asia blindly, without knowing more about what’s really happening on the ground.

Nicholas Farrelly and Ryan Manuel are Managing Partners at Glenloch Advisory, a political and economic consultancy focused on new Asian markets.

The new $40 billion Silk Road Fund has opened its doors for business, according to China's central bank. The new fund will operate like a long-term private equity venture and is focused on improving links between China and various Central Asian states.

Assistant governor Jin Qi has been appointed as chair of the new fund. 

A senior official from the State Administration of Foreign Exchange (SAFE) has been appointed general manager and will oversee the daily operations of the fund.

The major shareholders in the fund are SAFE (65 per cent), China Investment Corporation (15 per cent), The Export and Import Bank of China (15 per cent) and The China Development Bank (5 per cent).

The Silk Road Fund is a key part of Beijing’s new economic initiative to encourage exports and drive infrastructure investment in neighbouring states.

Twenty-six provinces have lowered their forecasts for fiscal revenue expansion on the back of slower than expected GDP growth, according to Caixin Media.

It's feared that the north-eastern provinces of Liaoning, Heilongjiang and Jilin, home to the country’s troubled rust-belt, could suffer the large falls in revenue growth rates. 

For example, Liaoning expects its fiscal revenue growth to fall from 9.5 per cent in 2014 to just 2 per cent this year.

Beijing has also ordered provincial and local governments to bring their hidden debts and contingent liabilities back onto their balance sheets in order to provide central authorities with a clear picture of the country’s debt problems.    

China is considering forging mega-mergers among its big state oil companies, seeking to create new national champions able to take on the likes of Exxon Mobil Corp and produce greater efficiencies at a time of low prices. 

At the request of China's leadership, government economic advisers are conducting a feasibility study of options for consolidation, according to officials with knowledge of the research. One involves potentially combining the country's largest oil companies, China National Petroleum Corp, or CNPC, and its main domestic rival, China Petrochemical Corp, or Sinopec, the officials said. Other options look at merging two other major energy companies, China National Offshore Oil Corp, or Cnooc, and Sinochem Group. 

No timetable has been set for a decision on whether or when to proceed with the various proposed mergers, said the officials. Spokespeople for the four Chinese oil companies and the State-owned Assets Supervision and Administration Commission, which oversees the largest state enterprises, declined to comment or didn't respond to queries. 

The possible mergers would be the latest consolidation of state companies blessed by the government as it tries to regear a slowing economy for a new phase of growth. As part of that effort, President Xi Jinping, now more than two years in office, is trying to revamp major state firms to make them more competitive globally. 

Though the government has taken some tentative steps to allow more private and foreign capital to flow into infrastructure, resources, banking and other areas long the preserve of state firms, Mr. Xi has said state companies remain an "important pillar of the national economy." The government "must ensure they thrive," Mr Xi said in remarks in August. Bigger and stronger state companies, according to officials and scholars familiar with the leadership's thinking, are viewed by Mr Xi as key to China's reclaiming its prominence in the world. 

Mergers could also boost efficiencies in an economy increasingly burdened by excess capacity -- a problem that has caused Chinese manufacturers to compete against one other by cutting prices. Late last year, the government announced a plan to merge the country's top two state-owned railcar makers with a goal of making the combined company capable of competing with Siemens AG in Germany and Canada's Bombardier Inc. 

The four oil companies -- CNPC, Sinopec, Cnooc and Sinochem -- have long dominated every phase of the industry; for years each had a geographic or business area of specialty. For instance, CNPC focused on exploration and production, and Sinopec on refining. Over the past 15 years, in response to earlier reform plans to spur competition, they' have expanded into the others' turf, creating overlapping operations that span exploration, refining to running gas pumps. 

"They're increasingly fighting among each other," said one of the officials with knowledge of the consolidation plan. "That has led to lots of waste and inefficiency." 

With international oil prices having halved in less than a year, those problems have become more pronounced, giving reform new urgency. Combining and then streamlining the operations of the major Chinese oil producers could help reduce waste caused by redundant staff and projects, the officials said. A combined enterprise could then focus on building up a better-funded company to compete around the world. 

Low oil prices have spurred talk of new deals activity across the globe, as stronger companies engage in opportunistic buying of weaker firms. Among big deals last year, Spain's Repsol SA agreed to acquire Canadian oil-and-gas producer Talisman Energy Inc. for $US8.3 billion. 

"We want to create a big Chinese brand to better compete overseas," the Chinese official said. "We want our own Exxon Mobil." 

The potential shake-up would cap what has been a tumultuous period for China's oil industry. Chinese oil giants -- in particular CNPC -- have been the focus of an antigraft campaign championed by President Xi. Leading industry executives have been detained for suspected graft, and added scrutiny has helped spur a huge pullback in new investment by wary executives. 

A decision to consolidate China's oil sector by making big state firms even bigger could end up tamping competition at home and stymie market-oriented reforms, some analysts said. It is unclear whether a possible consolidation would be followed by reforms, such as lowering barriers that have marginalized independent oil-and-gas producers. 

"If you are focused on the foreign market, you certainly want to consolidate because it's more competitive abroad," said Lin Boqiang, director of the China Center for Energy Economics Research at Xiamen University. "But if just for the domestic market it's better to have more competition, because competition leads to efficiency." 

Beijing has started inviting private capital into the oil industry. Sinopec last year sold a nearly 30 per cent stake in its retail sales-and-marketing unit to a group of 25 investors, mostly Chinese. But none of the initiatives involves selling a controlling stake to the private sector. 

A bigger challenge is whether the government would allow the combined entities to improve performance by reducing their huge workforces or shedding assets, said Philip Andrews-Speed, an expert on energy governance in China at the National University of Singapore. "That will be the test of whether this is old state-ism ... or are they really looking for better performance," he said. 

PetroChina Co, the listed arm of CNPC, has nearly 550,000 employees world-wide, more than seven times as big as Exxon Mobil Corp. The Chinese company delivered revenue of $US361 billion in 2013, compared with more than $US420 billion in sales and other revenue at Exxon. 

These days, all of China's big oil companies have been under pressure from prices and from the government to cut costs and focus on improving returns. For example, Cnooc Ltd., the listed unit of China National Offshore Oil, says it will cut capital spending by as much as 35 per cent in 2015 as a result of falling global oil prices. Expenditures at PetroChina and Sinopec are also expected to fall this year. 

Marrying CNPC and Sinopec would create one of the world's biggest companies. A combined entity at least in the short run could control a vast majority of China's onshore oil-and-gas production and would hold total assets of hundreds of billions of dollars. 

In the case of Cnooc, a merger with Sinochem, would give it more refining operations, giving it more sources of revenue that over time could help shield it against oil-market volatility. Cnooc is regarded by analysts as the most vulnerable to the oil-and-gas price drop, in part because it expanded aggressively abroad, buying assets including Canadian oil-sands operator Nexen Inc. for $US15.1 billion in 2013 when prices were high. 

If anyone has every participated in ‘scenario gaming’ of strategic hypotheticals, they will know that it can be a lot of fun. In the foreign policy and defence world, gaming became popular during the Cold War.

Questions such as what would happen if the Soviets invaded West Berlin or where would we end up if the US underestimated Russia’s second strike nuclear capacity and Moscow retaliated with a nuclear response, often led to terrifying conclusions -- or sometimes surprisingly upbeat ones.

The seriousness of the hypotheticals aside, they were fun and interesting because there was no right answer or predetermined outcome. The interest was in where the role playing expert participants would end up.

From early this century onwards, much of the scenario planning has been in response to a rising China: What might happen if Beijing acquires the capacity to inflict serious damage on an American aircraft carrier? How would Washington respond? What happens to the region if China reaches hard power parity with the US?

I am sure these and other more specific scenarios are being gamed as we speak.

With the burgeoning debate between China bulls and bears, let’s reverse the trend of scenario gaming beginning with the prospect of a rapidly rising China. Let’s instead assume that the bears are proven correct. The Chinese economy slows dramatically, triggered by a sudden halt in fixed investment growth which is the dominant driver of growth, credit slows and becomes much more expensive. Asset prices, especially real estate, begin to fall alarmingly. What happens then?

Given the brevity of this column, it is obviously not possible to comprehensively game what a dramatically slowing China might mean in strategic terms. But let’s begin the conversation and leave the conclusion to more able minds with some spare time. The starting point is that any dramatic slowdown will have a significant impact on Chinese national power and capabilities. This is the case for a number of reasons.

One is that any slowdown will have a disproportionately high impact on state-owned enterprises, since SOEs are the major drivers of fixed investment and fixed-investment growth in the country. Moreover, a drop in fixed-asset investment would not just affect construction companies since all major SOEs have substantial cross investments in fixed investment sectors. Any fall in capital asset prices would have a large impact on the balance sheets and profitability of SOEs and thus the tax revenue collected by Beijing.

Given that SOEs make a disproportionately high contribution to the fiscal revenue of the central government, and that around 15 per cent of the central budget is spent on national security (8.8 per cent on the PLA and 5.8 per cent on the People’s Armed Police which deals with internal security), the subsequent impact on the military budget would be considerable.

The problem would be further exacerbated by the high likelihood that a tightening of credit markets, the increased cost of credit and the resulting falls in capital asset values will have a severe impact on the balance sheets of tens of thousands of provincial and local government SOEs -- thousands of which are already under severe debt stress and are reliant on cheap credit and high asset valuations to remain solvent. Many provincial and local governments have become fiscally reliant on these ‘financing vehicles’ -- essentially SOEs -- and any fiscal shortfall will ultimately be met by the central government.

Another reason is that enhancing innovation and industrial capacity pertaining to state and national power is outsourced largely to state-backed ‘national champions’. These national champions are offered enormous resources from the central budget and have access to cheap credit from the state-controlled banking system. A dramatic tightening of fiscal revenues and tightening of credit markets will have clear adverse consequences for state-backed industrial policy and subsequently the development of Chinese national power.

The possible impacts of pressure on Beijing’s military budget will be significant given that the People’s Liberation Army (PLA) has become accustomed to annual budgets growing at double-digit rates. For example, smaller military budgets will undoubtedly increase opportunity costs since it becomes more difficult to simply throw more resources into areas where China is seeking to gain a future advantage and at the same time fund areas where gaps or shortcomings exist. Traditionally, a continental (land-based) military power, China is pouring money into becoming a formidable naval power in record time. What would a budget squeeze do to its naval ambition if the budget increases routinely sought by the PLA Navy is consistently knocked back?

Then think about some of the economic consequences that might have strategic implications. Should there be a dramatic slowdown in the Chinese economy, it is highly likely that Beijing will adopt a number of policies that will increase the competitiveness of export manufacturing as a response to declining fixed-asset investment. This might include further currency suppression (relative to consumer market currencies such as the US dollar and the euro) and additional tax and regulatory concessions to export manufacturers. The net effect of such policies is likely to come at the expense of other low-middle income East Asian economies all competing for a larger share of processing trade production with end products ultimately destined for the huge advanced economy markets in North America and the European Union. This will undoubtedly create further economic tension with neighbours.

Additionally, a loss of faith in the prospect that China will become a new net consumption economy of significant size that can create game-changing new market opportunities for East Asian neighbours may well alter the hedging and balancing behaviours of neighbours. Currently, China has managed to use the prospect of the future opportunities created by its expanding economy for current leverage. Even though America remains the preferred security partner of almost all countries in the region, very few countries are openly balancing against China and are instead merely hedging against China’s rise (by encouraging and facilitating an American presence).

In this scenario, there may well be significantly greater willingness by East Asian countries to more actively balance against a weakening China. Organisations like ASEAN may be more willing to take a collectively stronger diplomatic stance against Chinese assertiveness over claims in the South China Sea. China will remain respected but will no longer be feared to the same extent.

Then think about ramifications for the Chinese Communist Party. Who are the likely new economic and political winners and losers? Will President Xi Jinping’s already considerable authority be enhanced or degraded? This is important because it is widely accepted that President Xi has overseen an increasingly proactive but calculated change in Chinese policy over issues such as maritime claims in the region and is increasingly advocating for a reduced American strategic role in the region. A related question is how a President with diminished authority might respond -- whether there will be increased pressure on the President to be more or less compromising and risk averse when it comes to various foreign policy issues and responses in the region.

Much of China’s state media, and influential internet and social media actors, tend to take a much less temperate view of the national interest when responding to perceived national slights. Will actors like these become more or less influential?

What about the question of whether increasingly powerful SOEs will gain or decline in economic and therefore political influence. In recent economic crises, Beijing responded with policies that enhanced rather than weakened the role of SOEs in the economy, a trend that had been in existence since early this century. This is important because SOEs have become influential and increasingly trenchant over areas such as energy policy, which has ramifications for China’s stance with countries such as Iran and in the reportedly resource-rich South China Sea.

On the other hand, a weakened SOE sector accompanied by a relatively more influential domestic private sector -- seen as a potential antidote for China’s economic problems -- may well change not only China’s economic model but its political and policy environment. The domestic private sectors, supported generally by Chinese economic reformers and reforming institutions such as its central bank, tend to favour greater economic cooperation with East Asia and advanced American and European partners, and the opening of markets and lessening of SOE privilege and protection. Those advocating such policies also tend to emphasise the benefits of reducing tensions and a more cooperative approach to political and strategic relations with America and American allies in East Asia.

I am sure readers will think of other factors to consider, and different lines of reasoning. The point is much time and column inches have been spent on what a strong China might mean for the region, and rightly so. But it is also time to consider what a faltering Chinese economic power might look like and mean for the region.

Dr. John Lee is an Adjunct Associate Professor at the Strategic and Defence Studies Centre at the Australian National University and a senior fellow at the Hudson Institute in Washington DC.

Lowy Interpreter

“The really interesting part of the show is yet to come”, ventured the Politburo's point-man on Hong Kong affairs earlier this month, referring to 2014's Occupy Central protests. It seems Beijing has further modifications to the territory's affairs in mind.

Recent events are starting to clarify exactly how Hong Kong's governance will be more closely aligned with China: still 'one country, two systems', but with the emphasis on the former.

It was entirely foreseeable that the movement would lose Hong Kong some autonomy; the only question is how much Beijing will now choose to exact.

Will China's leaders see the protests last year as the venting of societal steam, to be managed and eventually forgotten? Or will it take a darker view and decide on more draconian control in the future?

The protests wrapped up in mid-December with a whimper. Arrests were made and some criminal charges are pending, but overall the winding up of the roadblocks was an impressive exercise in civility and moderation from both the protesters and the authorities. There was general relief that city life was normalising, which it did quickly.

Some pan-democrat members have threatened to quit their Legislative Council seats in order to force a by-election, and therefore a virtual referendum on universal suffrage, but that would be risky: the electorate seems torn down the middle on whether to accept Beijing's voting scheme for 2017. A democracy march earlier this month drew a modest crowd. Other polls suggest conservative pro-establishment candidates command greater credibility now.

The Hong Kong Government, sensing the public has shifted to its side, has opened a second round of consultations while sternly warning against the risks of anarchy, the importance of rule of law and the Basic Law's inherent limits to autonomy. It has submitted a report to Beijing, provoking howls of opposition outrage, claiming “it is the common aspiration of Hong Kongers to have universal suffrage strictly in accordance with the Basic Law and Beijing's rulings.” The local government is attempting to portray confidence that it can independently forge Beijing's designated path to 2017, with or without the democrats onboard.

But warnings from mainland officials on various issues may signify that in the future Beijing will exert a much tighter rein.

A PLA military staff chief has declared the territory a core interest of China which, of course, it is. The term is well understood to have security connotations, particularly with respect to foreign interference (Britain's Foreign Office has voiced support for Beijing's voting framework). Press freedoms are being challenged by mysterious acts of violence against journalists; it has been noted that these criminal attacks are always against the independent press, never against Beijing's newspapers. Some voices are piping up again in support of the dreaded Article 23 national security legislation which caused mass revolt in 2003, although some hardliners scarred by that experience are downplaying the law as 'inappropriate'. In the Leninist fashion reminiscent of the roundups that follow 'mass incidents' on the mainland, a campaign of exemplary prosecution may unfold.

The most significant impact will be on the education sector. Just as Deng Xiaoping concluded that the attitudes of youth were instrumental in the 1989 movement, so the topic of national education will become a future 'ideological battleground', as the state media likes to say.

Chen Zuo'er, a heavyweight adviser to Xi Jinping, maintains China has a national interest in education policy and must 'correctly guide' schools. That's taken by local teachers to mean 'obedience and loyalty, rather than freedom and critical thinking.' A nasty struggle over appointments at Hong Kong University, one of Asia's best, stems from its permission of radical, provocative publications. Beijing in particular objects to 'HongKongism' and its reaction to university independence movements is understandably irate.

There are calls for greater youth appreciation of, and connections to, China. A recent survey suggests only a few percent of Hong Kongers aged 18-29 want to live and work across the border. Schools are being offered funding to institute partnerships with mainland counterparts. A new national cadet program, kitting out kids in PLA uniforms, has raised hackles.

The question is whether the young will be receptive. 'We'll be back' was the combative message they chalked on walls and roads as the students dismantled and departed their giant campsite in December. This year threatens an ongoing test of strength between Hong Kong students and the world's mightiest authoritarian state.

Some are dismayed by the community's lack of resolve. But this was never a challenge Beijing would lose. The real question is whether it will wreak vengeance. The learned scholars behind the Occupy Central movement presumably did understand the risk of a comeback when they encouraged their students to confront the Chinese party-state. Didn't they?

This article was first published by Lowy Interpreter and is reproduced here with permission.