If we can agree that a fundamental interest of the Chinese Communist Party is maintaining its hold on power, then challenges to that power could have significant influence upon China’s foreign policy. One such challenge the the CCP’s power is the danger non-performing loans (NPLs) pose to Chinese economic growth (and, by extension, social stability and the continued survival of the regime).

Stratfor has been warning of this danger for more than two years now, but over the past few months the worry has spread beyond the circles of private intelligence and business analysts. In May Ernst and Young, PricewaterhouseCoopers, McKinsey Global Institute, and Fitch Raings all issued reports concerned with the magnitude of China’s NPL problem.

Ernst and Young withdrew their report under Chinese presssure (the above link leads to their retraction), but it is difficult to dismiss such a unified chorus of concern. Gary Schmitt and Jared Feiger’s article in the Weekly Standard sums up the problem thus:

Those in China who want it fixed are hoping that, by bringing in Western financial partners, they can raise additional funds and, through a coupling of management techniques, begin to bring better practices to mainland banks. But they are running headlong against a well-established and well-connected system of elite corruption. And to protect that system, the Chinese are only allowing their non-Chinese partners minority ownership positions which, in turn, only give them a limited say over banking practices. Moreover, the nearly 170,000 state-owned enterprises being supported by the banks cannot, Beijing believes, be allowed to go out of business. China’s leaders are increasingly worried about rising unemployment and the social unrest that might follow. In addition, Beijing rightly suspects that allowing Chinese citizens to place more savings and profits in markets outside of China would result in a run on deposits that the state banks could not survive.
…The laws of economics may be complex, but they do, in the end, punish those who ignore their most rudimentary precepts.
…[China’s] banks remain a critical element in the regime’s strategy for self-preservation.

Reading the World extensively quotes from Stratfor’s analysis, expressing an even more dire outlook:

…how much pain can Chinese society withstand before it fractures? This is clearly a concern for Beijing as it tries, simultaneously, to reform the economy and to crack down on dissent. The Chinese, like anyone in this fix, try to put the best possible face on the situation. Which is why they exploded at Ernst & Young. But even the government in Beijing couldn’t shout down the ensuing tidal wave of financial reports; instead, they grumbled and pointed to the passages that said it could all be managed.

Perhaps it can. But if it can, it won’t be easy – and we doubt that it is possible. We have been writing about this problem for several years now, and people keep asking when the crisis will come. Our answer is simple: If this isn’t a crisis, what would a crisis look like? The Chinese financial system is sinking under nonperforming and underperforming loans. Mainstream Western analysts are all writing about the problem and calling for reforms that the Chinese cannot possibly implement in time to make a difference. At some point, the weight of evidence will shift the behavior of the Western financial community, and that will be that.

This looming crisis indicates that Beijing is maneuving from a position of relative weakness; we’re not facing 87,000 incidents of “public order disturbances” every year. China faces the spectre of social upheaval and - worst case - a fracturing of the nation. Continued economic growth is essential to Beijing’s continued control of an increasingly agitated society. Attempts to expand energy resources, like last year’s bid to purchase Unocal, are motivated by more than just the desire for profit. At stake is the survival of the Chinese regime. Did preventing Chinese ownership of Unocal protect an equally significant American interest? Please. We passed up an opportunity to further draw China into the global free market (something that is very much in our interest), and instead we boxed them out.

This is essential for American policy makers to understand, lest they overlook this strategic weakness due to their focus on Chinese tactical moves. Will the CCP feel the need to pump up nationalism with some anti-US rhetoric and saber-rattling? Perhaps. At the very least, don’t expect to see Beijing back down its rheotric on any front. When one has a weak hand, the only alternatives are bluffing or folding… and folding is simply not an option. But this does not mean that they are hell-bent on expanding their global influence at our expense.

This internal threat is far more immediate and dire than any threat posed by the United States. With a clear vision of the whole board, and thus an accurate assessment of the relative strength of each side, the US ought to recognize that China’s struggle for stability and prosperity does not endanger our fundamental interests. As we hedge against potential risks and handle day-to-day diplomatic issues, we need to do it within the context of an accurate strategic framework.