Three things will shape events in East Asia in 2013: Beijing’s struggle to maintain social and political stability amid lower economic growth rates; China’s accelerating military modernization and

increasingly aggressive moves to secure its territorial and economic interests in the region; and varied efforts by other regional players, including the United States, to adapt to China’s changes.

In 2013, the Chinese economy will continue the gradual, painful process of moving away from high export-driven growth and toward a model that is more sustainable in the long run. Export growth will not pick up substantially, weighed down in part by continued economic malaise in Europe. The effects of rising wages and input costs in China’s traditional coastal export-oriented manufacturing powerhouses on overall Chinese competitiveness relative to emerging regional economies like Indonesia, the Philippines and Vietnam will also hamper export growth.

But barring another global financial meltdown on the scale of 2008-2009, China’s coastal manufacturing economy will not collapse outright. The decline will be gradual. In 2013, more factories — particularly low-end manufacturers with the thinnest profit margins — will move overseas. Many others, drawn to China’s superior transport and supply chain infrastructure, as well as its growing consumer market, will stay put or move inland, where labor is abundant and wages are lower. The ongoing, gradual eclipse of coastal China as a hub of global manufacturing over the next several years will lead to higher unemployment and social dislocation as more of China’s 250 million-strong migrant labor force returns inland in search of work.

Beijing therefore will continue to balance conflicting domestic needs in 2013. It must maintain high levels of industrial activity and employment, especially as more coastal factories lay off workers or close entirely. But the Communist Party cannot afford the potentially destabilizing effects — from high inflation to a bursting of the property bubble — of another round of stimulus such as that seen in 2009-2011. Overall employment will be sustained through a combination of investment into large-scale infrastructure projects (especially transport and urban infrastructure development in inland provinces) and cycles of targeted, temporary loosening of controls on the real estate market.

Beijing will continue economic rebalancing in the broad sense by encouraging greater economic activity in interior China, and especially in provinces lining the Yangtze River and in those bordering coastal provinces.

In an effort to accelerate inland urbanization, the government may introduce limited reforms to the hukou, or household registration, system. But the continued premium on employment will constrain any effort to genuinely restructure the economy toward greater efficiency, productivity and profitability. Government-led investment and debt will continue to underpin China’s economy in 2013.
As the Chinese export economy sputters and the government attempts to redirect investment away from property and toward more sustainable projects, it will have to guard against potential threats to its financial system, especially by the increasingly important shadow-lending sector. Shadow banking is by no means new in China. But it has grown significantly in the past few years from the geographically isolated informal loan markets of coastal cities to a complex network of semi-legal entities that provides between 12 and 30 trillion yuan (between $1.9 trillion and $4.8 trillion) in credit — at interest rates of 20-36 percent — to thousands of struggling small businesses nationwide.

Shadow lending is not inherently problematic. In fact, it is necessary in an economy where official financing is often limited to well-connected state-owned enterprises. But export growth is slowing and unlimited stimulus spending (much of which has gone toward construction, driving China’s skyrocketing demand for steel, cement, coal and other materials between 2009 and 2011) is at an end. This means that more and more recipients of shadow loans are likely to default. Beijing is quite capable of offsetting the short-term financial consequences if a shadow-banking crisis occurs in 2013. However, the residual effects — from inflation to unemployment to protests by shadow-banking products investors (including millions of ordinary Chinese citizens) — could significantly challenge social and political stability.

The Party’s Tasks
In 2013, the Communist Party of China will have to manage tremendous social and economic change even as it completes its own generational leadership transition and works to rebuild and reform the Party’s image, if not its actual practices. The political scandals of 2012 greatly harmed the Party’s public image, but the system survived. The generational transfer of power may give the Party a chance to reconsolidate its ranks and its control over China’s vast domestic security, censorship and military apparatuses, but the Party is not yet on safe ground. The Party’s growing sense of insecurity — both internally and with regard to the social consequences of China’s economic transition — likely will be reflected in continued censorship of online social platforms like Weibo, crackdowns on religious or other groups perceived as threatening, and the Chinese military’s growing assertiveness over China’s interests in the South and East China seas and Southeast Asia.

Regional effects of China’s changes
The ripple effects of China’s slow transition away from its two-decade reign as the world’s key supplier of low-cost goods will be felt more strongly throughout East Asia in 2013, but they will not be felt uniformly. The decline of low-end coastal manufacturing in China will present enormous opportunities for Southeast Asian countries like Indonesia, Vietnam, the Philippines and potentially Myanmar — all of whom will continue to push strongly for foreign investment not only into natural resources and raw materials industries but also into developing better urban, transport, power generation and materials processing infrastructure. At the same time, China’s readjustment to lower overall growth rates will pose near-term challenges, as Chinese consumption of raw materials — on which much of Southeast Asia has come to depend — stabilizes from the unsustainable highs of 2010-2011. More developed economies such as South Korea, Singapore and Australia, which also rely heavily on Chinese demand but are less well positioned to benefit from the diffusion of foreign investment away from coastal China, will be increasingly hard-pressed to maintain growth and employment.

Even as the region repositions itself in relation to China’s economic transition — and any resulting regional or global economic instability — Beijing’s growing military capabilities and assertiveness will pressure other East Asian countries. In Northeast Asia, China’s military modernization will add fuel to Japan’s military normalization process, including renewed efforts to lift constitutional limitations on the use of Japan’s armed forces. It could also accelerate the transfer of Japanese business and investment toward emerging Southeast Asian partners as diplomatic tensions and territorial disputes threaten Japanese manufacturing and business interests in China. The Korean peninsula, caught between Chinese military modernization and possible Japanese normalization, may push for greater rapprochement, especially as the North attempts to reduce gradually its dependence on Chinese support.

The Philippines, Vietnam, Myanmar and Asean
Meanwhile, Vietnam and the Philippines — China’s most vocal opponents in Southeast Asia — will continue to push for greater integration among members of the Association of Southeast Asian Nations and for US business and military engagement in the region.

2013 will be a critical year for Myanmar as it works to solidify its democratic opening — and in turn to reduce its strong dependence on Chinese investment. Beijing, recognizing the threat greater Western investment and influence in Myanmar pose to its own strategic and energy interests in Southeast Asia and the Indian Ocean basin, could undermine Myanmar’s opening — either through increased economic support or by stirring ethnic tensions along the China-Myanmar border. What happens in Myanmar in 2013 will in turn shape the Association of Southeast Asian Nations’ (Asean) political and economic development going forward as well as the potential for deeper ties between the United States and Asean.