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Dec 27, 2016 | 13:43 GMT

2017 Annual Forecast: East Asia

China remains the center of gravity in the Asia-Pacific, and the economy remains the center of gravity in China.

China remains the center of gravity in the Asia-Pacific, and the economy remains the center of gravity in China. After three decades of rapid economic growth fueled by low-cost exports and state-led infrastructure investment, China is in the early stages of a protracted shift toward an economic growth model grounded in private consumption and high value-added manufacturing. Increased consumption will certainly help to ease the economic pain expected in 2017 – namely, stagnant exports and weak growth in the construction sector. But it will be many years before consumption becomes China's engine for growth. In the meantime, China's leaders will have little option but to use state-led infrastructure investment, however inefficient it may be, to maintain the country's economic health and thus ensure social and political stability.

The Definition of Chinese Policy

China's economic well-being will therefore depend on Chinese policy. And what will define Chinese policy more than anything is President Xi Jinping's efforts to consolidate power over the Communist Party and over the state's institutions ahead of the 19th Party Congress, which will take place around October. Xi's administration will do all it can to contain any social or economic instability that might threaten his political objectives and status within the Party, an imperative that will include sidelining potential rivals and moving allies into key government posts. (As many as five of the Politburo Standing Committee's seven members may retire this year, so Xi's cause is as urgent as ever.) Until then, he will also continue to employ his anti-corruption drive to displace rivals and threats to his power.

That is not to say that amid all this political maneuvering Chinese leaders will ignore economic reform entirely. Where appropriate, authorities will take measured steps forward on initiatives such as a nationwide property tax and property registration system, and they will continue to encourage consolidation in heavy industries. But where such reforms create the risk of instability by, say, undermining employment or corporate solvency, they will be diluted or deferred. Instead, the government will use a tried-and-true method to maintain growth — credit creation and robust state-led spending on infrastructure and other construction-related industries — as Xi focuses on tightening his grip on the political system.

This economic strategy is not without serious risks. Corporate debt in China has reached perilous heights and is disproportionately concentrated in resources, construction and other heavy industries that suffer from overcapacity and inefficiency and that likely hold the lion's share of nationwide nonperforming loans. Even more concerning, corporate debt is maturing more quickly than ever across all industries, especially heavy industries and the construction sector, forcing companies to take on even more debt to invest and to cover old debt.

Corporate debt will be no less concerning in 2017. Despite unprecedented credit creation and robust government spending in 2016, the real estate sector – on which many of the above industries depend – saw continued declines in completed investment and construction starts last year. Taken together, these factors point to the steady degradation of credit and investment as tools of macroeconomic management and suggest that Beijing will have to expend even greater resources than in 2016 to maintain the economic status quo. The government has the resources to do so, of course, but maintaining the status quo in 2017 will only exacerbate corporate debt concerns in 2018 and beyond.

Breaking Diplomatic Norms

Daunting though China's internal challenges to economic stability may be, Beijing also faces pressing external challenges: a potential eurozone crisis and new trade policies under the Trump administration. During his presidential campaign, Trump pledged to label China a currency manipulator and to impose across-the-board tariffs on U.S. imports of Chinese goods. Though the former promise is unlikely to materialize, the administration could, if it wanted to, impose tariffs and anti-dumping restrictions on imports of goods such as steel from China. But even that would be fairly inconsequential; targeted protectionist measures would have a marginal impact on China's economic trajectory and would only encourage corporate supply chains to diversify in other parts of Asia with cheaper labor and large consumer markets. This dynamic will stir tensions between the two economic superpowers – tensions that could spill over into other spheres of U.S.-China relations, such as the status of and Washington's relationship with Taiwan.

Trump has made clear his willingness to break with diplomatic norms governing U.S.-China relations, particularly his intent to use the question of Taiwan's status as a bargaining chip in negotiations with China on other fronts, including cybersecurity, North Korea's nuclear program and trade. Beijing is unlikely to make any concessions on Taiwan, and Washington knows this. Instead of fundamentally re-evaluating Taiwan's status, the Trump administration will try to use the Taiwan issue to get concessions from Beijing. China can retaliate with trade barriers on selected goods and can threaten to limit cyber and military cooperation with the United States, as well as more openly confrontational actions in the South China Sea or elsewhere. In the near term, Washington's willingness will give Taipei some breathing room from China. But the island will carefully manage cross-strait ties to avoid a direct confrontation with Beijing. China can be expected to use diplomatic isolation, military intimidation and targeted economic coercion to increase pressure on Taiwan, a critical node in the global tech supply chain that is deeply integrated with the mainland.

Beijing will also work, overtly or otherwise, to ensure that a favorable candidate prevails in Hong Kong's chief executive election, which is set to take place in March. The election will surely incite protests, but it is nonetheless an opportunity for Beijing and Hong Kong to improve their relationship — even though Beijing has designs to integrate Hong Kong further into the mainland.

But Hong Kong and Taiwan are just two of many features in China's evolving strategic environment. Throughout 2017, eager to boost the economy's slow but steady shift up the industrial value chain, China's government will continue to promote overseas investment into sectors such as high-tech manufacturing, culture and entertainment, and information and communications technologies. Beijing will meanwhile capitalize on the opportunity created by the Trans-Pacific Partnership's demise to promote alternatives of its own divising: the Regional Comprehensive Economic Partnership and the Free Trade Area of the Asia-Pacific.

Continued economic weakness at home, combined with the government's efforts to curb illicit capital outflows, may slow the momentum of Chinese outbound investment somewhat in 2017. But it will not halt China's efforts to enhance infrastructural, economic and security ties to Central and Southeast Asia. The biggest obstacles confronting initiatives such as One Belt, One Road — the massive development and infrastructure strategy to better connect China to the rest of Asia, Europe and East Africa — in 2017 are local opposition and security risks in places such as Central Asia, Pakistan and Indonesia.

A New Strategy in the South China Sea

Things are changing in the South China Sea. In its waters, China's influence has steadily grown in recent years, thanks to a campaign meant to expand and modernize the Chinese military and to develop the sea's islands. In 2016, however, the pace of expansion appeared to slow somewhat. In part, the slowdown was due to an international court of arbitration's ruling against China's maritime territorial claims. But it was also due to the fact that China, having achieved many of its goals in the South China Sea, is now replacing a strategy of aggressive expansion with a strategy that, in addition to coercion, leaves some room for cooperation. In fact, Beijing has increasingly sought to cooperate with potentially amenable claimants, such as Malaysia and the Philippines, by making conciliatory gestures on economic and maritime issues. At the same time, Beijing has continued to press more outspoken critics of its regional claims through limited punitive economic measures and other confrontational actions.

China will try to maintain this strategy in 2017. To that end, it will prefer to handle disputes on a strictly bilateral basis, and it will likely extend concessions to areas such as energy development and potentially sign a code of conduct that limits its actions.

And though this strategy eased maritime tensions somewhat in 2016, it may have more mixed results in 2017. Challenging its success will be a strained relationship with the United States, Vietnam's continued ventures into maritime construction activities, and the entry of countries such as Indonesia, Singapore, Australia and Japan – none of them claimants to the South China Sea's most hotly contested waters – into regional maritime security affairs.

Beijing will be particularly concerned about Japan, which will expand economic and maritime security cooperation with key South China Sea claimants. (Tokyo may also work more closely with the United States in the South China Sea and the East China Sea.) Beijing may try to counter U.S.-Japanese cooperation by imposing an air defense identification zone, which would in theory extend Chinese control over civilian aircraft in the South China Sea, though doing so would threaten China's Southeast Asian relationships. And though China would probably prefer to be as conciliatory as it can as the situation warrants, heightened great power competition in the Asia-Pacific may compel it otherwise. The more Japan is involved, the more China will have to balance, with different degrees of success, its relationships and its interests with members of the Association of Southeast Asian Nations (ASEAN).

Japan's Pride of Place

Greater involvement in the South China Sea, however, is just one piece of the Japanese puzzle. In the two decades following the end of the Cold War, Japan found itself strategically adrift. Today, buffeted by demographic decline, China's rise and a growing recognition across the Japanese political spectrum that change is necessary, Tokyo is in the early stages of reviving Japan's economic vitality and military power — and reclaiming its pride of place in the region.

In 2017, the administration of Prime Minister Shinzo Abe will make notable progress in that regard. In addition to expanded involvement in the South and East China seas, the Abe administration is likely to ramp up Japan's diplomatic and economic outreach in Southeast Asia. Meanwhile, Abe will pursue a peace treaty with Russia over longstanding territorial disputes. (Even without a formal treaty, the two countries will deepen bilateral trade and investment.) Above all, Japan will expand bilateral diplomatic and security cooperation with the United States, seeking to ensure Washington's commitment and involvement in the region. At the same time, Japan will take advantage of opportunities opened by potential changes to the United States' regional strategy – namely, a shift from multilateral partnerships like the failed Trans-Pacific Partnership to bilateral relationships – to play a more active leadership role to constrain China.

Abe will use his strong political position – the ruling coalition has supermajorities in both houses of the Japanese parliament – to press his agenda at home. In 2017, Abe will do what he can to maintain the first two 'arrows' of his economic plan — monetary easing and fiscal stimulus — while pushing forward with structural reforms (the third arrow) in areas such as labor, women's workforce participation and immigration. His administration may also seek to capitalize on heightened regional security competition and uncertainty over Washington's regional position to press for constitutional reforms meant to normalize Japan's military forces.

Northeast Asia Bound

Caught between a rising China and a resurgent Japan, both North and South Korea find themselves entering new and precarious strategic waters, albeit in different ways. Naturally, the prospect of a nuclear North Korea has put China, South Korea and Japan on edge – so much so that it has disproportionately contributed to Seoul's and Tokyo's military expansions in recent years. In 2017, North Korea may carry out additional nuclear missile tests for technical purposes and to remind the world, and especially Washington, of the country's strategic importance. This will pressure Seoul to build up its defenses and procure more arms, though its current political crisis may hinder its progress. While Washington can be expected to expand its sanctions regime against North Korea, it will also petition Beijing to pressure Pyongyang as well. But such efforts may be made in vain: Barring signs of a collapse of the North Korean government, Beijing will avoid putting significant pressure on Pyongyang.

A Welcome Change for the Economy

The prospect of a modest recovery in global commodities demand will be a welcome change to exporters such as Australia and Indonesia, but a decline in prices triggered by a slowdown in China's housing sector remains a real risk. In the year ahead, Asia's emerging economies may fall victim to potential trade protectionism in the United States, to U.S.-Chinese trade disputes, to a likely increase in the pace of U.S. Federal Reserve interest rate hikes, and to China's continued efforts to consolidate heavy and resource-related industries. The countries most at risk to economic shock are those with greater exposure to foreign lending (Malaysia and Indonesia), those with undiversified economic and trade profiles (Cambodia), and those faced with domestic political uncertainty and instability (Thailand and South Korea). Still, Asia's smaller economies will continue to pursue regional economic, trade and investment integration, untouched as they are, so far, by the rising wave of trade skepticism in other parts of the world.

Southeast Asia

Thailand will focus on domestic affairs in 2017 as it mourns the death of King Bhumibol Adulyadej and as its military government tries to maintain domestic social and political stability. Its first major test will come during national elections, which are scheduled to take place sometime in the second half of the year.

Meanwhile, the Philippines will continue to strike a balance between its partnership with the United States and its warming ties with China. (An unexpected confrontation over the Scarborough Shoal could change that dynamic.) This strategy will give Manila more space to focus on domestic issues, such as political reform and ongoing peace negotiations in the south. As long as President Rodrigo Duterte's popularity is high, no serious threats will emerge to his power in 2017. His domestic initiatives and foreign policy agenda, however, will require a lot of political capital to maintain, even as they threaten to aggravate internal power struggles between members of the government and political elite.

With Malaysian elections possibly in the offing in 2017, political fragmentation and economic uncertainty will test the delicate ethnic and social cohesion that has been in place since the country's independence.

Likewise, concerns over domestic social, political and economic stability in Indonesia will both drive and constrain ongoing fiscal and economic reforms. These concerns come at a precarious time for Indonesia, a time when Jakarta is shifting its focus from ASEAN-wide mechanisms to bilateral negotiations to secure its maritime interests.

For Vietnam, 2017 will be a year of the status quo. It will continue to try to ease its economic dependence on China, and its unstable fiscal conditions and rising debt load will constrain ongoing political reforms.

Australia will seek to play a more prominent role in promoting regional trade and investment integration in the Asia-Pacific region. It will also try to ensure maritime security along vital trade routes. Domestically, however, the country will struggle to overcome growing political divisions and legislative gridlock.

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