Dissecting the 'Chinese Miracle'

By Peter Zeihan

The "Chinese miracle" has been a leading economic story for several years now. The headlines are familiar: "China's GDP Growth Fastest in Asia." "China Overtakes United Kingdom as Fourth-Largest Economy." "China Becomes World's Second-Largest Energy Consumer." "China Revises GDP Growth Rates Upward -- Again." Everywhere, one can find news articles about China, rising like a phoenix from the economic debris of its Maoist system to change and challenge the world in every way imaginable.

But just like the phoenix, the idea of an inevitable Chinese juggernaut is a myth.

Moreover, Western markets have been at least subconsciously aware of this for a decade. More than half of the $1.1 trillion in foreign direct investment that has flowed into China since 1995 has not been foreign at all, but money recirculated through tax havens by various local businessmen and governing officials looking to avoid taxation. Of the remainder, Western investment into China has remained startlingly constant at about $7 billion annually. Only Asian investors whose systems are often plagued (like Japan's) by similar problems of profitability or (like Indonesia's) outright collapse have been increasing their exposure in China.

Once the numbers are broken down, it's clear that the reality of China does not live up to the hype. While it is true that growth rates have been extremely strong, growth does not necessarily equal health. China's core problem, the inability to allocate capital efficiently, is embedded in its development model. The goals of that model -- rapid urbanization, mass employment and maximization of capital flow -- have been met, but to the detriment of profitability and return on capital. In time, China is likely to find itself undone not only by its failures, but also by its successes.

The Chinese Model

Until very recently, China's economic system operated in this way:

State-owned banks held a monopoly on deposits in the country, allowing them to take advantage of Asians' legendary savings rate and thus ensuring a massive pool of capital. The state banks then lent to state-owned enterprises (SOEs). This served two purposes. First, it kept the money in the family and assisted Beijing in maintaining control of the broader economic and political system. Second, because loans were disbursed frequently and at subsidized rates -- and banks did not insist upon strict repayment -- the state was able to guarantee ongoing employment to the Chinese masses.

This last point was -- and remains -- of critical importance to the Chinese Politburo: they know what can happen when the proletariat rises in anger. That is, after all, how they became the Politburo in the first place.

The cost of keeping the money circulating in this way, of course, is that China's state firms are now so indebted as to make their balance sheets a joke, and the banks are swimming in bad debts -- independent estimates peg the amount at around 35-50 percent of the country's GDP. Yet so long as the economic system remains closed, the process can be kept up ad infinitum: After all, what does it matter if the banks are broke if they are state-backed and shielded from competition and enjoy exclusive access to all of the country's depositors?

This system, initiated under Deng Xiaoping in 1979, served China well for years. It yielded unrestricted growth and rapid urbanization, and helped China emerge as a major economic power. And so long as China kept its financial system under wraps, it would remain invulnerable.

But the dawning problem is that China is not in its own little world: It is now a World Trade Organization member, and nearly half of its GDP is locked up in international trade. Its WTO commitments dictate that by December, Beijing must allow any interested foreign companies to compete in the Chinese banking market without restriction. But without some fairly severe adjustments, this shift would swiftly suck the capital out of the Chinese banking system. After all, if you are a Chinese depositor, who would you put your money with -- a foreign bank offering 2 percent interest and a passbook that means something, or a local state bank that can (probably) be counted on to give your money back (without interest)?

The Chinese are well aware of their problems, and perhaps their greatest asset at this point is that -- unlike the Soviets before them -- they are hiding neither the nature nor the size of the problem. Chinese state media have been reporting on the bad loan issue for the better part of two years, and state officials regularly consult each other as well as academics and businesspeople on what precisely they should do to avert a catastrophe.


The result has been a series of stopgap measures to buy time. Among these, the most far-reaching initiative has been a partial reform of the financial sector. The government has founded a series of asset-management companies to take over the bad loans from the state banks, thus scrubbing them free of most of the nonperforming loans. The scrubbed banks are then opened up so that interested foreign investors can purchase shares.


So far as it goes, this is a win-win scenario: Foreign banks get access to assets in-country before the December jump-in date, and the state banks avoid meltdown. In addition, a measure of foreign management expertise is injected into the system that hopefully will teach the state banks how to lend appropriately and -- if all goes well -- lead to the formation of a healthy financial sector. At the same time, the deep-pocketed foreign companies come away with a vested interest in keeping their new partners -- and by extension, the Chinese government -- fully afloat.

The only downside is that central government, through its asset-management firms, assumes responsibility for financially supporting all of China's loss-making state-owned enterprises.

But this rather ingenious banking shell game addresses only the immediate problem of a looming financial catastrophe. Left completely untouched is the existence of a few hundred billion dollars in dud loans -- linked to tens of thousands of dud firms for which the central government is now directly responsible.

Which still leaves for China the unsettled question: "Now what do we do?"

Two Opposing "Solutions"

As can be expected from a country that just underwent a leadership change, there are two competing solutions.


The first solution belongs to the generation of leadership personified by Deng Xiaoping and Jiang Zemin, and could be summed up as a philosophy of "Grow faster and it will all work out." It could be said that during Jiang's presidency, while the leadership certainly perceived China's debt problem, they -- like their counterparts in Japan -- felt that attacking the problem at its source -- the banking system -- would lead to an economic collapse (not to mention infuriate political supporters who benefited greatly from the system of cheap credit).

Jiang's recommendation was that everyone should build everything imaginable in hopes that the resulting massive growth and development would help catapult China to "developed country" status -- or, at the very least, raise overall wealth levels sufficiently that the population would not turn rebellious. In the minds of Jiang and his generation of leaders, the belief was that only rapid economic growth -- defined as that in excess of 8 percent annually -- could contain growing unemployment and urbanization pressures and thus hold social instability at bay.

The second solution comes from the current generation of leadership, represented by President Hu Jintao. This solution calls for rationalizing both development goals and credit allocation. The leadership wants to eliminate the "growth for its own sake" philosophy, consolidate inefficient producers and upgrade everything with a liberal dose of technology. Key to this strategy is a centrally planned effort to focus economic development on the inland areas that need it most -- and this entails tighter control over credit. Hu wants loans to go only to enterprises that will use money efficiently or to projects that serve specific national development goals -- narrowing the rich-poor, urban-rural and coastal-interior gaps in particular.

There are massive drawbacks to either solution.

Regional and local governors enthusiastically seized upon Jiang's program to massively expand their own personal fiefdoms. And as corporate empires of these local leaders grew, so too did Chinese demand for every conceivable industrial commodity. One result was the massive increases in commodity prices of 2003 and 2004, but the results for the Chinese economy were negligible. China consumes 12 percent of global energy, 25 percent of aluminum, 28 percent of steel and 42 percent of cement -- but is responsible for only 4.3 percent of total global economic output. Ultimately, while "solution" espoused by Jiang's generation did forestall a civil breakdown, it also saddled China with thousands of new non-competitive projects, even more bad debt, and a culture of corruption so deep that cases of applied capital punishment for graft and embezzlement have soared into the thousands.

Yet the potential drawbacks of the solution offered by Hu's generation are even worse. In attempting to consolidate, modernize and rationalize Jiang's legacy, Hu's government is butting heads with nearly all of the country's local and regional leaderships. These people did quite well for themselves under Jiang and are not letting go of their wealth easily. Such resistance has forced the Hu government to reform by a thousand pinpricks, needling specific local leaders on specific projects while using control of the asset management firms as a financial hammer. After all, since the central government relieved the state banks of their bad loan burden, it now has the perfect tool to strip power from those local leaders who prove less-than-enthusiastic about the changes in government policy.

Or at least that is how it is supposed to work. Local government officials have become so entrenched in their economic and political fiefdoms that they are, at best, simply ignoring the central government or, at worst, actively impeding central government edicts.

Hu's team is indeed making progress, but with the problem mammoth and the resistance both entrenched and stubborn, they can move only so fast for fear of risking a broader collapse or rebellion. And this does not take into consideration Beijing's efforts to strengthen the Chinese interior -- where the poorest Chinese actually live. Complicating matters even more, Hu's strategy relies upon the central government's ability to wring money out of the wealthy coastal regions to pay for the reconstruction of the interior.

That has made the coastal leaders even more disgruntled. However, they have come upon a fresh source of funding, replacing the traditional sources of capital that now are drying up as a result of the personnel changes in Beijing: the underground lending system, which was spurred by the official government monopoly over banks in years past. The central government now estimates that the underground banking sector is worth 800 billion yuan, or some 28 percent of the value of all loans granted in country.

Dealing with Failure -- And Success

The question in our mind is which strategy will fail -- or even succeed -- first. If Jiang's system prevails, then growth will continue, along with the attendant rise in commodity prices -- but at the cost of growing income disparity and environmental degradation. The likely outcome of such "success" would be a broad rebellion by the country's interior regions as money becomes increasingly concentrated in the coastal regions long favored by Jiang. And that is assuming the financial system does not collapse first under its own weight.

Local rebellions in China's rural regions have already become common, but two of are particular note.

In March, the villagers of Huaxi in the Zhejiang region protested against a local official who had used his connections to build a chemical plant on the outskirts of town. When rumors of police brutality surfaced, some 20,000 villagers quite literally seized control of the town from 3,000 security personnel. Before all was said and done, the villagers invited regional press agencies in to chronicle events in the town that had told the Politburo to go to hell, and started burning police property and parading riot control equipment before anyone who would watch. They actually sold tickets to their rebellion. Huaxi marked the first time local officials actually lost control of a town.

Then, in December, protests erupted against a local official in Shanwei, who had similarly lined his pockets with the money that was supposed to have been made available to farmers displaced by his expanding wind-power farm. The local governor figured that since he was investing not just in an energy-generating project in energy-starved China, but a green energy project, that he would have carte blanche to run events as he saw fit. He was right. When the protests turned violent, government forces opened fire -- the first authorized use of force by government troops against protesters since the Tiananmen Square incident in 1989.

Such events are, in part, evidence of a degree of success for the strategy espoused by Jiang's generation. The grow-grow-grow policy results in massive demand for labor by tens of thousands of economically questionable -- and typically state-owned -- corporations. This, in turn, draws workers from the rural regions to the rapidly expanding urban centers by the tens of millions. The dominant sense among those who are left behind -- or those who find their urban experiences less-than-savory -- is that they have been exploited. This is particularly true in places like Shanwei, on the outskirts of urban regions, when urban governors begin confiscating agricultural land for their pet projects.

But for all the complications created by Jiang's solution to China's economic challenges, it is Hu's counter-solution that could truly shatter the system. In addition to dealing with all the corrupt flotsam and high-priced jetsam of Jiang's policies, Hu must rip down what Jiang set out to accomplish: thousands of fresh enterprises that are unencumbered by profit concerns. A steady culling of China's non-competitive industry is perhaps a good idea from the central government's point of view -- and essential for the transformation of the Chinese economy into one that would actually be viable in the long term -- but not if you happen to be one of the local officials who personally benefited from Jiang's policies.

The approach of Hu's generation is nothing less than an attempt to recast the country in a mold that is loosely based on Western economics and finance. Even in the best-case scenario, the central government not only needs to put thousands of mewling firms to the sword and deal with the massive unemployment that will result, it also needs to eliminate the businessmen and governing officials who did well under the previous system (which did not even begin to loosen its grip until 2003). And the only way Beijing can pay for its efforts to develop the interior is to tax the coast dry at the same time it is being gutted politically and economically.


The challenge is to keep this undeclared war at a tolerable level, even while ratcheting up pressure on the coastal lords in terms of both taxation and rationalization. But just as Jiang's "solution" faces the doomsday possibility of a long rural march to rebellion, Hu's strategy well might trigger a coastal revolution. As the central government gradually increases its pressure on the assets and power of China's coastal lords, there is a danger that those in the coastal regions will do what anyone would in such a situation: reach out for whatever allies -- economic and political -- might become available. And if China's history is any guide, they will not stop reaching simply because they reach the ocean.

The last time China's coastal provinces rebelled, they achieved de facto independence -- by helping foreign powers secure spheres of influence -- during the Boxer Rebellion. This resulted, among things, in a near-total breakdown of central authority.

 

Update: Curzon likes Stratfor, and SimonWorld likes the analysis.

Russia's Gas Strategy: Turning Up the Heat on Ukraine

By Peter Zeihan

During the past few weeks, Russia and Ukraine
have been arguing
over the terms of their natural gas supply contracts.

Under previous
arrangements -- struck in efforts by Moscow to influence the outcome of
Ukraine's presidential election in 2004 -- Russia's state-owned monopoly
Gazprom supplied Ukraine with natural gas at the rate of $50 per 1,000 cubic
meters. But Russia's preferred presidential candidate, Viktor Yanukovich,
lost
the 2004 election to the pro-Western Viktor Yushchenko. That loss, combined
with Russia's hopes of raising income levels in general (or, switching "to a
market basis," in Gazprom-speak) prompted Moscow to demand payments of $230
per 1,000 cubic meters from Ukraine -- terms Kiev refused. Gazprom then
sliced its exports to Ukraine on Jan. 1, triggering a European uproar.
Because Europe also depends heavily on Russian natural gas -- with 80
percent of those supplies transiting Ukraine -- the Russian cutoff hurt
Europe rather than Kiev.

On Jan. 4, Moscow and Kiev settled the
matter by agreeing to a compromise five-year contract. Under terms of that
deal, natural gas from the Central Asian states of Turkmenistan, Uzbekistan
and Kazakhstan will be transported through Russia, making up a mix that
would supply Ukraine at a rate of $95 per 1,000 cubic meters. Any Russian
gas fed into that mix will be sold at Gazprom's full rate of $230.


From a strictly commercial standpoint, all now seems right with the
world. The Central Asians, who previously were able to sell natural gas only
to the heavily subsidized Russian market, now have gained a significant
export market for their supplies; the Ukrainians have substituted a mere
doubling in prices for what would have been a fourfold increase; and the
Europeans have their natural gas supplies re-established.

But that is not the really interesting -- much less important -- part of what has just occurred. When the crisis first erupted, it centered on Russia's desire to reassert influence directly in Ukraine; but as the game has played out, it has come to center on Russia's ability to use Europe as a lever.


The Ukrainian Keystone

From the beginning, the natural gas spat has been about much more than a few (billion) dollars in annual
energy sales. This squabble is over the orientation of Ukraine between West
and East, and ultimately over the ability of Russia to regenerate its
geopolitical fortunes.

Ukraine's �Orange Revolution� was a seminal event in the Russian mind -- a jarring development that ranks second only to the dissolution of the Soviet Union in December 1991. Russians view the
Soviet collapse as the day they lost their empire, and they fear that
history may mark the Orange Revolution as the day that Russia degraded past
the point of no return.

Viewed from any angle, Ukraine is critical
to the long-term defense and survival of the Russian state. This is not
about ethnic kin, although eastern Ukraine does host the largest Russian
community in the world outside of Russia. Even before the Soviet era,
Ukraine was integrated into the industrial and agricultural heartland of
Russia; today, it not only is the transit point for Russian natural gas to
Europe, but actually is a connecting point for nearly all the country's
meaningful infrastructure between East and West -- whether of the pipe,
road, power or rail variety.



Politically
and militarily, a Russia denied Ukraine cannot easily project power into the
Northern Caucasus. Nor could Moscow reliably exert control over Belarus,
since that country's primary water transport route, the Dnieper, flows south
to Ukraine, and it is nearly as well linked into Poland and the Baltics as it
is to Russia proper. That geographic reality means that, should anything
happen to the government of pro-Russian President Alexander Lukashenko,
Minsk's geopolitical orientation could quite easily shift to match
Ukraine's.

And of course, taking the long view, it is easy to see
why the Russians are so nervous. Ukraine pushes deep into the former Soviet
territory, with borders a mere 300 miles from either Volgograd or Moscow,
and the Ukrainian port of Sevastopol on the Black Sea has long been Russia's
only deep, warm-water port. There are no European armies prepared to march
east now, nor are there likely to be anytime soon, but throughout history --
apart from the Soviet period -- Europe has profited from Russian weakness.
Without meaningful influence over Ukraine, Russia has no reliable links to
Europe, no reliable control over Belarus, a pinched supply line to the
Caucasus -- where an insurgency rages -- no navy to speak of and, most
importantly for a country with no natural borders, significantly less
strategic depth.

Simply put, with Ukraine in its orbit, Russia
maintains strategic coherence and a chance of eventually reattaining
superpower status. Without Ukraine, Russia's status as a regional power
grows tenuous, and the issue of Russia's outright disintegration leaves the
realm of the ridiculous and enters the realm of the possible.

This
is not about money; it is about control and survival.

Russia's
Thin Wedge

Ukraine's position in the natural gas dispute has
been to take advantage of the fundamental duality in Russian foreign policy.
On one hand, the Russian leadership fully realizes just how critical Ukraine
is to its national interests. But on the other hand, Russia must have at
least relatively warm relations with the Europeans -- if for no reason other
than to keep its options open.

Ukraine has viewed the natural gas
issue as an opportunity to present the Russians with a zero-sum game. Kiev
did not see the need to agree to pay European price levels because its
leaders knew that Russia could not afford to cut off supplies -- that would
ruin relations with Europe. Additionally, encouragement from the United
States -- the most enthusiastic supporter of Ukraine's Orange Revolution --
gave the Yushchenko government a bit of an invulnerability complex, and
encouraged Kiev to push the Russians consistently and painfully.


There was also a timing issue. Since the Orange Revolution, Yushchenko
has been having a rocky ride, and his popularity is at an all-time low. With
parliamentary elections scheduled for March, he needed an anti-Russian crisis
in order to bleed support away from Yanukovich's party.

But what
Yushchenko -- or, for that matter, many Europeans now congratulating
themselves for their victory over Russia -- appears not to realize is that
Russia has changed.

In mid-November, Russian President Vladimir
Putin named Dmitry
Medvedev as first deputy prime minister. Medvedev is a rather rare
personality in Russian politics, in that he is a modernizer who has not
become unrealistically optimistic about Russia ever looking like -- much
less joining -- the West, and a nationalist who has not fallen prey to the
debilitating paranoia that often characterizes Russian policy. He also
happens to be Putin's prot�g� and the board chairman of Gazprom. The Ukraine
natural gas crisis was his first Russian foreign-policy initiative.


Medvedev, like all Russians, recognizes that his country's long-term
prospects without Ukraine are, at best, bleak. That means that Russia's
European relations have become of secondary importance -- they are no longer
an end in their own right, but rather a means to other ends.

Prior to
the Jan. 1 shutoff, the Europeans had become complacent, unappreciative of
the scope of their dependency upon Russia or how much they have taken a
"friendly" Moscow for granted since the end -- or even before the end -- of
the Cold War. Energy supplies to Europe continued throughout the Afghan war,
the 1983 war scare, the Moscow Olympic boycott, the putsch against Gorbachev,
the Soviet breakup, the Chechen war, the Kosovo war, and the enlargements of
NATO and the EU. The Europeans grew confident that as far as energy supplies
were concerned, the Russians -- while unpredictable in their rhetoric -- were
rock-solid in their reliability.

Medvedev's primary goal was to
redefine European perceptions of Russia. As of Dec. 31, Western Europeans
perceived Russia primarily as an easily dismissed, benign former foe. But
with the Gazprom cutoff -- which diminished gas supplies needed for heating
in the middle of winter -- Russia proved itself not only sufficiently
erratic to be taken seriously, but also capable of inflicting very real pain
with a modicum of effort.

Now, did the Russians want to hurt
the Europeans? Of course not. Europe, particularly "old" Europe, remains a
potential partner for Moscow, and there is no reason for the Kremlin to
introduce spite into an already complex relationship. But did the Russians
want the Europeans to know that the Kremlin has the capacity and chutzpah to
turn the screws? Absolutely. And doing so at a time of year when the wind
whipping off the North Sea is anything but balmy adds that ever-incisive
Russian touch.

This is not about establishing trust, but about
establishing in Europe a respect for Russia's strengths and an awareness of
Russia's concerns.

Which brings us back to Ukraine.

Moscow
wants to capitalize on Europe's dawning realization of Russia's forcefulness
and convince the Europeans this is not just about Ukraine, but also about the
United States. U.S. pressure made the Orange Revolution possible. U.S.
support has emboldened Kiev -- even specifically on the natural gas issue.


And now Ukraine's American-encouraged invulnerability complex has
demonstrated an ability to endanger Europe's economic and personal
well-being. However, unlike the Europeans, the Americans do not import so
much as a molecule of Russian natural gas. For Washington, supporting
Ukraine against Russia is a low-risk, high-payoff issue; for Europe, it is
the reverse. When natural gas supplies dropped on Jan. 1, many Europeans
were left wondering exactly what it was that they were supposed to get out
of this revolution that the Americans were so excited about.

The
question for Europe now is simple: How to ensure that the Russians don't cut
off the heat? The answer is equally simple: Take Russian interests in Ukraine
to heart.

The Fine Print

This is hardly the end of the
matter. The way the Russians set up the final compromise deal on Jan. 4 also
gives them heretofore unheard-of flexibility in pressuring Ukraine and Europe
in the future.

Up to this point, Gazprom has maintained a monopoly on
natural gas exports from the former Soviet states to Europe, and only
Turkmenistan was allowed to export natural gas to Ukraine. This derives from
a longstanding Gazprom position: Because the company is required to supply
natural gas to the Russian market at prices below the cost of production,
Gazprom has jealously protected its monopoly on exports. Turkmenistan was
granted an exemption to supply a few former Soviet republics because Moscow,
in an effort to maintain political alliances, dictated that their supplies
should be subsidized. Gazprom, therefore, had Turkmenistan sell to its
regional undesirables for peanuts, while the company pocketed hard currency
from European customers paying top dollar.

Under the new deal,
Turkmenistan, Kazakhstan and Uzbekistan will be able to sell natural gas
directly to Ukraine at sharply higher rates than before. While that might
seem like an improvement for Ukraine in terms of both political palatability
-- the natural gas is not Russian -- and supply diversification, it is
neither. Just as Russian natural gas must go through Ukraine en route to
Europe, all Central Asian natural gas must go through Russia to reach
Ukraine. The terms of the new agreement mean that Europe's natural gas
supplies now will depend not only on the tenor of Russian-European and
Russian-Ukrainian relations, but also on Russian-Kazakh, -Uzbek, and
-Turkmen relations. Suddenly Europe has a vested, if reluctant, interest in
ensuring that Moscow is satisfied with its level of influence in the bulk of
the largest former Soviet territories.

Such developments cannot come
as much of a shock to the United States. Truth be told, American policy
toward Ukraine has been a bit of a Hail Mary all along. Washington's tools
of influence in Ukraine and Russia are few and far between, and it cannot
even pretend to offer an alternative energy supplier for the Europeans or
Ukrainians. In fact, some of Washington's policies have even encouraged
Europe's dependence on Russian energy: The Continent's most viable
alternative to Russian natural gas is Iran -- which, with President Mahmoud
Ahmadinejad regularly shouting "Death to Israel," is hardly a place the
United States wants the Europeans to foster warm relations.

The
elegance of Medvedev's strategy lies in the fact that simply causing the
Europeans to think about Russian interests means that the Kremlin has
driven a wedge not only between the Europeans and the Ukrainians, but between
the Europeans and the Americans. If Russia is to recover what it has lost in
geopolitical stature these past 15 years, this is precisely the sort of
policy that will give it a fighting chance.

A Word on the
Germans

While Russia's perspective on the matter is certainly
central, this is not all about Moscow -- Germany has a stake as well.


There, Chancellor Angela Merkel is in a bit of a fix. Her East
German roots prompt her instinctually to side with her fellow Central
Europeans, and by extension, the Ukrainians. But she is hardly oblivious to
the fact that Germany is the "old" European country that relies most heavily
on Russian energy supplies. In Germany, more than in any European state,
power rests upon location and economic strength (Germany has not had a
military to speak of in more than a decade). With the one internationally
approved vehicle for German ambition -- the European Union -- in rather less
than the best shape, Berlin's options for furthering its interests are nil.
Without energy to power its economy, Germany will remain the underwhelming
geopolitical power it has been since the end of World War II.

For
most Central European states, this would be no large disaster -- if not for
the possibility of flickering lights or sudden mid-winter cold. The Poles,
Hungarians, Balts, Czechs and others -- all of whom have visceral memories
of wartime experiences at German or Russian hands -- like the idea of German
nationalism being contained by pan-European organizations such as the
European Union, even if they do not embrace everything that the EU requires
them to do.

But now Medvedev's maneuvering will force Germany to
take the greatest interest of all the European powers in keeping the
Russians happy, even if Merkel might be personally inclined to let Moscow
rot. Which means that, moving forward, whatever compromises are made in
relations between Moscow and the West will be actively brokered by Berlin.
And while that may ensure steady energy supplies to Europe, having affairs
in the region managed by a de facto partnership between Germany and Russia
is not the sort of development that will lead to restful nights in the vast
tracts of easily-marchable land between Berlin and Moscow.

Send questions or comments on this article to analysis@stratfor.com.

The Iraqi Election's Effects, from Washington to Tehran

Note: The Geopolitical Intelligence Report will resume Jan.
3.

By George Friedman

Let's begin with two facts.
First, the Iraqi elections were held Dec. 15. That is the important news:
They were held. The Sunni population, along with Shia and Kurds,
participated. Second, U.S. President George W. Bush did not break below 37
percent popularity. In fact, he bounced to about 47 percent.

The
first fact indicates that the Iraqi situation did not collapse into utter
chaos. The second fact indicates that the Bush presidency did not collapse
into impotence. These two facts are obviously connected. They do not end the
story by any means, but they do open a new chapter.

In September and
October, as Bush sank below 40 percent in the polls, we argued that he was
reaching a critical point: As presidents fall below about 35-37 percent,
they start losing their core constituency -- an event from which recovery is
extremely difficult. Bush's presidency was at its red line. We also argued
that the crisis' cause was not just Hurricane Katrina -- although it
certainly hurt -- but also that Bush couldn't seem to pull the situation
together in Iraq. But even though Bush's political base shuddered, it did
not break. And that bought him time to see Iraq develop a sense of order
with the Dec. 15 election.

Looked at in reverse, if Bush had been
flattened completely by plummeting popularity figures, pulling things
together Dec. 15 would have been impossible. The Sunnis were looking to
Washington to guarantee their interests as they entered the political
process. If Bush had collapsed completely, those guarantees would have been
of little value, and the Sunnis might well have pursued a different course.
However, Bush did not collapse, and the Sunnis entered the political
process. Thus the two political processes became intimately bound up
together.

The Baathist and traditional Sunni leadership's decision
to participate in the elections was conditioned by two considerations.
First, and most important, had they not participated they would have been
completely excluded from the regime the Shia and Kurds were crafting. The
Sunnis realized the insurrection was not spreading beyond their own region.
They could sustain their resistance, but the political process was under way
in the rest of Iraq -- the larger part of Iraq -- and they would be left with
chaos in their own region, isolation from the rest of the country and no
political power. Moreover, if they succeeded in driving out the Americans,
they would have been left to the tender mercies of their historical enemies.
So, if they failed to drive out the Americans, they would be in chaotic
isolation; if they did drive out the Americans, they would face much harsher
treatment at the hands of the Shia. The revelation of conditions in Shiite
prisons for Sunnis just before the elections helped drive that point home
neatly.

Secondly, the native Sunni leadership was not happy with
the inroads foreign jihadists were making into the Sunni community. The
Baathists are secular, and the rest of the Sunni community is far from
Wahhabi jihadists. That the jihadists were effective in fighting the
Americans did not necessarily thrill the Sunni leadership, who did not want
to see their sons come under the radicals' influence. Jihadist leader Abu
Musab al-Zarqawi -- useful while the Sunnis were trying to force a military
solution to their situation -- posed an increasing danger to the traditional
leadership. As foreigners and jihadists, al-Zarqawi and his followers in all
likelihood could not supplant the local leadership. Nevertheless, they posed
a challenge that would only increase as the insurrection continued. Also, the
Iraqi Sunnis were not exactly thrilled about Sunnis regularly dying at the
hands of jihadists -- whether as collateral damage or due to
"collaboration." In the Sunni mind there is a difference between killing
Americans (resistance) and killing Sunnis (terrorism). The jihadists were a
useful tool, but only when they could be controlled.

For the United
States, splitting the Sunnis between the jihadist and Baathist/traditional
faction had been a fundamental strategy. Following the miscalculations of
2003, the first U.S. strategy had been to play the Shia against the Sunnis
in order to contain the insurrection in the Sunni region. That having
succeeded, the United States now wanted to split the Sunnis among
themselves, and especially isolate the al-Zarqawi faction.

U.S.
efforts were much more sophisticated than just pitting Sunni nationalists
against jihadists. Washington also worked to exploit internal Sunni
nationalist differences between Baathists and Islamists, between different
tribes, within tribes and even within other groups such as the religious
scholarly body. In other words, it was the ability of the Bush
administration to take advantage of multiple fault lines that led to the
split within the Sunnis -- which, in turn, allowed the constitution to pass
in the Oct. 15 referendum and forced most Sunnis to take part in the Dec. 15
polls.

American thinking was that if the native Sunnis could be
brought (forced) into the political process, the foreign jihadists -- alien
to Iraq -- would have to either start a civil war among the Sunnis that they
couldn't win, or reduce the violence to a level which the Sunnis could
tolerate in their political mode. There was no expectation that the violence
would simply end -- only that in due course it would subside.

From
the Sunnis' standpoint, the election represented a turning point, but not an
irreversible one. Put differently, the Sunnis got to where they were by
waging an insurrection and appearing willing to wage it indefinitely. Hated
by the Shia and Kurds for their role in Saddam Hussein's regime, the Sunnis
understood that, other things being equal, it was their turn to be oppressed
and the United States wouldn't lift a finger to help them.


Therefore, launching an insurrection created a situation in which they
would be neither simply ignored nor reduced to victim status. The
insurrection was the Sunnis' bargaining chip. Indeed, the jihadists, with
their willingness to go to any length to fight the Americans -- and Shia --
were the Sunnis' ultimate weapon. No one could control them but the Sunnis
-- and that only delicately. Using the insurgency and the jihadists, the
Sunnis maneuvered the Americans into a position in which their relationship
with the Shia and Kurds would not provide a sufficient base for managing
Iraq. They created a situation in which the Americans needed the Sunnis in
order to pacify Iraq -- and therefore were willing to protect Sunni
interests against the Shia.

Truth be known, the Americans were not
all that unhappy being forced into this position. The Americans had
developed a complex dependency on the Shia in the fall of 2003 and urgently
wanted Shiite acquiescence. Had the Shia risen, the U.S. position would have
been untenable. Needing Shiite support, Washington had effectively guaranteed
the Shia control of Iraq -- a price it was not happy to pay. The American
concern was not the Shia per se, but their Iranian allies.


Washington's fear was that containment of the Sunni uprising would
create an Iranian satellite in Iraq. That would have had massive
repercussions throughout the region -- particularly for Saudi Arabia, which
fears growing Iranian power. Now, it should be remembered that the Iraqi
Arab Shia are not identical to Iranian Shia. There are serious tensions
between the two groups, which are ethnically, theologically, culturally and
linguistically distinct. So a Shiite government in Iraq is not simply an
Iranian satellite. However, it could well be an Iranian ally, and that was
not the outcome the United States wanted.

Of course, the United
States was also concerned about Shiite ambitions to transform Iraq from a
secular state to an Islamic one -- the last thing Washington needed was
another Iran. So the United States needed to almost double-cross the Shia
without actually doing so -- and cooperating with the Sunnis gave Washington
the opportunity to do just that.

Thus, as much as the United States
-- and the Bush presidency -- was hurt by the Sunni insurrection, the
insurgency carried with it a silver lining. The United States demonstrably
had to contain the Sunnis, and the only option it had was political:
championing Sunni interests against the Shia. The most glaring example of
this was Bush phoning the leader of Iraq's Islamist Shiite-dominated United
Iraqi Alliance (UIA) and urging him to make concessions to Sunni demands in
order to break the deadlock in the constitutional negotiations. Ali
al-Adeeb, a Shiite member of the constitutional committee, said Aug. 26 that
Bush asked Abdel Aziz al-Hakim, leader of the Supreme Council for Islamic
Revolution in Iraq, to accept compromises that deal with purging the Baath
party from public life. While the United States could not be accused of
simply double-crossing the Shia, it could use the Sunnis' demands as a
platform from which to try to reshape the new regime so that it had a
built-in degree of complexity that would prevent outright Shiite control.
That, in turn, would prevent outright Iranian domination.

The Sunnis
still see the insurgency as their only bargaining chip. They want to
demonstrate that they can moderate it, but they do not -- at this point --
want it to fade. The more al-Zarqawi does, the greater the U.S. dependency
on the Sunnis. They don't want al-Zarqawi to get out of control -- as
stated, he could threaten their own interests -- but they don't quite want
him to go away. The Sunnis will walk a fine line until they reach an
acceptable political settlement with the Shia that can be guaranteed in some
way.

So, the Shia become the dominant power in Iraqi politics. The
Kurdish position is protected. The Sunnis get their piece of the government,
and al-Zarqawi loses his base of operations as Sunni confidence rises. There
is, however one huge loser in this scenario: Iran. Iran should be going wild
over what is happening in Iraq, and indeed it is. We must never forget Iran's
war with Iraq and the trauma it created in Iran. Iran is obsessed with the
ideal of a neutral or pro-Iranian Iraq. The U.S. maneuverings with former
Baathists terrify the Iranians. They have minimal confidence in the
political cleverness of Iraqi Shia, given the historical record. A coalition
of Americans and Baathists is Tehran's worst nightmare. Depending on Iraqi
Shia to protect their interests in the face of this coalition -- interests
the Shia in Iraq don't always share -- is not something they can do.


It is therefore not an accident that, as their primary national security
interests have been torn to shreds, the Iranians have tried to raise the
ante. In ranting about the Jews and the Holocaust and moving Israel to
Alaska, the Iranians are trying to play the North Korea game. The North
Koreans maximize their leverage by appearing to be nearly a nuclear power
and more than a little nuts. This brings the U.S. -- and a bunch of other
nations -- to the table to negotiate with them and give them money or grain
or other little gifts.

The Iranians have deliberately made it clear
that they are going to get nuclear weapons and have hinted that they might
already have them. Then, Iran's president started playing the role of Kim
Jong Il, making it clear that he is crazy enough to use nuclear weapons.


One of the unremarkable constants in the Middle East of late is how
hands-off a position the Israelis have been taking on everything.
Threatening not-so-subtly to take action against Israel is old hat, but
doing so against the background of increasingly touchy nuclear negotiations
is another issue entirely. When the Iranian president began saying that
Israel should be wiped off the map -- or at least moved to Alaska -- the
Israelis obediently perked up and began dusting off battle plans to
neutralize (read: nuke) Iran, with March bandied about as a realistic
timeframe.

There are many things that could complicate U.S. goals in
the Middle East, but none would do so more efficiently than Israeli missiles
striking Iran. Since the last thing the United States needs is an Israeli
preemptive strike on Iran, and the second-to-last thing the United States
wants is a new war in Iran, the Iranians are betting that the Americans will
try to placate them as Washington does with North Korea.

What the
Iranians want, of course, are guarantees on future Iraqi policy. They also
want to make certain that their Baathist enemies are never again in a
position to return to power. And they are expecting the United States to
guarantee all these things. Of course the Sunnis are expecting the United
States to guarantee their interests. The Kurds have always relied on the
United States. And the Israelis want to make sure that the Iranian nuclear
threat is not left to them to handle. Each has its own threat. The Sunnis
can crank up the insurgency. The Shia can invite in more Iranians. The Kurds
can try to instigate an uprising in Turkey (or Iraq, Iran or Syria). The
Iranians can threaten Israel with nuclear weapons, and the Israelis can
threaten a preemptive strike.

Washington does not want any of these
things. That means the United States must juggle a series of nearly
incompatible interests to get a situation where it can draw down its troops.
On the other hand, the Shia need the Americans to protect them from the
Sunnis and the Iranians. The Sunnis need the Americans to protect them from
the Shia. The Kurds need the Americans to protect them from the Turks (and
the Sunnis). The Iranians need the Americans to protect them from the
Israelis. And the Israelis generally need the Americans.

So, there
is enough symmetry in the situation that the Bush administration might just
be able to pull it off. What "it" consists of is less clear and less
important than the balancing act that precedes it. It is in that balancing
act that the United States reduces its forces, pushes al-Zarqawi to the
wall, plays Iraqi and Iranian Shia against each other and gives the Iranians
enough to keep them from going nuclear before Washington is ready to deal
with the issue on its terms. It is dizzying, but that's what happens when
war plans don't work out on the field the way they did in the computer --
which is usually. The administration has actually crafted something
resembling a solution, or a solution has presented itself. Between that and
polls that are a bit above awful, there is a chance the situation could work
out in the administration's favor.

However, as all of this suggests, a
final agreement is not only nowhere in sight, but not even in mind.
Any conclusive agreement that would be acceptable to one group would be
unacceptable to at least one other. In fact, the only thing that all of the
domestic players agree on is that Washington has a role to play as the
ultimate guarantor of any new government. The United States has no problem
with this save one condition: that Washington is not responsible for
day-to-day security. That in turn requires one item: a functional, united
Iraqi army. That too has a precondition: a united army must include the
Sunnis. Again, there is a follow on: the only Sunnis with military expertise
are the Baathists.

Of all the possible Iraqi arrangements, the one
that terrifies Iran is the one that is actually happening: a political
agreement, with the support of all the local players, that involves a
united, functional military complete with unrepentant Baathist elements.
Memories of the 1980-1988 war are suddenly running a lot closer to the
surface. Iran's biggest problem in challenging this scenario is that it does
not have an effective lever. All of the Iraqi power brokers have signed on
for their own reasons, and no one -- even the Iraqi Shia leadership --
believes Tehran would offer a better deal.

Which means that the only
power Tehran can talk to is the one player that has no interest in talking to
it if Iraq is about to be settled: the United States.

Since
Washington is trying to avoid an Israeli preemptive strike against Tehran,
the United States suddenly has an interest in making Israel feel better. To
do that, it needs to get the Iranians under control. To do that, it needs to
talk to the Iranians. And now we have Iran with something the United States
wants (an Israel that is not about to go ballistic) and the United States
with something Iran wants (an Iraq that Iran can tolerate).

The
United States is not going to hand Iraq over to Iran, but should Tehran
choose to complicate matters, neither is the United States going to be able
to withdraw its forces.

Within that imbroglio there is room for
compromise: have the United States -- via a permanent occupation --
guarantee Iraqi neutrality. An Iraq with 165,000 U.S. troops is in neither
Iran's nor the United States' interest, but an Iraq with 40,000 troops at
bases in the western Iraqi desert is. It is enough of a force to prevent
unsavory governments from arising, but not enough to make Iran fear that
Tehran could be flying the Stars and Stripes after a hectic weekend.

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Al Qaeda as Warfighting Entity

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