[2013 Report to Congress of the U.S.-China Economic and Security Review Commission]
[2013 Report to Congress of the U.S. China Economic and Security Review Commission]
[From the U.S. Government Printing Office, www.gpo.gov]

 
                                  2013
 
                           REPORT TO CONGRESS

                                 of the

                        U.S.-CHINA ECONOMIC AND
                       SECURITY REVIEW COMMISSION

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                               __________

                             NOVEMBER 2013

                               __________

                       Printed for the use of the
           U.S.-China Economic and Security Review Commission
         Available via the World Wide Web: http://www.uscc.gov



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           U.S.-CHINA ECONOMIC AND SECURITY REVIEW COMMISSION

                   Hon. WILLIAM A. REINSCH, Chairman

                   Hon. DENNIS C. SHEA, Vice Chairman

                             COMMISSIONERS

CAROLYN BARTHOLOMEW                  DANIEL M. SLANE
PETER T.R. BROOKES                   Hon. JAMES M. TALENT
ROBIN CLEVELAND                      Hon. KATHERINE C. TOBIN
JEFFREY L. FIEDLER                   MICHAEL R. WESSEL
Hon. CARTE P. GOODWIN                LARRY M. WORTZEL

                  Michael R. Danis, Executive Director

The Commission was created on October 30, 2000, by the Floyd D. 
  Spence National Defense Authorization Act for 2001 Sec. 1238, 
  Pub. L. No. 106-398, 114 STAT. 1654A-334 (2000) (codified at 22 
  U.S.C. Sec. 7002 (2001), as amended by the Treasury and General 
  Government Appropriations Act for 2002 Sec. 645 (regarding 
  employment status of staff) & Sec. 648 (regarding 
  changing annual report due date from March to June), 
  Pub. L. No. 107-67, 115 STAT. 514 (Nov. 12, 2001); as amended 
  by Division P of the ``Consolidated Appropriations Resolution, 
  2003,'' Pub. L. No. 108-7 (Feb. 20, 2003) (regarding Commission 
  name change, terms of Commissioners, and responsibilities of 
  Commission); as amended by Pub. L. No. 109-108 (H.R. 2862) 
  (Nov. 22, 2005) (regarding responsibilities of Commission and 
  applicability of FACA); as amended by Pub. L. No. 110-161 (Dec. 
  26, 2007) (regarding changes in annual report due date; 
  submission of financial reports; printing and binding of 
  Congressional reports; employee compensation and performance 
  reviews; and applicability of House rules for travel by members 
  and staff).
The Commission's full charter http://www.uscc.gov/about/uscc-
 charter and Statutory Mandate http://www.uscc.gov/about/
fact--sheet are available via the World Wide Web.

                   

                                  (ii)
                                     



           U.S.-China Economic and Security Review Commission

November 13, 2013
The Honorable Patrick Leahy,
President Pro Tempore of the U.S. Senate, Washington, DC 20510
The Honorable John Boehner,
Speaker of the U.S. House of Representatives, Washington, DC 20510

    Dear Senator Leahy and Speaker Boehner:

    On behalf of the U.S.-China Economic and Security Review 
Commission, we are pleased to transmit the Commission's 2013 
Annual Report to the Congress--the eleventh major Report 
presented to Congress by the Commission--pursuant to Public Law 
106-398 (October 30, 2000), as amended by Public Law No. 109-
108 (November 22, 2005). This report responds to the mandate 
for the Commission ``to monitor, investigate, and report to 
Congress on the national security implications of the bilateral 
trade and economic relationship between the United States and 
the People's Republic of China.'' In this Report, the 
Commission reached a broad and bipartisan consensus, approving 
the Report by a vote of 11 ayes to 1 nay.
    In accordance with our mandate, this Report, which is 
current as of November 13, includes detailed treatment of our 
investigations of the areas identified by Congress for our 
examination and recommendation. These areas are:

  PROLIFERATION PRACTICES--The role of the People's 
Republic of China in the proliferation of weapons of mass 
destruction and other weapons (including dual-use 
technologies), including actions the United States might take 
to encourage the People's Republic of China to cease such 
practices;

  ECONOMIC TRANSFERS--The qualitative and quantitative 
nature of the transfer of United States production activities 
to the People's Republic of China, including the relocation of 
high technology, manufacturing, and research and development 
facilities, the impact of such transfers on United States 
national security, the adequacy of United States export control 
laws, and the effect of such transfers on United States 
economic security and employment;

  ENERGY--The effect of the large and growing economy 
of the People's Republic of China on world energy supplies and 
the role the United States can play (including joint research 
and development efforts and technological assistance), in 
influencing the energy policy of the People's Republic of 
China;

  UNITED STATES CAPITAL MARKETS--The extent of access 
to and use of United States capital markets by the People's 
Republic of China, including whether or not existing disclosure 
and transparency rules are adequate to identify People's 
Republic of China companies engaged in harmful activities;

  REGIONAL ECONOMIC AND SECURITY IMPACTS--The 
triangular economic and security relationship among the United 
States, [Taiwan] and the People's Republic of China (including 
the military modernization and force deployments of the 
People's Republic of China aimed at [Taiwan]), the national 
budget of the People's Republic of China, and the fiscal 
strength of the People's Republic of China in relation to 
internal instability in the People's Republic of China and the 
likelihood of the externalization of problems arising from such 
internal instability;

  UNITED STATES-CHINA BILATERAL PROGRAMS--Science and 
technology programs, the degree of noncompliance by the 
People's Republic of China with agreements between the United 
States and the People's Republic of China on prison labor 
imports and intellectual property rights, and United States 
enforcement policies with respect to such agreements;

  WORLD TRADE ORGANIZATION COMPLIANCE--The compliance 
of the People's Republic of China with its accession agreement 
to the World Trade Organization (WTO); and

  FREEDOM OF EXPRESSION--The implications of 
restrictions on speech and access to information in the 
People's Republic of China for its relations with the United 
States in the areas of economic and security policy.

    The Commission conducted its work through a comprehensive 
set of seven public hearings and one public roundtable, taking 
testimony from 57 witnesses from the executive branch, 
industry, academia, policy groups, and other experts. For each 
of its hearings, the Commission produced a transcript (posted 
on its Web site--www.uscc.gov). The Commission also received a 
number of briefings by officials of executive branch agencies, 
intelligence community agencies, and the armed services, 
including classified briefings on Chinese investment, China's 
cyber operations, China's foreign policy, and China's navy. The 
Commission is preparing a classified report to Congress on 
these and other topics.
    Commissioners also made an official delegation visit to 
Taiwan, Japan, China, and Hong Kong to hear and discuss 
perspectives on China and its global and regional activities. 
In these visits, the Commission delegations met with U.S. 
diplomats, host government officials, representatives of the 
U.S. and foreign business communities, and local experts.
    The Commission also relied substantially on the work of its 
excellent professional staff, and supported outside research in 
accordance with our mandate.
    The Report includes 41 recommendations for Congressional 
action. Our 10 most important recommendations appear on page 27 
at the conclusion of the Executive Summary.
    We offer this Report to the Congress in the hope that it 
will be useful as an updated baseline for assessing progress 
and challenges in U.S.-China relations.
    Thank you for the opportunity to serve. We look forward to 
continuing to work with you in the upcoming year to address 
issues of concern in the U.S.-China relationship.

            Yours truly,
            
            

         William A. Reinsch             Dennis C. Shea
             Chairman                  Vice Chairman
                                     


                                CONTENTS

                              ----------                              
                                                                   Page

Transmittal Letter to the Congress...............................   iii

Commissioners Approving the Report...............................     v

Executive Summary................................................     1

    Key Recommendations..........................................    27

Introduction.....................................................    31

                     2013 Report To Congress of the
           U.S.-China Economic and Security Review Commission

Chapter 1: The U.S.-China Trade and Economic Relationship........    35

 Section 1: Trade and Economics Year in Review...................    35

 Section 2: Trends in Chinese Investment in the United States....    91

 Section 3: Governance and Accountability in China's Financial 
    System.......................................................   113

 Section 4: China's Agriculture Policy, Food Regulation, and the 
    U.S.-China Agriculture Trade.................................   153

 Recommendations.................................................   203

Chapter 2: China's Impact on U.S. Security Interests.............   207

 Section 1: Military and Security Year in Review.................   207

 Section 2: China's Cyber Activities.............................   243

 Section 3: China's Maritime Disputes............................   266

 Recommendations.................................................   293

Chapter 3: China and the World...................................   295

 Section 1: China and the Middle East and North Africa...........   295

 Section 2: Taiwan...............................................   325

 Section 3: Macau and Hong Kong..................................   354

 Recommendations.................................................   395

Comprehensive List of the Commission's Recommendations...........   397

Additional Views of Commissioners................................   403

Appendices:

Appendix I:   U.S.-China Economic and Security Review Commission

  Charter........................................................   415

Appendix II:   Background of Commissioners.......................   425

Appendix III:  Public Hearings of the Commission During 2013.....   435

Appendix IIIA: List of Witnesses Testifying Before the Commission

  During 2013....................................................   439

Appendix IV:  List of Interlocutors During Commission Fact-
  Finding Trips

  to Asia During 2013............................................   443

Appendix V:   List of Research Material..........................   445

Appendix VI:  Acronyms and Abbreviations.........................   449

2013 Commission Staff and Acknowledgements.......................   453

 
                           EXECUTIVE SUMMARY

       Chapter 1: The U.S.-China Trade and Economic Relationship

Trade and Economics Year in Review

    China's economy grew at a 7.66 percent annualized rate in 
the first three quarters of 2013, continuing a three-year trend 
of decelerating output. This marked a significant decline from 
the three decades of growth in the 1980s, 1990s, and 2000s 
averaging 10 percent annually. Demand for China's exports 
stalled, and the domestic economy adjusted to a drop in 
government spending on massive infrastructure projects--
undermining the two main pillars of China's economic surge over 
the previous decade.
    China underwent a leadership change with a new president 
and premier and several new members of the Politburo and 
Standing Committee. No prominent political or economic 
reformers were elevated to the Politburo Standing Committee, 
China's highest decision-making body, though the backgrounds of 
Wang Qishan and Zhang Gaoli suggest that they might be open to 
further economic reform. There is uncertainty over the 
prospects for economic reform as a result of contradictory 
statements and actions by the new leadership. While there are 
signs that President Xi Jinping and Premier Li Keqiang are 
preparing a package of reforms to be unveiled at the Third 
Plenary Session of the 18th Central Committee, expected to take 
place in November 2013, President Xi has also been reaffirming 
the role of the state in the economy and introducing Maoist-
style ideological campaigns aimed at stamping out political 
liberalization. In recent months, the government has introduced 
some important initiatives aimed at addressing some of the 
country's growing inequalities of wealth and opportunity. One 
initiative has been a focus on urbanization. The hope is that 
urbanization will become the next growth engine, initiating a 
new wave of investment, adding to the consumer class, and 
creating a surge in demand for housing and infrastructure. The 
urbanization drive may also boost Chinese efforts to make more 
land available for agriculture and improve farming efficiency.
    Growing demand from China has supported exporters in 
certain sectors of the U.S. economy, such as aerospace, the 
auto industry, and agricultural products. However, the U.S. 
trade deficit with China continues to widen. In July 2013, the 
monthly deficit exceeded $30 billion for the first time. 
Moreover, the Chinese government policies driving economic 
growth have resulted in what the International Monetary Fund 
(IMF) calls a ``pattern of growth [that] has become too reliant 
on investment and an unsustainable surge in credit, resulting 
in rising domestic vulnerabilities.'' The most important--and 
most challenging--element of domestic rebalancing is increasing 
household consumption as a share of gross domestic product 
(GDP), which has declined as a share of China's GDP for decades 
while the share of fixed-asset investment has grown.
    China continues to intervene in foreign exchange markets to 
keep its currency undervalued. Such interventions, combined 
with China's subsidies to exporting industries, have helped 
China accumulate the world's largest foreign currency 
reserves--$3.66 trillion by the end of September 2013. While 
maintaining a preference for government securities, China 
continues to diversify its foreign exchange assets. China's 
nonfinancial outbound foreign direct investment (FDI) for the 
first half of 2013 totaled $45.6 billion, up 29 percent from 
the prior year. China rapidly accumulated foreign currency in 
2013, but the pace of currency inflows varied during the course 
of the year. In the first quarter, currency inflows surged, 
followed by outflows in the second quarter as the country's 
banks encountered a liquidity crisis. These movements caused 
volatility in China's external accounts that carried over into 
the domestic financial sector.

Trends in Chinese Investment in the United States

    China has amassed the world's largest trove of dollar-
denominated assets. Although the true composition of China's 
foreign exchange reserves, valued at $3.66 trillion, is a state 
secret, outside observers estimate that about 70 percent is in 
dollars. In recent years, China has become less risk averse and 
more willing to invest directly in U.S. land, factories, and 
businesses. This trend appears to be accelerating. In June 
2013, China announced its largest purchase of a U.S. asset to 
date: a $7.1 billion acquisition of Virginia-based Smithfield 
Foods, Inc. Given China's large holdings of U.S. dollars, China 
has a huge potential for FDI, particularly if China should 
substitute or abandon portfolio investment for direct 
investment.
    The 12th Five-Year Plan (2011-2016) called for a three-
pronged approach for increasing China's investment abroad. 
First, Chinese manufacturing companies should invest overseas 
in order to establish international networks and globally 
recognized brands. Second, Chinese companies should invest in 
research and development outside of China. Lastly, the plan set 
goals for shifting acquisitions toward sectors that promote a 
high-tech economy. This policy focused on investment goals in 
which domestic state-owned or state-controlled firms were 
already intended to be dominant by policy. These sectors 
included energy, machinery, construction, and information 
technology. The Chinese government wields many tools to drive 
these goals, including requiring permission for overseas 
investments by Chinese firms.
    Despite China's large holdings of portfolio investment, 
China's FDI is still relatively modest. According to the U.S. 
Bureau of Economic Analysis, in 2012, the United States 
attracted $174.7 billion of global FDI, of which only $219 
million came from China. Official estimates of Chinese FDI in 
the United States are too low, because they do not account for 
flows of FDI though Hong Kong and other offshore financial 
centers, among other things. Chinese FDI in the United States 
has emphasized services, energy, and technology and is notable 
for its focus on brand acquisition.
    State-owned enterprises (SOEs) have dominated Chinese FDI 
in the United States, making investments that follow the 
industrial policies of the Chinese government. Chinese SOEs 
receive substantial benefits from the central and provincial 
governments that are not available to their foreign 
competitors, including preferential policies and low cost of 
capital. Furthermore, SOEs investing in the United States may 
engage in particular predatory or anticompetitive behavior that 
U.S. trade remedies cannot address.
    Trade-related aspects of foreign investments often 
intersect with national security concerns. For example, foreign 
intelligence collection efforts and espionage that target U.S. 
technology, intellectual property, trade secrets, and other 
proprietary information can be concealed under the pretext of 
foreign investment in cleared government contractors. The 
United States has a limited screening process for determining 
the potential national security threat from a specific foreign 
investment. The Committee on Foreign Investment in the United 
States (CFIUS) is an interagency committee that reviews certain 
mergers, acquisitions, and takeovers of U.S. businesses by 
foreign persons, corporations, or governments for national 
security risks. China presents new challenges for CFIUS, 
because investment by SOEs can blur the line between national 
security and economic security. The possibility of government 
intent or coordinated strategy behind Chinese investments 
raises national security concerns. For example, Chinese 
companies' attempts to acquire technology track closely the 
government's plan to move up the value-added chain. There is 
also an inherent tension among state and federal agencies in 
the United States regarding FDI from China. The federal 
government tends to be concerned with maintaining national 
security and protecting a rules-based, nondiscriminatory 
investment regime. The state governments are more concerned 
with local economic benefits, such as an expanded tax base and 
increased local employment, rather than national strategic 
issues, especially as job growth has stagnated.

Governance and Accountability in China's Financial System

    China's 12th Five-Year Plan calls for less dependence on 
exports and state-funded infrastructure projects and more 
domestic consumption to support China's economy. A shift from 
government-led to private-led growth requires that Chinese 
families and private sector businesses have sufficient access 
to credit and capital. Bank lending, the traditional source of 
credit for entrepreneurs and startups in most countries, is 
largely inaccessible to Chinese individuals and small- to 
medium-sized enterprises (SMEs), because China's financial 
system is dominated by large, state-owned banks that mainly 
service government-directed projects.
    Banks hold a unique position in China and are even more 
important to the national economy than banks in Europe or North 
America, where alternate sources of financing are available. 
China's financial sector is dominated by five massive, state-
owned commercial banks that account collectively for about 50 
percent of all deposits and loans. Additionally, three policy 
banks were established in 1994 to take over government-directed 
spending functions like financing of major development 
projects. China's policy banks are funded primarily by selling 
bonds to the big commercial banks, and all are ultimately back-
stopped by the Chinese government. The incestuous relationship 
between the government; the large, state-owned policy banks; 
and their state-owned commercial cousins provides borrowers a 
considerable benefit: artificially low interest rates. The 
banks' depositors, meanwhile, are paid very low rates, 
sometimes below the rate of inflation, to help hold down the 
rates charged to borrowers. Thus, the state-owned corporate 
sector receives a subsidy from the bank's depositors (Chinese 
households) in the form of low interest rates.
    A ``shadow banking system'' of unofficial credit has sprung 
up to fill the gaps left by the big banks' lending practices. 
China's shadow banking system can broadly be defined as lending 
that falls outside of the official banking system. It can 
involve both traditional and nontraditional institutions and is 
best understood not in terms of the institutions engaged in the 
system but in terms of the activities that they undertake. 
Because shadow banking activity occurs outside of formal 
banking channels, it does not appear on bank balance sheets and 
is far less transparent than official lending activity. Chinese 
demand for shadow banking is largely driven by the growth of 
China's private sector, a sector with limited access to 
official bank credit; and the Chinese government's tolerance of 
shadow banking in recent years has been tied to the reality 
that the private sector is the increasingly dominant source of 
the nation's employment.
    Demand for credit has led Chinese companies to seek capital 
overseas even as its shadow banking system has expanded. In the 
late 1990s, Chinese companies began raising capital on major 
international stock exchanges. This trend has been driven by 
large Chinese companies, many state owned, that have sought to 
broaden their shareholder base, increase the liquidity of their 
shares, and enhance the visibility of their brand names. U.S. 
stock markets are among the most popular global exchange 
destinations for Chinese firms.
    Initially, U.S. investors purchased stock in U.S.-listed 
Chinese companies in hopes of profiting from China's rapid 
growth rate. However, investors in U.S.-listed Chinese 
companies have increasingly found that insufficient corporate 
governance standards make these companies high-risk 
investments. Many have been implicated in frauds and accounting 
scandals, and U.S. regulators have deregistered about 50 
Chinese companies in the past two years following fraud probes. 
During recent probes, the Securities and Exchange Commission 
(SEC) has sought audit work papers from Chinese branches of 
multinational accounting firms that service U.S.-listed Chinese 
companies, a common request during fraud investigations. To 
date, the firms have refused to produce these documents, 
arguing that doing so would put them in violation of Chinese 
state secrets laws and subject them to criminal liability in 
China. In December 2012, the SEC charged five firms with 
breaking U.S. securities laws by refusing to turn over the 
requested audit work papers.
    In May 2013, the United States and China announced a deal 
for limited information-sharing between their regulatory 
agencies when there are questions regarding audits of U.S.-
listed Chinese companies. In July, Chinese regulators agreed to 
turn over certain requested documents of some listed Chinese 
companies to assist the SEC in ongoing investigations. No 
agreement has yet been reached that would grant more general 
direct access to documents for U.S. regulators conducting 
investigations or inspections. Although it is considered a last 
resort option, if an agreement is not reached, the SEC and the 
Public Company Accounting Oversight Board could choose to ban 
Chinese accounting firms and Chinese branches of multinational 
accounting firms from auditing U.S.-listed Chinese companies, 
which could in turn lead to these companies being delisted from 
U.S. exchanges.

China's Agriculture Policy, Food Regulation, and the U.S.-China
    Agriculture Trade

    China's World Trade Organization (WTO) accession in 2001 
was a watershed event for U.S. agriculture. China is now the 
primary export market for U.S. agriculture products. While the 
United States ran a $315 billion trade deficit in goods with 
China in 2012, it achieved a $21 billion surplus in 
agriculture. Since full implementation of the WTO accession in 
2005, China's agriculture imports from the United States have 
risen by an average of $2.5 billion each year, exceeding the 
U.S. Department of Agriculture's (USDA) initial estimate of $2 
billion. China must feed a fifth of the world's population with 
less than a tenth of its arable land and potable water. As 
China transforms into an urban society with a growing middle 
class, per capita food consumption is rising and, with it, the 
demand for higher-protein diets--a demand that U.S. farmers are 
well positioned to fill.
    There remain serious problems within the U.S.-China 
bilateral agriculture trade relationship, however. Many in the 
U.S. agriculture industry lobbied Congress in 2000 to grant 
China permanent normal trade relations, because they expected 
China to become a major purchaser of U.S. food products once it 
joined the WTO. But farm belt advocates have been disappointed 
that China has concentrated its purchases on bulk commodities, 
such as soybeans used as animal feed for China's outsized 
livestock industry. China's agriculture policy favors domestic 
production, even when it is unsustainable and nonessential to 
food security. In trade, China has used nontariff barriers to 
restrict imports of higher value-added products from the United 
States, including excessive subsidies; government control over 
import quotas; discriminatory taxes; and sanitary and 
phytosanitary restrictions that are not based on proper 
scientific analysis. These measures have contributed to an 
imbalanced food trade that has been particularly damaging to 
U.S. meat producers, who enjoy a comparative advantage over 
China in terms of resources, quality, and efficiency.
    China's agribusinesses have pursued outbound investment in 
several countries and sectors in recent years. In the United 
States, this trend came into focus in June 2013, when Shuanghui 
International Holdings Limited, a subsidiary of Shuanghui 
Group, proposed to acquire the U.S. pork producer Smithfield 
Foods, Inc. As the largest U.S. pork producer, Smithfield is a 
strategic node in the U.S. food industry.
    China's WTO accession was primarily envisaged as an 
opportunity for U.S. exporters. But U.S. consumer food imports 
from China have surged as well, part of a greater reliance on 
imported food by U.S. consumers. The bulk of U.S. food imports 
from China consists of farm-raised fish and fruits and 
vegetables. China also supplies ingredients for U.S.-processed 
foods, as well as organic foods that are USDA-approved through 
third-party certifiers. For the United States, these imports 
from China present significant food safety risks. Over the past 
decade, China's major trade partners have repeatedly banned its 
food shipments on the basis of food safety. Current regulation 
of food entering the United States from China is insufficient. 
For one, the Chinese government's own food safety regulation is 
inadequate. The Chinese government in 2009 introduced a 
comprehensive Food Safety Law to establish a modern framework 
for food safety regulation and in 2013 created a China Food and 
Drug Administration to consolidate regulatory authority. 
However, it is uncertain whether these and other reforms will 
improve oversight of China's large and fragmented food 
industry.
    In the absence of effective regulation by the Chinese 
government, U.S. consumers depend on U.S. food safety 
inspectors to provide protection against the importation of 
unsafe food products. The Food and Drug Administration (FDA), 
which is in charge of inspecting all nonmeat imports, is making 
substantial efforts to dedicate more staff and funding to 
China, to modernize its regulatory system, and to propose 
useful policies, such as foreign supplier verification. And 
yet, there are numerous problems with U.S. food regulation. The 
FDA still inspects only a fraction of the food that enters 
through U.S. borders. The agency has also found it difficult to 
increase on-the-ground inspections on the Mainland, in part 
because Chinese authorities have delayed visas for FDA 
inspectors and restricted access to food production sites.

Conclusions
Trade and Economics Year in Review

     LChina underwent a once-a-decade leadership change 
with a new president and premier and several new members of the 
Politburo and Standing Committee. The leadership indicated that 
China's overall economic policy goal--to transition from an 
export and investment-led growth model to a greater reliance on 
domestic consumption, remained the same. In reality, this 
change proved difficult to implement by a new government 
concerned about a slowing economy, real estate speculation, 
stagnating wages, and unemployment. The incoming government 
issued statements supporting a large and powerful state-owned 
sector in the economy, disappointing advocates of a larger 
private sector.

     LThe new Chinese leadership introduced initiatives 
aimed at reducing inequality, cracking down on corruption, and 
promoting urbanization. There are significant impediments to 
the government's ability to implement these reforms. For 
example, corruption is endemic at all levels of government, 
while local governments oppose urbanization due to fear that 
they will be overwhelmed by a flood of new migrants.

     LChina's progress in external rebalancing 
following the financial crisis was only temporary and largely 
driven by a weak global demand that reduced the relative size 
of China's export sector. Trade data for 2012-13 show that 
Chinese exports are again growing at a higher rate than 
imports, signaling a continued reliance on exports to fuel 
economic growth and a reversal in reducing China's massive 
trade surplus. As a result of failed measures to rebalance its 
economy, China has continued to expand its already record 
foreign currency reserves, reaching $3.66 trillion by the end 
of September 2013.

     LChina's trade surplus with the United States in 
goods in 2012 was $315 billion, a record. For the first seven 
months of 2013, China's trade surplus with the United States 
was $178 billion, also a record. China continues to manipulate 
the value of its currency, the RMB, to achieve a competitive 
advantage with the United States. China also continues to 
follow mercantilist policies to foster a trade surplus with the 
United States.

     LChina has had little success transitioning toward 
a consumption-led growth model and reducing its reliance on 
massive infrastructure projects to boost economic growth. 
Consequently, China's high investment levels have led to 
overcapacity in multiple industries, including steelmaking, 
shipbuilding, and solar panel manufacturing. A slowdown in 
urban household disposable income growth and an increase in the 
household savings rate have cut into consumer purchasing power 
and contributed to a decline in total retail sales growth.

     LChinese officials have played down the 
significance of lower growth, saying the slowdown is partly due 
to economic rebalancing. However, the government continues to 
stimulate the economy through a variety of small steps. For 
example, the State Council, China's cabinet, instituted a 
temporary tax cut (scraping all value-added and operating 
taxes) for more than 6 million small- and medium-sized 
enterprises; reduced approval procedures and administrative 
costs for exporting companies; and provided more investment in 
railway construction in China's central and western regions. In 
a similar vein, securities regulators and the central bank 
issued record amounts of investment approvals to the Qualified 
Foreign Institutional Investors program.

     LDue to its restrictive monetary policy, China's 
central bank has accumulated the world's largest foreign 
exchange reserves. The bulk of these reserves are invested in 
U.S. Treasury securities, so that Chinese ownership accounts 
for nearly one-quarter of foreign-owned U.S Treasuries. In 
addition, China's two largest sovereign wealth funds, China 
Investment Corporation and SAFE Investment Company, have 
expanded their equity and real estate investments in the United 
States.

     LThe People's Republic of China (PRC) has 
concluded 13 trade agreements, the latest with Iceland and 
Switzerland this year--the first signed with European 
governments. China is in the process of negotiating six 
additional trade agreements, which include the ASEAN-led 
Regional Comprehensive Economic Partnership, an initiative to 
link ASEAN member states and preferential trade agreement 
partners to form the world's largest trading bloc. The Regional 
Comprehensive Economic Partnership, which excludes the United 
States, is competing with the U.S.-led Trans-Pacific 
Partnership, which excludes China. Formal negotiations of the 
Regional Comprehensive Economic Partnership began in May 2013 
and are scheduled to conclude by the end of 2015.

     LChina's attempts to keep the value of the RMB 
artificially low while strictly limiting the flow of RMB from 
the country, coupled with its efforts to control a large state 
banking sector, led to a banking crisis. The collapse in 
liquidity threatened economic growth in China and demonstrated 
the difficulty of conducting a monetary policy so at odds with 
its trading partners and international norms.

     LThe fifth round of the U.S.-China Strategic and 
Economic dialogue was held on July 10-11, 2013, in Washington, 
DC. There were no significant achievements in the strategic 
track. On the economic front, the most relevant announcements 
were (1) resumption of bilateral investment treaty talks; (2) 
the launch of the Shanghai Free Trade Zone; and (3) new 
measures to liberalize China's financial sector. In the 
multilateral arena, the United States successfully challenged 
China's improper imposition of antidumping and countervailing 
duties at the WTO.

     LChina continues to take incremental steps toward 
RMB internationalization, but the goal of making the RMB a 
major international currency remains out of reach as the 
government continues to maintain strict controls on cross-
border capital flows.

     LBeijing's efforts to reform the financial system 
continue to be hampered by risky off-balance-sheet lending by 
banks and nonbank financial institutions. Beijing has 
undertaken efforts to curb these risky lending practices, 
removing the floor on lending rates and imposing a short-term 
credit crunch in a clumsy effort to send a strong signal to the 
financial sector. However, there is little evidence so far that 
these efforts have succeeded. The ceiling on rates paid to 
depositors remains low, and some risky lending actually 
increased during the credit crunch.

Trends in Chinese Investment in the United States

     LChinese foreign direct investment (FDI) in the 
United States continues to grow, though from a very low base. 
According to official U.S. statistics, in 2012 the United 
States attracted $174.7 billion of global FDI, of which $219 
million came from China. An estimate by country of ultimate 
beneficiary owner, which better tracks actual investors, put 
stock of Chinese FDI in the United States at $9.5 billion at 
the end of 2011. For the same year, China's Ministry of 
Commerce put the flows of Chinese FDI to the United States at 
$1.8 billion, with stock of FDI estimated at around $9 billion.

     LOfficial statistics underestimate the true volume 
of Chinese investment, because they do not account for flows of 
FDI through Hong Kong and other offshore financial centers, 
which are likely transit points for Chinese money on the way to 
the real investment destination. Official data are also 
provided after a significant delay, which hinders analysis.

     LTo date, state-owned enterprises (SOEs) have 
dominated Chinese FDI in the United States measured by the 
value of deals, though private companies lead by the number of 
deals. One reason is that the biggest investments so far have 
been made in the oil and energy fields, which are dominated by 
Chinese state-owned giants.

     LChinese investors have primarily targeted those 
sectors where China lacks know-how and technology, particularly 
in the Strategic and Emerging Industries identified in the 12th 
Five-Year Plan. Energy and services (in particular real estate 
and financial services) have received the most investment. 
High-end manufacturing is another important destination for 
China's investments, particularly when measured in terms of the 
number rather than the value of deals.

     LDue to the considerable government ownership of 
the Chinese economy, provision by Chinese companies of critical 
infrastructure to U.S. government or acquisition by Chinese 
companies of U.S. firms with sensitive technology or 
intellectual property could be harmful to U.S. national 
interests. The Committee on Foreign Investment in the United 
States (CFIUS) investigates the national security implications 
of mergers and acquisitions by foreign investors of U.S. 
assets.

     LInvestigations by CFIUS and other national 
security review and mitigation mechanisms may be hampered by 
limited resources or limited statutory authority.

     LInvestments made by Chinese state-owned or -
controlled companies can also pose economic security threats. 
The Chinese government provides significant financial and 
logistical support. This puts U.S. firms, which receive no such 
support, at a competitive disadvantage. When Chinese SOEs 
invest abroad, they do not necessarily seek profit and may 
instead pursue government goals such as resource acquisition or 
technology transfer.

     LChinese investments in the United States are 
subject to the same set of rules and regulations as investment 
from other foreign countries in the areas of foreign corrupt 
practices, export administration, sanctions, and antitrust. If 
Chinese firms run afoul of these rules, they will be subject to 
legal sanction. But gaps exist in the U.S. government's ability 
to address the competitive challenges posed by SOEs.

     LIn areas where there are no national security 
considerations, and when the investment is driven by economic 
rather than strategic rationale, Chinese FDI can benefit the 
U.S. economy through creation of jobs and other positive 
spillovers.

Governance and Accountability in China's Financial System

     LThe Chinese economy weathered the first few years 
of the global economic downturn by doubling down on its time-
tested strategy of funneling capital into domestic development 
projects. But five years on, global demand for Chinese exports 
remains too weak to sustain the country's factories, much less 
new ones, and the merits of massive infrastructure projects 
have more than run their course. The policy decisions that kept 
the Chinese economy chugging over the last few years have also 
sped it closer to a reckoning that economists have long 
forecast would eventually be necessary. If a rebalancing of the 
U.S.-China economic relationship is to be achieved, China must 
reform its financial system to support newer, nonstate sources 
of economic growth, which will require that China's banks 
better service its private sector.

     LAs long as China's official, regulated channels 
of credit do not possess the flexibility to meet the needs of 
the Chinese economy's main job creators, China will be at risk 
of depressed economic growth, which in turn may limit the 
growth of U.S. exports to China and the prosperity of U.S. 
investments in China, slowing economic recovery here at home. 
The shadow banking system that Beijing has allowed to step into 
this credit gap is insufficiently regulated and, if left 
unchecked, will pose an increasingly serious threat to Chinese 
and global economic stability.

     LThe opacity of Chinese corporate governance and 
accountability policies, as well as conflicts with U.S. 
securities laws and regulations, hurts investor confidence in 
Chinese companies trading on U.S. exchanges. The current 
situation threatens U.S. investors with unforeseeable and 
unmanageable losses and may lead to a broad delisting of 
Chinese companies. China's lack of sophisticated banking, 
corporate governance, and auditing policies and practices also 
hinders much-needed growth and opportunity for the very U.S. 
financial services firms that could help China to restructure 
its system if they were allowed greater access to the Chinese 
market.

     LInsufficient transparency and accountability in 
China's financial sector put U.S. firms at risk of violating 
laws in both China and the United States; pose unreasonable 
hazards for U.S. investors with shares in Chinese companies; 
and render some U.S. laws and regulations unenforceable. 
Without greater regulatory transparency and assurance of 
China's regulatory, oversight and enforcement capabilities, 
Chinese firms also risk curtailment or even revocation of 
access to the U.S. market.

China's Agriculture Policy, Food Regulation, and the U.S.-China 
        Agriculture Trade

     LFor the past three years, China has been the 
largest export market for U.S. agricultural goods. However, 
trade is far from free, and enormous opportunities are being 
withheld. China's WTO accession has not been as productive to 
the United States as initially expected. In contrast to U.S. 
agricultural exports to the rest of the world, most U.S. 
exports to China are bulk commodities, particularly raw 
soybeans that supply China's outsized livestock sector. 
Conversely, processed commodities, meat products, consumer 
foods, and other higher value-added products have not kept pace 
with the overall growth in bilateral trade.

     LSince the 1980s, China has developed into the 
world's largest agricultural economy, producing a fifth of the 
world's grains, a quarter of its meat, and half of its 
vegetables. But demand in China is beginning to outstrip 
supply. As more people move to cities and earn higher incomes, 
China's population is demanding safer food and a more diverse, 
protein-rich diet at an affordable cost. The United States is 
well-positioned to meet that demand. U.S. farmers enjoy a 
comparative advantage in resources, productivity, and quality, 
particularly in meat production.

     LChina's agriculture policy favors domestic 
production over imports. China maintains ambitious self-
sufficiency targets that are unsustainable and unjustifiable in 
terms of food security. This policy is now being challenged by 
the decline in China's farm labor surplus, deteriorating land 
and resource endowments, and fragmented producer and land use 
systems. A related problem is that efforts to modernize 
agriculture conflict with rural welfare aims. Millions of rural 
migrants continue to rely on farmland and smallholder 
agriculture for insurance in the absence of a functioning 
welfare state.

     LChina has failed to fully perform its obligations 
under the WTO. It has erected a series of nontariff barriers 
that include state trading; excessive domestic subsidies and 
stockpiling of commodities; discriminatory taxes; uncalled-for 
antidumping duties; and slow approvals of biotechnology 
applications for U.S. crops. Damaging to U.S. interests as well 
are sanitary and phytosanitary restrictions, especially BSE-
based bans on beef and zero tolerance for ractopamine in pork. 
Although China has significantly lowered its tariffs and 
increased its agricultural imports since accession, numerous 
trade restrictions remain in place.

     LU.S. companies, universities, and government 
agencies are helping China to improve the quantity and quality 
of its food output. In a sign of deepening bilateral ties, the 
United States and China signed the first U.S.-China Plan of 
Strategic Cooperation in Agriculture (2012-2017) in February 
2012, and in March of that year the largest-ever U.S. 
agricultural trade mission visited China. However, U.S. 
companies operating in China are hamstrung by regulatory 
uncertainty, restricted market access, and weak intellectual 
property enforcement.

     LChina is fostering globally competitive 
agribusinesses, in the process becoming an active acquirer of 
agricultural assets overseas. In June 2013, China's largest 
pork producer, Shuanghui, proposed a $7.1 billion acquisition 
of Smithfield, the leading pork producer in the United States. 
While the deal has been approved by CFIUS and Smithfield's 
shareholders, it raises critical issues regarding net economic 
benefits, intellectual property, reciprocal market access, and 
the treatment of quasi-private Chinese companies that maintain 
links to the Chinese government.

     LChina accounts for a large share of the fruits, 
vegetables, fish, and processed foods that Americans consume, 
but the United States has little assurance that the food 
imports coming into the United States from China are safe. 
China's own food safety regulation is still ineffective, in 
spite of recent efforts to consolidate agencies and improve 
legislation. U.S. consumers rely on U.S. food safety inspectors 
to do their jobs, but U.S. regulation is also fragmented and 
underfunded. U.S. regulators have increased their presence 
within China but have struggled to obtain work visas and to 
gain access to food production facilities. Although the United 
States does not permit raw meat imports from China, the USDA 
has granted equivalence status to Chinese poultry processors, 
which will permit them to process poultry raised in the United 
States and Canada and ship it to the United States.

          Chapter 2: China's Impact on U.S. Security Interests

Military and Security Year in Review

    China's late 2012 leadership transition brought the largest 
turnover to the Central Military Commission (CMC) in a decade. 
Xi Jinping assumed the position of both CMC chairman and 
Chinese Communist Party (CCP) general secretary at the CCP's 
18th Party Congress on November 15, 2012. President Xi then 
completed his accession as China's senior leader by becoming 
the People's Republic of China (PRC) president on March 14, 
2013. Although President Xi was widely expected to eventually 
assume all three of China's top leadership posts, many 
observers were surprised by the speed of his elevation to CMC 
chairman. Mr. Hu broke with the pattern established by his two 
predecessors, who retained the CMC chairmanship for two years 
after finishing their terms as CCP general secretary.
    Since becoming CMC chairman, President Xi has used public 
speeches and visits to People's Liberation Army (PLA) units to 
reaffirm China's long-term military modernization goals; 
emphasize the importance of a strong military to the 
fulfillment of the ``China Dream,'' his new political slogan 
and party campaign; and signal his intent to focus on 
increasing combat readiness and reducing corruption in the PLA.
    In November 2012, President Xi introduced the ``China 
Dream'' concept, which envisions the ``great renewal of the 
Chinese nation'' and the advancement of an international system 
in which China's successful rise provides an attractive 
alternate political model to Western ones. Achieving the dream 
means building a ``moderately prosperous society'' by 2021 and 
a ``modern socialist society that is strong, democratic, 
cultured, and harmonious'' by 2049. Although President Xi 
emphasizes that ``peaceful development'' and a sta- 
ble regional environment are essential to create the conditions 

for this vision, he linked its fulfillment to a strong military 
in a 
December 2012 speech while aboard a PLA Navy destroyer. In June 
2013, official PLA media explained, ``To the armed forces, 
the China dream is the strong-army dream, the China dream leads 
the strong-army dream, and the strong-army dream supports the 
China dream.''
    During his first reported visit to a PLA base as CMC 
chairman in December 2012, President Xi called for the PLA to 
increase ``combat readiness'' through ``realistic training.'' 
Combat readiness has been a central theme of subsequent 
speeches to the military by President Xi and now features 
prominently in official PLA statements and documents. For 
example, official PLA media in January 2013 said the military 
needs to prevent and overcome the ``harmful'' practice of 
training ``for show.'' Furthermore, describing the PLA's 2013 
training priorities, a PLA official said: ``The `scent of 
gunpowder' in the `fighting' will be stronger. The entire 
military will make `training like real war' . . . the main 
theme of the entire year's training, powerfully strengthening 
training of mission topics, ensuring that as soon as there is a 
situation, the military will be able to go forward and fight to 
victory.''
    In a meeting shortly after becoming the CMC chairman, 
President Xi urged senior PLA officers ``to take a firm stand 
against corruption'' and to maintain a ``strict work style'' 
and ``iron discipline.'' Since then, reducing corruption and 
waste in the PLA has been one of President Xi's most consistent 
messages in his public speeches to the military. In addition to 
rhetoric, President Xi has announced stronger anticorruption 
regulations for the PLA, including restrictions on military 
personnel holding banquets, drinking excessive amounts of 
alcohol, and using luxury hotels.
    In March 2013, China announced its official defense budget 
for 2013 rose 10.7 percent to 720.168 billion RMB 
(approximately $117.39 billion), signaling the new leadership's 
support for the PLA's ongoing modernization efforts. This 
figure represents 5.3 percent of total government outlays and 
approximately 1.3 percent of estimated GDP. China's official 
annual defense budget now has increased for 22 consecutive 
years and more than doubled since 2006. The Institute of 
International Strategic Studies assesses China's actual defense 
spending is 40 to 50 percent higher than the official figure. 
The U.S. Department of Defense (DoD) estimated China's actual 
defense spending in 2012 fell between $135 and $215 billion, 
which was approximately 20 to 90 percent higher than China's 
announced defense budget.
    In April 2013, China released the latest version of its 
biennial defense white paper. This is the first defense white 
paper published since President Xi became CMC chairman. 
Although Chinese military leaders likely began to draft the 
document before President Xi assumed the position, official 
Chinese press suggests it contains strategic priorities 
specific to him. Official Chinese media hailed the 2012 defense 
white paper as a milestone in transparency, citing the 
``declassification'' of military information. However, most of 
this was widely-known information that Beijing had never 
officially acknowledged. Furthermore, as in previous 
iterations, the 2012 defense white paper offers no substantive 
information on important defense issues.
    Since commissioning its first aircraft carrier, the 
Liaoning, in September 2012, the PLA Navy has continued to 
develop a fixed-wing carrier aviation capability for air 
defense and offensive strike missions. China plans to follow 
the Liaoning with at least two indigenously built carriers. The 
first likely will enter service by 2020 and the second by 2025. 
China's Julang-2 (JL-2) submarine-launched ballistic missile 
(SLBM) is expected to reach initial operations capability by 
late 2013. The JL-2, when mated with the PLA Navy's JIN-class 
nuclear ballistic missile submarine (SSBN), will give China its 
first credible sea-based nuclear deterrent. The SLBN/SSBN 
weapon system will be able to target the continental United 
States from China's littoral waters.
    The PLA Navy continues to steadily increase its inventory 
of modern submarines and surface combatants. China is known to 
be building seven classes of ships simultaneously but may be 
constructing additional classes. China also recently began 
developing its first sea-based land attack capability. Modern 
submarines and surface combatants equipped with land attack 
cruise missiles (LACMs) will enhance Beijing's flexibility for 
attacking land targets throughout the Western Pacific, 
including U.S. facilities in Guam.
    China also continues to pursue new space and counterspace 
capabilities. In May 2013, China fired a missile into nearly 
geosynchronous Earth orbit, marking the highest known 
suborbital launch since the U.S. Gravity Probe A in 1976 and 
China's highest known suborbital launch to date. Although 
Beijing claims the launch was part of a high-altitude 
scientific experiment, available data suggest it was intended 
to test at least the launch vehicle component of a new high-
altitude antisatellite (ASAT) capability. If the launch is part 
of China's ASAT program, Beijing's attempt to disguise it as a 
scientific experiment would demonstrate a lack of transparency 
about its objectives and activities in space. Furthermore, such 
a test would signal China's intent to develop an ASAT 
capability to target satellites in an altitude range that 
includes U.S. Global Positioning System (GPS) and many U.S. 
military and intelligence satellites. Throughout 2013, China 
also made significant advances in its manned space and regional 
satellite navigation programs. The PLA's extensive role in 
China's civilian space programs suggests these activities 
support the development of PLA space, counterspace, and 
conventional capabilities in addition to serving China's 
overall development strategy.
    In late January 2013, China conducted the first test flight 
of its indigenously developed cargo transport aircraft, the 
Yun-20 (Y-20). China previously was unable to build heavy 
transports, so it has relied on a handful of Russian aircraft 
for strategic airlift since the 1990s. Once large-scale 
deliveries of the new plane begin, the Y-20 aircraft will be 
able to support a variety of domestic and international 
military operations. The Y-20 will enhance the PLA's ability to 
respond to internal security crises and border contingencies, 
support international peacekeeping and humanitarian assistance 
operations, and project power in a regional conflict.
    In June 2013, the PLA Air Force began to receive new 
Hongzha-6K (H-6K) bomber aircraft. The H-6K has an extended 
range and can carry China's new long-range LACM. The bomber/
LACM weapon system provides the PLA Air Force with the ability 
to conduct conventional strikes against regional targets 
throughout the Western Pacific, including U.S. facilities in 
Guam. Although the H-6K airframe could be modified to carry a 
nuclear-tipped air-launched LACM, and China's LACMs likely have 
the ability to carry a nuclear warhead, there is no evidence to 
confirm China is deploying nuclear warheads on any of its air-
launched LACMs.
    In July 2013, the PLA began to deploy peacekeepers to the 
United Nations (UN) Multidimensional Integrated Stabilization 
Mission in Mali (MINUSMA). The PLA contingent includes what 
Beijing calls a ``security force'' from a PLA group army. This 
marks the first time Beijing has deployed infantry to support a 
peacekeeping operation since it began participating in UN 
missions in 1990. China previously had limited the PLA's 
participation in peacekeeping operations to noncombat troops.

China's Cyber Activities

    In 2013, strong evidence emerged that the Chinese 
government is directing and executing a large-scale cyber 
espionage campaign against the United States. Mandiant, a 
private U.S. cybersecurity firm, issued a report that provides 
evidence that the PLA since 2006 has penetrated the networks of 
at least 141 organizations, including companies, international 
organizations, and foreign governments. These organizations are 
either located or have headquarters in 15 countries and 
represent 20 sectors, from information technology to financial 
services. Of the organizations penetrated, 81 percent were 
either located in the United States or had U.S.-based 
headquarters.
    The Mandiant report was followed by DoD's first direct 
accusation that the Chinese government and military are 
conducting cyber espionage against U.S. networks. DoD's 2013 
annual report to Congress on China's military stated: ``In 
2012, numerous computer systems around the world, including 
those owned by the U.S. government, continued to be targeted 
for intrusions, some of which appear to be attributable 
directly to the Chinese government and military.'' Previously, 
DoD had stopped short of attributing cyber espionage to the 
Chinese government or military, instead merely acknowledging 
cyber espionage ``originated'' in China.
    There are no indications the public exposure of Chinese 
cyber espionage in technical detail throughout 2013 has led 
China to change its attitude toward the use of cyber espionage 
to steal intellectual property and proprietary information. It 
is clear naming and attempting to shame will not be sufficient 
to deter entities in China from engaging in cyber espionage 
against U.S. companies. Mitigating the problem will require a 
multifaceted approach. Many potential actions to address the 
problem are being discussed by Congress, the Obama 
Administration, and outside experts. These actions include 
linking economic cyber espionage to trade restrictions, 
prohibiting Chinese firms using stolen U.S. intellectual 
property from accessing U.S. banks, and banning U.S. travel for 
Chinese organizations that are involved with cyber espionage. 
To date, Washington has not implemented a comprehensive 
framework for addressing China's ongoing cyber espionage.

China's Maritime Disputes

    Although sovereignty disputes in the East and South China 
Seas are not new, China's growing diplomatic, economic, and 
military clout is improving China's ability to assert its 
interests. It is increasingly clear that China does not intend 
to resolve the disputes through multilateral negotiations or 
the application of international laws and adjudicative 
processes but instead will use its growing power in support of 
coercive tactics that pressure its neighbors to concede to 
China's claims. Viewing a public defense of its maritime claims 
as central to political legitimacy, leaders in Beijing exploit 
deep-seated popular nationalism to support foreign policy aims 
in the East and South China Seas. China also views sovereignty 
over the East and South China Seas as critical to its national 
security, territorial integrity, and economic development. 
China has been more assertive since the publication of the 
Commission's 2012 Report, offering counterclaimants the choice 
of either facing the brunt of Chinese power as a result of 
challenging Chinese claims or benefitting from economic and 
political rewards for moderating their positions or even 
acquiescing to China's claims. Chinese official statements and 
use of maritime law enforcement rather than military forces 
suggest Beijing prefers to avoid direct military conflict over 
its maritime disputes and rely on the shift in the balance of 
regional power in its favor to resolve its maritime disputes in 
the long term.
    The East China Sea dispute involves China, Japan, and 
Taiwan. The dispute can be divided into two distinct issues: 
territorial sovereignty over the Senkaku Islands (known as the 
Diaoyu Dao in China, and Diaoyutai in Taiwan), and demarcation 
of maritime zones that have implications for natural resource 
rights. Given the historical animosity between China and Japan 
and the strong nationalist sentiment on both sides regarding 
the sovereignty of the islands, the Senkaku Islands dispute is 
especially intense. The Japanese government's September 2012 
purchase of three of the islands from a private Japanese owner 
angered China, sparking an escalation in tensions between China 
and Japan. PLA Navy and Chinese maritime law enforcement 
activity near the Senkaku Islands, previously irregular and 
sporadic, increased to a robust and near-persistent presence 
following Japsn's purchase of the islands. Tensions continued 
to simmer throughout 2013 as both sides enhanced their naval 
and maritime law enforcement presence in the disputed waters to 
assert their claims.
    The South China Sea dispute involves China, Taiwan, 
Vietnam, the Philippines, Malaysia, and Brunei. Beijing denotes 
its claim on its South China Sea maps using a nine-dash line, 
with an additional dash off the coast of Taiwan to demonstrate 
its sovereignty over Taiwan. China's diplomatic preference on 
the South China Sea is to ``divide and conquer'' by negotiating 
the issue on a bilateral basis rather than under the auspices 
of multilateral forums such as ASEAN.
    In addition to boosting its presence in the East and South 
China Seas, Beijing has taken a number of steps since mid-2012 
to address shortcomings in its coordination of maritime policy 
to better align China's maritime activity with national policy. 
In an effort to streamline its maritime policy-making 
bureaucracies to manage its maritime disputes more effectively, 
China created a high-level policy advisory group on maritime 
security issues in mid-2012 and consolidated multiple maritime 
law enforcement agencies into a single China Coast Guard in 
mid-2013.
    Beijing discourages and seeks to prevent the diplomatic 
involvement of the United States in the East and South China 
Seas because Beijing considers these disputes bilateral issues 
between China and each claimant. However, U.S. treaty 
commitments and forward-deployed military presence bind the 
United States to the region in ways that link its security 
interests to the peaceful resolution of China's maritime 
disputes. Despite a generally improving military-to-military 
relationship, mutual mistrust about one another's long-term 
intentions continues to pervade the overall security 
relationship. This strategic backdrop poses challenges for the 
operational environment at sea, especially as the maritime 
operating areas of the two countries increasingly overlap.

Conclusions
Military and Security Year in Review

     LPLA modernization is altering the security 
balance in the Asia Pacific, challenging decades of U.S. 
military preeminence in the region.

     LThe PLA Navy is in the midst of an impressive 
modernization program. China's acquisition of naval platforms, 
weapons, and systems has emphasized qualitative improvements, 
not quantitative growth, and is centered on improving its 
ability to strike opposing ships at sea and operate at greater 
distances from the Chinese mainland. Today, the PLA Navy is 
able to conduct high-intensity operations in China's immediate 
periphery as well as low-intensity operations beyond the 
region. Trends in China's defense spending, research and 
development, and shipbuilding suggest the PLA Navy will 
continue to modernize. By 2020, China could have approximately 
60 submarines that able are able to employ submarine-launched 
intercontinental ballistic missiles or antiship cruise missiles 
and approximately 75 surface combatants that are able to 
conduct multiple missions or that have been extensively 
upgraded since 1992.

     LThe PLA is rapidly expanding and diversifying its 
ability to strike U.S. bases, ships, and aircraft throughout 
the Asia Pacific region including those that it previously 
could not reach, such as U.S. military facilities on Guam.

     LThe PLA's expanding involvement in real world 
missions allows it to field-test equipment and obtain hands-on 
experience in areas such as addressing unconventional threats 
in harsh and potentially hostile environments, satisfying 
expeditionary logistics requirements, and integrating into 
multilateral operations.

     LThe PLA is improving its day-to-day readiness 
levels and conducting longer-range and more frequent, robust, 
and realistic training. As these reforms continue, the PLA will 
become more proficient and confident operating its advanced 
platforms and weapon systems and better able to rapidly respond 
to regional contingencies.

     LThe PLA Navy's growing presence in foreign EEZs 
contradicts its longstanding policy on military activities in 
its own EEZ. Rather than resolve the inconsistency between its 
actions and policy, Beijing likely will continue to assert its 
authority to regulate U.S. military activities in its EEZ.

China's Cyber Activities

     LThe Chinese government is directing and executing 
a large-scale cyber espionage campaign against the United 
States and to date has successfully targeted the networks of 
U.S. government and private organizations, including those of 
DoD and private firms. These activities are designed to achieve 
a number of broad economic and strategic objectives, such as 
gathering intelligence, providing Chinese firms with an 
advantage over their competitors worldwide, advancing long-term 
research and development objectives, and gaining information 
that could enable future military operations.

     LChina has not reduced its cyber intrusions 
against the United States despite recent public exposure of 
Chinese cyber espionage in technical detail. This suggests 
Beijing has decided to continue its cyber campaign against the 
United States.

     LDevelopments in cloud computing in China may 
present cybersecurity risks for U.S. users and providers of 
cloud computing services. The relationship between China's 
Ministry of State Security and the Chongqing Special Cloud 
Computing Zone represents a potential espionage threat to 
foreign companies that might use cloud computing services 
provided from the zone or base operations there. In addition, 
the plan to link 21Vianet's data centers in China and 
Microsoft's data centers in other countries suggests the 
Chinese government one day may be able to access data centers 
outside China through Chinese data centers.

     LThere is an urgent need for Washington to take 
action to prompt Beijing to change its approach to cyberspace 
and deter future Chinese cyber theft. Actions and policies 
under discussion include the following: passing new legislation 
or modifying existing legislation; changing the cost-benefit 
calculus of Chinese cyber actors and China's leaders through 
sanctions and counterintelligence tactics; undertaking 
multilateral measures; appointing a Cabinet-level official to 
oversee an interagency process regarding the protection of 
intellectual property; and enhancing cooperation between the 
U.S. government and the private sector. These would be more 
effective if used in combination, as they probably would lead 
Beijing to make only temporary or minor changes to its cyber 
espionage activities if used in isolation.

China's Maritime Disputes

     LChina relies on a coercive and persistent 
maritime law enforcement and naval presence to gain control of 
disputed territory in the East and South China Seas. A 
consolidated maritime policymaking bureaucracy and streamlined 
maritime law enforcement fleets could increase Beijing's 
confidence in its capability for coercion in the ongoing 
maritime disputes.

     LTwo key drivers shape China's approach to its 
maritime disputes: First, China encourages ardent popular 
nationalism, which it exploits to support its foreign policy 
aims in the East and South China Seas. Second, China views 
sovereignty over claims in the East and South China Seas as 
central to its national security, territorial integrity, and 
economic development.

     LChina uses legal and administrative measures to 
assert de jure governance over its disputed maritime regions; 
it deploys maritime law enforcement and naval vessels to its 
claimed waters to demonstrate and lay the groundwork for de 
facto governance.

     LBeijing's tendency to demonstrate resolve in its 
maritime disputes; its large and complicated political, foreign 
affairs, and military bureaucracy; and its inconsistent 
adherence to internationally accepted norms of air and maritime 
operations may contribute to operational miscalculations in the 
East and South China Seas. Unyielding positions on sovereignty 
and nationalist sentiment surrounding these maritime disputes 
increase the risk of escalation from a miscalculation at sea to 
a political crisis.

                     Chapter 3: China and the World

China and the Middle East and North Africa

    China employs a multifaceted foreign policy approach to the 
Middle East and North Africa (MENA). It is characterized by 
growing economic (and particularly energy) ties; the pursuit of 
friendly relations with all countries (as well as the 
Palestinian territories) in the region; the protection of 
domestic stability and control in China; and the promotion of 
regional stability in support of China's own domestic economic, 
political, and security priorities. China has in recent years 
faced challenges in the region, particularly in responding to 
political upheaval and regime changes during and after the Arab 
Spring. China also has taken positions in support of regimes in 
Syria and Iran that put it at odds with the United States and 
other regional and international communities.
    China is expanding and deepening its trade and investment 
ties with countries in the region. Between 2003 and 2012, 
China-MENA annual trade increased more than twelvefold, from 
$20.8 billion to $262.1 billion. In 2009, China overtook the 
United States to become the world's largest exporter to the 
region. China's energy demand is the primary driver of these 
economic ties. MENA accounts for more than 50 percent of 
China's crude oil imports; these imports are projected to grow 
in the coming decades. China's leaders view the country's 
growing reliance on MENA oil imports as a strategic 
vulnerability. This sense of vulnerability appears to drive 
Beijing's efforts to enhance the security of its imports by 
strengthening its relations with the region's largest oil 
producers, particularly Saudi Arabia and Iran, but also Iraq, 
Oman, and others.
    China seeks to develop and maintain friendly ties with all 
MENA countries without being drawn into the region's conflicts 
and power struggles. As such, China has more or less 
successfully maintained positive relationships with the major 
powers in the region, simultaneously strengthening ties with 
regional rivals like Israel and Iran, Saudi Arabia and Iran, 
and the Israelis and Palestinians. Beijing's approach generally 
has been well-received in the region, where China enjoys mainly 
positive views among leaders and the public.
    China also seeks to leverage its relations in MENA in 
support of its own domestic security, particularly in the 
Xinjiang Uighur Autonomous Region, home to many of China's 
ethnic Turkic Muslims. Episodic ethnic and political unrest in 
Xinjiang has in the past attracted support from overseas Muslim 
groups in MENA. Beijing fears these overseas groups could 
encourage or exacerbate what it refers to as ``separatist 
insurgencies'' in Xinjiang. To mitigate this perceived risk, 
China solicits support from countries in the region for its 
policies to suppress ``separatist'' activities in Xinjiang.
    In addition, China has taken steps to promote stability 
within MENA. Offers of support for the Israeli-Palestinian 
peace process, counterpiracy operations in the Gulf of Aden, 
and participation in UN peacekeeping operations in MENA are 
among China's contributions to regional security and stability. 
However, China also has undermined security in the region with 
its support for the Assad regime in Syria and its continued 
economic and political ties to Iran.
    As China's interests and presence in MENA grow, they 
inevitably will impact U.S. objectives and influence. Although 
Beijing has in the past avoided directly opposing Washington on 
issues related to MENA, this appears to be changing. Beijing's 
relationship with Tehran and its position on the Syrian 
conflict seem to indicate that, when key interests are at 
stake, China is willing to challenge the United States.

Taiwan

    Cross-Strait economic ties continue to expand and deepen. 
From January through July 2013 (the most recent months for 
which official statistics are available), the total value of 
trade between China and Taiwan was $71.8 billion. The total 
value of cross-Strait trade during this period grew by 2.79 
percent compared to the same period in 2012. Through the first 
seven months of 2013, China remained Taiwan's largest export 
market, accounting for approximately $47.3 billion worth of 
exports (26.9 percent of Taiwan's total exports). China 
followed behind Japan as Taiwan's second-largest source of 
imports, accounting for approximately $24.5 billion worth of 
imports (15.5 percent of Taiwan's total imports). Although 
China remained the top destination for Taiwan FDI in 2012, 
Taiwan's approval of $10.9 billion in investments in China in 
2012 represented a 16.6 percent decrease from the previous year 
and a three-year low. From January through July 2013, the value 
of Taiwan FDI to China continued to decrease, slipping 17.23 
percent from the previous year. Officials at the American 
Institute in Taiwan (AIT), which serves as the de facto U.S. 
embassy in Taiwan, told the Commission that Taiwan businesses 
increasingly are looking for investment opportunities in 
Southeast Asia, Africa, and Latin America as manufacturing 
costs in China continue to rise. Mainland investment in Taiwan 
continued to grow in the first seven months of 2013, with the 
value of investments increasing 79.34 percent compared to the 
same period in 2012.
    In 2013, Taiwan used creative diplomacy to secure 
participation in a key international organization and to sign 
two free trade agreements despite China's continued efforts to 
restrict Taiwan's full participation in the international 
community. The president of the UN's International Civil 
Aviation Organization (ICAO) in September 2013 invited a Taiwan 
delegation to attend the upcoming ICAO assembly as his 
``guests.'' Furthermore, Taiwan and New Zealand signed a free 
trade agreement in July 2013, which marks Taiwan's first such 
deal with a country with which it does not have official 
diplomatic relations; Taiwan and Singapore agreed in principle 
to a free trade agreement in May 2013; and Taiwan is 
participating in negotiations with 22 other WTO members, 
including the United States, on a multilateral Trade in 
Services Agreement. Taiwan's Ministry of Economic Affairs told 
the Commission that Taiwan's efforts to expand its trade ties 
with the Asia Pacific region are part of Taiwan President Ma 
Ying-jeou's larger push to diversify Taiwan's economic partners 
to avoid overreliance on China. Other Taiwan officials 
explained to the Commission that the agreements will help 
promote Taiwan's inclusion in Asia's broader economic 
integration, including participation in multilateral trade 
pacts such as the Trans-Pacific Partnership and the Regional 
Comprehensive Economic Partnership.
    In April 2013, Taiwan and Japan signed a fisheries 
agreement after 17 years of intermittent negotiations. 
President Ma said the agreement demonstrates Taiwan's 
constructive role in reducing tension in the East China Sea 
without compromising Taiwan's maritime claims and could be used 
as a blueprint and impetus for a similar agreement between 
Taiwan and other countries with claims in the South China Sea.
    In March 2013, the Philippine Coast Guard opened fire on a 
Taiwan fishing boat operating in disputed waters in the South 
China Sea, resulting in the death of a Taiwan fisherman and 
sparking a diplomatic row with Taiwan. Manila and Taipei both 
assert the incident took place within their respective 
exclusive economic zones in the South China Sea. After Taiwan 
claimed that the Philippines failed to adequately address its 
demands in the aftermath of the shooting, Taiwan stopped 
accepting new Filipino labor applications; suspended trade, 
fishery, and technology exchanges with the Philippines; and 
removed the Philippines from Taiwan's visa waiver program. 
Taiwan removed the sanctions in August after the Philippines 
offered an official apology on behalf of the Philippine 
president, agreed to pay compensation to the victim's family, 
and recommended homicide charges for the Philippine Coast Guard 
personnel who opened fire on the Taiwan fishing boat. Taiwan 
and the Philippines also are discussing measures to reduce the 
risk of future incidents and working to establish a bilateral 
fisheries mechanism.
    Taiwan's ability to defend against China's growing military 
capabilities is declining. The key shortcoming in Taiwan's 
defensive capabilities is its inability to survive initial 
Chinese air and missile strikes due to insufficient 
infrastructure hardening and lack of mobile systems. China's 
overwhelming quantitative and qualitative advantage over Taiwan 
also will challenge the Taiwan military's ability to sustain 
high-intensity operations during a conflict. Nevertheless, 
Taiwan's defense budget continues to decline. Taiwan's official 
defense budget contracted to $10.5 billion in 2013 from $10.6 
billion in 2012. Taiwan's 2013 defense spending represents 2.1 
percent of its GDP, a record low matched only in 2006 and 2011. 
This is less than 3 percent of GDP--the level at which 
President Ma pledged to maintain defense spending--and marks a 
substantial decrease from 3.8 percent of GDP in 1994. In 
response to concerns about Taiwan's declining defense budget 
relative to GDP, President Ma has explained defense spending 
cannot be expected to keep pace with Taiwan's GDP growth. 
Taiwan's GDP growth rate was 10.7 percent in 2010, 4 percent in 
2011, and 1.3 percent in 2012.
    Despite warming cross-Strait ties, China continues to 
engage in aggressive espionage activities against Taiwan. Since 
September 2012, Taiwan has arrested at least six former or 
active Taiwan military officers, including one flag officer, 
for espionage. In one case, a former Taiwan Navy officer may 
have provided to China classified submarine nautical charts as 
well as hydrographic information about the waters surrounding 
Taiwan. These cases underscore the breadth and depth of China's 
espionage activities against Taiwan and highlight the 
increasing counterintelligence risks to Taiwan and U.S. 
military information shared with Taiwan.
    The recent cross-Strait rapprochement benefits the United 
States by reducing the likelihood of a U.S.-China conflict over 
Taiwan; contributing to peace, prosperity, and stability in 
East Asia; and allowing U.S. policymakers to focus their time 
and attention on other priorities in the U.S.-China and U.S.-
Taiwan relationships. At the same time, warming ties between 
China and Taiwan raise concerns for Washington and Taipei. 
Increasing cross-Strait economic integration will continue to 
tie Taiwan closer to China. This could strengthen China's 
bargaining power over Taiwan and allow China to make progress 
toward its long-term goal of unification. Responding to these 
concerns, officials from Taiwan's National Security Council 
insisted to the Commission that Taipei's economic engagement 
with Beijing is carefully calibrated to promote both Taiwan's 
economic growth and continued autonomy.

Macau

    The gaming sector is the most important element of the 
Macau Special Administrative Region (SAR) economy and is the 
highest-grossing gambling location in the world. Tax 
collections from the gaming sector in 2012 totaled $13.9 
billion, which accounted for 87.5 percent of total government 
revenue. Macau's casino-oriented economy and its proximity to 
the PRC present a significant risk of money laundering. The 
main channel for money laundering is in the gaming sector 
through underregulated junket operators and their affiliates, 
which include the underground banking system that supports 
their operations.
    Junket operators in Macau are significantly more involved 
in gambling operations than is common throughout the world, 
operating with far fewer restrictions. Macau's independent 
junket operators and independent VIP rooms are not subject to 
the same regulatory requirements as casinos. There is a risk of 
money laundering within the independent VIP gaming room 
operations which are physically conducted within the casinos 
but can remain outside of the casino's official oversight. The 
risk is enhanced because so much of the money that is wagered 
in Macau goes through the loosely regulated independent VIP 
rooms. In 2012, VIP baccarat rooms in Macau casinos accounted 
for 69.3 percent of total revenue from games of chance.
    A 2007 evaluation by the Financial Action Task Force 
recognized the risk of money laundering in Macau's gaming 
sector and noted multiple deficiencies in its anti-money-
laundering and counter-terrorist-financing framework. The 
evaluation also discovered several specific deficiencies in 
Macau's compliance with the Financial Action Task Force 
recommendations, including the refusal to respond to foreign 
requests to freeze assets, the inability to effectively 
implement UN Security Council resolutions on the financing of 
terrorism, and the inability of Macau's Customs Service to 
investigate money-laundering cases.
    Since the report was published in 2007, there remain 
significant vulnerabilities with unlicensed junket operators 
and the junket affiliates that play an integral role in Macau's 
gaming system. Macau's junket operators are not subject to the 
same transparency requirements as casinos, and strict privacy 
controls prevent U.S. regulators from obtaining information on 
individuals operating in Macau subsidiaries of U.S. parent 
casinos. The Macau SAR Gaming Inspection and Coordination 
Bureau, Macau's gaming regulator, does not disclose financial 
information. The lack of information presents difficulties in 
determining the origin of money flowing through such 
operations, and U.S. state regulators do not have the authority 
or resources to independently conduct investigations in Macau 
or other foreign jurisdictions.
    The PRC's capital controls have caused more money to cycle 
through Macau due to Macau's thriving VIP gaming industry, 
which relies on junket operators and their affiliates to 
facilitate cross-border money transfers for clients via 
underground banks. However, Beijing is beginning to take some 
measures to restrict illicit cross-border transfers and money 
laundering in Macau as part of the nationwide crackdown on 
corruption promoted by PRC President Xi.

Hong Kong

    The most significant problem for democratic rights 
activists is the Hong Kong government's lack of progress toward 
ensuring universal suffrage in the election of the Legislative 
Council and the chief executive (Hong Kong's highest office). 
At present, the chief executive is chosen from a slate of 
nominees by a 1,200-person election committee. The Basic Law 
states that the ultimate aim for chief executive elections is 
through universal suffrage, and current Chief Executive Leung 
Chun-ying (CY Leung) has indicated that the city is working 
toward this goal. In March 2013, Chief Executive Leung said in 
meetings with Chinese President Xi that he was committed to the 
process of achieving universal suffrage in Hong Kong by 2017. 
In July he also promised free and open elections for the 
Legislative Council by 2020.
    Despite these stated goals, the dominance of the Hong Kong 
government by politicians allied to Beijing has stymied 
progress in achieving universal suffrage. The current election 
committee is heavily populated with business figures as well as 
politicians and labor leaders with strong connections to 
Beijing, giving it a distinctly pro-Beijing slant. Beijing 
effectively controls roughly 950 of the 1,200 election 
committee votes for chief executive. Currently, 30 members of 
the 70-person Legislative Council are elected by traditional 
functional constituencies, in which professionals in specific 
fields such as insurance, transportation, health care, finance, 
and tourism are allowed to cast a vote in addition to their 
vote in their geographic constituency. The greater 
representation of some segments of society as a result of the 
functional constituencies, combined with the dominant support 
for pro-Beijing candidates among functional constituency 
voters, ensures that the Legislative Council remains controlled 
by pro-Beijing representatives.
    Between 2005-2012, Hong Kong's Freedom House ranking for 
press freedom fell from a status of ``free'' to ``partly 
free.'' The Hong Kong press itself reports a sense of 
diminishing freedom. Following the election of Mr. Leung to 
chief executive in 2012, press freedom advocates reported an 
escalation in government efforts to censor and control media 
access to official information. Free press advocates contend 
that the government has reduced the number of full press 
conferences it holds for Hong Kong media, thereby denying 
journalists the opportunity to ask questions. Media self-
censorship is also a pervasive concern. A poll conducted in May 
2013 by the Public Opinion Program of the University of Hong 
Kong found that 48 percent of respondents believed that the 
local news media practiced self-censorship. Self-censorship has 
increased as the Chinese central government has co-opted media 
company owners. According to the 2013 annual report of the Hong 
Kong Journalists Association, roughly 50 percent of Hong Kong 
media owners have been appointed to the National People's 
Congress or the Chinese People's Political Consultative 
Conference.
    Newly proposed legislation would further limit journalists. 
An antistalking bill that may be considered this year could 
hinder journalists' ability to seek out information from 
sources. Another law would limit personal data that corporate 
directors must make public. While supporters argue that this 
law is important for enhancing protections of individual 
personal data, detractors are concerned that it will unduly 
shield directors from media scrutiny.
    Police surveillance is also a growing concern in Hong Kong. 
The 2006 posthandover Interception of the Communications and 
Surveillance Ordinance granted police broader and more explicit 
authority to conduct physical and communications surveillance 
for the sake of public security. The introduction of police 
cameras comes at a time when protests against the Hong Kong 
leadership are up sharply. In addition to the Occupy Central 
efforts and the rallies against the national education 
proposal, thousands of Hong Kong residents have participated in 
protests calling for the resignation of Chief Executive Leung. 
Pan-Democratic legislators meeting with Commissioners in Hong 
Kong reported that police are now monitoring and arresting 
prodemocracy demonstrators as much as 12 to 24 months after 
their participation in political events. In July 2013, for 
example, Yau Ka-yu was reportedly arrested and charged with 
illegal assembly in relation to her 15-month-old participation 
in an April 2012 protest outside the China Liaison Office in 
Hong Kong.

Conclusions
China and the Middle East and North Africa

     LChina is expanding and deepening its trade and 
investment ties with countries in MENA. More than half of 
China's crude oil imports are from MENA producers, and China 
increasingly looks to the region as an export market for 
manufactured goods and services.

     LEnergy security is a key driver of China's 
engagement in MENA. As China's continued economic growth 
becomes more dependent on a steady supply of oil and natural 
gas from the region, Beijing likely will augment already robust 
economic ties with stronger political and security engagement.

     LChina, driven primarily by its growing demand for 
energy, seeks to promote a framework for stability in MENA that 
supports its own economic, political, and security interests. 
These efforts include supporting the resolution of the Israeli-
Palestinian conflict, conducting counterpiracy operations, and 
participating in UN peacekeeping missions. Conversely, China's 
position on the Syrian conflict and its support for Iran 
undermine peace and stability in the region.

     LChina struggled to diplomatically adapt to regime 
changes across MENA during and after the Arab Spring. Beijing's 
instinct has been to support sitting regimes in Egypt, Libya, 
and Syria and to oppose international intervention in these 
countries.

     LMost MENA governments appear to judge China plays 
a positive role in the region. Oil- and natural gas-producing 
states in particular look to China as their future primary 
market. Moreover, governments in China and some MENA countries 
appear to share similar stances on issues of sovereignty, human 
rights and democracy, and the role of the state in the economy. 
However, many MENA countries have criticized China for its 
support for the Assad regime in Syria.

     LHistorically, China largely has avoided 
challenging U.S. influence and power in the Middle East. In 
recent years, however, when key Chinese interests are at stake, 
China has made use of its permanent membership in the UN 
Security Council to oppose U.S. policies and objectives in the 
region.

Taiwan

     LCross-Strait economic, cultural, and educational 
ties continue to expand and deepen. However, domestic political 
dynamics and priorities in China and Taiwan still constrain 
movement on political and security issues.

     LSince the Commission's 2012 report, Taiwan has 
used creative diplomacy to sign two free trade agreements and 
secure participation in a key international organization. 
Taiwan's expanding international space helps the country 
counterbalance its economic reliance on China by increasing its 
competitiveness in the world economy, raises the cost to 
Beijing of military coercion against Taiwan, and promotes 
regional stability.

     LPresident Ma since his reelection in January 2012 
has accelerated efforts to increase Taiwan's economic 
engagement with the United States and gain U.S. support for 
expanding Taiwan's international space, while continuing to 
advocate for future U.S. arms sales.

     LTaiwan's military over the last decade has 
improved its ability to conduct joint operations and has 
developed some asymmetric capabilities. However, China's rapid 
military modernization during this time has outpaced these 
improvements and negated many of the military advantages Taiwan 
previously held over China.

Macau and Hong Kong

     LThe rapid inflow of money to Macau, its casino-
oriented economy, and its proximity to the PRC present a 
significant risk of money laundering and financing of 
terrorism, particularly in the underregulated shadow banking 
and junket system supporting the VIP gaming business in Macau.

     LA combination of the PRC's strict capital 
controls and restrictions on the collection of gambling debts 
has given rise to grey market alternatives to facilitate the 
movement of gambling funds into Macau. Gambling debt collection 
conducted by unregulated third-party affiliates in the Mainland 
is susceptible to organized crime and violence.

     LMacau's junkets with alleged criminal 
affiliations present legal risks for U.S.-licensed casinos 
operating VIP rooms in Macau. Casinos found to be working with 
junkets directly or indirectly associated with Asian organized 
crime may be subject to revocation of their state-issued 
license to operate in the United States.

     LMacau's loose regulation of the junket system and 
its strict privacy law prevent U.S. regulators from accessing 
information they are accustomed to, and U.S. state regulators 
lack the authority and resources to independently conduct 
investigations in foreign jurisdictions. This prevents U.S. 
regulators from accurately accessing the situation in Macau and 
effectively stops them from evaluating individuals conducting 
business with U.S.-licensed casinos.

     LMacau's anti-money-laundering and counter-
terrorist-financing framework has fallen short in complying 
with internationally recognized standards. Numerous 
vulnerabilities remain in its regulations, including 
deficiencies relating to Macau's inability to effectively 
freeze financial assets and its inadequate inspection and 
oversight of casinos and junket operators and promoters.

     LDespite reports that the PRC aims to more closely 
monitor Macau's gaming industry as part of its nationwide 
initiative to crack down on corruption, there is no substantial 
evidence to suggest that Beijing intends a crackdown on illicit 
money transfers and money laundering in Macau.

     LTo protect their licenses to do business in the 
United States, American casinos have adopted a number of 
measures designed to prevent illegal activities in their VIP 
rooms. The Commission is not in a position to evaluate whether 
those measures are fully adequate to insulate the operations of 
those rooms from illegal activity.

     LDespite official statements of support from 
Beijing and the Hong Kong chief executive, the continued lack 
of meaningful progress calls into question Beijing's real 
intentions. Prospects for universal suffrage by 2017 are 
dimming. Political interference, government restraints on 
access to information, and self-censorship continue to take a 
toll on press freedom in Hong Kong. Public perceptions of media 
credibility have declined since the handover. Violent attacks 
on prodemocracy news outlets and their owners are on the rise, 
and the totality of the evidence suggests that Beijing does not 
intend to allow real democracy to develop in Hong Kong.

     LProdemocracy activists express alarm over 
stepped-up police surveillance at protests, which they fear may 
be aimed at chilling public discourse or quelling public 
dissent.

     LAll of these trends run counter to the Basic 
Law's assurances that Hong Kong's traditional democratic and 
civil rights would be preserved for the first 50 years 
following the handover.

     LThe systematic disenfranchisement of those who 
support greater democratic freedoms and civil liberties has 
created a climate of political polarization that may undermine 
Hong Kong's fundamental governability.

                  THE COMMISSION'S KEY RECOMMENDATIONS

    The Commission believes that ten of its 41 recommendations 
to Congress are of particular significance. The complete list 
of recommendations appears at the Report's conclusion on page 
397.

The Commission recommends:

     LCongress fund the U.S. Navy's shipbuilding and 
operational efforts to increase its presence in the Asia 
Pacific to at least 60 ships and rebalance homeports to 60 
percent in the region by 2020 so that the United States will 
have the capacity to maintain readiness and presence in the 
Western Pacific, offset China's growing military capabilities, 
and surge naval assets in the event of a contingency.

     LCongress ensure that the Food and Drug 
Administration (FDA) makes it a priority to increase the number 
of physical inspections of Chinese food imports at the border; 
to increase the rigor of those inspections to include testing 
for pathogens and chemical, pesticide, and drug residues, and 
processed food ingredients; and to conduct more frequent and 
thorough inspections in food facilities in China. Congress 
should also urge the U.S. Department of Agriculture (USDA) to 
permanently assign inspection personnel to China so that the 
exporting plants receive regular visits by USDA inspectors.

     LCongress direct the Department of Commerce to 
develop a comprehensive, ongoing inventory of Chinese foreign 
direct investment (FDI) in the United States and, on an annual 
basis, update the inventory. The inventory should identify the 
ownership structure of the entity engaging in the investment. 
In preparing the inventory, the department should call on 
private sector entities engaged in monitoring Chinese 
investments in the United States and such other entities to 
ensure that its report is complete and accurate. The department 
should prepare a comprehensive report to Congress on an annual 
basis identifying the FDI by Chinese entities that were made in 
the previous calendar year. In its report, the department 
should indicate those investments that received any assistance 
from the ``Select USA'' program. The department should also 
identify, on an ongoing basis, the lines of commerce that each 
of the investments are engaged in.

     LCongress direct the Administration to prepare an 
inventory of existing federal use of cloud computing platforms 
and services and determine where the data storage and computing 
services are geographically located. Such inventory should be 
prepared annually and reported to the appropriate committees of 
jurisdiction.

     LCongress assess whether to amend the Committee on 
Foreign Investment in the United States (CFIUS) statute to 
allow review of greenfield investments for threats to U.S. 
national security.

     LCongress require the USDA and the U.S. Trade 
Representative (USTR) to conduct a comprehensive review of 
China's agricultural subsidies, discriminatory taxes, state 
trading, and procurement practices; take account of the damages 
incurred by U.S. farmers and downstream industries; and suggest 
appropriate remedies.

     LCongress fund departments of Defense and State 
efforts to improve the air and maritime capabilities of U.S. 
partners and allies in Asia, particularly with regard to 
intelligence, surveillance, and reconnaissance, to improve 
maritime domain awareness in the East and South China Seas.

     LCongress assess the extent to which existing laws 
provide for inadequate or ineffective remedies against the 
anticompetitive actions of Chinese state-owned or state-
invested enterprises operating in the U.S. market. Additional 
remedies may be required to account for the fact that these 
enterprises may not be operating based on commercial 
considerations.

     LCongress empower the Securities and Exchange 
Commission (SEC) to set minimum standards for companies listing 
and maintaining listings on U.S. exchanges and enable the SEC 
to directly delist foreign companies not in compliance with 
these standards.

     LCongress urge the Administration to expedite 
progress in its implementation of Section 806 of the National 
Defense Authorization Act for Fiscal Year 2011 (Public Law 111-
383), which was intended to enhance the Department of Defense's 
ability to address supply chain risks.

 
                              INTRODUCTION

    While 2013 has been a year of leadership change for China, 
it is too early to say that the initial economic policy 
pronouncements will lead to quick reforms. Less heralded but 
longstanding and continuing improvements in China's military 
capabilities, however, could have a major impact on the region.
    The Chinese leadership accomplished a peaceful turnover 
during the past year, complicated by factional political 
maneuvering. The handoff for the new five-year term took place 
with both ceremony and caution. In the absence of immediate 
policy changes from the newcomers, the government in Beijing 
coasted on the momentum from the previous decade. While China's 
economy slowed from a 30-year double-digit sprint to a more 
sustainable pace of 7.66 percent growth, Beijing's new economic 
policymakers appear to be clinging to the old formula of 
exports and infrastructure projects and a strong state-
controlled sector to boost employment and maintain the regime's 
political control.
    The Chinese renminbi continued to appreciate against the 
dollar but remains undervalued. The rise in the Chinese 
currency did not jeopardize China's expanding trade surplus 
with the United States nor its growing foreign exchange 
reserves, which hit $3.66 trillion at the end of September. 
China's new leaders, President and Party General Secretary Xi 
Jinping and Premier and Party Secretary of the State Council Li 
Keqiang, reaffirmed the government's long-promised goal of 
shifting the economy to one more driven by domestic 
consumption. However, the major market-based tools and reforms 
that China could use to empower Chinese workers and consumers 
remain unused: opening China's financial services sector to 
foreign investment; shrinking the size and number of state-
owned enterprises; and expanding opportunities for private 
investment and savings beyond low interest-bearing deposits in 
state-owned banks or risky speculation in the volatile real 
estate market. Such moves by China would help reduce the 
growing trade imbalance with the United States and boost 
employment in America.
    Also troublesome were the press reports in April 2013 of an 
official but secret party-approved directive known as 
``Document No. 9'' that seeks to enhance party authority. 
Widely attributed to President Xi, the memo lists seven perils 
to be avoided, among them ``Western constitutional democracy,'' 
``universal values'' of human rights, press freedom and 
independence from the government, pro-market ``neo 
liberalism,'' an independent judiciary, and ``nihilist'' 
criticisms of the Chinese Communist Party.
    U.S. companies investing in China reported the same problem 
areas as the year before. In a survey of the top ten problems 
experienced by the foreign affiliates of U.S. companies, the 
majority were of the Chinese government's making. U.S. 
companies cited competition with Chinese government-owned 
companies, onerous licensing procedures, lax intellectual 
property protections, discriminatory laws and standards, and 
restrictions on foreign investment.
    After announcing with some fanfare a free trade zone in 
Shanghai, Beijing diluted its potential impact by exempting 
segments of 18 different sectors, such as construction, 
finance, and manufacturing, from foreign investment and 
imposing a variety of other restrictions, highlighting 
continued disputes within the government over the pace and 
direction of economic reform. Beijing's leadership also reacted 
haltingly to the emerging problems in China's lightly regulated 
shadow banking system, particularly the buildup of unsecured, 
off-balance sheet loans. The system has proliferated because 
China's state-owned banking system still heavily favors 
government-run enterprises over the efforts of Chinese 
entrepreneurs and small- and medium-sized business owners. 
Without fundamental banking reform and expanded credit to 
private industry and consumers, China's goal of economic 
diversification will remain stuck in low gear.
    One positive development in bilateral trade has been 
agriculture, the only sector in which the United States enjoys 
a substantial trade surplus with China. U.S. food producers 
stand to benefit from China's growing demand for consumer 
foods, especially meat products. But at present, China 
concentrates its imports on lower value-added bulk commodities 
while exporting consumer foods to the United States that pose 
significant safety risks.
    Under its new political leadership, China's actions in the 
East and South China Seas continued to increase tensions in the 
region. It is becoming clear China does not intend to resolve 
its maritime disputes through multilateral negotiations or the 
application of international laws and adjudicative processes 
but prefers to use its growing power in support of coercive 
tactics that pressure its neighbors to concede China's claims.
    Since the Commission's 2012 Report, strong evidence has 
emerged that the Chinese government is directing and executing 
a large-scale cyber espionage campaign against the United 
States. China to date has compromised a range of U.S. networks, 
including those of the Department of Defense and private 
enterprises. These activities are designed to achieve a number 
of China's broad security, political, and economic objectives, 
such as gathering intelligence, providing Chinese firms with an 
advantage over their competitors worldwide, advancing long-term 
research and development objectives, and gaining information 
that could enable future military operations.
    Meanwhile, China continued to develop and field advanced 
military platforms and weapon systems. China's comprehensive 
military modernization is altering the balance of power in the 
Asia Pacific, challenging decades of U.S. military preeminence 
in the region.
    China in 2013 expanded and diversified its arsenal of 
weapon systems capable of placing U.S. ships, aircraft, and 
bases in the Western Pacific at risk. The People's Liberation 
Army (PLA) also continued to pursue cyber, electronic warfare, 
and counterspace capabilities that will enable Beijing to 
degrade or disrupt the command, control, communications, 
computers, intelligence, surveillance, and reconnaissance that 
are essential to U.S. military power projection on behalf of 
its interests in the region. As these capabilities mature, the 
costs and risks to the United States of intervention in a 
potential regional conflict involving China will increase.
    Furthermore, the PLA enhanced its regional power projection 
capabilities, improving Beijing's ability to use force against 
Taiwan, Japan, and rival claimants in the South China Sea. This 
could increase China's willingness to respond militarily to a 
perceived provocation or to consider preemptive attacks in a 
crisis involving Taiwan or China's maritime sovereignty claims. 
Many of these scenarios could require the U.S. military to 
protect U.S. regional allies and partners as well as to 
maintain open and secure access to the air and maritime commons 
in the Western Pacific.
    Most Asian countries welcomed the U.S. rebalance to Asia 
when it was announced by the Obama Administration in 2011. 
However, there is growing concern among U.S. allies and 
partners that the Department of Defense will be unable to 
follow through on its commitment to the rebalance due to 
declining defense budgets and continuing security challenges 
elsewhere.
    The Commission's Report addresses these and other issues in 
depth as it continues to monitor the evolving economic and 
security relationship between our two countries.
                               CHAPTER 1

                          THE U.S.-CHINA TRADE

                       AND ECONOMIC RELATIONSHIP

                     SECTION 1: TRADE AND ECONOMICS

                             YEAR IN REVIEW

Introduction
    China's economy grew at a 7.66 percent annualized rate in 
the first three quarters of 2013, continuing a three-year trend 
of decelerating output (see figure 1). This marked a 
significant decline from the three decades of growth in the 
1980s, 1990s, and 2000s averaging 10 percent annually. Demand 
for China's exports stalled, and the domestic economy adjusted 
to a drop in government spending on massive infrastructure 
projects--undermining the two main pillars of China's economic 
surge over the previous decade.* The slowing of the world's 
second-largest economy rippled through much of the world, 
hobbling the economies of commodity-exporting countries. While 
the economic slowdown matched the central government's stated 
numerical target for growth, the change was not necessarily the 
result of a deliberate government policy. Rather, China's 
growth decline largely stemmed from the effects of a 
government-induced credit crunch, a precipitous drop in 
manufacturing, volatility in banking and real estate, a 
declining rate of growth in household incomes, the strain of 
meeting interest payments on a growing debt burden, and 
uncertainty about the new government's direction after a once-
a-decade leadership transition. This section will explore the 
factors behind China's changing economy, the evolution of 
China's economic policy, and their implications for the United 
States.
---------------------------------------------------------------------------
    * During the decade that ended with 2011, China's share of global 
exports rose from 7 percent to 21 percent. James R. Hagerty, ``U.S. 
Manufacturers Gain Ground,'' Wall Street Journal, August 18, 2013. 
http://online.wsj.com/article/
SB1000-1-4-2-4-1-2-7-8-8-7-3-2-3-4-2-3-8-0-4-5-7-9-0-2-0-7-3-2-6-6-1-0-9
-2434.-html#printMode.

   Figure 1:  China's Quarterly Gross Domestic Product (GDP) Growth, 
                             2009Q1-2013Q3

               (percent year-on-year growth, real terms)



    Source: China National Bureau of Statistics, via Trading Economics. 
http://www.tradingeconomics.com/china/gdp-growth-annual

    In order to rebalance the domestic economy, Chinese 
policymakers say they intend to raise household income and 
consumption, but the past year saw limited progress on this 
front. In urban areas, growth in disposable income, the measure 
of personal income minus taxes, fell to its lowest levels since 
the global financial crisis, suggesting that urban wages did 
not rise at the same rate as in previous years. Urban 
households, which have very high savings rates, thus had less 
capacity to raise their consumption expenditure (see figure 
2).\1\ Growth in Chinese retail sales slowed, and the share of 
the economy represented by consumer spending declined in the 
first half of 2013 compared to the same period in 2012. As a 
share of gross domestic product (GDP), China's domestic 
consumption remained half that of the United States--following 
an established pattern.\2\

    Figure 2:  Urban Household Disposable Income Growth, 2008-2013Q2

                (quarterly, percent year-on-year growth)



    Source: China National Bureau of Statistics, via CEIC database.\3\

    In China's repressed financial system, households still 
deposit the bulk of their savings in low-yielding bank 
accounts. According to estimates from the investment bank 
Nomura, China's household debt was only 20 percent of GDP last 
year, compared to 86 percent in the United States. Still, 
China's debt burden increased from 121 percent to 155 percent 
of GDP in 2008-2012--a rapid build-up similar to the United 
States before the subprime mortgage crisis. Given the explosion 
of China's shadow banking sector, actual debt levels are likely 
even higher. Debt is concentrated not among households, but 
among state-owned industrial enterprises, government-backed 
property developers, and local governments. The debt-to-asset 
ratio of property developers, for example, increased from 40 
percent to 71 percent in 2009-2012. Unlike the United States, 
China's households act as net lenders to the rest of the 
economy, subsidizing the state sector with easy credit.*
---------------------------------------------------------------------------
    * In the United States prior to the subprime mortgage crisis, the 
overall debt ratio rose by 30 percentage points of GDP, from 214 
percent in 2003 to 244 percent in 2007. Zhang Zhiwei and Wendy Chen, 
``China: Rising Risks of a Financial Crisis'' (Hong Kong, China: Nomura 
International (Hong Kong) Limited, March 15, 2013), pp.4-7; Federal 
Reserve Bank of St. Louis, ``Household Debt to GDP for United States'' 
(St. Louis, Missouri: October 2013). http://research.-stlouisfed.org/
fred2/series/HDTGPDUSQ163N; Tom Orlik, ``Debt Binge Threatens China 
Growth,'' Wall Street Journal, August 27, 2013, p. c1. http://
online.wsj.com/article/
SB1000-1-4-2-4-1-2-7-8-8-7-3-2-4-9-0-6-3-0-4-5-7-9-0-3-6-592255182758.ht
ml.
---------------------------------------------------------------------------
    Chinese leaders vow to deemphasize exports as a source of 
income. Export growth in China has slowed as demand in much of 
the world dropped, though not enough to correct the country's 
external imbalances. China still sends five dollars' worth of 
goods to the United States for every dollar in U.S. imports. In 
2012, the U.S. deficit with China in goods reached $315 
billion--the highest on record. In July 2013, China's monthly 
bilateral surplus with the United States surpassed $30 billion 
for the first time.\4\ China's vast current account surplus, 
coupled with restrictions on its capital accounts and exchange 
rate, has caused the central bank to accumulate foreign 
currency reserves exceeding $3.66 trillion, by far the largest 
in the world.

Leadership Transition and Economic Policy

    In the spring of 2013, Xi Jinping became president of the 
People's Republic of China (PRC). Li Keqiang, in turn, was 
appointed the premier and Communist Party secretary of the 
State Council, China's cabinet. No prominent political or 
economic reformers were elevated to the Politburo Standing 
Committee, China's highest decision-making body, though the 
backgrounds of Wang Qishan and Zhang Gaoli * suggest that they 
might be open to further economic reform.\5\ Proteges of former 
PRC President Jiang Zemin captured more spots than the allies 
of former President Hu Jintao (the sole protege of Hu Jintao on 
the Standing Committee is Premier Li Keqiang). Although 
Jiang Zemin's era is associated with more economic reform than 
the subsequent Hu Jintao period, when many reforms were rolled 
back,= there are few signs of a renewed push for reform. (For 
coverage of the leadership change relating to foreign policy 
and military matters, please see chap. 2, sec. 1, of this 
Report.)
---------------------------------------------------------------------------
    * Zhang Gaoli was appointed the PRC executive vice premier (Wang 
Qishan was widely expected to be appointed to this position), in charge 
of economics and domestic policy. Mr. Zhang has extensive leadership 
experience in economically advanced regions (Shenzhen, Shandong, and 
Tianjin), but he has kept a low profile, and his views on further 
reform are unclear.
     For a more detailed assessment of China's new leadership 
lineup, see John Dotson, The China Rising Leaders Project, Part 2: 
Outcomes of the Chinese Communist Party's 18th National Congress 
(Washington, DC: U.S.-China Economic and Security Review Commission, 
Decem- 
ber 21, 2012), pp. 19-20. http://origin.www.uscc.gov/sites/default/
files/Research/18th-CCP----Party-Congress----Overview.pdf.
    = The state sector has prospered in the past decade, with 
financing, market access, and various policies aimed at protecting its 
interests. The consolidation and concentration of economic power in the 
government's hands has given rise to the catch-phrase ``The state 
advances, the private [sector] retreats.'' For a detailed discussion of 
the Chinese government's role in and control over the Chinese economy, 
see U.S.-China Economic and Security Review Commission, 2012 Report to 
Congress (Washington, DC: U.S. Government Printing Office, November 
2012), pp. 47-72.
---------------------------------------------------------------------------
    The uncertainty over the prospects for economic reform is 
the result of contradictory statements and actions by the new 
leadership. On the one hand, there are signs that President Xi 
and Premier Li are preparing a package of reforms that will be 
unveiled at the Third Plenary Session of the 18th Central 
Committee scheduled for November 2013. On the other hand, 
President Xi has been reaffirming the role of the state in the 
economy and introducing Maoist-style ideological campaigns 
aimed at stamping out political liberalization. A Chinese 
Communist Party (CCP) leadership statement approved by 
President Xi, ``Document No. 9,'' enumerates seven perils for 
China, among them, ``Western constitutional democracy,'' human 
rights, media independence, and market-based ``neo-
liberalism.'' \6\ The fundamental conflict is that the economic 
liberalization the leadership expounds is impossible to achieve 
if the government continues to expand its ownership of and 
control over the economy.
    Before handing over the reins, President Hu delivered a 
joint report at the beginning of the 18th Party Congress. 
Speeches delivered to the Party Congress are considered guides 
to future policy, especially during a power transition, because 
they are drafted by both incoming and outgoing leaders. The 
outgoing president's speech was interpreted by many analysts as 
a blow to economic reform. For example, the report contained 
strong language on the need to strengthen the state-owned 
portion of the economy. The departing President Hu said China 
would ``unwaveringly consolidate and develop public ownership'' 
and ``steadily enhance the vitality of the state-owned sector 
of the economy and its capacity to leverage and influence the 
economy.'' \7\ The report proclaimed that state-owned 
enterprises (SOEs) are the principal part of the Chinese 
economy and that they will increase their investment in areas 
of the economy that impact national security and core national 
interests.
    Six months earlier, Mr. Xi had made his first trip as 
leader to the southern Chinese city of Shenzhen, in a gesture 
interpreted as more reformist, because it paralleled a similar 
trip by Deng Xiaoping during his famous ``southern tour'' to 
the same area 20 years ago.* President Xi followed up with 
trips to the countryside to highlight the plight of the rural 
poor.
---------------------------------------------------------------------------
    * During his 1992 southern tour, Deng Xiaoping stressed the 
importance of continuing economic reforms launched in 1978 and 
criticized those who were against further economic and openness 
reforms.
---------------------------------------------------------------------------
    Premier Li, who is broadly responsible for formulating and 
implementing economic and domestic policy, gave an early speech 
at a meeting of representatives of the 11 national 
``Comprehensive Reform Pilot Areas,'' which was interpreted by 
some western analysts as signaling his commitment to economic 
reform.\8\ In particular, the speech started off noting that 
``reform is like a boat beating against the current; if you 
don't move forward, you will slip backwards.'' At the March 
2013 annual Party Congress, Premier Li gave his first news 
conference. He pointed to the need to ``shake up vested 
interests,'' stating that ``however deep the water may be, we 
will wade into the water.'' \9\ The government would have to 
enact a ``self-imposed revolution,'' which would be ``very 
painful and even feel like cutting one's wrist.'' \10\ The 
reformist tone aside, Premier Li has loyally supported former 
President Hu's policies, which have hindered or reversed 
economic reform.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
The New Economic Leadership Team
 
  The National People's Congress meeting in March 2013 revealed the
makeup of the economic leadership team that will be in charge of
crafting economic policy for China's new administration. The lineup
appears encouraging for economic reform; however, these individuals,
though involved in policy-making, are not on the Standing Committee and,
therefore, do not set the direction of China's economic policy. Much
will depend on whether these individuals will be willing and able to
sway the leadership toward economic reforms. Three top decisionmakers
are highlighted below.
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
The New Economic Leadership Team--Continued
 
  Zhou Xiaochuan was asked to stay on as head of the People's Bank of
China (PBOC), the central bank. Observers were surprised by the
announcement that Mr. Zhou will remain in his position since he turned
65 in January 2013, the ordinary retirement age for a minister-level
official. According to insiders, the move is aimed at ensuring
continuity in financial-sector policy-making and signals a desire to
stay on course with the kind of financial reforms Mr. Zhou has
championed, including a more flexible renminbi (RMB) exchange rate and
market-based interest rate system.\11\
 
  Lou Jiwei was appointed minister of finance. Mr. Lou, best known
abroad as the former head of China's most public sovereign wealth fund,
the China Investment Corporation (CIC), was a deputy finance minister
for ten years and is known for his support of financial
liberalization.\12\ His comments at the 2013 Strategic and Economic
Dialogue (S&ED) talks in Washington generated some controversy when
Xinhua, the official CCP propaganda arm and news agency, censored his
remarks regarding China's target GDP growth in 2013. Mr. Lou said,
``There is no doubt that China can achieve the growth target, though the
7 percent goal should not be considered as the bottom line,'' but Xinhua
changed that to ``7.5 percent'' (the official target) in its
reporting.\13\
 
  Liu He, long recognized as the key economic adviser to Xi Jinping, was
confirmed as the official head of the Leading Group for Financial and
Economic Affairs of the CCP Central Committee.\14\ Mr. Liu will also
hold an appointment as a vice head of the National Development and
Reform Commission (NDRC), China's chief economic planning body. As the
head of the Leading Group for Financial and Economic Affairs, Mr. Liu
will lead the writing of the official documents framing economic reforms
planned over the next five years.\15\ According to Cheng Li, a China
scholar at The Brookings Institution, Mr. Liu was a ``major
collaborator'' in last year's World Bank report \16\ that advocated
accelerating market-driven change and is a proponent of financial
liberalization.\17\
 
------------------------------------------------------------------------


    Economic policymakers have identified and registered some 
limited successes in addressing problems that threaten to 
foment unrest among Chinese citizens who are not part of the 
urban coastal elite. In recent months, the government has 
introduced some important initiatives aimed at addressing some 
of the country's growing inequalities of wealth and 
opportunity.

    Inequality: Even as President Xi and Premier Li's rhetoric 
indicates a reformist bent, resistance to reform from 
entrenched local interests and the export sector remains 
strong.\18\ Although the Chinese government has been successful 
in lifting millions out of poverty, China's level of inequality 
has been steadily rising. In February 2013, the State Council 
released a new plan aimed at curbing inequality and redressing 
some of the worst gaps in development between urban and rural 
populations.* The plan includes an ambitious agenda for 
expanding the social safety net, improving healthcare and 
education, limiting the power of SOEs, and tackling corruption 
by government officials.
---------------------------------------------------------------------------
    * For an in-depth analysis of the new reform plan, see Nargiza 
Salidjanova, China's New Income Inequality Reform Plan and Implications 
for Rebalancing (Washington, DC: U.S.-China Economic and Security 
Review Commission, March 12, 2013). http://origin.www.uscc.gov/sites/
default/files/Research/China-%20-Inequality-%20-
%20-3-%20-12-%20-13-.-pdf.
---------------------------------------------------------------------------
    The 35-point ``Income Distribution Plan'' is aimed at 
boosting minimum wages to at least 40 percent of average 
salaries, loosening controls on bank lending and deposit rates, 
and increasing spending on education and affordable 
housing.\19\ Other reforms include a requirement that SOEs 
contribute more of their profits to the effort of reducing 
inequality and a commitment to push through market-oriented 
interest rate reforms to give savers a better return and more 
security. In theory, these measures signal an attempt to shift 
the economy toward increased domestic consumption as an 
underpinning for economic growth. As with most sweeping Chinese 
government plans, everything depends on implementation. For 
example, past proposals to encourage higher dividend payments 
from SOEs collapsed under fierce resistance from the 
politically powerful heads of the SOEs, who are also ranking 
Communist Party members. Similarly, corruption is endemic among 
local government officials, and addressing its manifestations, 
such as land seizures from peasant farmers, might undermine the 
stability of the CCP (see below).

    Corruption: A Pew Research Center poll last year showed a 
rise between 2008 and 2012 in Chinese public concern about 
corrupt officials. The anticorruption group Transparency 
International last year ranked China number 80 out of 174 
countries in terms of perceptions of corruption in the public 
sector, worse than Liberia, Italy, and South Africa. 
Transparency International excluded China from its 2013 survey 
on corruption because local polling survey firms, which are 
licensed by the government, said they would have to omit 
certain questions in order to be allowed to conduct the 
survey.\20\
    Upon becoming president last November, Mr. Xi vowed to 
eliminate the ``tigers and flies'' (i.e., high-ranking as well 
as low-ranking officials) who had enriched themselves through 
bribery and patronage. He denounced the prevalence of 
corruption and said officials needed to guard against its 
spread, or it would ``doom the Party and the state.'' \21\ Some 
observers took Wang Qishan's assignment as the director of the 
CCP's watchdog agency for corruption, the Central Disciplinary 
Inspection Commission, as a sign of the government's 
seriousness about the issue. Mr. Wang's previous experience in 
banking and international trade might have made him a better 
fit in an economic position, but reformers applauded Mr. Wang's 
choice because he has a strong reputation as a ``firefighter'' 
and capable problem solver.\22\
    In the past, the Chinese government has paid lip service to 
tackling corruption without undertaking any actual reform. The 
current anticorruption campaign appears similarly aimed at 
placating the public anger or eliminating political enemies 
rather than creating genuine change. For example, the focus on 
Chinese officials and executives at China's big, state-run 
companies appears to be politically motivated.\23\ The head of 
the State-owned Assets Supervision and Administration 
Commission, the agency responsible for supervising state-owned 
assets, was recently removed for ``serious disciplinary 
violations.'' He is a close associate of Zhou Yongkang, former 
domestic security chief, who is also targeted in the current 
campaign.\24\ Four senior managers at PetroChina have been 
removed amid separate investigations by authorities; one of the 
executives is a former aide to Mr. Zhou.\25\
    President Xi has spearheaded an austerity drive, banning 
banquets, gift-giving, and other lavish trappings of Chinese 
officialdom. There are signs that this is having a real impact: 
First-class airline ticket sales have dropped by a tenth in 
recent months; luxury goods dealers have reported a 20 percent 
to 30 percent decrease in sales; and restaurants surveyed in 
February experienced a 60 percent drop in reservations over the 
same period in 2012.\26\
    The Chinese government also issued a directive banning the 
construction of government buildings for the next five years. 
The new directive is a continuation of the anticorruption 
campaign, describing the ban as ``important for building a 
clean government'' and improving the ties between the party and 
the people.\27\ Grandiose official galas, which often feature 
variety shows and celebrity appearances, are likewise banned, 
because they are ``wasteful'' and had ``damaged the image of 
the Chinese Communist Party and the government, triggering 
public complaints.'' \28\
    The affected local governments are finding ways to side-
step these bans. According to a report in Xinhua, local 
government officials in some provinces are reclassifying 
government buildings in order to avoid notice. For example, in 
Jiangsu Province, the government power company offices have 
been renamed ``dispatch centers,'' and public security offices 
have been renamed ``technical investigation centers.'' \29\ 
Furthermore, the construction ban does not address the 
proliferation of so-called ``luxurious canteens,'' or deluxe 
cafeterias in government offices.
    While the anticorruption efforts have appeared in the 
headlines, the reality presents a more confusing picture. For 
example, a proposed regulation that would require top officials 
to publicly disclose their personal assets has stalled.\30\ 
Moreover, just as the prohibition on new government buildings 
was being announced, the government started to round up and 
prosecute activists who called on officials to disclose their 
wealth and the wealth of their families. In the most celebrated 
case, Xu Zhiyong, a prominent human rights activist, was 
charged with ``assembling a crowd to disrupt order in a public 
place.'' \31\
    Despite official proclamations, so far the CCP has 
demonstrated ``little inclination'' to pursue any fundamental 
reforms to root out corruption, according to Elizabeth Economy, 
director for Asia Studies at the Council on Foreign Relations. 
Instead, the latest measures will most likely follow an 
established pattern: ``a number of high-profile arrests, no 
institutional change [. . .], and an endless cycle of 
anticorruption campaigns.'' \32\ According to Minxin Pei, 
professor of political science at Claremont McKenna University, 
President Xi does not actually want to end corruption, because 
it is the lifeblood of the Chinese government: ``The Communist 
Party is a patronage machine and patronage by definition is 
corruption.'' \33\ In other words, while fighting corruption 
might endanger the party, cracking down on the appearance of 
corruption is a good measure to address the ``public relations 
nightmare that accompanies corruption.'' \34\ Party officials 
remain staunchly opposed to disclosing their assets, and both 
The New York Times and Bloomberg websites were blocked in China 
after reporting on the wealth amassed by the families of former 
Premier Wen Jiabao and Xi Jinping, respectively.

    Urbanization: Premier Li has made urbanization the core of 
his agenda, calling it ``the biggest development potential.'' 
\35\ Government departments are drawing up policies to guide 
rural citizens into cities over the next decade.\36\ The hope 
is that urbanization will become the next growth engine, 
initiating a new wave of investment, adding to the consumer 
class, and creating a surge in demand for housing and 
infrastructure.\37\ The urbanization drive may also boost 
Chinese efforts to make more land available for agriculture and 
improve farming efficiency (for more on the government's 
agriculture modernization efforts, see chap. 1, sec. 4, of this 
Report).
    The effect is likely exaggerated. For example, in many 
cases urbanization will simply entail the reclassification of 
rural areas as urban and not boost consumption or 
investment.\38\ In addition, unscrupulous officials might use 
the excuse of urbanization to seize village land, which they 
then may sell to developers without compensating the farmers.
    The key test of the Chinese government's ability to push 
through greater urbanization will be how it plans to pay for 
it. The Chinese Academy of Social Sciences, a government think 
tank, estimates the cost (including spending on healthcare, 
housing, and schools) at $106 billion a year, the equivalent of 
5.5 percent of fiscal revenue in 2012.\39\ Local governments 
cannot pick up the check for the expansion of such costly 
spending since they do not have a steady tax revenue stream: By 
law they must give most tax receipts to the central government. 
As a result, most local governments rely on land seizures and 
sales to fund spending, already a large contributor to public 
perceptions of corruption since farmers receive comparatively 
little from the government,
    No urbanization initiative can be fully successful without 
first tackling one of the key factors behind the rural-urban 
disparity: China's system of household registration, known as 
hukou.* People from the countryside with a rural registration, 
or hukou, are restricted from enjoying the far better education 
and health benefits available to those with an urban hukou. 
Allowing migrants to the cities to obtain an urban hukou has 
been met with strong resistance from local governments that 
fear being overwhelmed by a flood of new migrants.\40\ There 
are small signs of change. A report issued by the State Council 
suggests that the government is considering relaxing hukou in 
small cities ``in an orderly manner'' in tandem with the 
urbanization drive, to be followed by bigger cities.\41\
---------------------------------------------------------------------------
    * Created in its current form in 1960, China's modern hukou was 
first developed after 20 million migrants rushed to China's urban 
cities during the Great Leap Forward (1958-1960) in order to fill a 
perceived labor gap. The hukou system requires the registration of all 
citizens in China at birth and then limits access to government 
services based on the residency permits issued after registration. 
Citizens' residency permits fall into one of two categories, urban or 
rural hukou, and entitle a holder access to social services in the town 
or city to which their hukou is registered. For more on the hukou 
registration and its impact on migrant workers, see ``China's Internal 
Dilemmas'' in U.S.-China Economic and Security Review Commission, 2011 
Report to Congress (Washington, DC: U.S. Government Printing Office, 
November 2011), pp. 107-128. www.uscc.gov/Annual--Reports.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
The Mini Stimulus
 
  In July 2013, the Chinese government announced a package of measures
aimed at boosting the slowing economy while at the same time staying
away from the massive investment drive. It also appears aimed primarily
at small- and medium-sized private enterprises rather than SOEs, which
were the main beneficiaries of the 2008 stimulus package. A statement by
the State Council described a three-pronged approach: a temporary tax
cut (scrapping all value-added and operating taxes) for more than six
million small- and medium-sized enterprises; reduction of approval
procedures and administrative costs for exporting companies; and more
investment in railway construction in China's central and western
regions.\42\
  In recent decades, the CCP has derived its legitimacy from growth, so
the government's willingness to tolerate slow growth may be finite,
particularly if unemployment rates rise. A major test for China will be
how the rest of the global economy performs. Many analysts believe the
top priority for the new leadership is not reform but making sure that
growth does not deviate far from the official 7.5 percent target. If the
economies of China's biggest trading partners, the United States, the
European Union (EU), and Japan, remain weak, the pressure on the Chinese
economy may force the new government to return to such policies as
further credit expansion or infrastructure investment, which shore up
growth in the short term but also create more problems in the future,
such as inflation, overcapacity, excessive debt, and economic
uncertainty.
 
------------------------------------------------------------------------


Rebalancing China's Economy

    Economic rebalancing is a multifaceted challenge for China 
that not only entails lowering investment and increasing 
overall consumption but also scaling down the role of the state 
sector, reducing speculative investment in real estate, 
altering the way credit is allocated, and speeding growth of 
the services sector. Some economists predict that effective 
rebalancing of China's economy will result in more sustainable 
long-term growth.\43\ Failure to make necessary reforms to 
rebalance China's economy may result in reduced output, 
widespread defaults, stress on the banking sector, and social 
unrest.\44\ But in the past year, China has made little 
progress toward its stated goal and, in some cases, has 
regressed to the old, short-term solutions: ramping up exports 
through subsidies to exporters and borrowing to undertake 
infrastructure projects and increase factory output.
    Although China marginally reduced its massive trade surplus 
in the years immediately following the 2007-2008 global 
financial crisis, this progress was temporary and largely 
attributed to domestic stimulus and slowing demand in western 
economies. Rebalancing China's domestic economy has lagged even 
more so, as some positive trends proved to be short-lived.
    There are good reasons for the Chinese government not to 
try to boost growth with additional stimulus or policies to 
expand exports: A GDP slowdown may help Beijing tackle some of 
the structural problems with the economy, once described by 
former Premier Wen Jiabao as ``unbalanced, uncoordinated, and 
unsustainable.'' Patrick Chovanec, an economist who has written 
extensively about the Chinese economy, says that ``if China 
slowed for the right reasons, by being more selective with 
their investments, and moving toward more consumption, a slight 
slowdown would actually be a good thing.'' \45\ Proper economic 
rebalancing, however, cannot happen without a significant 
decrease in medium-term growth rates, and the government's 
willingness to tolerate slow growth on a sustained basis is 
untested.

External Rebalancing

    Balancing China's external accounts with other nations--or 
reducing China's massive trade surplus by increasing the import 
share of total trade--is a key element in rebalancing China's 
economy. Following the global financial crisis, China made 
progress in reducing its global trade surplus, which fell as a 
share of GDP from a peak of 10 percent in 2007 to 2.7 percent 
in the first half of 2013.\46\ However, the decline in China's 
trade surplus with the world is not necessarily an outcome of 
deliberate structural rebalancing. In the first half of 2013, 
China's goods exports outpaced goods imports by 4 percentage 
points, causing its trade surplus with the world to grow by 40 
percent year-on-year to $157 billion.\47\ The International 
Monetary Fund (IMF) projects that China's current account 
surplus will rise from 2.7 percent to 4 percent of GDP by 2018. 
This forecast assumes that there will be a gradual recovery in 
global demand, minimal appreciation of the RMB, and limited 
progress in domestic rebalancing.\48\
    The United States is among the countries most affected by 
China's export surplus (see figure 3). The U.S. cumulative 
bilateral deficit with China has risen to more than $3 trillion 
since 1979.\49\ For the first six months of 2013, China's goods 
trade surplus with the United States was $148 billion; a decade 
ago, that figure stood at $54 billion. While China sold 17 
percent of its total goods exports to the United States in 
2012, it purchased just 7 percent of total U.S. exports.\50\ 
More strikingly, China in 2012 was responsible for nearly 
three-quarters of the U.S. trade deficit in non-oil 
products.\51\

        Figure 3:  U.S.-China Trade Deficit in Goods, 2000-2012

                             (US$ billions)



    Source: U.S. Bureau of Economic Analysis.

    To be sure, U.S. manufactures exports to the world improved 
slightly in the first half of 2013, registering a lower deficit 
than in the prior year. Some industry experts have interpreted 
this as a sign of rising competitiveness in U.S. industry, 
driven in part by low energy prices.\52\ Nevertheless, the only 
manufacturing sector in which the United States registered a 
substantial trade surplus with China was transportation 
equipment ($3.6 billion), which comprises automotive, aircraft, 
and ship products. Other sectors with a substantial surplus 
were agriculture ($6.3 billion), waste and scrap ($4.2 
billion), and minerals and ores ($1.3 billion). The United 
States has a persistent trade deficit with China in advanced 
technology products. Although exports to China have improved in 
the first half of 2013, the total value of trade in those 
sectors is small (see table 1).


         Table 1: U.S. Trade Balance with China in Advanced Technology Products, January-June, 2012-2013
                                                 (U.S. millions)
----------------------------------------------------------------------------------------------------------------
                                                                                   YTD         YTD
                                                           Exports   Imports     Balance     Balance     Change
                                                                                 Jun'13      Jun'12    2012-2013
----------------------------------------------------------------------------------------------------------------
    TOTAL...............................................    7,828     42,327     -34,499     -35,418        919
(01) Biotechnology......................................      122         25          97          58         39
(02) Life Science.......................................      901        667         234         156         78
(03) Optoelectronics....................................      102      1,335      -1,233      -2,429      1,196
(04) Information & Communications.......................    1,375     38,607     -37,232     -35,717    (1,515)
(05) Electronics........................................    1,439      1,049         390         163        227
(06) Flexible Manufacturing.............................      713        278         435         185        250
(07) Advanced Materials.................................       77         70           7          15        (8)
(08) Aerospace..........................................    2,901        256       2,645       2,162        483
(09) Weapons............................................        1         39         -38         -34        (4)
(10) Nuclear Technology.................................      199          1         198          23        175
----------------------------------------------------------------------------------------------------------------
Source: U.S. Census Bureau, NAICS database (Washington, DC: U.S. Department of Commerce, Foreign Trade
  Division). http://censtats.census.gov/cgi-bin/naic3--6/naicCty.pl.


    There are four important preconditions for increasing 
China's imports as a share of total trade. First, China must 
further open its market to imports in order to allow increased 
competition to stimulate consumption. At the China Development 
Forum held in March, Premier Li acknowledged as much, promising 
that ``China will expand its opening-up policy, and the nation 
needs to promote domestic consumption through continuing to 
open up its markets.'' \53\ Second, the RMB must continue to 
appreciate against the dollar, to lower the price of U.S. goods 
and services in China. Third, household disposable income must 
continue to grow to create sufficient domestic demand. Fourth, 
China must reduce its household and corporate savings rate. 
Money that is not saved or invested is necessarily spent, often 
on imports. In 2012, however, China's private savings rate 
reached the world's highest level, surpassing 50 percent, well 
above the global average of 20 percent. The high savings rate 
is largely attributed to China's low level of government safety 
net spending on health, education, and old age pensions, high 
down payment requirements for securing mortgages, negative or 
low real interest rates on ordinary bank deposits, and capital 
controls that restrict Chinese citizens from investing 
abroad.\54\

RMB Revaluation

    The RMB has continued to slowly appreciate against the 
dollar, gaining less than 2 percent in the first half of 
2013.\55\ This represents a slowdown in appreciation from 
previous years, particularly when compared to the period 2005-
2008 (see figure 4). The rise of the RMB is still not 
controlled by market forces; the PBOC resets the value of the 
currency at the start of each trading day, allowing only 1 
percent daily fluctuation. In January, strong market pressures 
to appreciate the currency were offset by interventions in the 
international currency market by the central bank and China's 
state-owned commercial banks, which purchased a record $110 
billion worth of foreign exchange within a matter of days.\56\

            Figure 4:  Appreciation of the RMB, 2004-2013H1



    Note: ``2013H1'' includes data from January to June 2013.

    Source: China State Administration of Foreign Exchange, via CEIC 
database.

    The Commission in past years has characterized the value of 
the RMB as ``manipulated'' by the Chinese central bank in an 
effort by the government to discount its exports to the United 
States and raise the price of U.S. exports to China. The 
intended purpose is to create and maintain an artificially high 
surplus in China's bilateral trade with the United States. The 
U.S. Treasury Department chooses not to use this technical term 
in order to avoid mandatory countermeasures dictated by U.S. 
law * but acknowledges that China's exchange rate ``continues 
to be tightly managed'' and ``continues to exhibit significant 
undervaluation.'' \57\
---------------------------------------------------------------------------
    * The U.S. Treasury Department is required by the Trade Act of 1988 
to report to Congress twice yearly on the exchange rate policies of 
major trading partners and to identify countries that ``manipulate the 
rate of exchange between their currency and the United States dollar 
for purposes of preventing effective balance of payments adjustment or 
gaining unfair competitive advantage in international trade.'' The 
Administration would be required to open negotiations with any country 
so designated.
---------------------------------------------------------------------------
    As in previous administrations, the U.S. Treasury 
Department has taken up the issue with China during bilateral 
talks and received assurances from top Chinese officials that 
change will be forthcoming and that market forces will be 
allowed a ``bigger role'' in determining the value of the RMB. 
However, China still refuses to publish data on exchange rate 
interventions by the central bank, in contrast to other G-20 
members. Such interventions, combined with China's subsidies to 
exporting industries, have helped China accumulate the world's 
largest foreign currency reserves--$3.66 trillion by the end of 
September 2013--almost as large as the total amount of foreign 
exchange reserves held by all advanced economies combined.\58\ 
The monthly U.S. trade deficit in goods with China hit a record 
$30.1 billion in July.\59\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Further Developments in RMB Internationalization
 
  As part of a push to internationalize the RMB, China has been
developing an offshore market for it as a precursor to allowing global
firms, banks, and asset managers access to its domestic market. China
has currency swap lines * with around 20 countries, mostly small,
emerging economies that have natural resources, such as Argentina and
Indonesia, but no major economic powers like the United States or EU
countries. That may be about to change as China established two
important swap agreements with major trade partners. First, the Bank of
England, Britain's central bank, and the PBOC established a currency
swap line in June 2013. The agreement will initially last for three
years and has a maximum value of 200 billion RMB ($32.6 billion).\60\
Then, in October 2013, China agreed to swap euros and RMB with the
European Central Bank, China's second largest swap deal. The swap
agreement has a maximum size of RMB 350 billion ($60.8 billion) and is
valid for three years.\61\
  In January 2013, Taiwan and China formally established a direct RMB-
clearing system between them, following a signing of a cross-Strait
currency clearing last year. Taiwan will become the third place with
such a clearing arrangement with China, after Hong Kong and Macau. Under
the agreement, Taiwan's and China's central banks will be able to settle
directly in RMB payments without first converting their currencies into
U.S. dollars, which is the current practice.\62\
  On April 25, 2013, the government in Hong Kong loosened restrictions
on interbank trading of the RMB, a move that is intended to enhance Hong
Kong's status as an offshore RMB trading center, a segment that is
witnessing competition from other financial centers.\63\ Global use of
the RMB for trade settlement is limited but has been rising steadily. By
June 2013, the volume of RMB used to settle trade was 174 percent higher
than in January 2012, when the policy was first introduced.\64\ The
Chinese currency now ranks 13th in the world for cross-border payments,
up from 20th this time last year, according to SWIFT, the global
payments company.\65\ True RMB internationalization stays out of reach,
however, as long as China's capital account remains closed, which makes
use of RMB for trade settlement and investment difficult.
 
------------------------------------------------------------------------


Domestic Rebalancing

    As of 2013, imbalances in China's domestic economy remain 
substantial. Beijing's economic policy has resulted in what the 
IMF calls a ``pattern of growth [that] has become too reliant 
on investment and an unsustainable surge in credit, resulting 
in rising domestic vulnerabilities.'' \66\ Rebalancing toward 
consumption-driven growth can only be achieved if consumption 
continually grows faster than investment for many years. Yet 
while private and government consumption accounted for more 
than half of China's GDP growth in 2011-12, the trend reversed 
in the first half of 2013.\67\ Nicholas Borst of the Peterson 
Institute for International Economics rated China's progress in 
rebalancing a grade of ``D'' and ``F'' for the first and second 
quarters of 2013, respectively.\68\ His perspective summed up 
the consensus that China has experienced no significant 
domestic rebalancing this year.
---------------------------------------------------------------------------
    * Under a swap agreement, central banks agree to exchange each 
other's currency and can then lend the money to domestic banks to 
improve liquidity.
---------------------------------------------------------------------------
    In the first half of 2013, consumption's contribution to 
economic growth fell below investment for the first time since 
2010. Consumption contributed 45.2 percent to GDP growth, down 
15.4 percentage points from the first half of 2012. Investment, 
however, increased to 53.9 percent, up 2.7 percent from 2012 
(see figure 5).\69\ In China, consumption's share of GDP 
remains low compared to other countries. Globally, it 
represents about 65 percent of GDP, and China's share of 
consumption is still far lower than developed western 
economies, where consumption accounts for over 70 percent of 
GDP (see figure 6).\70\

        Figure 5:  China's Consumption vs. Investment, 2009-2013

                  (as share of GDP growth; in percent)



    Source: China National Bureau of Statistics, via CEIC database.

    The IMF has warned that if credit-fuelled investment in the 
manufacturing sector remains high, resources are likely to be 
wasted and nonperforming assets will accumulate, because such 
investment will only add to China's industrial 
overcapacity.\71\ Numerous examples of overinvestment and 
excess supply resulting in overcapacity have already arisen in 
the steel, shipbuilding, and solar manufacturing industries, 
which has resulted in insolvency and employee layoffs for many 
companies.\72\ This slowdown in the manufacturing sector has 
resulted in diminishing returns on the government's investment. 
Beijing has expressed tolerance for slower economic growth 
while it claims to be directing China's economy toward more 
domestic consumption.\73\ Despite this, independent analysts 
believe that China's new leaders lack the political will to 
adopt an ambitious rebalancing agenda.\74\

            Figure 6:  Composition of China's GDP, 2000-2012



    Note: 2012 data for ``imports of goods and services'' and ``exports 
of goods and services'' were not yet released by the World Bank at the 
time of publication.

    Source: World Bank China data (Washington, DC: 2013). http://
data.worldbank.org/country/china.

    The most important--and most challenging--element of 
domestic rebalancing is increasing household consumption as a 
share of GDP.* Households' consumption has declined as a share 
of China's GDP for decades while the share of fixed-asset 
investment has grown. Although year-on-year growth of urban 
household consumption has been expanding at a steady rate of 
9.7 percent for the past ten years, in the first half of 2013, 
growth in urban household consumption dropped to 7.2 
percent.\75\ Meanwhile, fixed-asset investment grew by 20 
percent.\76\ Although for the past decade real annual growth of 
household consumption in China has outperformed a dozen major 
economies, including Brazil and India, as long as 
fixed-asset investment is growing faster than household 
consumption, it will be difficult to rebalance China's domestic 
economy.
---------------------------------------------------------------------------
    * Household consumption is generally defined as expenditures for 
goods and services by a household, excluding the purchase of a home but 
adjusting for ``imputed rent'' or the amount that a household would pay 
to rent the same residence. It includes healthcare and education--even 
that portion supplied by the government--but does not include taxes 
paid to government nor does it include savings or investments by the 
household.
     According to Daniel H. Rosen and Beibei Bao of the Rhodium 
Group, it is unreasonable to expect household consumption to grow 
faster than its current rate. They argue that effective rebalancing 
will not depend on a growth in household consumption but on reduced and 
better managed investment growth. Daniel H. Rosen and Beibei Bao, 
``China Has Problems, But Household Consumption Isn't One,'' Caixin, 
September 20, 2013. http://english.caixin.com/2013-09-20/
100584374.html.
---------------------------------------------------------------------------
    An important factor in increasing household consumption's 
share of GDP is sustained growth in disposable income minus any 
increase in the household savings rate.\77\ If disposable 
income grows and the household savings rate remains stable or 
declines, this will result in more spending by Chinese 
consumers--a positive sign for domestic rebalancing. In the 
first half of 2013, however, the opposite occurred. Growth in 
nominal median urban household income took a dive, declining by 
5.8 percentage points. The urban household savings rate 
remained high, reaching 35.6 percent, up 1.1 percent from 2012. 
And, most notably, there was lower growth of real urban 
disposable income.\78\ These three factors--slowing income 
growth, an increasing household savings rate, and a drop in 
growth of urban disposable income--cut into overall household 
consumption. In turn, the slowdown in household consumption 
contributed to an overall slowdown in retail sales. Year-on-
year growth in retail sales for the first half of 2013 was down 
to 12.7 percent from 14.4 percent in 2012.\79\ On a quarterly 
basis, growth in retail sales was down an average 1.3 percent 
from last year.*
---------------------------------------------------------------------------
    * Data used in calculation exclude the months of January and 
February. China National Bureau of Statistics, via CEIC database.
---------------------------------------------------------------------------
    Financial reform is also integral to rebalancing China's 
economy. Continued reform in China's banking system is a 
precondition to increasing access to credit and providing 
higher returns on household deposits. The new leadership made 
progress toward financial reform in July 2013 when the PBOC 
announced it would eliminate the floor on lending rates, 
allowing banks more freedom to compete by offering cheaper 
loans.\80\ As a result, loans may become more accessible to 
small- and medium-sized enterprises. Although removing the 
floor on lending rates is a major step in financial reform, the 
PBOC did not remove the more important ceiling on deposit 
rates. The ceiling limits the rate that banks can pay 
depositors and ultimately stymies growth in household 
disposable income.\81\ The PBOC acknowledged that removing 
curbs on deposit rates would have a greater effect on 
consumption than lending rate reform.\82\
    Maintaining positive real interest rates would also play a 
role in increasing the returns for China's households. Interest 
rates on one-year deposits lagged behind inflation and were 
thus negative from 2010 to 2011, which adversely affected 
household consumption by cutting into disposable income. 
Depositors find that their savings have less purchasing power 
over time when inflation exceeds their return on savings. 
Although real interest rates have been positive since peaking 
at 1.5 percent in June 2012, they dropped to 0.3 percent in 
2013.\83\ As a result of the low interest rates, many seeking 
higher returns will favor alternatives in China's property 
sector, a cycle that will only result in increased fixed-asset 
investment and further inflation of China's real estate bubble.
    China implemented a new set of controls in March 2013 on 
the housing market that were targeted at curbing speculative 
investment in real estate.\84\ However, growth of investment in 
residential real estate continues to exceed real GDP growth, 
and reports of excess housing stock have indicated that it is 
unlikely that real estate investment is driven by actual 
demand.\85\

Monetary Policy

Management of Foreign Exchange Reserves

    The reserve assets held by China's central bank grew by 
$169 billion in the first half of 2013--$37 billion more than 
in all of 2012. Although China's reserve accumulation 
has slowed significantly since 2011, cumulative reserves are 
still extremely large, exceeding the combined foreign holdings 
of Japan, Norway, the United Arab Emirates, and Saudi Arabia, 
which rank directly behind China as the top foreign exchange 
reserve holders (see figure 7).\86\
---------------------------------------------------------------------------
     Total ``reserve assets'' are primarily comprised of 
foreign exchange. By the end of September 2013, China's foreign 
exchange reserves reached $3.66 trillion.
---------------------------------------------------------------------------
    China's share of U.S. Treasuries in foreign hands increased 
to 23.2 percent in 2013, cementing its rank as the world's 
largest holder of U.S. Treasury securities. Other top holders 
of U.S. Treasuries, such as Japan, Brazil, and Taiwan, all saw 
their shares decrease over this period.\87\ As of June 2012 
(most recent data), China was also the second-largest holder of 
U.S. agency debt, at $202 billion.

         Figure 7:  Growth of China's Reserve Assets, 2003-2013

           Cumulative (US$ trillions); Annual (US$ billions)



    Note: ``2013H1'' refers to first half of 2013. Numbers for 2003 to 
2010 are from China State Administration of Foreign Exchange's balance 
of payments data. Numbers for 2011 to 2013 are from the State 
Administration of Foreign Exchange's quarterly report on the 
international investment position, which are more widely used by 
economists but are not available for the period before 2011.

    Source: China State Administration of Foreign Exchange, via CEIC 
database.

    While maintaining a preference for government securities, 
China continues to diversify its foreign exchange assets. 
China's nonfinancial outbound foreign direct investment (FDI) 
for the first half of 2013 totaled $45.6 billion, up 29 percent 
from the prior year.\88\ One motive behind China's outbound FDI 
is to acquire resources and enter new markets overseas. In this 
context, China is increasing its direct ownership of foreign 
companies. Another motive, which also relates to China's 
portfolio investments and overseas loans, is to counteract the 
depreciation of the dollar against the RMB and to earn a higher 
yield than is provided by U.S. Treasuries.\89\ (For an analysis 
of China's foreign investment in the United States, see chap. 
1, sec. 2, of this Report.)


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Rising Competition among China's Sovereign Wealth Funds
 
  China Investment Corp. (CIC),* established in 2007, is the only state-
sponsored investment vehicle recognized by the Chinese government as a
sovereign wealth fund. But, according to the Sovereign Wealth Fund
Institute, an international research body, mainland China currently has
three other entities that may qualify as sovereign wealth funds--State
Administration of Foreign Exchange (SAFE) Investment Company,
the National Social Security Fund, and the China-Africa Development
Fund.Sec.  Each investment fund serves separate interests among branches
of the Chinese government and competes with other state-sponsored
entities for access to China's foreign exchange reserves.
  The Ministry of Finance has been the strongest supporter of CIC and
has advocated that the fund act as China's primary outbound
investor.\90\ Lou Jiwei, formerly the vice minister of Finance, served
as CIC's chairman in 2007-2013.\91\ As part of the leadership
transition, he was appointed as minister of finance in March 2013.\92\
After some bureaucratic infighting, Mr. Lou was replaced at CIC by
another Ministry of Finance official, effectively allowing the ministry
to retain its influence over the fund.\93\ China's central bank, on the
other hand, has preferred to invest the country's dollar reserves
through other state-sponsored investors. SAFE, the subsidiary of the
central bank that manages the bank's foreign exchange, is subject to
less external pressure than CIC, because it does not participate in
internationally recommended practices on transparency.para.
 
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * CIC is registered as a state-owned enterprise under China's 
Company Law. Unlike SAFE Investment Company and the National Social 
Security Fund, it is not a legal subsidiary of any government agency. 
It reports like a ministry directly to the State Council, China's 
highest administrative body. Under CIC's Articles of Association, five 
government agencies--the People's Bank of China, SAFE, the Ministry of 
Finance, the Ministry of Commerce, and the National Development and 
Reform Commission--have a seat on the fund's board.
     SAFE Investment Company is a limited company that was 
registered in Hong Kong prior to the handover of the island to mainland 
China. It constitutes one of four overseas investment arms of the State 
Administration of Foreign Exchange. The State Administration of Foreign 
Exchange is the branch of the People's Bank of China, China's central 
bank, which exclusively manages China's foreign exchange reserves. SAFE 
Investment Company's primary objective is to retain the value of 
China's foreign exchange by making portfolio investments overseas.
    = Established by the State Council, under the auspices of the 
Ministry of Social Security, the National Social Security Fund is a 
public pension fund under China's Social Insurance Law. Its objective 
is to maintain the real value of public pension proceeds as a means to 
support future social security expenditures. The National Social 
Security Fund can invest 20 percent of its funds outside China.
    Sec. The China-Africa Development Fund is a small fund set up to 
foster economic ties between China and Africa. It functions as a branch 
of China Development Bank, China's largest policy bank, though various 
government ministries are represented on its board. It is worth noting 
that the China Development Bank is majority owned by Central Huijin, 
the domestic subsidiary of CIC.
    para. CIC is a participant in the International Forum of Sovereign 
Wealth Funds (IFSWF) and has endorsed the Generally Accepted Principles 
and Practices, or ``Santiago Principles,'' a set of recommended 
practices for sovereign wealth funds that calls for increased 
transparency. SAFE, however, does not participate in the IFSWF.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Rising Competition among China's Sovereign Wealth Funds--Continued
 
  China's sovereign wealth funds rank among the world's largest in terms
of assets and have developed substantial portfolios in the United
States. CIC has acquired stakes in and loaned capital to major U.S.
companies in energy and financial services.\94\ CIC's subsidiary, the
bank holding company Central Huijin, also owns shares in China's largest
commercial banks, which have opened branches in the United States.\95\
SAFE has become a more aggressive investor and has moved beyond U.S.
Treasuries to riskier asset classes.\96\ In 2013, SAFE opened a new
branch in New York that will invest in U.S. private equity and real
estate.\97\ In addition, China's sovereign wealth funds are contracting
U.S. fund managers, such as Blackrock and TPG, to manage large portions
of their portfolios.\98\
 
------------------------------------------------------------------------


    Foreign exchange is being channeled into overseas lending 
as well. Among the top lenders is China Development Bank, 
China's largest policy bank. The bank was established in 1994 
to subsidize development projects in China's most backward 
regions but has vastly expanded its dollar-denominated loan 
portfolio in recent years. In May, it signed a $1 billion oil-
for-loan deal with India's largest oil company, Essar Oil Ltd. 
China Development Bank has issued several such loans to energy-
rich countries since 2007, notably Venezuela, Russia, and 
Brazil.\99\

Currency Inflows and the Cash Crunch

    China's foreign currency inflows in the first half of 2013 
were large but volatile: reserve accumulation surged in the 
first quarter, followed by outflows in the second quarter.\100\ 
Volatility in China's external accounts carried over into the 
domestic financial sector, which encountered a temporary 
liquidity crisis. The central bank intervened to maintain 
stability in a slowing economy exposed to high levels of debt.
    Export earnings and inbound FDI grew at a slow pace in the 
first half of 2013, making only a moderate contribution to 
China's dollar inflows (see figure 8). China's foreign exchange 
reserves increased by $128 billion in the first quarter, well 
above the $43 billion trade surplus and $30 billion in foreign 
investments.\101\ Other factors, less tied to the health of the 
economy, played a significant role in attracting capital to the 
Mainland. One was the reversal of capital flight. According to 
a February 2013 briefing to the Commission by the U.S. 
Treasury, many wealthy individuals took money out of the 
country during China's once-in-a-decade leadership transition 
in 2012, due in part to concerns about political and economic 
instability.\102\ China's central bank records indicate that 
some $79 billion of foreign exchange outflows went unaccounted 
for. The outflows of capital were so large that China's foreign 
exchange reserves in 2012 grew by less than the trade surplus--
a pattern not seen since China joined the World Trade 
Organization (WTO). The resumption of currency inflows in early 
2013 suggested that some of the flight capital reentered the 
country.\103\ Due to China's tight capital controls, a 
considerable portion of the inflows entered illicitly through 
over-invoicing of export revenues and other means.\104\

          Figure 8:  Growth of China's Exports and Inbound FDI

                       (January--June, 2010-2013)

                         YTD (year-on-year, %)



    Source: China General Administration of Customs, China Ministry of 
Commerce, via CEIC database.

    Another factor behind China's surging capital inflows was 
financial speculation. International investors borrowed U.S. 
dollars at low rates of interest to purchase assets denominated 
in RMB, which offered a higher yield and the potential to 
profit from currency appreciation. Although the RMB did not 
appreciate much in 2012, the upward pressure on the currency 
resumed in 2013. This investment pattern was reinforced by the 
U.S. Federal Reserve's purchases of longer-maturity assets, 
such as commercial bank bonds, under the stimulus program known 
as ``quantitative easing.'' First implemented in November 2008, 
quantitative easing substantially lowers the longer-term cost 
of borrowing in dollars.\105\
    As it has done persistently since 2005, the PBOC 
counteracted rapid capital inflows by heavy market 
intervention. The PBOC purchased dollars with RMB in order to 
support the targeted RMB-dollar exchange rate. That not only 
added to the PBOC's bulging foreign exchange reserves but also 
increased China's money supply, raising the risk of inflation. 
To reduce those risks, the PBOC took additional 
``sterilization'' measures to absorb liquidity out of the 
economy--essentially issuing RMB-denominated bonds in an effort 
to remove the money from circulation.\106\
    Nonetheless, the liquidity buildup contributed to an 
expansion of lending and debt in China. The broad money supply 
(M2) * grew by 16.1 percent through April, above market 
forecasts of 15.5 percent.\107\ The Chinese government's 
measurement of debt, or ``total social financing,'' rose at its 
fastest pace since the stimulus in 2009 (see figure 9). Much of 
this credit expansion was in the ``shadow banking'' sector, in 
products such as trust company loans.\108\ At the same time, 
worrying trends appeared in the traditional banking sector. 
Foreign currency lending increased by 37 percent year-on-year 
through May--versus 16 percent for RMB-denominated loans--as 
banks recycled the excess dollars coming into their 
accounts.\109\ Chinese banks are less restricted in terms of 
the amount of deposits they need to have available when lending 
in foreign currency, a loose regulation that prompts riskier 
lending. Nonperforming loans at Chinese banks also grew at 
their fastest quarterly rate in a decade; an indication that 
credit was not well allocated (see figure 10).
---------------------------------------------------------------------------
    * Broad money (M2) is a measure of liquid money supply beyond 
physical currency and demand deposits (also termed narrow money, or 
M1). M2 includes time-related deposits, savings deposits, and 
noninstitutional money market funds.

  Figure 9:  Aggregate Credit Growth in China, January 2009-July 2013

                       Monthly (year-on-year, %)



    Source: People's Bank of China, via CEIC database.

     Figure 10:  Growth of China's Nonperforming Loans, 2006-2013Q1

                      Quarterly (year-on-year, %)



    Source: People's Bank of China, via CEIC database.

    Faced with a sudden rise in liquidity, the PBOC in June 
began to take more drastic measures, such as imposing tougher 
lending conditions on banks. These policies, which came to be 
known as the ``credit crunch,'' were effective in reducing 
dollar inflows. A concurrent development was the U.S. Federal 
Reserve's announcement in May that it might taper quantitative 
easing, a major policy shift that would raise the cost of 
borrowing in dollars and reduce the relative yield on RMB-
denominated assets. In response to the Federal Reserve's 
announcement, international investors rushed to transfer funds 
out of China and other emerging markets.
    However, the credit crunch also destabilized China's 
financial sector. The primary effect was to raise interest 
rates in the interbank lending market to record highs--lending 
among Chinese banks froze temporarily in late June. Many 
indebted borrowers worried that they would be unable to 
refinance their debt.\110\ The average price-to-earnings ratio 
for China's major commercial banks fell sharply on the 
country's major stock exchanges, part of a broader decline in 
China's capital markets.\111\
    Ultimately, the cash crunch did not do much to rein in 
China's debt. Once the initial scare of tight liquidity passed, 
aggregate credit growth continued to rise in June and July. 
Even as banks have found themselves increasingly strapped for 
cash, other signs indicate that they may actually be expanding 
their issuance of risky loans. Shortly after the engineered 
rate spike that froze interbank lending, nearly every major 
Chinese bank was selling a short-term wealth management product 
(a particularly popular vehicle for financing high interest 
rate, off-balance-sheet loans) that had to be completed by the 
end of June.\112\ (For more on shadow banking, see chap. 1, 
sec. 3, of this Report.)

Capital Account Liberalization

    Beijing took moderate steps in 2013 to further open its 
capital account. The primary motive was to attract foreign 
investors, an indirect way to stimulate a sluggish economy. 
Financial regulators launched the Qualified Foreign 
Institutional Investor program in 2002 to allow licensed 
foreign investors to buy and sell shares on China's stock 
exchanges. China's central bank and securities regulators 
approve any increase in the number of institutions and the 
amount of funds that these institutions can invest in China 
under the scheme. In 2013, the Qualified Foreign Institutional 
Investor program saw its largest-ever increases in investment 
approvals (see figure 11). Most of the approvals were given to 
investors who already held Qualified Foreign Institutional 
Investor licenses.
    In addition to individual approvals, the quota for total 
investment under the Qualified Foreign Institutional Investor 
program was increased from $80 billion to $150 billion. Raising 
the quota seemed relatively pointless; with total cumulative 
funding approvals of $43 billion over 11 years, even the 
original $80 billion quota has yet to be filled. Nonetheless, 
the policy had its intended effect of generating interest among 
foreign investors, as several financial services companies 
quickly applied for a larger quota.*
---------------------------------------------------------------------------
    * According to the Qualified Foreign Institutional Investor 
program, the China Securities Regulatory Commission grants Qualified 
Foreign Institutional Investor licenses and market access to foreign 
investors, while the State Administration of Foreign Exchange approves 
quotas for individual Qualified Foreign Institutional Investor funds. 
Josh Noble, ``China Approves HSBC for Onshore Currency Investing,'' 
Financial Times, July 26, 2013, via Factiva database.

 Figure 11:  Increase in Investment Quota under the Qualified Foreign 
        Institutional Investor Program, January-July, 2005-2013

                             (US$ billions)



    Source: China State Administration of Foreign Exchange, via CEIC 
database.

    The RMB Qualified Foreign Institutional Investor program, 
first established in December 2011 to complement the Qualified 
Foreign Institutional Investor program, was also expanded. 
Whereas the Qualified Foreign Institutional Investor program 
allows investors to bring U.S. dollars onshore and exchange 
them into RMB, the RMB Qualified Foreign Institutional Investor 
program allows select institutions to raise RMB offshore as 
well.\113\ RMB Qualified Foreign Institutional Investor funding 
approvals reached $20 billion by July 2013, four times higher 
than the year before, with 34 institutions approved for 
investment.\114\ The China Securities Regulatory Commission 
removed rules on how quotas could be used, so that fund 
managers could invest in either China's equity or domestic bond 
markets without requiring separate licenses.\115\ The China 
Securities Regulatory Commission also allowed units of Chinese 
banks and insurers in Hong Kong--as well as other financial 
institutions based in the city--to apply for RMB Qualified 
Foreign Institutional Investor quotas. Previously, only the 
Hong Kong units of Chinese fund management and securities 
companies were allowed to invest in mainland China via the 
program.\116\ In June, the RMB Qualified Foreign Institutional 
Investor program was then extended beyond Hong Kong to other 
offshore RMB trading centers, such as London, Singapore, and 
Taiwan, to the dislike of mainland Chinese fund managers who 
hoped to monopolize this new market.\117\
    It is questionable, however, whether the Chinese government 
is making a genuine effort to open the capital account or is 
merely luring foreign investors into China to stimulate the 
economy. It has done much less to open up the capital account 
for Mainland investors looking to send money overseas. Chinese 
domestic investors are allowed to access foreign equity markets 
via pilot trustees called Qualified Domestic Institutional 
Investors, which comprise banks, fund management firms, 
insurance companies, dealers, and brokers approved by the China 
Securities Regulatory Commission.\118\ The amount of investment 
permitted for Qualified Foreign Institutional Investors barely 
increased in the first half of 2013.\119\ The government 
announced plans in 2012 to introduce a Qualified Domestic 
Individual Investor program that would permit individuals from 
the Mainland to trade Hong Kong securities directly. By October 
2013, the plan had yet to proceed.\120\ The government in 2013 
introduced a less ambitious Qualified Domestic Institutional 
Investors scheme that would allow firms set up in the new 
Qianhai special economic zone to invest a certain amount of 
money in Hong Kong securities or bond markets.\121\

Excess Industrial Capacity

The Excess Capacity Crisis

    In 2012-2013, China's manufacturers recorded their worst 
performance since the height of the financial crisis four years 
ago. Monthly growth in China's industrial production, averaging 
13.3 percent in 2010, slowed to 6.1 percent in the first half 
of 2013. The purchasing managers' index, a monthly survey of 
manufacturers in China, consistently showed stagnation or 
decline in production and orders. China's exports were also 
sluggish, due to weak external demand.\122\ The construction 
sector, a key source of demand for many industrial materials, 
recovered slightly in the first half of 2013 from 2012 levels 
but was still growing at 7 percentage points less than in 2010-
2011.\123\
    The economic slump exacerbated the problem of excess 
capacity in China's heavy industry. The sectors affected 
extended along the value chain, from suppliers of basic 
materials, such as metals and cement, to manufacturers of 
ships, solar panels, and chemical additives. China today is the 
world's leading producer of most of these goods. According to 
official estimates, industrial enterprises in many of these 
sectors were operating at only three-fifths to three-quarters 
of capacity in 2012, below the Chinese government's target 
minimum of 80 percent capacity (see table 2).


    Table 2: Capacity Utilization in Select Chinese Industries, 2012
                        Capacity utilization (%)
------------------------------------------------------------------------
                                                            Capacity
                        Sector                          utilization  (%)
------------------------------------------------------------------------
Chinese government target                                          >80%
------------------------------------------------------------------------
Glass                                                               75%
------------------------------------------------------------------------
Cement                                                              75%
------------------------------------------------------------------------
Aluminum                                                            73%
------------------------------------------------------------------------
Wind turbine                                                        70%
------------------------------------------------------------------------
Steel                                                               75%
------------------------------------------------------------------------
Solar panels                                                        60%
------------------------------------------------------------------------
Source: Xinhua News Agency, based on official Chinese government
  estimates.


    Due to excess capacity, business conditions in many 
industries deteriorated. In order to sell off their inventory 
and attract new orders, producers slashed prices, leading 
China's producer price index to contract throughout 2012-2013 
(see figure 12). Some enterprises took on more debt in order to 
offer generous financing terms to their customers. Shipyards, 
for instance, accepted down payments of just 5 to 10 percent 
for new orders, versus up to 60 percent at the high mark in 
2007.\124\ To some extent, these measures proved effective--the 
total losses of the industrial sector, and the total number of 
loss-making industrial enterprises, declined in the first half 
of 2013, after steep increases in 2012.\125\

   Figure 12:  Producer Price Index in China, January 2002-July 2013

                    Monthly (year-on-year change, %)



    Source: China National Bureau of Statistics, via CEIC database.

    Still, many firms incurred debts that brought them to the 
brink of insolvency. Among 88 private steel enterprises, the 
number of companies suffering losses grew from a third to half 
in 2012-2013.\126\ In the solar sector, China's state-owned 
banks grew wary of lending to panel makers after product prices 
fell 66 percent in two years.\127\ Suntech Power, the world's 
largest solar panel manufacturer, declared bankruptcy in March 
2013 after running out of cash and defaulting on a bond payment 
of more than $541 million.\128\ In the shipbuilding sector, 
China Rongsheng Heavy Industries Group Holdings Ltd., a 
publicly listed company and China's largest private shipyard, 
sought a bailout in July from the local government in Jiangsu 
Province.\129\ In its 2012 annual report, Rongsheng 
acknowledged that it had only $343 million of cash and cash 
equivalents to service debts of $2.7 billion.\130\
    Although producers were affected by a slowing economy, 
structural imbalances and ineffective government policies 
created the underlying problem. China's industrial sector 
remains very fragmented. For example, while Japan and South 
Korea have only a few dozen large-scale shipyards, China has 
some 1,650 yards of various sizes. Such industrial enterprises 
have failed to coordinate production or pool resources on a 
national level, creating cut-throat competition in 
undifferentiated product lines. They have done so with 
subsidies from local governments keen on attracting business to 
grow the economy and raise government revenue. Low-interest-
rate loans from state-owned banks, with a bias toward 
industrial enterprises, created additional capacity without 
regard for insufficient demand. The 2009 economic stimulus 
accelerated this pattern. Fixed asset investment in 
manufacturing grew by an average of 35 percent in 2010-
2011.\131\ For 35 steel companies listed on the Shanghai and 
Shenzhen stock exchanges, local government subsidies increased 
by 128 percent year-on-year in 2010-2011.\132\ One shipbuilder, 
Rongsheng, received some $550 million in local government 
subsidies in 2010-2013, along with two five-year financing 
deals with Export-Import Bank of China, a Chinese policy bank, 
and a ten-year agreement with Bank of China, one of China's 
``Big Four'' commercial banks.\133\
    Reinforcing these patterns was the deliberate expansion of 
productive capacity in China's poorer inland regions. In the 
case of aluminum, more than 90 percent of new capacity has 
emerged in western areas since 2010. Excess capacity in the 
cement industry was as high as 30 percent in the Northeast and 
West of the country, versus 10 to 15 percent in the more 
developed eastern regions.\134\ Industrial enterprises have 
relocated to where land and labor are cheaper, urban density is 
lower, and local governments are less likely to enforce 
environmental regulations decreed by the central 
government.\135\
    Some of China's industries have also fallen behind their 
international competitors, who have performed better in a 
difficult economic climate. In the aluminum sector, the U.S. 
firm Alcoa registered profits of $191 million in 2012, while 
China's aluminum giant Chinalco had a loss of $780 million, its 
worst since going public in 2007.\136\ In shipbuilding, China 
in 2012 received orders of $14.3 billion, its lowest order 
value since 2004, while its South Korean rivals received $29.6 
billion worth of new orders.\137\
    Market forces are unlikely to correct the structural 
problems of China's heavy industry. Heavily indebted firms 
often have an incentive to maintain current output levels, 
because their loans are contingent upon future output. Due to 
fierce competition, there is also a concern that distributors 
will turn to other producers if deliveries are cut. Because 
many local communities depend on industry for employment, it is 
difficult to reduce pay or shed jobs. For example, Wuhan Iron 
and Steel, one of China's top-five steelmakers, supports a 
workers' town of 300,000 people in Hubei Province.\138\
    While such overcapacity is harmful to the affected Chinese 
industries and individual businesses, as well as any 
shareholders involved, it also spreads damage beyond China's 
borders. Industries within the United States, such as steel and 
glass, are sometimes forced to match the ``China price'' even 
if it is below the cost of production, leading to business 
losses and unemployment.

Tougher Policy Responses by the New Leadership

    Excess capacity in China's industry is not a new problem. 
The central government's restructuring of the country's state-
owned enterprises in the 1990s was partly aimed at reducing 
overcapacity, particularly in the industrial northeast. The 
11th Five-Year Plan (2006-2010) focused on the consolidation of 
capacity, and in the 12th Five-Year Plan (2011-2015), issued in 
2010, the State Council introduced a specific five-year Plan 
for Industrial Transformation and Upgrading.\139\ An important 
proponent of consolidation has been the NDRC, the coordinating 
ministry in charge of China's industrial policy. In September 
2009, it issued Document 35, ``On Restraining Excess Capacity 
and Industrial Redundancy in Certain Industries.'' The document 
identified industries such as steel, cement, aluminum, and 
shipbuilding. It placed much of the blame on the lavish 
subsidies and lax regulation of local governments and warned 
that unchecked capacity expansion would eventually lead to 
fierce competition and cost-cutting at the national level, 
threatening the financial health of enterprises and their 
creditors; depleting China's resource base; increasing reliance 
on raw material imports; and worsening industrial pollution 
near urban centers.\140\
    However, these efforts by the government did not suffice to 
check industrial expansion. Instead, industrial capacity 
continued to increase under the $586 billion economic stimulus 
program introduced during the global financial crisis. The EU's 
Chamber of Commerce in China warned in a 60-page report in 2009 
that industries such as steel, cement, and plastics were 
``still blindly expanding'' despite a slump in export demand. 
Referring to the steel industry, the report noted that China, 
with annual production capacity of 660 million tons of steel, 
and with an additional 58 million tons coming online, had sold 
less than 500 million tons the previous year.\141\ With 20 
million tons of primary aluminum capacity in 2008, China could 
sell only 13.5 million tons, or just 68 percent of its 
capacity.\142\
    By the spring of 2013, during the National People's 
Congress's annual meetings, top officials openly acknowledged 
that excess capacity was untenable, particularly in the steel 
sector. NDRC head Zhang Ping urged ``mergers and acquisitions, 
eliminating backward production, and encouraging more companies 
to tap into the overseas market.'' \143\ In April, the new 
leadership took its first tentative steps to address the issue. 
Based on a comprehensive set of criteria, including product 
quality, environmental sustainability, and resource efficiency, 
the Ministry of Industry and Information Technology (MIIT) 
chose 45 out of a pool of 104 enterprises for consolidation of 
the steel industry under the 12th Five-Year Plan. MIIT 
announced that those companies that could not meet the criteria 
would eventually be forced to exit the market, either by 
legislative fiat or reduced access to capital.\144\
    From June to August, the government's efforts to reduce 
capacity intensified. The ``credit crunch'' in June, widely 
attributed to China's central bank, helped to clamp down on 
short-term borrowing, forcing dozens of companies to cancel or 
delay bond sales, including China Development Bank, a key 
backer of the shipping industry.\145\ Weeks after the credit 
crunch, the central bank lifted the floor on bank lending 
rates. According to economist Nicholas Lardy, at the Peterson 
Institute for International Economics, the leadership used the 
credit crunch and rate reform to signal that the corporate 
sector would need to cut costs and improve productivity in 
order to remain profitable.\146\
    Beijing followed with more targeted measures aimed directly 
at heavy industry. The most far-reaching measure came on July 
25, when MIIT ordered more than 1,400 companies in 19 
industries to permanently retire entire production lines within 
factories by the end of 2013. In a break from past policy, the 
government published detailed lists of exactly which plants 
should reduce capacity and by how much.\147\ The lists were 
downloadable from the MIIT website and included publicly listed 
companies, some of which saw their share price drop as a 
result.\148\ Although the industries were wide-ranging, the 
companies targeted were primarily in metals, cement, and other 
basic materials.\149\ MIIT reinforced these policies with 
specific documents targeting the aluminum and rare earths 
sectors.*
---------------------------------------------------------------------------
    * MIIT in July convened several agencies, including the Environment 
Ministry, Customs, the Ministry of Land and Resources, and the Ministry 
of Commerce, to deliberate a new wave of crackdowns in the rare earths 
industry, with a focus on rooting out illegal production through higher 
fines and the closure of mines and smelting facilities. On July 24, 
MIIT released new aluminum industry standards: only large alumina 
projects would be authorized to use imported bauxite; alumina projects 
using high-aluminum fly ash for production were to locate in a place 
close to fly ash production, to reduce pollution; and the minimum 
capital ratio of electrolytic aluminum projects was raised to 40 
percent from the previous 35 percent, to ensure less leveraged 
investments in new capacity. Shanghai Securities News, `` `Zhengzhi 
fang'an' lidu kongqian: Xitu jiage fantan huo zhicheng'' 
(`Unprecedented Crackdown' to Support Price Rebound for Rare Earths) 
July 23, 2013, p. 5; Xinhua's China Economic Information Service, 
``MITT Rolls Out Policies to Resolve Excess Aluminum Capacity,'' July 
24, 2013, via Factiva database.
---------------------------------------------------------------------------
    On September 17, MIIT released another list for industrial 
capacity retirement--the third of the year--involving a total 
of 58 companies operating in 14 sectors. The affected 
industries were largely the same as before, comprising steel, 
coking, battery, copper smelting, zinc smelting, cement, and 
plate glass, among others. Black-listed capacities were to be 
demolished before the end of the year. MIIT expressly forbid 
the relocation of production to the hinterland.\150\

A Lenient Approach to the Shipbuilding and Solar Photovoltaic 
        Industries

    Although the central government took concrete steps to 
rationalize production, vested interests appeared to impede 
similar efforts in the shipbuilding and solar photovoltaic 
sectors. A three-year plan to upgrade the country's 
shipbuilding industry, released by the State Council on July 
31, encouraged local governments to provide subsidies to 
shipbuilders. It also offered ship-holders incentives to scrap 
their ships in advance, until the end of 2015, in order to 
raise demand for new ships. Banks were ordered to extend 
favorable loans to overseas ship-buyers and provide credit 
support to domestic ship-builders. Although the plan also 
called for industry consolidation, the measures were less 
targeted at individual plants.\151\
    Similarly, in the ``Guidance on Promoting the Healthy 
Development of the Solar Industry,'' issued on July 15, the 
State Council announced new measures to spur solar panel 
installations. The policy called for raising the capacity 
target for solar power generation in China to 35 gigawatts (GW) 
by 2015, a large step up from the 21 gigawatt target set in the 
2011-2015 Solar Development Plan issued by the National Energy 
Administration in 2012.\152\
    The Chinese government also supported the solar industry 
through an aggressive trade policy. China followed through on a 
probe it launched in 2012 into alleged subsidies for U.S. and 
South Korean polysilicon producers, applying antidumping duties 
on these imports in July 2013. Many critics interpreted the 
move as retaliation for U.S. antidumping duties leveled against 
Chinese solar panel makers in September 2012. The duties also 
protect China's domestic polysilicon industry, which is 
suffering from overcapacity.\153\
    In parallel to its rift with the United States, China 
engaged in a protracted trade dispute with the European Union, 
which in May 2013 threatened to apply antidumping duties on 
Chinese solar panels, similar to those being enforced by the 
United States.\154\ The proposed duties, averaging 47.6 
percent, would have been the largest duties that the European 
Union has applied to China and involved some $27 billion worth 
of imports.\155\ The Chinese government made extensive efforts 
to block the duties. In mid-May, the Ministry of Commerce 
(MOFCOM) warned that imposing duties would ``seriously harm'' 
bilateral trade ties between the European Union and China.\156\ 
A statement posted on the Chinese government's main website on 
May 30 asserted that EU member states did not all agree on the 
need for the tariff duties.\157\ Premier Li Keqiang used his 
first trip to Europe to encourage Germany and other major 
countries to oppose the measures.\158\
    China's diplomatic offensive proved effective. On June 4, 
the European Commission agreed to temporarily lower the new 
tariffs from the proposed level of 47.6 percent to a mere 11.8 
percent, while the two sides attempted to negotiate a 
solution.\159\ In late July, China scored a major victory in 
the negotiations, as the European Union agreed to scrap its 
proposed duties in favor of a ``price undertaking.'' The 
settlement allows Chinese exporters to sell into the European 
Union only enough solar panels to generate up to seven GW of 
capacity each year, at a minimum price of 0.56 euros per watt. 
Only Chinese firms that do not comply are subject to duties. 
The outcome effectively permitted China's subsidized solar 
panel exports to the European Union to continue unabated, only 
at a higher sales price. As The Wall Street Journal noted, the 
deal was much like the voluntary export restraints negotiated 
between the Japanese and U.S. governments in the 1980s.\160\

U.S.-China Strategic and Economic Dialogue

    The fifth round of the U.S.-China Strategic and Economic 
Dialogue (S&ED) was held on July 10-11, 2013, in Washington, 
DC. Prior to the S&ED, the United States and China held the 
first meeting of the civilian-military Cyber Working Group, 
where the two sides committed to work together on cooperative 
activities and hold further discussions on international norms 
of state behavior in cyberspace, but there were no tangible 
results.\161\ Both sides agreed to hold the next meeting before 
the end of 2013. (For discussion of U.S.-China tensions over 
cybersecurity, see chap. 2, sec. 2, of this Report.)
    On the economic front, the most relevant announcements were 
(1) resumption of Bilateral Investment Treaty (BIT) talks; (2) 
the launch of the Shanghai Free Trade Zone; and (3) new 
measures to liberalize China's financial sector.

Announcement 1: BIT Talks Resumed

    Of the economic outcomes, the most significant development 
was an agreement to restart the 2008 talks to reach a BIT. Six 
months before leaving office, the Bush Administration had 
launched talks for a U.S.-China BIT. In November 2009, 
President Obama then issued a joint statement with President Hu 
Jintao, announcing plans to expedite these negotiations. Until 
now, little progress has been made.\162\
    At the S&ED talks, China agreed to negotiate market access 
using a ``negative list'' approach (which means that all 
sectors are negotiable, except for those specifically 
exempted). China also agreed to grant U.S. investors national 
treatment in the ``pre-establishment'' phase of investment, or 
before U.S. firms are actually invested in China. This means, 
for example, that China will not discriminate against U.S. 
firms while they are trying to obtain a license or treat them 
differently than a domestic firm.\163\
    Treasury Secretary Jacob Lew described this as a 
``significant breakthrough'' that ``would work to level the 
playing field for American workers and businesses by opening 
markets for fair competition.'' \164\ U.S. business groups 
welcomed the development as a possible solution to Chinese 
opposition to foreign investment in large sectors of the 
Chinese economy, most notably financial services.
    Others have urged caution, however. Dr. Lardy called the 
BIT ``a noble goal but one which will be very difficult to 
conclude in any reasonable time period and it might well 
fail.'' \165\ Derek Scissors, then at the Heritage Foundation, 
was similarly skeptical, noting, ``BITs are primarily about 
protecting investors from discriminatory government policies. 
They are not transformative instruments that change the nature 
of economies, especially not large economies.'' \166\
    A comprehensive BIT with China would be highly 
controversial and involve protracted Senate debate over 
details. BITs are treaties rather than executive agreements,* 
such as the North American Free Trade Agreement, and require a 
two-thirds vote of the Senate to ratify. A BIT would also 
potentially curtail the powers of state and local governments 
to regulate health and safety issues and even zoning, raising 
sovereignty concerns. Moreover, with the exception of a few 
failed deals, Chinese firms have had success investing in the 
United States even without an investment treaty. Similarly, 
U.S. companies have been investing in China for years, fully 
cognizant of various restrictions on investment, policies that 
discriminate against foreign investors in favor of Chinese 
firms, and rampant intellectual property rights theft. China 
may not be willing to make major concessions for a deal.
---------------------------------------------------------------------------
    * Free trade agreements are generally passed under an expedited 
``fast track'' rule that does not allow amendments on the floor and 
calls for expedited procedures.

---------------------------------------------------------------------------
Announcement 2: Shanghai Free Trade Zone

    At the S&ED talks, China also agreed to expand access to 
its financial services sector for foreign investors. The most 
relevant outcome involves the establishment of a pilot free 
trade zone in Shanghai, which will guarantee equal access to 
domestic and foreign enterprises. Led by Premier Li, the State 
Council approved the plans on July 3, a week prior to the S&ED 
talks. Unlike China's existing special economic zones, which 
were established in the early 1980s to attract foreign 
investment in manufacturing to boost exports, the Shanghai free 
trade zone will not simply provide fiscal and other incentives; 
it will also serve as a platform to test an assortment of 
controversial market reforms.\167\
    China's Ministry of Commerce approved the establishment of 
the free trade zone in August 2013, touting it as a ``new path 
and a new mode of opening to the outside world.'' \168\ After 
months of media speculation, on September 27, 2013, the State 
Council released rules to govern the new free trade zone. 
Beijing has agreed to allow RMB convertibility and market-based 
setting of exchange rates and interest rates, the first such 
steps toward full currency convertibility.\169\ Financial 
institutions in the zone would be allowed more freedom to 
experiment with new products and services, which may allow 
foreign firms to increase the quantity and sophistication of 
financial products. The government also pledged to open up 
shipping, commerce, specialized services (including legal), and 
travel. Further details remain vague. No specific timeline was 
given for implementing any of the reforms, though the State 
Council announcement said that financial liberalization will 
proceed ``as conditions allowed'' and ``risks would be 
controlled,'' forestalling any suggestion of rapid change.\170\
    The government announced that unlike other Chinese free 
trade zones the investment at the Shanghai free trade zone will 
be governed by a ``negative list'' approach. The use of the 
negative list suggested that the ability of Chinese regulators 
to arbitrarily constrain foreign investors might be curtailed. 
However, expectations for broad reform were dampened following 
the publication of this list by Shanghai government 
officials.\171\ The list includes restrictions covering 18 
sectors, including finance, media, utilities, property, and 
manufacturing.\172\ Analysts and banking officials noted that 
the wide range of restrictions reflects continued jockeying 
among Chinese government officials over the speed of 
liberalization.\173\ The list applies to the remainder of 2013 
and will be updated as the government continues testing 
liberalization policies in the free trade zone.
    The South China Morning Post, a Hong Kong publication, 
reported that the government would suspend some Internet 
controls, granting people inside the Shanghai free trade zone 
access to websites blocked elsewhere in the country, such as 
Facebook and Twitter.\174\ However, the statement by the State 
Council did not mention any such change. It did say foreign 
companies might be allowed to offer ``specialized 
telecommunications services'' in the zone, and permission to 
offer services that break existing Chinese laws might be 
granted on a case-by-case basis by the State Council.\175\
    The new pilot zone will take up to ten years to construct 
and will cover 28 square kilometers within Shanghai's existing 
Waigaoqiao bonded trade zone and three other special customs 
supervision zones. If successful, the model may be replicated 
nationwide. In response to the Shanghai free trade zone, other 
port cities, including Xiamen and Tianjin, have expressed 
interest in establishing similar pilot zones.\176\

Announcement 3: Financial Sector Liberalization

    As in past S&ED talks, China once again promised to move 
toward a market-determined exchange rate and to submit another 
proposal to join the WTO's Government Procurement Agreement. 
After China was admitted to the WTO in 2001, it agreed to sign 
the procurement agreement ``as soon as possible.'' However, its 
first bid was only submitted in February 2008. Because the 
terms of accession that China offered did not satisfy other WTO 
members, China subsequently submitted two more bids, the latest 
in November 2012. Three bids are generally the maximum required 
for Government Procurement Agreement applicants; yet several 
obstacles make China's imminent accession unlikely, not least 
its huge public sector and narrow definition of procurement in 
domestic law. China has resisted U.S. demands to include SOEs 
as government entities that would be bound by the agreement.
    China also hinted at greater market access for U.S. 
financial firms, particularly in trading government bond 
futures and underwriting corporate bonds. This form of foreign 
participation would be conducive to China's financial sector 
reform, as the government seeks novel ways to raise funds for 
companies while reining in credit issued by trust companies, 
local government financing vehicles, and other nontraditional 
lenders. China also welcomed participation by foreign banks in 
RMB settlement of cross-border trade and investment.\177\ A day 
after the adjournment of the S&ED talks, China announced that 
the Qualified Foreign Institutional Investor program will 
expand to $150 billion (the current quota stands at $80 
billion, but only $43 billion of that has been allocated for 
use in investment).\178\ A similar plan for Hong Kong-based RMB 
investors will grow to encompass Singapore, London, and other 
cities.\179\
    China's securities regulator also announced at the S&ED 
talks that it will begin providing certain audit work papers to 
the U.S. Securities and Exchange Commission (SEC) and the 
Public Company Accounting Oversight Board, a first step toward 
resolving a longstanding impasse on enforcement cooperation 
related to companies that are listed in the United States. U.S. 
and Chinese audit regulators also committed to accelerating 
cooperation for cross-border audit oversight.\180\ However, the 
S&ED joint factsheet makes no mention of a formal mechanism for 
sharing audit papers, so much work remains to be done on this 
issue. (For further discussion of the U.S.-China friction over 
the audit issue, see chap. 1, sec. 3, of this Report.)

The U.S.-China Relationship at the WTO

    On August 2, 2013, a WTO panel found that China had 
violated WTO rules in applying antidumping (AD) and 
countervailing duties (CVD) on U.S. exports of chicken broiler 
products.* China's MOFCOM imposed AD and CVD on these products 
in August and September 2010, respectively. The AD duties 
ranged from 50.3 percent to 53.4 percent for the U.S. producers 
who responded to MOFCOM's investigation notice, while MOFCOM 
set an ``all others'' rate of 105.4 percent. In the CVD 
investigation, MOFCOM imposed CVDs between 4 percent and 12.5 
percent for the participating U.S. producers and an ``all 
others'' rate of 30.3 percent. According to the Office of the 
U.S. Trade Representative, U.S. exports to China of broiler 
products fell by 80 percent following the application of the 
duties.\181\ The United States brought the case in September 
2011.
---------------------------------------------------------------------------
    * Broiler products include most chicken products, with the 
exception of live chickens and a few other products such as cooked and 
canned chicken.
---------------------------------------------------------------------------
    In its report, the WTO dispute settlement panel found in 
favor of the United States on nearly all U.S. claims, including 
substantive errors in MOFCOM's calculations and procedural 
errors.\182\ The United States scored a major victory against 
China's use of the average cost of production methodology in 
calculating dumping margins (i.e., the difference between the 
price of poultry products in the U.S. market and the price of 
the same product in China). In order to estimate the cost of 
production for a given chicken part, China would estimate the 
average cost of producing a whole chicken and assign the cost 
of producing that part depending on its weight. The United 
States argued that this methodology dramatically overestimated 
the cost of production for cheap parts of a chicken, such as 
paws.\183\ Both sides agreed not to appeal the ruling, and it 
was adopted by the WTO on September 25, 2013.
    In addition to the broiler case, there are pending WTO 
cases between the United States and China, whose status is 
summarized in tables 3 and 4 below.


                                          Table 3: Active WTO Cases Brought by the United States against China
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                              Appellate
                             No.                                        Title              Request for       Panel Report        Body       Compliance
                                                                                          Consultations                         Report        Status
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS419                                                         Measures concerning wind     December 22,   In consultations;
                                                                      power equipment              2010      panel not yet
                                                                                                                    formed
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS427                                                                 Antidumping and     September 20,     August 2, 2013          N/A       The panel
                                                                  Countervailing Duty              2011                                     upheld most
                                                                  Measures on Broiler                                                      U.S. claims.
                                                              Products from the United                                                    The two sides
                                                                               States                                                     agreed not to
                                                                                                                                             appeal the
                                                                                                                                                 ruling
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS431                                                         Measures Related to the    March 13, 2012     Panel composed
                                                                  Exportation of Rare                        September 24,
                                                                Earths, Tungsten, and                         2012; report
                                                                           Molybdenum                              pending
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS440                                                                 Antidumping and      July 5, 2012     Panel composed
                                                              Countervailing Duties on                        February 11,
                                                              Certain Automobiles from                        2013; report
                                                                    the United States                              pending
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS450                                                                Certain Measures     September 17,   In consultations;
                                                              Affecting the Automobile             2012      panel not yet
                                                                 and Automobile-Parts                               formed
                                                                           Industries
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: WTO Dispute Settlement Gateway. www.wto.org.



                                          Table 4: Active WTO Cases Brought by China against the United States
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                              Appellate
                             No.                                        Title              Request for       Panel Report        Body       Compliance
                                                                                          Consultations                         Report        Status
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS437                                                             Countervailing Duty      May 25, 2012     Panel composed
                                                                  Measures on Certain                         November 26,
                                                                  Products from China                         2012; report
                                                                                \184\                              pending
--------------------------------------------------------------------------------------------------------------------------------------------------------
DS449                                                              Countervailing and     September 17,     Panel composed
                                                              Antidumping Measures on              2012     March 4, 2013;
                                                                Certain Products from                      report expected
                                                                          China \185\                     by December 2013
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: WTO Dispute Settlement Gateway. www.wto.org.


China's Preferential Trade Agreements

    Following its accession to the WTO, China has actively 
worked to negotiate and implement bilateral and multilateral 
trade agreements across the globe. As China transforms from a 
regional player to a global power, it has not only created a 
growing web of international legal obligations but has also 
gradually advanced its economic and political influence. As of 
August 2013, China has signed thirteen preferential trade 
agreements (PTA),* including two with Iceland and Switzerland 
this year. The Iceland and Switzerland PTAs were the first 
signed between China and European countries--both representing 
a significant milestone in strengthening China's trade 
relationship with Europe.\186\ China is currently in the 
process of negotiating additional bilateral and multilateral 
PTAs with neighboring and distant countries, each encompassing 
particular economic and political motives (see table 5).
---------------------------------------------------------------------------
    * Many PTAs negotiated by China are not comprehensive, meaning 
provisions on trade in goods, services, and investment are not all 
included or are signed separately. The 20 bilateral PTAs negotiated by 
the United States, such as those with Chile, Costa Rica, Singapore, and 
South Korea, differ markedly from the 11 negotiated by China. U.S. 
agreements tend to cover more product categories and are negotiated 
from the start with as comprehensive a list as possible. China's PTAs 
have a narrower scope with fewer product categories.


                               Table 5: Preferential Trade Agreements with the PRC
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
 
                                                                            Asia-Pacific Trade Agreement (2000)
Signed
                                              Hong Kong (2003) Macau (2003)       ASEAN (2004)     Chile (2005)
Trade
                                           Pakistan (2006)    New Zealand (2008) Singapore (2008)   Peru (2009)
Agreements
                                        Taiwan (2010)    Costa Rica (2010)    Switzerland (2013) Iceland (2013)
----------------------------------------------------------------------------------------------------------------
 
                                                                              Norway          China-Japan-Korea
Under
                                                                Australia        Gulf Cooperation Council (GCC)
Negotiations
                                                             Regional Comprehensive Economic Partnership (RCEP)
----------------------------------------------------------------------------------------------------------------
 
Under
                                                                             India        Korea        Colombia
Consideration
----------------------------------------------------------------------------------------------------------------
Notes: Number in parentheses indicates the year initial agreement of PTA was signed. ASEAN=Association of
  Southeast Asian Nations
 
Source: Liu Debiao, ``Zhongguo Ziyou Maoyi Xieding Gailun'' (Introduction to China's Free Trade Agreements)
  (Beijing, China: China Commerce and Trade Press, June 2012), p. 10; Ministry of Commerce, China FTA Network
  (Beijing, China). http://fta.mofcom.gov.cn/topic/eniceland.shtml.


    While economic development remains the focus and primary 
objective of China's national policy, PTAs also serve as an 
important diplomatic tool and a means to expand regional 
influence and secure resources. The recently signed PTA with 
Iceland, for example, was not exclusively motivated by the 
reduction of barriers to trade but was likely a strategic move 
by Beijing to advance its access to Arctic shipping routes 
between China and Europe.\187\ Other PTAs currently under 
negotiation demonstrate Beijing's desire to secure natural 
resources, especially oil, which is not abundant domestically. 
China is strategically advancing its domestic agenda by 
negotiating trade agreements with oil-rich countries such as 
Norway and international organizations such as the Gulf 
Cooperation Council, an economic union of oil-rich Arab 
nations.\188\
    On a multilateral level, the United States and China have 
diverging and competing trade initiatives, each of which 
excludes the other. The U.S.-led Trans-Pacific Partnership is a 
free trade agreement among 12 Pacific Rim countries. The Trans-
Pacific Partnership is based on the principles of ``open 
regionalism,'' \189\ meaning that any Asia-Pacific country, 
including China, is welcome to apply on the condition that 
other parties to the agreement agree that it made a credible 
commitment to meet the high standards of the agreement.* The 
second, the China-supported Regional Comprehensive Economic 
Partnership, is an initiative to link Association of Southeast 
Asian Nations (ASEAN) member states and its free trade 
agreement partners. The Regional Comprehensive Economic 
Partnership includes China and multiple countries concurrently 
participating in the U.S.-backed Trans-Pacific Partnership 
negotiations, such as Australia, Japan, and New Zealand.\190\
---------------------------------------------------------------------------
    * At the 2011 Asia-Pacific Economic Cooperation (APEC) summit 
meeting in Honolulu, Hawaii, the leaders of the (then) nine Trans-
Pacific Partnership countries agreed to the broad outlines of the 
agreement. In their statement, they envisaged the Trans-Pacific 
Partnership as a ``living agreement,'' meaning that it will be open to 
addressing new issues as they evolve, and permit new members to join if 
they are willing to sign up to its commitments. See Office of the U.S. 
Trade Representative, ``Trans-Pacific Partnership (TPP) Trade 
Ministers' Report to Leaders'' (Washington, DC: November 12, 2011). 
http://www.ustr.gov/about-us/press-office/press-releases/2011/
november/trans-pacific-partnership-tpp-trade-ministers-%-E2-%-80-%-99-
re. The process by which new members are added has not been formalized. 
The aspiring candidates have followed a process agreed to by current 
members informally, with each aspiring candidate being approved with 
the consensus of the other parties. In practice, the aspiring 
participant must not only agree to full trade liberalization but must 
also demonstrate a genuine willingness to negotiate on issues sensitive 
to others and to commit to a high-standard agreement overall. See Ian 
F. Ferguson et al., The Trans-Pacific Partnership Negotiations and 
Issues for Congress (Washington, DC: Congressional Research Service, 
August 21, 2013).
---------------------------------------------------------------------------
    Negotiations on the Regional Comprehensive Economic 
Partnership began in early 2013 and are to conclude by the end 
of 2015.\191\ If realized, the agreement would create the 
world's largest group of trading partners, accounting for about 
half of the global market and about a third of the world's 
economic output.\192\ The Regional Comprehensive Economic 
Partnership has been seen as a move to counteract the U.S.'s 
high-profile involvement and promotion of the Trans-Pacific 
Partnership regional trade agreement, which has been 
interpreted by the PRC as a strategy to reduce China's economic 
influence in the Asia-Pacific region.\193\ Furthermore, Beijing 
is leading its own regional trade agenda in Asia through the 
China-South Korea, China-Australia, China-India, and the 
trilateral China-Japan-South Korea negotiations, ultimately 
seeking to construct a regional web of its own free trade 
agreements and establish an independent ring of influence.\194\

Doing Business in China--Investment and Antitrust Challenges

Investment

    China continues to adopt measures designed to encourage FDI 
into the country even as FDI into China dropped from a record 
$116 billion in 2011 to $111.7 billion in 2012. In the first 
half of 2013, FDI into China recovered slightly to $62 
billion.\195,196\ Declining optimism about the returns on 
investment results from China's slowing growth rate, rising 
labor costs, and regulatory conflicts. Among the major 
impediments cited by American-based multinationals operating in 
China are the government's favoritism toward Chinese SOEs and 
private domestic firms, restrictions on foreign ownership; a 
lack of regulatory transparency; inequity in licensing 
processes; increased pressure to transfer technology; weak 
intellectual property protection; an unreliable legal system; 
and corruption on the part of government officials.\197,198\
    FDI has shown signs of recovering in 2013 and was up 4.9 
percent to $62 billion in the first half of the year.\199,200\ 
Beijing's current, targeted efforts to bolster FDI are 
consistent with its history of relying on a set of measures, 
including investment catalogues and tax policy, to guide FDI 
inflows in accordance with development priorities set by the 
CCP. China's 12th Five-Year Plan for Foreign Capital 
Utilization and Overseas Investment seeks to attract higher-
quality foreign investment in designated strategic emerging 
industries.* The Plan also encourages multinational 
corporations to establish regional headquarters and centers for 
research and development, procurement, and financial management 
in China. It also indicates that China will open a variety of 
sectors to foreign investors.\201\ In November 2012, Beijing 
announced plans to simplify procedures for FDI, ``including new 
rules under which investors will not require approval for 
opening foreign currency accounts or for reinvesting foreign 
exchange earnings.'' \202\ Beijing is also considering 
suspending FDI-related laws and regulations in newly proposed 
free-trade zones  in order to encourage investments by 
foreign companies and joint ventures between foreign and 
Chinese companies.\203,204\ Nevertheless, concerns persist, 
particularly amid high-profile Chinese antitrust and corruption 
investigations, which have implicated a growing list of foreign 
firms.
---------------------------------------------------------------------------
    * There are seven strategic emerging industries designated in the 
12th Five-Year Plan (2011-2015): (1) energy saving and environmental 
protection; (2) next-generation information technology; (3) 
biotechnology; (4) high-end equipment manufacturing; (5) new energy; 
(6) new materials; and (7) new energy vehicles. Strategic emerging 
industries benefit from preferential policies and funding.
     On July 3, 2013, the State Council approved the 
establishment of a free-trade zone in Shanghai, ``more akin to a free-
market zone subject to less regulation and interference than an area of 
duty-free trade.'' Bloomberg, ``China to Ease Foreign Investment Rules 
for New Free Trade Zones,'' August 17, 2013.

---------------------------------------------------------------------------
China Targets Foreign Firms with its Antimonopoly Law

    In July 2008, China enacted its Antimonopoly Law. Three 
agencies = evaluate effects on competition in the marketplace, 
as well as national security ramifications of corporate 
practices, and other issues relevant to China's economic 
development. MOFCOM is authorized to handle merger clearances; 
NDRC to handle cartels and pricing conduct; and the State 
Administration for Industry and Commerce (SAIC) has authority 
over abuse of dominance and other non-price-related, 
anticompetitive conduct. Until recently, however, only MOFCOM 
was actively engaged in Anti-Monopoly Law investigation and 
enforcement activities. In the five years since the law came 
into effect, MOFCOM has reviewed approximately 650 mergers and 
acquisitions, while NDRC has concluded about 30 cases, and SAIC 
has handled only 12.\205\
---------------------------------------------------------------------------
    = MOFCOM, NDRC, and the State Administration for Industry and 
Commerce.
---------------------------------------------------------------------------
    In recent months, the NDRC has stepped up investigations of 
foreign companies suspected of price fixing, particularly the 
pharmaceutical and milk powder industries. The milk powder 
investigations culminated with the issuance of record fines 
totaling $109 million in August 2013, after companies admitted 
to entering into contracts with distributors to set a minimum 
sales price for milk powder.\206,207\ U.S.-based Mead Johnson 
Nutrition was issued the largest fine, RMB 204 million ($33 
million) or 4 percent of the company's total revenue in 
2012.\208\ The NDRC's antimonopoly bureau chief, Xu Kunlin, 
told China Central Television in August that the petroleum, 
telecommunications, banking, and auto industries could be 
next.\209\ The State Administration for Industry and Commerce 
is also stepping up its investigative efforts. As of August 15, 
it is separately investigating claims of bribery, fraud, and 
anticompetitive behavior in the pharmaceutical industry.\210\
    Although both domestic and foreign firms have been targeted 
in these investigations, there has been speculation that 
Beijing is specifically targeting multinationals either in 
reaction to recent antitrust cases penalizing Chinese companies 
overseas or as a means of protecting domestic industry.* \211\ 
This speculation was bolstered by revelations that at a July 
2013 Antimonopoly Law training session, NDRC officials 
pressured some 30 foreign firms to confess antitrust violations 
and advised them against hiring outside counsel to defend them 
in investigations.\212\
---------------------------------------------------------------------------
    * In March 2013, for instance, a U.S. federal district court found 
North China Pharmaceutical Group and its affiliate firm to have 
violated U.S. antitrust law by colluding to raise prices on vitamin C 
exports to the United States. The Chinese plaintiffs were fined $162 
million.
---------------------------------------------------------------------------
    The broad scope of the new Antimonopoly Law makes it 
difficult for foreign companies to determine whether they are 
breaking the law. On July 31, 2013, Maureen Ohlhausen, head of 
the U.S. Federal Trade Commission, told a Beijing audience that 
she hoped Chinese competition authorities would move to 
``promote predictability, fairness and transparency.'' \213\

Protecting Business Abroad--Chinese Corporate Litigation in 
        International and Foreign Domestic Courts

    Beijing has long encouraged domestic enterprises to learn 
to defend themselves in foreign markets. Under the Regulations 
on Responding to Antidumping Suits (2001), the government also 
authorized the Ministry of Foreign Trade and Economic 
Cooperation (now a division of the Ministry of Commerce) to 
coordinate companies' legal activities in order to ensure that 
individual cases are harmonized with national trade policies 
and objectives.\214,215\ Over the last decade, China has 
increasingly initiated cases in international courts as a means 
of pursuing and defending its trade and economic interests and, 
in recent months, there has also been a surge in Chinese 
corporate litigation in international and foreign domestic 
courts, backed by official actions and statements of support.
    Bringing legal challenges directly is a means for Chinese 
companies to assert influence over foreign economic policies 
and practices in forums not designed for state-vs.-state 
litigation. The idea that corporate litigation can influence 
trade and investment relationships is not novel, but Beijing's 
increasing use of such litigation suggests a strategic policy 
that will play an important role in China's relations with its 
trading partners. It also has potentially significant 
implications for China's use of trade and investment 
agreements.
    In 2012, in concert with Chinese government actions at the 
WTO, Chinese companies successfully used European courts to 
challenge and overturn CV and AD duties.* Speaking to the press 
about the 2012 legal victory of Aokang Shoes in overturning 
duties levied by the European Union, a spokesman for the 
Chinese Ministry of Commerce said it ``boosted the confidence 
of Chinese companies in protecting their interests through 
legal action.'' \216\ China Daily cited the victory in a call 
for Chinese companies to take ``bolder moves to defend 
themselves through legal means;'' and China Central Television 
featured a panel discussion of how the case could serve as an 
example for dealing with international economic 
challenges.\217\ Chinese companies are also employing this 
strategy in the United States, as exemplified by the GPX Tire 
cases brought in U.S. federal courts last year, which 
supplemented Beijing's WTO actions, though less 
successfully.
---------------------------------------------------------------------------
    * In late 2012, Aokang Shoes, the largest private Chinese shoe 
manufacturer, won a major victory when the European Court of Justice 
overturned duties that the European Union had levied on imported 
Chinese leather shoes in 2006. In July 2012, Zhejiang Xinan Chemical 
Company, a manufacturer of the herbicide glyphosate, also won a 
landmark victory at the same court on similar grounds. Both companies' 
cases coincided closely with related WTO challenges brought by the 
Chinese government.
     In December 2011, the U.S. Court of Appeals for the 
Federal Circuit ruled that the Department of Commerce had incorrectly 
applied double remedies against imported tires from China's GPX 
International Tire Co., because statutory and case law both dictated 
that countervailing duties could not be applied to nonmarket economy 
countries. (See 1984, 1988, and 1994 amendments to the United States 
Tariff Act of 1930. See also Georgetown Steel Corp. v. United States, 
801 F.2d 1308, Fed. Cir. 1986, where the court concluded that 
countervailing duties could not be applied to nonmarket economy 
countries because such duties are applied in response to subsidies; a 
subsidy is a financial contribution by a government that distorts a 
market; and there can be no finding of a subsidy where there is not a 
market to distort). This landmark decision threw a host of open 
countervailing duty investigations into limbo. Fearing that the ruling 
had encouraged Chinese challenges of the application of countervailing 
duties on a host of products, the U.S. Congress adopted a legislative 
fix in the form of Public Law 112-99. This legislation, signed into law 
on March 13, 2012, amended the Tariff Act of 1930 such that the 
Department of Commerce was required to apply countervailing duties to 
nonmarket economy countries where it found subsidies, and made this 
requirement retroactively applicable to ``all proceedings initiated . . 
. on or after November 20, 2006.''
---------------------------------------------------------------------------
    Chinese companies are also beginning to bring investment-
related claims, both in foreign domestic courts and at the 
International Center for the Settlement of Investment Disputes. 
In foreign domestic courts, these companies are questioning 
other nations' assertions of what constitutes a national 
security issue and challenging the legality and 
constitutionality of other countries' domestic applications of 
their own laws. Ralls Corporation, for example, launched a 
precedent-setting challenge to the Committee on Foreign 
Investment in the United States (CFIUS), constitutional due 
process claim, in response to President Obama's executive order 
that it divest its investment in an Oregon wind farm.*
---------------------------------------------------------------------------
    * Ralls Corporation, a U.S. subsidiary of one of China's largest 
private enterprises, filed suit in U.S. district court in October 2012, 
presenting a precedent-setting constitutional challenge to CFIUS and 
the U.S. president. The suit was filed after the president issued an 
executive order that halted the company's planned construction of four 
wind farms in Oregon. The U.S. District Court for the District of 
Columbia dismissed the last remaining claim in October 2013, but Ralls 
is appealing the Court's decision. Earlier in 2012, Chinese-owned 
Shanghai Pengxin won a protracted legal challenge to its efforts to 
acquire a group of bankrupt New Zealand dairy farms, prevailing over 
contentions that the acquisition might pose a threat to New Zealand's 
strategic national resources.
---------------------------------------------------------------------------
    At the International Center for the Settlement of 
Investment Disputes, Chinese companies are employing novel and 
more expansive interpretations of the investor protection 
clauses in their bilateral investment treaties. For example, 
China's second-largest insurer, Ping An, is currently pursuing 
a $2.28 billion claim at the International Court for the 
Settlement of Investment Disputes against the government of 
Belgium, arguing that Belgium violated the investor protections 
in the China-Belgium BIT. Though China is one of the world's 
most prolific BIT negotiators, historically, its agreements 
have been geared toward managing foreign investment within 
China and have provided only narrow investor protections in 
order to protect Beijing's sovereign authority. However, in 
both the Ping An case and a prior one, Tza Yup Shum v. The 
Republic of Peru (2011), Chinese companies have asserted 
broader interpretations of investor protection clauses in 
existing Chinese BITs in order to protect their investments 
abroad.
---------------------------------------------------------------------------
     In Tza Yup Shum v. The Republic of Peru (2011), Mr. Tza 
successfully contended that the Peruvian regulators had violated 
Peruvian law and the China-Peru Bilateral Investment Treaty in their 
treatment of his investment.
---------------------------------------------------------------------------
    From Beijing's perspective, these private corporate actions 
may be a necessary part of a defensive strategy abroad. 
According to Pu Lingchen, a partner at one of the Chinese law 
firms that represented Aokang Shoes in its European court 
cases, ``Without effective legal challenges against [foreign 
countries'] administrative measures, the often erroneously-
applied legal articles used to defeat Chinese companies will be 
taken as precedent in future cases,'' and this will encourage 
other foreign markets to follow suit, attacking Chinese 
products and companies without fear of retaliation.\218\ The 
upshot of this new trend in Chinese corporate litigation is 
that it indicates a growing reliance on the rule of law. This 
is good because, as one Economist article succinctly points 
out, the alternative to reliance on the law ``would likely be 
escalating retaliations unrestrained by rules.'' \219\ But the 
trend of Chinese corporate plaintiffs directly litigating 
disputes with foreign governments also suggests a diminishing 
willingness to rely on the dispute resolution mechanisms 
offered by international legal regimes, which is not promising 
for the navigability of the future international legal 
landscape.

Implications for the United States

    China's failure to rebalance its economy harms the United 
States in two ways. China's emphasis on fixed investment has 
created overcapacity in many industries, such as steelmaking, 
which has depressed world prices and caused unemployment in the 
United States and other developed countries where subsidies to 
industry are few. Privately owned companies cannot compete on a 
commercial basis against Chinese state-owned and state-
subsidized companies exporting goods at below the cost of 
production. China's resistance to imports and foreign 
investment in its financial and services sector, and its 
reliance on exports to fuel economic growth, has helped to 
create an enormous trade imbalance with the United States. 
China's share of U.S. exports is rising slowly, benefitting a 
few industries, such as carmakers and soybean growers. And yet, 
the world's second-largest economy accounted for just 7 percent 
of total U.S. exports in 2012, a reflection of China's 
discriminatory market. The cumulative U.S. trade deficit with 
China since 1979 has risen to more than $3 trillion, reducing 
employment in the United States. This trade surplus represents 
a claim on the productive assets of the United States.
    The ASEAN-led Regional Comprehensive Economic Partnership, 
supported by China, has been seen as a move to counteract the 
U.S. promotion of the Trans-Pacific Partnership regional trade 
agreement. The Trans-Pacific Partnership, in turn, has been 
interpreted by the PRC as a strategy to reduce China's economic 
influence in the Asia-Pacific region. Concurrent negotiation of 
two competing Asia-Pacific trade pacts may lead to disunion 
among ASEAN member states and serve as a point of contention 
between the United States and China as both countries seek to 
establish economic and political influence over the region.
    The Chinese government's attitude toward foreign investment 
creates an uncertain environment for U.S. firms. On the one 
hand, in light of slowing economic growth, Beijing has 
undertaken steps to reinvigorate foreign investment flows. On 
the other, recent government actions appear to unfairly single 
out foreign companies for scrutiny in bribery and pricing 
investigations and enforcement of the Anti-Monopoly Law.
    In July 2013, Chinese regulators launched a series of 
antibribery and antimonopoly probes into foreign and domestic 
firms. The probes began with an NDRC-led antibribery probe into 
British multinational pharmaceutical firm GlaxoSmithKline.\220\ 
Subsequently, numerous antibribery and antimonopoly 
investigations were conducted on foreign firms. China fined six 
manufacturers of baby formula more than $100 million for price-
fixing, among them New Zealand's Fonterra, the world's largest 
dairy company.\221\ Critics have argued that targeting foreign 
companies is merely a convenient scapegoat for the government, 
which is eager to assuage consumers who are upset about high 
prices and questionable safety of food and medicine 
products.\222\
    While Chinese BITs have traditionally focused on protecting 
China from foreign litigants, Chinese companies' increasing 
reliance on international and foreign domestic courts to pursue 
and protect investment interests abroad suggests a shift toward 
a more aggressive use of investment treaties. Chinese corporate 
litigants can also be expected to directly pursue grievances 
against U.S. trade policies in U.S. courts with increasing 
frequency, just as they are doing in other jurisdictions around 
the world.

Conclusions

 LChina underwent a once-a-decade leadership change 
with a new president and premier and several new members of the 
Politburo and Standing Committee. The leadership indicated that 
China's overall economic policy goal--to transition from an 
export and investment-led growth model to a greater reliance on 
domestic consumption, remained the same. In reality, this 
change proved difficult to implement by a new government 
concerned about a slowing economy, real estate speculation, 
stagnating wages, and unemployment. The incoming government 
issued statements supporting a large and powerful state-owned 
sector in the economy, disappointing advocates of a larger 
private sector.

 LThe new Chinese leadership introduced initiatives 
aimed at reducing inequality, cracking down on corruption, and 
promoting urbanization. There are significant impediments to 
the government's ability to implement these reforms. For 
example, corruption is endemic at all levels of government, 
while local governments oppose urbanization due to fear that 
they will be overwhelmed by a flood of new migrants.

 LChina's progress in external rebalancing following 
the financial crisis was only temporary and largely driven by a 
weak global demand that reduced the relative size of China's 
export sector. Trade data for 2012-13 show that Chinese exports 
are again growing at a higher rate than imports, signaling a 
continued reliance on exports to fuel economic growth and a 
reversal in reducing China's massive trade surplus. As a result 
of failed measures to rebalance its economy, China has 
continued to expand its already record foreign currency 
reserves, reaching $3.66 trillion by the end of September 2013.

 LChina's trade surplus with the United States in goods 
in 2012 was $315 billion, a record. For the first seven months 
of 2013, China's trade surplus with the United States was $178 
billion, also a record. China continues to manipulate the value 
of its currency, the RMB, to achieve a competitive advantage 
with the United States. China also continues to follow 
mercantilist policies to foster a trade surplus with the United 
States.

 LChina has had little success transitioning toward a 
consumption-led growth model and reducing its reliance on 
massive infrastructure projects to boost economic growth. 
Consequently, China's high investment levels have led to 
overcapacity in multiple industries, including steelmaking, 
shipbuilding, and solar panel manufacturing. A slowdown in 
urban household disposable income growth and an increase in the 
household savings rate have cut into consumer purchasing power 
and contributed to a decline in total retail sales growth.

 LChinese officials have played down the significance 
of lower growth, saying the slowdown is partly due to economic 
rebalancing. However, the government continues to stimulate the 
economy through a variety of small steps. For example, the 
State Council, China's cabinet, instituted a temporary tax cut 
(scraping all value-added and operating taxes) for more than 6 
million small- and medium-sized enterprises; reduced approval 
procedures and administrative costs for exporting companies; 
and provided more investment in railway construction in China's 
central and western regions. In a similar vein, securities 
regulators and the central bank issued record amounts of 
investment approvals to the Qualified Foreign Institutional 
Investors program.

 LDue to its restrictive monetary policy, China's 
central bank has accumulated the world's largest foreign 
exchange reserves. The bulk of these reserves are invested in 
U.S. Treasury securities, so that Chinese ownership accounts 
for nearly one-quarter of foreign-owned U.S Treasuries. In 
addition, China's two largest sovereign wealth funds, China 
Investment Corporation and SAFE Investment Company, have 
expanded their equity and real estate investments in the United 
States.

 LThe PRC has concluded 13 trade agreements, the latest 
with Iceland and Switzerland this year--the first signed with 
European governments. China is in the process of negotiating 
six additional trade agreements, which include the ASEAN-led 
Regional Comprehensive Economic Partnership, an initiative to 
link ASEAN member states and preferential trade agreement 
partners to form the world's largest trading bloc. The Regional 
Comprehensive Economic Partnership, which excludes the United 
States, is competing with the U.S.-led Trans-Pacific 
Partnership, which excludes China. Formal negotiations of the 
Regional Comprehensive Economic Partnership began in May 2013 
and are scheduled to conclude by the end of 2015.

 LChina's attempts to keep the value of the RMB 
artificially low while strictly limiting the flow of RMB from 
the country, coupled with its efforts to control a large state 
banking sector, led to a banking crisis. The collapse in 
liquidity threatened economic growth in China and demonstrated 
the difficulty of conducting a monetary policy so at odds with 
its trading partners and international norms.

 LThe fifth round of the U.S.-China Strategic and 
Economic dialogue was held on July 10-11, 2013, in Washington, 
DC. There were no significant achievements in the strategic 
track. On the economic front, the most relevant announcements 
were (1) resumption of bilateral investment treaty talks; (2) 
the launch of the Shanghai Free Trade Zone; and (3) new 
measures to liberalize China's financial sector. In the 
multilateral arena, the United States successfully challenged 
China's improper imposition of antidumping and countervailing 
duties at the WTO.

 LChina continues to take incremental steps toward RMB 
internationalization, but the goal of making the RMB a major 
international currency remains out of reach as the government 
continues to maintain strict controls on cross-border capital 
flows.

 LBeijing's efforts to reform the financial system 
continue to be hampered by risky off-balance-sheet lending by 
banks and nonbank financial institutions. Beijing has 
undertaken efforts to curb these risky lending practices, 
removing the floor on lending rates and imposing a short-term 
credit crunch in a clumsy effort to send a strong signal to the 
financial sector. However, there is little evidence so far that 
these efforts have succeeded. The ceiling on rates paid to 
depositors remains low, and some risky lending actually 
increased during the credit crunch.

                     ENDNOTES FOR SECTION 1

      1. Tom Orlik and Bob Davis, ``China Falters in Effort to Boost 
Consumption,'' Wall Street Journal, July 16, 2013. http://
online.wsj.com/news/articles/
SB1000-1-4-2-4-1-2-7-8-8-7-3-2-3-6-6-4-2-0-4-5-78607340845518674?mod=wsj
_streaming_stream.
      2. China's domestic consumption remains at 36 percent of GDP, 
while that of the United States is 70 percent.
      3. The majority of Chinese government data in this year's Annual 
Report stem from CEIC database. Founded in 1992 by a team of economists 
and analysts, CEIC database provides data for both developed and 
developing economies around the world. CEIC is the product of Euromoney 
Institutional Investor. Its China Premium database aggregates data 
published by several Chinese government agencies.
      4. U.S. Census Bureau, NAICS database (Washington, DC: U.S. 
Department of Commerce, Foreign Trade Division, September 2013). http:/
/censtats.census.gov/cgi-bin/naic3-_-6/naicCty.pl.
      5. Cheng Li, ``China's Top Future Leaders to Watch'' (Washington, 
DC: The Brookings Institution, John L. Thornton China Center, profiles 
of Wang Qishan and Zhang Gaoli). http://www.brookings.edu/about/
centers/china/top-future-leaders/zhang----gaoli; http://
www.brookings.edu/about/centers/china/top-future-leaders/wang----qishan.
      6. Chris Buckley, ``China Takes Aim at Western Ideas,'' New York 
Times, August 20, 2013; Stanley Lubman, ``Document No. 9: The Party 
Attacks Western Democratic Ideals,'' Wall Street Journal China Realtime 
Report blog, August 27, 2013.
      7. Jane Cai, ``State-Owned Enterprises Welcome Hu Jintao's 
Backing,'' South China Morning Post (Hong Kong), November 10, 2012; 
Leslie Hook and Jamil Anderlini, ``Hu Jintao Reasserts Party's Tight 
Grip,'' Financial Times, November 8, 2012.
      8. Barry Naughton, ``Signaling Change: New Leaders Begin the 
Search for Economic Reform,'' China Leadership Monitor 40 (January 14, 
2013).
      9. Benjamin Kang Lim and Nick Edwards, ``China's New Premier 
Pledges Reform, Sees Risks,'' Reuters, March 17, 2013. http://
www.reuters.com/article/2013/03/17/us-china-parliament-
id-US-BRE-92G-02M-2013-03-17.
     10. Bloomberg, ``Li Urges Paring State Role to Fuel 7.5% China 
Growth,'' March 17, 2013. http: // www.bloomberg.com/news/2013-
03-17/china-s-li-vows-to-keep-7-5-growth-and-spread-
wealth-benefits.html.
     11. Lingling Wei and Bob Davis, ``China Poised to Extend Central-
Bank Chief,'' Wall Street Journal, February 22, 2013.
     12. Daniel Ren, ``Ex-Wealth Fund Guru Lou Jiwei to be Finance 
Minister,'' South China Morning Post (Hong Kong), March 17, 2013.
     13. Nerys Avery and Feiwen Rong, ``Xinhua Corrects Report on Lou's 
China Growth-Target Comments,'' Bloomberg, July 2013. http://
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china-growth-target-comments.html.
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//
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Times, March 20, 2013. http://www.nytimes.com/2013/03/21/business/
energy-environment/suntech-declares-bankruptcy-china-says.html.
    129. Bloomberg, ``Rongsheng Talks with Chinese Cities to Seek 
Financial Aid,'' July 9, 2013. http://www.bloomberg.com/news/2013-07-
09/rongsheng-talks-with-chinese-cities-to-seek-financial-aid.html.
    130. Bloomberg, ``China Rongsheng's Government-Aid Call Drives 
Shares Down,'' July 5, 2013, via Factiva database.
    131. National Bureau of Statistics, via CEIC database.
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kuozhang `qu channenghua' weihe yue qu yue duo?'' (Steel Capacity Keeps 
Expanding: What Is Driving Excessive Industrialization?), July 23, 
2013, p. 5.
    133. Tyler Durden, ``Presenting China's Too Big to Fail `Lack of 
Liquidity' Casualty,'' Zerohedge, July 9, 2013. http://
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lack-liquidity-casualty.
    134. Lange Steel Net, ``Huajie gangtie channeng guosheng: Gongxinbu 
he Fagaiwei jiang zai chuzhao'' (Overcoming Excess Capacity in the 
Steel Sector: MIIT and NDRC Will Soon Unveil a New Policy),'' August 
22, 2013.
    135. Xinhua's China Economic Information Service, ``China Focus: 
Aluminum Prices in China Likely to Remain Weak in H2,'' July 4, 2013, 
via Factiva database; Shanghai Securities News, ``Gangtie channeng deng 
jixu kuozhang `qu channenghua' weihe yue qu yue duo?'' (Steel Capacity 
Keeps Expanding: What Is Driving Excessive Industrialization?), July 
23, 2013, p. 5; Xinhua's China Economic Information Service, 
``Analysis: High Aluminum Fly Ash Helps China Reduce High Dependence on 
Imports,'' March14, 2013, via Factiva database.
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(Beijing, China: April 2013), p. 9. http://quote.morningstar.com/stock-
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Annual Report (New York, NY: April 2013), p. 51. http://www.alcoa.com/
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hegan'' (How the Losses of Central SOEs Relate to Traditional Practices 
of Industry), July 22, 2013, p.15.
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China,'' Financial Times, June 20, 2013, via Factiva database.
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Enterprises and State Capitalism in China'' (Washington, DC: U.S.-China 
Economic and Security Review Commission, October 26, 2012), p.162; 
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    140. National Development and Reform Commission, ``Guanyu yizhi 
bufen hangye channeng guosheng he chongfu jianshe'' (Document 38: On 
Restraining Excess Capacity and Industrial Redundancy in Certain 
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Overinvestment Could Drive Up Exports, Strain Trade Ties,'' Associated 
Press, November 26, 2009, via Factiva database.
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Recession,'' China Daily, April 12, 2010, via Factiva database.
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Economic Planner,'' March 11, 2013, via Factiva database.
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guosheng channeng'' (China Comprehensively Regulates Excess Capacity 
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Stealth,'' Financial Times, June 28, 2013, via Factiva database.
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in Steel, Aluminum,'' August 15, 2013, via Factiva database.
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capacity, filed in April, meant that some companies were already braced 
for the capacity reduction and had made those production lines idle for 
a long time, ``China Cuts Capacity in Some Industries to 
Reshape Economy,'' Bloomberg News, July 26, 2013. http://
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on EU in Solar Row,'' Reuters, May 30, 2013. http://www.reuters.com/
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fangwen'' (Li Keqiang Arrives in Berlin for Official Germany Visit), 
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Launches 
Investigation into EU Wine Exports,'' Financial Times, June 4, 2013. htt
p://www.-ft.-com--/--intl--/--cms--/--s--/--0--/--9229031a-----cdb1---
--11e2-----8313---
--00144feab7de.html--?--ftcamp-=--published\_\-links%-2Frss--%--2Fworld-
_-asia-----pacific-_-china%2Ffeed%2F%2Fproduct#axzz2VFWfhCDu.
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Track Fact Sheet of the Fifth Meeting of the U.S.-China Strategic and 
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www.treasury.gov/press-center/press-releases/Pages/jl2010.aspx.
    163. Inside U.S.-China Trade, ``China Agrees to Key BIT Principles; 
Negotiations Now Poised to Intensify,'' July 16, 2013.
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Times, July 12, 2013. http://www.ft.com/intl/cms/s/0/83094a3e-ea76-
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Eye,'' Wall Street Journal China RealTime Report, July 12, 2013. http:/
/blogs.wsj.com/chinarealtime/2013/07/12/u-s-china-investment-treaty-
less-than-meets-the-eye/.
    166. Derek Scissors, ``An Investment Treaty with China: Don't Hold 
Your Breath,'' The Heritage Foundation Foundry blog, July 12, 2013. 
http://blog.heritage.org/2013/07/12/an-investment-treaty-with-china-
dont-hold-your-breath/.
    167. Xinhua, ``Shanghai Ziyou Maoyi Shiyanqu Fangan Huopi Dazao 
Jingji `Shengjiban' '' (Shanghai Pilot Free Trade Zone Plan Approved 
Creating an Economic Upgrade), July 5, 2013. http://www.gov.cn/jrzg/
2013-07/05/content-_-2440946.htm.
    168. Victoria Ruan, ``Shanghai Gets to Set Up Free-Trade Zone,'' 
South China Morning Post (Hong Kong), August 22, 2013; Simon Denyer, 
``Creeping Reforms as China Gives Shanghai Free Trade Zone Go-Ahead,'' 
Wall Street Journal, August 25, 2013.
    169. George Chen, ``Shanghai Free-Trade Zone to Lead on Yuan 
Reform,'' South China Morning Post (Hong Kong), September 5, 2013.
    170. Bob Davis and Richard Silk, ``China to Test Looser Grip on 
Economy in Shanghai Free-Trade Zone,'' Wall Street Journal, September 
27, 2013.
    171. Shanghai Municipal People's Government, ``Zhongguo (Shanghai) 
ziyou maoyi shiyan qu waishang touzi zhun ru tebie guanli 
cuoshi&(fumian qingdan)'' (China [Shanghai] Pilot Free Trade Zone 
Special Measures to Control Foreign Investment Access [Negative List]), 
September 29, 2013. http://www.shanghai.gov.cn/shanghai/node2314/
node2319/node12344/u26ai370-36.html.
    172. Richard Silk, Grace Zhu, and Liyan Qi, ``List of Restricted 
Sectors for Shanghai Free-Trade Zone Published,'' Wall Street Journal, 
September 29, 2013. http://online.wsj.com/article/BT-CO-20130929-
701666.html.
    173. Richard Silk and Bob Davis, ``China Releases Restrictions on 
Investment in Shanghai Free-Trade Zone,'' Wall Street Journal, 
September 30, 2013.
    174. George Chen, ``China to Lift Ban on Facebook--But Only within 
Shanghai Free-Trade Zone,'' South China Morning Post (Hong Kong), 
September 25, 2013.
    175. Bob Davis and Richard Silk, ``China to Test Looser Grip on 
Economy in Shanghai Free-Trade Zone,'' Wall Street Journal, September 
27, 2013.
    176. Bloomberg, ``Shanghai Economic Test Zone Lures Imitators From 
China Ports,'' July 11, 2013. http://www.bloomberg.com/news/2013-07-11/
shanghai-trade-zone-test-attracts-attention-from-chinese-cities.html; 
Yu Ran and Shi Jing, ``Shanghai Gets Go-ahead for Free Trade Zone,'' 
China Daily, July 4, 2013. http://www.chinadaily.com.cn/cndy/2013-07/
04/content-_-16722759.htm.
    177. U.S. Department of the Treasury, ``U.S. Fact Sheet--Economic 
Track Fifth Meeting of the U.S.-China Strategic and Economic Dialogue'' 
(Washington, DC: Press Release, July 12, 2013). http://
www.treasury.gov/press-center/press-releases/Pages/jl2011.aspx
    178. Ding Qi and Jonathan Standing, ``UPDATE 1-China to increase 
QFII quota, expand RQFII to London, Singapore--CSRC,'' Reuters, July 
12, 2013.
    179. Bloomberg, ``China Almost Doubles Foreign Funds' Access to 
Capital Markets,'' July 12, 2013. http://www.bloomberg.com/news/2013-
07-12/china-almost-doubles-foreign-funds-access-to-capital-
markets.html.
    180. For details on this issue, see U.S.-China Economic and 
Security Review Commission, June 2013 Trade Bulletin (Washington, DC: 
June 4, 2013). http://www.uscc.gov/trade-bulletin/june-2013-trade-
bulletin. U.S. Department of the Treasury, ``U.S. Fact Sheet--Economic 
Track Fifth Meeting of the U.S.-China Strategic and Economic Dialogue'' 
(Washington, DC: Press Release, July 12, 2013). http://
www.treasury.gov/press-center/press-releases/Pages/jl2011.aspx.
    181. Office of the U.S. Trade Representative, ``United States Wins 
Trade Enforcement Case for American Farmers, Proves Export-Blocking 
Chinese Duties Unjustified Under WTO Rules'' (Washington, DC: Press 
Release, August 2, 2013).
    182. World Trade Organization, ``China -- Anti-Dumping and 
Countervailing Duty Measures on Broiler Products from the United 
States,'' Dispute DS427 (Geneva, Switzerland). http://www.wto.org/
english/tratop----e/dispu----e/cases----e/ds427----e.htm#-bkmk427r.
    183. Inside U.S.-China Trade, ``U.S. Wins China Poultry Dispute in 
WTO, Including on `Average Cost' Method,'' August 5, 2013.
    184. China's claims relate to 31 initiations of investigations or 
preliminary or final determinations in 17 CVD investigations conducted 
from 2007 through 2012. For a full list, see WTO, ``United States--
Countervailing Duty Measures on Certain Products from China,'' request 
for consultation by China, WTO WT/DS437/1 (Geneva, Switzerland: May 30, 
2012). https://docs.wto.org/dol2fe/Pages/FE----Search/FE----S----S009-
DP.aspx?language-=-E&CatalogueIdList=116469,-115003,-113669,-100434,-102
077,-38671-&-Current-Catalogue-Id-Index-=-5&FullTextSearch=.
    185. China's claims relate to the imposition or collection of 
duties in connection with investigations or reviews initiated between 
November 20, 2006, and March 13, 2012. For a full list, see WTO, 
``United States--Countervailing and Antidumping Measures on Certain 
Products from China,'' request for consultations by China, WTO WT/
DS449/1 (Geneva, Switzerland: September 20, 2012). https://
docs.wto.org/dol2fe/Pages/FE----Search/FE----S----S009-
Html.aspx-?-Id-=-53282-&-Box-Number-=-3-&-Document-Part-Number-=-1&Langu
age---=---E&Window---=---L--&--PreviewContext---=---DP--&--FullTextSearc
h-=-#KV-_-GENERATED-_-FILE-_-000007.htm.
    186. Shirouzu Norikiko, ``China, Switzerland Sign Free Trade 
Agreement,'' Reuters, June 6, 2013. http:--//--www.reuters.com--/
--article--/--2013/07/06/us-china-trade-id-USBR-E-96503E20130706; 
Xinhua, ``Chinese Premier Holds Talks with Icelandic Counterpart, FTA 
Inked,'' April 15, 2013. http://news.xinhuanet.com/english/china/2013-
04/15/c----132310958.htm.
    187. Economist, ``Warming Up to Iceland,'' April 17, 2013. http://
www.economist-.com/blogs/analects/2013/04/china-and-iceland.
    188. J.D. Wilson, ``Resource Security and FTAs in Asia-Pacific,'' 
Pacific Review 25:4 (Routledge 2012): 439.
    189. Ellen Frost, ``Strategic Implications of TPP [Trans-Pacific 
Partnership]: Answering the Critics,'' Asia Pacific Bulletin 220 
(Washington, DC: July 9, 2013): 1. http://www.eastwestcenter.org/sites/
default/files/private/apb220.pdf.
    190. Sanchita Basu Das, ``RCEP [Regional Comprehensive Economic 
Partnership] and TPP [Trans-Pacific Partnership]: Comparisons and 
Concerns'' (Singapore: Institute of Southeast Asian Studies, January 7, 
2013): 6. http://www.iseas.edu.sg/documents/publication/
ISEAS%20Perspective%202013-_-2.pdf.
    191. Rohit Sinha and Geethanjali Nataraj, ``Regional Comprehensive 
Economic Partnership (RCEP): Issues and Way Forward,'' Diplomat 
(Tokyo), July 30, 2013. http://thediplomat.com/pacific-money/2013/
07/30/regional-comprehensive-economic-partnership-rcep-issues-and-way-
forward/.
    192. Sanchita Basu Das, ``RCEP [Regional Comprehensive Economic 
Partnership] and TPP [Trans-Pacific Partnership]: Comparisons and 
Concerns'' (Singapore: Institute of Southeast Asian Studies, January 7, 
2013): 2. http://www-.iseas.edu.sg/documents/publication/
ISEAS%20Perspective%202013-_-2.pdf.
    193. Ellen Frost, ``Strategic Implications of TPP [Trans-Pacific 
Partnership]: Answering the Critics,'' Asia Pacific Bulletin 220 
(Washington, DC: July 9, 2013).
    194. Guoyou Song and Wen Jin Yuan, ``China's Free Trade Agreement 
Strategies,'' Washington Quarterly 35:4 (Fall 2012): 107-119.
    195. Reuters, ``China wants fewer curbs in free trade zones to lure 
foreign investment,'' August 18, 2013. http://www.reuters.com/article/
2013/08/18/us-china-investment-idUSBRE97H02Z20130818.
    196. Bloomberg, ``China to Ease Foreign Investment Rules for New 
Free Trade Zones,'' August 17, 2013. http://www.bloomberg.com/news/
2013-08-17/china-to-ease-free-trade-zone-laws-to-boost-foreign-
investment.html.
    197. American Chamber of Commerce in China, ``China Business 
Climate Survey Report, 2013.'' http://web.resource.amchamchina.org/
cmsfile/2013/03/29/0640e5a7e-0c8-f86-ff4a380150357bbef.pdf
    198. U.S. Department of State, 2013 Investment Climate Statement-
China (Washington, DC: February 2013). http://www.state.gov/e/eb/rls/
othr/ics/2013/204621.htm.
    199. Reuters, ``China wants fewer curbs in free trade zones to lure 
foreign investment,'' August 18, 2013. http://www.reuters.com/article/
2013/08/18/us-china-investment-idUSBRE97H02Z20130818.
    200. Bloomberg, ``China to Ease Foreign Investment Rules for New 
Free Trade Zones,'' August 17, 2013. http://www.bloomberg.com/news/
2013-08-17/china-to-ease-free-trade-zone-laws-to-boost-foreign-
investment.html.
    201. National Development and Reform Commission, 12th Five Year 
Plan for Foreign Capital Utilization and Overseas Investment (Beijing, 
China: July 17, 2012). http://www.sdpc.gov.cn/gzdt/
W020120724346802518900.pdf.
    202. BBC News, ``China Foreign Investment Growth Hits Two-Year 
High,'' July 17, 2013.
    203. Reuters, ``China wants fewer curbs in free trade zones to lure 
foreign investment,'' August 18, 2013. http://www.reuters.com/article/
2013/08/18/us-china-investment-idUSBRE97H02Z20130818.
    204. Bloomberg, ``China to Ease Foreign Investment Rules for New 
Free Trade Zones,'' August 17, 2013. http://www.bloomberg.com/news/
2013-08-17/china-to-ease-free-trade-zone-laws-to-boost-foreign-
investment.html.
    205. Michael Han and Jenny Connolly, ``China's Anti-monopoly Law 
celebrates fifth anniversary,'' Freshfields Bruckhaus Deringer LLP, 
August 16, 2013.
    206. Michael X. Y. Zhang, ``China Hands Milk Producers the Largest 
Anti-Monopoly Violation Fine,'' Sheppard, Mullin, Richter & Hampton 
LLP, August 21, 2013. http://www.natlawreview.com/article/china-
hands-milk-producers-largest-anti-monopoly-violation-fine
    207. Kazunori Takada, ``China could target oil firms, telecoms, 
banks in price probes: report,'' Reuters, August 15, 2013.
    208. Michael X. Y. Zhang, ``China Hands Milk Producers the Largest 
Anti-Monopoly Violation Fine,'' Sheppard, Mullin, Richter & Hampton 
LLP, August 21, 2013. http://www.natlawreview.com/article/china-
hands-milk-producers-largest-anti-monopoly-violation-fine
    209. Kazunori Takada, ``China could target oil firms, telecoms, 
banks in price probes: report,'' Reuters, August 15, 2013.
    210. Patti Waldmeir, Jamil Anderlini, and Andrew Jack, ``China 
widens probe into drug pricing and corruption,'' Financial Times, 
August 15, 2013.
    211. Grace Ng, ``China flexing its anti-monopoly law muscle: 
Revenge or self-defense?'' MedCity News, July 10, 2013.
    212. CNBC, ``China sought antitrust confessions from foreign 
firms,'' August 21, 2013.
    213. Melissa Lipman, ``FTC [Federal Trade Commission] Commissioner 
Urges China to Play it Straight on Antitrust,'' Law 360, July 31, 2013.
    214. Julia Ya Qin, ``Trade, Investment and Beyond: The Impact of 
WTO Accession on China's Legal System,'' in Donald C. Clarke, ed., 
China's Legal System: New Developments, New Challenges (Cambridge, 
United Kingdom: Cambridge University Press, 2008).
    215. People's Daily, ``China Promotes Antidumping, Antisubsidy 
study,'' December 13, 2001. http://english.peopledaily.com.cn/200112/
12/eng20011212-_-86527.shtml.
    216. Li Jia, ``Come out swinging: Chinese exporters are learning to 
use international trade rules to defend their market power,'' News 
China, February 2013.
    217. China Daily, ``Bolder legal defenses needed for Chinese 
companies going abroad,'' November 21, 2012; Brett Zhu, ``Trade suit 
victory suggests new `Aokang Model' for Chinese Business Abroad,'' Tea 
Leaf Nation, December 16, 2012.
    218. Li Jia, ``Come out swinging: Chinese exporters are learning to 
use international trade rules to defend their market power,'' News 
China, February 2013.
    219. Economist, ``When Partners Attack: China will test the WTO's 
dispute-settlement system,'' February 11, 2010.
    220. Patti Waldmeir and Andrew Jack, ``China Launches Drug Pricing 
Probe,'' Financial Times, July 5, 2013. http://www.ft.com/intl/cms/s/0/
837e3fd6-e47e-11e2-875b-00144feabdc0.html#axzz2g0inOYh7.
    221. South China Morning Post (Hong Kong), ``China Fines Milk 
Powder Makers US$110m for Price-Fixing,'' August 29, 2013. http://
www.scmp.com/business/companies/article/1294898/china-fines-milk-
powder-makers-us110m-price-fixing.
    222. Julien Girault, ``Foreign Firms Scapegoats in China Probes: 
Analysts,'' Agence France-Presse, August 14, 2013. http://
www.foxnews.com/world/2013/08/14/foreign-firms-scapegoats-in-china-
probesanalysts/#ixzz2bwnxLH1p.
                      SECTION 2: TRENDS IN CHINESE

                    INVESTMENT IN THE UNITED STATES

Introduction
    China has amassed the world's largest trove of dollar-
denominated assets. Although the true composition of China's 
foreign exchange reserves, valued at $3.66 trillion, is a state 
secret, outside observers estimate that about 70 percent is in 
dollars.* China's concentration on accumulating dollar-
denominated assets is unusual for another reason: China's 
government has deliberately adopted a conservative investment 
strategy, even accepting low or negative returns on its 
holdings.
---------------------------------------------------------------------------
    * Official U.S. government figures show that China holds $1.28 
trillion in U.S. Treasuries, making China the largest foreign holder of 
U.S. Treasury securities. This figure does not include holdings of U.S. 
agency or corporate debt nor does it reveal China's purchases of U.S. 
Treasury securities on the secondary market or through foreign 
exchanges. U.S. Department of the Treasury, ``Major Foreign Holders of 
Treasury Securities'' (Washington, DC: September 17, 2013). http://
www.treasury.gov/resource-center/data-chart-center/tic/Documents/
mfh.txt.
---------------------------------------------------------------------------
    In recent years, China has become less risk averse and more 
willing to invest directly in U.S. land, factories, and 
businesses. This trend appears to be accelerating. In June 
2013, China announced its largest purchase of a U.S. asset to 
date: a $7.1 billion acquisition of Virginia-based Smithfield 
Foods, Inc. Given China's large holdings of U.S. dollars, China 
has a huge potential for foreign direct investment 
(FDI), particularly if China should substitute or 
abandon portfolio investment for direct investment.
---------------------------------------------------------------------------
     FDI is investment to acquire a ``long-term relationship 
and reflecting a lasting interest and control'' in an enterprise 
operating in an economy other than that of the investor. It is the sum 
of equity capital, reinvestment of earnings, other long-term capital, 
and short-term capital as shown in the balance of payments. There are 
two types of FDI: inward FDI and outward FDI, resulting in a net FDI 
inflow (positive or negative) and stock of FDI, which is the cumulative 
number for a given period. FDI excludes most portfolio investment, 
which is usually investment through the purchase of shares of an 
insufficient number to allow control of the company or its board of 
directors. A foreign direct investor may acquire voting power or 
control of an enterprise through several methods: by incorporating a 
wholly owned subsidiary or company (e.g., a ``greenfield'' investment); 
by acquiring shares in an associated enterprise; through a merger or an 
acquisition of an unrelated enterprise; or by participating in an 
equity joint venture with another investor or enterprise. For more 
information, see UNCTAD [United Nations Conference on Trade and 
Development], World Investment Report 2010: Investing in a Low Carbon 
Economy ``Methodological Note'' (New York and Geneva: United Nations, 
2010); and World Bank, ``Foreign Direct Investment.'' http://
data.worldbank.org/indicator/BX.KLT.DINV.CD.WD.
---------------------------------------------------------------------------
    This section, which draws on the Commission's May 9, 2013, 
public hearing, continues the Commission's assessment of 
Chinese investment in the United States. It examines the 
motives and incentives driving Chinese investment, and the 
sectoral and geographical distribution of Chinese investment in 
the United States. The section also examines the mechanisms to 
screen and monitor such investments for threats to national 
security. Finally, it evaluates the proposals for reforming 
such mechanisms and amending them to include a net economic 
benefit test.

China's National Outward Direct Investment Strategy

    While the Chinese government has been encouraging large 
amounts of inward FDI to foster domestic economic growth for 
decades, policies supporting outward FDI have only recently 
been put in place.\1\ The Chinese government explicitly adopted 
a policy encouraging Chinese companies to invest abroad in its 
10th Five-Year Plan (2001-2005).\2\ The ``go out'' policy 
became one of China's main development strategies and has 
focused largely on Chinese state-owned enterprises (SOEs). 
According to Derek Scissors, then-senior research fellow at The 
Heritage Foundation, state-owned and state-controlled entities 
dominate China's global outward FDI: From 2005 to 2012, SOEs 
accounted for 86 percent of total outward investment, and 
private entities accounted for 14 percent.\3\
    The 12th Five-Year Plan (2011-2016) accelerated China's 
``go out'' strategy by calling for a three-pronged approach. 
First, competitive Chinese manufacturing companies should 
invest overseas in order to establish international sales 
networks and globally recognized brand names. Second, Chinese 
companies should invest in research and development (R&D) 
outside China. Finally, the plan set goals for shifting 
acquisitions from sectors that support resource-intensive and 
polluting manufacturing in favor of services and those sectors 
that promote a cleaner, high-tech economy.\4\
    The ``go out'' policy focused China's outward investment 
goals on sectors in which domestic state-owned or state-
controlled firms were already intended to be dominant by policy 
(the so-called ``strategic and heavyweight industries''), such 
as energy, machinery, construction, and information technology 
(IT).\5\ The 12th Five-Year Plan expanded this list with the 
Strategic Emerging Industries, which the government has 
selected for special promotion and support. The seven Strategic 
Emerging Industries are energy conservation/environmental 
protection, next-generation IT, biotechnology, high-end 
equipment manufacturing, new energy, new materials (raw 
materials), and new energy automobiles. As part of its ``go 
out'' strategy, the Chinese government has developed specific 
investment funds to promote outward investment in natural 
resources and in fields with technological promise.\6\
    According to the 12th Five-Year Plan, the contribution of 
the Strategic Emerging Industries to China's gross domestic 
product (GDP) is to grow from roughly 3 percent in 2010 to 8 
percent by 2015 and 15 percent by 2020. The government promised 
to offer financial support, promote technical innovation and 
education policies, and to create a market environment to 
facilitate the development of the Strategic Emerging 
Industries.* With this change, China's outward FDI has expanded 
from securing natural resources to include helping Chinese 
companies ``upgrade their technology, pursue higher levels of 
the value chain previously conceded to foreign firms, and 
augment managerial skills and staffing to remain globally 
competitive.'' \7\
---------------------------------------------------------------------------
    * For background on the 12th Five-Year Plan generally, and the 
``Strategic and Emerging Industries'' specifically, see U.S.-China 
Economic and Security Review Commission, 2011 Annual Report to Congress 
(Washington, DC: U.S. Government Printing Office, 2011), chapter 1, 
section 4. http://www.uscc.gov/content/2011-annual-report-congress.
---------------------------------------------------------------------------
    Another important goal of Chinese outward FDI is creation 
and promotion of globally competitive brands. With some notable 
exceptions (such as technology firm Lenovo, telecommunications 
giant Huawei Technology Co. Ltd., and Haier Group, a home 
appliance and consumer electronics manufacturer), Chinese 
companies have stumbled in efforts to build home-grown brands 
that have global recognition. The alternative strategy for many 
Chinese companies looking to create global reputations has come 
to mean buying strong brands abroad that already have marketing 
power rather than attempting to build Chinese brands and 
businesses.\8\ The aim is to create multinational companies 
through acquisition, particularly in the areas that are 
critical to China's economic development goals.\9\ Finally, 
investment can be a crucial tool of soft power and may be used 
by the Chinese government to link financial incentives 
to meeting political goals or simply to burnish China's image ab
road.
    The Chinese government wields many tools to encourage and 
guide investment to favored companies or industries. Overseas 
investments by Chinese firms require permission from the 
government, because the country controls capital movements 
across its borders, and such clearances are easier to receive 
if the investment is in the area favored by the Chinese 
government, such as food, technology, and natural 
resources.\10\ Favored industries also enjoy preferential 
access to financing and other benefits, making them more likely 
to have incentives and opportunities to go abroad. These more 
indirect policies are highly effective. For example, many 
Chinese investments in the United States reflect the Strategic 
Emerging Industries mentioned in the latest Five-Year Plan. In 
addition, evidence is growing that the Chinese government is 
using or sanctioning use of cyber espionage against private 
enterprises to give companies in favored industries a 
competitive edge. (For more on China's use of cyberespionage in 
general, and industrial espionage in particular, see chap. 2, 
sec. 2, of this Report.)

Patterns of Chinese Investment in the United States

    In contrast to China's large holdings of portfolio 
investment, China is still a relative newcomer when it comes to 
FDI. According to official statistics from the U.S. Bureau of 
Economic Analysis (BEA), in 2012, the United States attracted 
$174.7 billion of global FDI, of which $219 million came from 
China. For 2011, BEA estimates that flows of Chinese FDI were 
valued at $576 million (with FDI stock * of $3.8 billion). A 
better estimate--by country of ultimate beneficiary owner--put 
stock of Chinese FDI in the United States at $9.5 billion at 
the end of 2011. For the same year, China's Ministry of 
Commerce (MOFCOM) estimates the flows of Chinese FDI to the 
United States at $1.8 billion, with stock of FDI estimated at 
around $9 billion. Despite a sustained upward trend (see figure 
1), Chinese FDI accounts for less than 2 percent of total FDI 
in the United States.
---------------------------------------------------------------------------
    * FDI stock is the cumulative value of the capital and reserves 
attributable to the parent enterprise (the investor). FDI flows 
comprise capital provided by a foreign direct investor to an FDI 
enterprise, or capital received from an FDI enterprise by a foreign 
direct investor (these data are commonly compiled for a given period, 
usually per annum). For details, see UNCTAD, World Investment Report 
2010: Investing in a Low Carbon Economy ``Methodological Note'' (New 
York and Geneva: United Nations, 2010). http://www.unctad.org/en/docs/
wir2010meth--en.pdf.
     Unlike the standard reporting method, which attributes 
each investment to the direct purchaser of record, the method known as 
``country of ultimate beneficiary owner'' tracks the investment to the 
actual owner.
---------------------------------------------------------------------------
    Whether one uses the U.S. or Chinese figures, the official 
estimates are too low (for example, just adding together the 
value of the deals publicly announced in 2012, exceeds the U.S. 
government's estimates for cumulative Chinese investment). One 
key reason is that the estimates do not account for flows of 
FDI through Hong Kong and other offshore financial centers, 
such as the Cayman Islands, which are likely transit points for 
Chinese money on the way to the real investment destination. 
Private estimates of Chinese FDI in the United States provide 
more up-to-date information but also vary depending on the 
methodology used.* Dr. Scissors estimates that in 2012, China 
invested over $14 billion in the United States, with cumulative 
FDI between 2005 and 2012 reaching $54.2 billion. According to 
estimates by the Rhodium Group, in 2012 Chinese firms invested 
$6.7 billion, for a total of $23.1 billion between 2000 and 
2012.
---------------------------------------------------------------------------
    * The International Trade Administration (ITA), a bureau within the 
U.S. Department of Commerce, stated in a 2013 report on Chinese FDI in 
the United States that it is ``important to be aware of different 
estimates'' of Chinese investment. ITA noted that private sector 
valuations employ different definitions of FDI, data gathering 
mechanisms, and accounting methods that lead to differences in reported 
value of investments. See International Trade Administration, Report: 
Foreign Direct Investment (FDI) in the United States from China and 
Hong Kong SAR (Washington, DC: July 17, 2013). Private sector estimates 
help bridge a gap that currently exists in classifying FDI by ownership 
(for example, private vs. state-owned investor), as the U.S. Department 
of Commerce is unable to report on company-level data for FDI in the 
United States. BEA, which prepares the U.S. international transactions 
accounts, is required by law to keep such company-level data 
confidential.

      Figure 1:  Chinese FDI Stock in the United States, 2002-2011



    Source: U.S. Bureau of Economic Analysis; China MOFCOM, various 
years.

    At the Commission's May 9, 2013, hearing, witnesses 
suggested a variety of reasons for Chinese FDI into the United 
States. According to Thilo Hanemann, research director of the 
Rhodium Group, the recent increase in Chinese FDI in the United 
States is driven by changing policies and commercial 
considerations. On the policy side, Beijing has become 
increasingly aware of the ``strategic vulnerability'' of having 
most of its foreign exchange reserves invested in low-interest-
bearing U.S. Treasury securities and is looking to diversify 
its investments. On the economic side, U.S. leadership in 
technology and services has made the United States an 
attractive prospect for Chinese investors seeking to ``increase 
their competiveness at home and preserve access to U.S. 
customers abroad.'' \11\ Mr. Hanemann noted that a related 
trend is growing investment in R&D and modern service 
operations such as customer service and retail: ``Those 
investments complement the acquisition of advanced 
manufacturing assets and allow Chinese firms to tap 
into the U.S. talent base and move closer to their U.S. customer
s.'' \12\
    Dr. Scissors concurred that the United States is an 
attractive destination for any investment, including Chinese 
investment, by virtue of its abundant land and energy assets, 
technology, and skilled labor. But Dr. Scissors has identified 
a more strategic dimension behind the interest of the Chinese 
government in foreign investment:

        There is almost surely a plan behind Chinese 
        investment, both globally and in the U.S. state-owned 
        enterprises dominate outward investment volume, making 
        it feasible to have a coordinated strategy beyond 
        simply seeking demand or higher financial return. More 
        specifically, Beijing has repeatedly indicated that 
        ownership of overseas commodities is a valuable means 
        of ensuring the continuous imports the [Chinese] 
        economy so badly needs.\13\

    Andrew Szamosszegi of Capital Trade Inc. concluded in his 
testimony that Chinese investment in the United States was 
motivated both by market forces and by government policies and 
guidance, focusing, in particular, on the Chinese government's 
role as a ``gatekeeper'' in the investment approval 
process.\14\ Mr. Szamosszegi also pointed out that a minor 
motivating factor may be the desire by private Chinese firms 
that have difficulty raising capital in China (because state-
owned banks tend to favor SOEs) to come to the United States to 
take advantage of the U.S. stock exchanges. From 2007 to 2011, 
more Chinese firms entered U.S. capital markets through the 
purchase of listed U.S. shell companies, a technique known as a 
``reverse merger,'' than through initial public offerings 
(IPOs) by a ratio of three to one.\15\ (See chap. 1, sec. 3, of 
this Report for fuller treatment of the reverse merger issue.)

Distribution of Investment by Sector and Ownership

    In the United States, Chinese investments have emphasized 
services, energy, and technology and are also notable for their 
focus on brand acquisition. Examples include Lenovo's purchase 
of IBM's personal computer division, and a purchase by a unit 
of China Aviation Industry Corp., a state-run company, of 
Cirrus Industries, a Minnesota-based company famous for its 
very light jet aircraft.
    Though Chinese FDI in the United States comes in a variety 
of shapes and sizes, by value, it is dominated by SOEs that 
closely follow the industrial policies of the Chinese 
government and that tend to make far larger investments. 
Private investors, which Rhodium defines as having 20 percent 
or less government ownership, are more likely to be involved in 
smaller deals. According to Rhodium estimates, in the years 
between 2000 and 2012, state-owned companies concluded 149 
deals valued at over $12.6 billion, while private companies 
made 444 deals, valued at $10 billion.
    Energy and services have been primary targets for Chinese 
investors. Chinese FDI in the energy sector is dominated by a 
few major deals by state-owned energy giants, as they pursue 
know-how and technology such as fracking, which China lacks 
(see figure 2). Chinese energy majors have been particularly 
active in the last five years. In January 2012, Sinopec paid 
$2.5 billion to Devon Energy (of Oklahoma City) for a stake in 
about 1.3 million acres of drilling property in Michigan, Ohio, 
and elsewhere. In February 2013, Chesapeake Energy Corp. sold a 
stake to Sinopec for $1 billion in an oil and natural-gas field 
straddling the Oklahoma and Kansas border. In 2010 and 2011, 
China National Offshore Oil Corporation (CNOOC) bought stakes 
in Chesapeake's oil and gas shale assets in south Texas for 
$1.08 billion and in Colorado and Wyoming for $570 million, 
respectively.

  Figure 2:  Cumulative Chinese FDI in the United States, by Sector, 
                              2000-2013Q2

                    (total deal value $27.9 billion)



    Source: Rhodium Group, China Investment Monitor (New York, NY: 
2013).

    Services are also playing a major role, accounting for over 
a quarter of China's outward FDI value in the United States. In 
this segment, a burgeoning industry is real estate, which is 
favored by many Chinese investors as a more secure investment 
than Chinese equities. Last year's purchases included major 
investments in U.S. cities, especially San Francisco, where 
China's largest developer, China Vanke Co., partnered with 
Tishman Speyer Properties, a U.S. real estate business, to 
build a $620 million apartment complex downtown. (Under the 
deal, Vanke provides 70 percent equity, and Tishman is 
responsible for the construction.)
    High-tech manufacturing is another important component of 
China's investments, particularly when measured in terms of the 
number rather than the value of deals. Industries such as IT 
and industrial equipment take top positions, reflecting Chinese 
interest in U.S. technology (see figure 3).

  Figure 3:  Cumulative Chinese FDI in the United States, by Sector, 
                              2000-2013Q2

                           (670 deals total)



    Source: Rhodium Group, China Investment Monitor (New York, NY: 
2013).

    To date, the largest Chinese acquisition in the United 
States has been the 2013 Shuanghui International Holding Ltd.'s 
$7.1 billion bid (including debt assumption) for Virginia-based 
Smithfield Foods Inc., the biggest U.S. pork producer. 
Smithfield and Shuanghui submitted the deal voluntarily for 
review by the Committee on Foreign Investment in the United 
States (CFIUS), and it was cleared in early September 2013, 
according to the companies (Smithfield shareholders approved 
the deal on September 24, 2013).\16\ The agricultural sector 
has not been an important target for Chinese FDI in the United 
States so far, but it is a part of a broader trend of Chinese 
global investment in farm assets or food technologies.\17\ 
China's acquisitions in agriculture and other sectors are being 
driven by the desire to secure higher volumes of safe products 
and, in the long term, access to advanced production and 
processing technologies. (For a discussion of China's food 
security concerns and agricultural policy, see chap. 1, sec. 4, 
of this Report.)
    Chinese FDI is present in most U.S. states, but states with 
certain industry clusters, such as oil, gas, and automotive, 
stand out among Chinese investors. According to Mr. Hanemann, 
California is by far the number one destination for Chinese 
investment by the number of deals, with over 170 transactions 
between 2000 and 2012, or roughly one-quarter of all Chinese 
FDI in the United States. Other top recipients by the number of 
deals are New York, Texas, Illinois, and Michigan. These five 
states account for 352 deals out of 620 concluded between 2000 
and 2012. By value of deals, New York, Texas, and Virginia 
lead, followed by California.\18\
    China's attempts to diversify its investment away from U.S. 
Treasury bonds are also evident in its investments in U.S. 
private equity. For example, the State Administration of 
Foreign Exchange (SAFE), which manages China's foreign exchange 
holdings, has set up a New York operation to invest in private 
equity, real estate, and other assets.* Unlike China Investment 
Corporation (CIC), China's less publicity-shy sovereign wealth 
fund, SAFE has been very secretive, so little is known about 
the nature and magnitude of SAFE's deals.\19\ SAFE has been 
active in buying United Kingdom (UK) property and 
infrastructure and Japanese equities, according to some 
analysts. Dr. Scissors estimates that SAFE's nonbond 
investments in the United States total $4.5 billion, mostly in 
private equity funds and similar investments. For example, in 
2011, SAFE invested $500 million in a real estate private 
equity fund managed by the Blackstone Group.\20\
---------------------------------------------------------------------------
    * In addition to SAFE, another Chinese investment entity, China 
Investment Federation, established an office in the Trump Building in 
Manhattan. The group was started in the summer of 2012 with the aim of 
helping Chinese investors overcome cultural, political, and logistical 
hurdles to doing business in the United States. It is sponsored by DKI 
Capital, a Beijing-based investment firm. Lingling Wei and Carolyn Cui, 
``China is Seeking U.S. Assets,'' Wall Street Journal, May 20, 2013; 
Bloomberg, ``China Said to Study U.S. Property Investments with 
Reserves,'' May 27, 2013. http://www.bloomberg.com/news/2013-05-27/
china-said-to-study-investing-reserves-in-u-s-property-market.html; and 
William Alden, ``A Toehold for China on Wall Street,'' New York Times, 
May 17, 2013. http://dealbook.nytimes.com/2013/05/17/a-toehold-for-
china-on-wall-street/?partner=bloomberg.

Economic Security Issues Related to Chinese Investment in the United 
---------------------------------------------------------------------------
        States

    The potential economic benefits of investment are well 
known: job creation, expansion of the tax base, and improvement 
in productivity and overall competitiveness. This is especially 
the case for ``greenfield'' investments (i.e. investments in 
which entirely new factories or businesses are created). 
Mergers and acquisitions also can generate or save jobs if the 
new investors revitalize ailing firms or expand local 
capacities. An investment in the United States made by a 
Chinese company on market-based terms free from strategic 
considerations or political interference has the potential for 
providing the same benefits made by any other purely economic 
investor.
    But as is evident from the figures, Chinese investment in 
the United States is more often than not undertaken with a nod 
to Chinese industrial policy goals, such as the acquisition of 
valuable technology to enhance China's carefully chosen 
Strategic Emerging Industries (for example, Chinese investments 
in U.S. battery and solar technology). When such investments 
are made by Chinese companies owned or controlled by the 
government, they attract extra scrutiny for their apparent 
policy goals.
    Experts testifying at the Commission's May 9 hearing agreed 
that the issue of the Chinese government's role in promoting 
foreign investment was further complicated by the difficulty in 
separating truly private Chinese companies from those under 
government influence or control. For example, if a private 
company in China sees that the government favors investment in 
a certain industry, it will try to invest in that industry to 
curry favor and take advantage of subsidies provided by the 
government. Mr. Szamosszegi said that ``it would be the same as 
if the government had said . . . `we want you to invest a lot 
and we want you to invest in the U.S. industry.' '' \21\ Dr. 
Scissors pointed out that for private firms in China ``there is 
no rule of law; there is no right of refusal for private 
firms'' to reject government pressure to make an 
investment.\22\
    Furthermore, even genuinely private companies benefit from 
a slew of local and provincial government subsidies, creating 
an uneven playing field for their foreign competitors. A recent 
study by Usha and George Haley, U.S. researchers on China's 
economy, found that Chinese steel, glass, paper, and auto parts 
producers turned into global players with the benefit of local 
subsidies.\23\ Another study, by Matthew Forney and Laila 
Khawaja from Fathom China, a research consultancy, found that 
most non-state-owned Chinese companies received some form of 
direct subsidy.\24\
    Witnesses at the Commission's hearing pointed out that U.S. 
trade laws may not be sufficient to address negative aspects of 
state-driven Chinese investment. For example, when a U.S. firm 
has to obtain credit at market rates to finance its activities, 
but a Chinese firm can obtain financing at minimal or even zero 
interest from Chinese state-owned banks, it distorts 
competition in the U.S. market. According to Elizabeth J. 
Drake, partner at Stewart and Stewart, current U.S. law does 
not adequately protect U.S. workers and firms from this type of 
unfair competition. She noted:

        Existing antitrust rules, for example, are based on 
        assumptions about the profit-maximizing behavior of 
        market actors that simply may not apply to certain 
        Chinese firms. In the area of predatory pricing, the 
        U.S. applies a recoupment test, under which pricing is 
        only deemed anticompetitive if the predator is likely 
        to eventually collect enough profits to make up for the 
        losses caused by the predatory behavior. . . . A 
        Chinese SOE, by contrast, may be able to rely on state 
        support to maintain losses that may never be recouped, 
        and engage in predatory pricing in order to gain U.S. 
        market share in the furtherance of political or 
        industrial policy goals. Such a firm could engage in 
        predatory pricing behavior that causes severe damage to 
        its U.S. competitors, but, under current law, such 
        behavior would not be considered anticompetitive as 
        long as the Chinese firm was not expected to recoup its 
        losses.\25\

    Mr. Szamosszegi and Ms. Drake noted that one motivation for 
Chinese investment may be to access markets that are otherwise 
restricted by trade barriers such as tariffs or duties imposed 
to counteract unfair trade practices, such as antidumping and 
countervailing duties.\26\ Chinese producers are currently 
subject to 121 antidumping and countervailing duty orders. 
According to Mr. Szamosszegi, some Chinese firms have sought to 
avoid the duty orders by shipping to the United States 
illegally through third markets, while other Chinese firms from 
the steel, aluminum, and solar panel industries have attempted 
to invest in the United States to avoid existing trade remedy 
orders or to preempt an investigation.

National Security Issues Related to Chinese Investment in the United 
        States

    Trade-related aspects of foreign investments may intersect 
with national security concerns. For example, foreign 
intelligence collection efforts and espionage that target U.S. 
technology, intellectual property, trade secrets, and other 
proprietary information can be concealed under the seemingly 
benign pretext of foreign investment in cleared government 
contractors. In order to protect classified national security 
information, the federal government created the National 
Industrial Security Program (NISP), a program administered by 
the U.S. Defense Security Service on behalf of the U.S. 
Department of Defense and 25 other government agencies. This 
program seeks to prevent unauthorized disclosure of classified 
information, and to mitigate the threat posed by companies 
determined to be under foreign ownership, control, or influence 
(FOCI).* The Defense Security Service can mitigate some dangers 
of such foreign investment using a specialized set of methods, 
which vary from case to case (for example, altering the terms 
of the deal or board membership).\27\
---------------------------------------------------------------------------
    * A company is considered to be operating under FOCI whenever a 
foreign interest has the power, direct or indirect, whether or not 
exercised, and whether or not exercisable, to direct or decide matters 
affecting the management or operations of that company in a manner that 
may result in unauthorized access to classified information or may 
adversely affect the performance of classified contracts. Defense 
Security Service, ``Foreign Ownership, Control or Influence (FOCI)'' 
(Quantico, VA). http://www.dss.mil/isp/foci/foci--info.html.
---------------------------------------------------------------------------
    There may be gaps, however, in the ability of the Defense 
Security Service to identify and mitigate FOCI. Approximately 
75 percent of NISP companies are privately held and are not 
required to disclose their ownership or investor information to 
an independent regulatory agency such as the Securities and 
Exchange Commission. When a company enters the NISP, it must 
fill out a special form,\28\ and the Defense Security Service 
then attempts to verify this self-reported information. Such 
verification efforts are often hampered by limited resources 
and the lack of disclosure requirements to an independent 
regulatory agency. Furthermore, a foreign entity could be the 
primary investor in a U.S. private equity fund with ownership 
in a company in the NISP without this potential influence ever 
being disclosed. Such indirect ownership further complicates 
analysis of possible foreign influence.

The Committee on Foreign Investment in the United States

    The United States has a limited FDI screening process. 
CFIUS is an interagency committee that reviews certain mergers, 
acquisitions, and takeovers of U.S. businesses by foreign 
persons, corporations, or governments for national security 
risks. Submitting the details of an acquisition for national 
security review is voluntary, but CFIUS can also initiate an 
investigation on its own after a merger or acquisition of a 
U.S. company by a foreigner. CFIUS can demand that the deal be 
unwound or restructured on national security grounds if a deal 
is considered a security risk, even after the deal has been 
completed.
    There is no definition of national security in the CFIUS 
legislation, which allows some discretion in initiating a 
review process. Screening only applies to potential mergers and 
acquisitions and does not extend to greenfield investments 
(i.e. a foreign entity is establishing a company or affiliate 
where none exists). CFIUS also does not assess economic costs 
or benefits to the United States of any given acquisition. 
Several other countries, including Canada, Australia, France, 
and China have screening programs similar to CFIUS that also 
apply a net economic benefit test.
    Among other things, CFIUS considers two elements when 
evaluating whether an investment by a foreign entity warrants 
an investigation: the degree of foreign state control, and 
whether the transaction could affect U.S. national 
security.\29\ For China, the question of state control can be 
particularly complicated, because the government's role is not 
always straightforward or even disclosed. Despite economic 
reforms and moves toward privatization, large swathes of the 
Chinese economy remain under control by various parts of the 
Chinese government.\30\
    In addition to outright ownership or control, the Chinese 
government or the Chinese Communist Party (CCP) can also 
control a publicly traded corporation by influencing the 
composition of corporate boards and the corporation's 
management team.\31\ Finally, it remains debatable whether 
privately held Chinese corporations, especially in industries 
the government deems critical, such as the Strategic Emerging 
Industries, are free of state control or influence. For 
example, a report by the House Intelligence Committee flagged 
Chinese telecommunications-equipment makers Huawei and ZTE for 
potentially providing opportunities for Chinese intelligence 
services to tamper with U.S. telecommunications networks.\32\
    Chinese managers often complain that their firms face 
discrimination from regulators in the West. For example, Gao 
Xiqing, vice chairman of CIC, complained during a visit to 
Washington in April 2013 that his fund was being ``singled out 
as a different investor'' by the U.S. authorities, going as far 
as to say that certain people were ``slapping [us] in the face 
and telling [us], OK, we don't like you.'' \33\
    The perceived bias against Chinese investment has been 
caused by a few failed deals and largely precipitated by 
Chinese investors' confusion over U.S. regulatory structures. 
In China, deals are approved in a centralized, top-down 
process, but in the United States, the control and regulation 
of foreign investment are decentralized. Federal regulations 
are largely responsible for vetting deals on national security 
grounds, with local governments, private individuals, labor 
unions, nongovernmental organizations, and Congressional 
leaders weighing in on various aspects of the deal. Chinese 
investors often attribute the derailment of a deal due to 
political or activist opposition to purposeful discrimination 
by the U.S. government against Chinese investors, but in 
reality it is a natural consequence of a robust democratic 
process. In contrast, China has several major industries, 
including finance, agriculture and telecommunications services, 
walled off from foreign investors, often as part of a policy to 
promote domestic companies.
    U.S. regulators have blocked at least six major 
acquisitions from China since 2005; however, there were 
hundreds of projects (including deals done by CNOOC, known 
previously for a failed 2005 bid for Unocal) that were not 
rejected. Overall, despite perceptions in China, to date, the 
number of Chinese deals reviewed by CFIUS has been very small 
and those rejected even smaller (see figure 4).

      Figure 4:  Chinese Transactions Covered by CFIUS, 2006-2011



    Source: Committee on Foreign Investment in the United States, 
Annual Report to Congress (Washington, DC: various years).

    According to the 2012 CFIUS report to Congress, in 2011, 
out of 111 covered transactions, 10 were from China. Out of 114 
planned and completed critical technology transactions in 2011, 
China was linked to four.\34\ (For a list of select 
controversial Chinese investments, see Addendum I.)

Proposals for Amending the CFIUS Mandate
    At the Commission's May 9, 2013, hearing, witnesses debated 
whether CFIUS should be amended to address some of the 
perceived gaps in the current mandate (for example, CFIUS 
cannot investigate and block greenfield investments, even those 
that might pose national security threats).* Investors and 
analysts frequently criticize CFIUS for the secrecy of its 
reviews, the opacity of its national security criteria and 
decision-making process, and its limited scope.
---------------------------------------------------------------------------
    * There appear to be no federal laws or screening mechanisms that 
empower the federal authorities to evaluate whether a greenfield 
investment may pose a national security threat.
---------------------------------------------------------------------------
    To address some of these concerns, Dr. Scissors proposed 
that CFIUS develop a very narrow definition of national 
security, which would make the reviews more predictable and 
make it easier to understand CFIUS's actions.\35\ Dr. Scissors 
advocated expanding the CFIUS mandate to include any domestic 
transaction, including greenfield investments, involving a 
foreign entity. Under the expanded mandate proposed by Dr. 
Scissors, for example, CFIUS should be able to investigate 
equipment contracts, with a particular focus on telecom 
equipment in light of cybersecurity worries.\36\ Dr. Scissors 
also criticized CFIUS for its extreme secrecy, arguing that a 
more transparent review, with both Congress and foreign 
investors receiving more information about transactions, would 
enhance the credibility and accountability of the CFIUS 
process.\37\
    Mark Plotkin, partner, Covington & Burling, agreed that the 
CFIUS review process could be made more transparent:

        CFIUS today will not even acknowledge that it is 
        reviewing a ticket or transaction if asked. I do think 
        it is important for the public to know that CFIUS is 
        reviewing transactions. . . . The regulation of CFIUS 
        could be enhanced to provide more information to 
        foreign investors as to what kind of issues CFIUS takes 
        into account when CFIUS is reviewing a transaction.\38\

    Ms. Drake proposed that the CFIUS review process be 
expanded to include a ``net benefit test'' to review ``all 
investments that are subsidized by or owned or controlled by 
foreign governments. Such investment should be reviewed from 
the standpoint of competitive neutrality and be reviewed for 
their economic as well as national security implications.'' 
\39\ In other words, under her proposed revision, CFIUS would 
not just screen foreign investment for national security 
concerns but also for any potential economic benefit or risk to 
the United States.
    Mr. Plotkin, on the other hand, argued against an 
introduction of a clear definition of national security under 
CFIUS because it would impede CFIUS's ability to address new or 
emerging problems:

        That flexibility [of the definition of national 
        security] allows the CFIUS agencies the ability to 
        weigh and address their individual equities and 
        mandates during the course of a CFIUS review, and it 
        also allows CFIUS to adapt to an ever-changing threat 
        environment. I'd like to offer two examples of that 
        adaptability: cyber security and state-owned 
        enterprises.\40\

    Similarly, Mr. Plotkin said it would be a mistake to expand 
the CFIUS mandate to include a net benefit, or economic, test, 
because the ``principles underlying an economic test are beyond 
the core competency of CFIUS. . . . Moreover, CFIUS operates in 
strict secrecy. Secrecy in the conduct of an economic benefit 
test risks being perceived as protectionist.'' \41\

Implications for the United States
    The federal government is responsible for national security 
and has put in place a system to review transactions with 
potential security implications. China presents new challenges, 
because investment by SOEs can blur the line between national 
security and economic security. The possibility of government 
intent or coordinated strategy behind Chinese investments 
raises national security worries. Recent investments by Chinese 
companies in global shale oil and gas projects match Chinese 
government interests in acquiring relevant technologies and 
diversifying its energy mix. More broadly, Chinese companies' 
attempts to acquire technology track closely the government's 
plan to move up the value-added chain. There is also an 
inherent tension among the different levels of government in 
the United States regarding FDI from China. The federal 
government tends to be concerned with maintaining national 
security and protecting a rules-based, nondiscriminatory 
investment regime. The state governments are more concerned 
with local economic benefits, such as an expanded tax base and 
increased local employment, rather than national strategic 
issues, especially as job growth has stagnated.
    While Chinese FDI in the United States has been quite low 
so far, it has substantial room to grow. The United States 
needs to be prepared to harness the benefits and address the 
problems posed by Chinese funds flowing into our economy. 
Though estimates vary, even the most generous assessment shows 
that Chinese FDI constitutes less than 2 percent of total 
inward direct investment coming to the United States. Chinese 
companies are most interested in the U.S. energy, real estate, 
and service sectors, particularly financial services. In 
energy, as in other sectors, they are pursuing technology and 
expertise they do not yet have.
    If current trends continue, much of China's outward FDI, at 
least in value terms, will be made by Chinese SOEs. Chinese 
SOEs receive substantial benefits from the central and 
provincial governments, which are not available to their 
foreign competitors, including preferential policies and low 
cost of capital. These SOEs are increasingly active globally, 
seeking to expand China's economic reach and power around the 
globe. They are involved in aerospace, autos, oil, steel, 
telecommunications, and other industries that the Chinese 
government has designated as strategic. U.S. companies face an 
uneven playing field when competing against Chinese SOEs in the 
United States and in the global market while enjoying none of 
the benefits afforded to SOEs by the Chinese government.
    Chinese investments in the United States are subject to the 
same set of rules and regulations as investment from other 
foreign countries in the areas of foreign corrupt practices, 
export administration, sanctions, and antitrust. If Chinese 
firms run afoul of these rules, they will be subject to legal 
sanction. But gaps exist in the U.S. government's ability to 
address the competitive challenges posed by SOEs.
    Chinese SOEs commonly receive subsidies from central or 
local governments, such as low-cost loans, loan forgiveness, 
favorable regulatory and tax treatment, discounted land 
purchases, free infrastructure improvements, and such inputs as 
electricity or fuel at below-market rates--benefits that are 
not available to U.S. competitors. By contrast, U.S. affiliates 
in China operate at a distinct disadvantage in sectors where 
favored Chinese SOEs enjoy extensive government support.
    When companies favored by the Chinese government invest 
overseas, the situation becomes more problematic. Often, 
Chinese SOEs do not have to worry about making a profit, 
because they can rely on government support. They need not 
worry about their fiduciary obligations to their shareholders. 
Instead, they are often encouraged by the government to pursue 
other goals. These include resource acquisition, technology 
transfer, and capturing market share, regardless of cost.\42\
    Furthermore, SOEs investing in the United States may engage 
in particular predatory or anticompetitive behavior that U.S. 
trade remedies cannot address. For example, an SOE exporting 
goods below cost to the United States can be penalized through 
antidumping and countervailing duty laws. Such laws, however, 
do not apply to goods made in the United States by a competitor 
subsidized by the government, a practice that could leave U.S. 
companies at a disadvantage at home and in third-country 
markets.

Conclusions

 LChinese foreign direct investment (FDI) in the United 
States continues to grow, though from a very low base. 
According to official U.S. statistics, in 2012 the United 
States attracted $174.7 billion of global FDI, of which $219 
million came from China. An estimate by country of ultimate 
beneficiary owner, which better tracks actual investors, put 
stock of Chinese FDI in the United States at $9.5 billion at 
the end of 2011. For the same year, China's Ministry of 
Commerce put the flows of Chinese FDI to the United States at 
$1.8 billion, with stock of FDI estimated at around $9 billion.

 LOfficial statistics underestimate the true volume of 
Chinese investment, because they do not account for flows of 
FDI through Hong Kong and other offshore financial centers, 
which are likely transit points for Chinese money on the way to 
the real investment destination. Official data are also 
provided after a significant delay, which hinders analysis.

 LTo date, state-owned enterprises (SOEs) have 
dominated Chinese FDI in the United States measured by the 
value of deals, though private companies lead by the number of 
deals. One reason is that the biggest investments so far have 
been made in the oil and energy fields, which are dominated by 
Chinese state-owned giants.

 LChinese investors have primarily targeted those 
sectors where China lacks know-how and technology, particularly 
in the Strategic and Emerging Industries identified in the 12th 
Five-Year Plan. Energy and services (in particular real estate 
and financial services) have received the most investment. 
High-end manufacturing is another important destination for 
China's investments, particularly when measured in terms of the 
number rather than the value of deals.

 LDue to the considerable government ownership of the 
Chinese economy, provision by Chinese companies of critical 
infrastructure to U.S. government or acquisition by Chinese 
companies of U.S. firms with sensitive technology or 
intellectual property could be harmful to U.S. national 
interests. The Committee on Foreign Investment in the United 
States (CFIUS) investigates the national security implications 
of mergers and acquisitions by foreign investors of U.S. 
assets.

 LInvestigations by CFIUS and other national security 
review and mitigation mechanisms may be hampered by limited 
resources or limited statutory authority.

 LInvestments made by Chinese state-owned or -
controlled companies can also pose economic security threats. 
The Chinese government provides significant financial and 
logistical support. This puts U.S. firms, which receive no such 
support, at a competitive disadvantage. When Chinese SOEs 
invest abroad, they do not necessarily seek profit and may 
instead pursue government goals such as resource acquisition or 
technology transfer.

 LChinese investments in the United States are subject 
to the same set of rules and regulations as investment from 
other foreign countries in the areas of foreign corrupt 
practices, export administration, sanctions, and antitrust. If 
Chinese firms run afoul of these rules, they will be subject to 
legal sanction. But gaps exist in the U.S. government's ability 
to address the competitive challenges posed by SOEs.

 LIn areas where there are no national security 
considerations, and when the investment is driven by economic 
rather than strategic rationale, Chinese FDI can benefit the 
U.S. economy through creation of jobs and other positive 
spillovers.

             Addendum I:  Select Controversial Chinese Investments in the  United States, 1990-2013
----------------------------------------------------------------------------------------------------------------
               Year                      Investor               Target                      Summary
----------------------------------------------------------------------------------------------------------------
1990                               China National Aero   Mamco Manufacturing   CFIUS found that the acquisition
                                    Tech (CATIC)          Co.                   of Mamco, which manufactured
                                                                                machines and fabricated metal
                                                                                parts for aircraft, would pose
                                                                                national security risks.
                                                                                Formally blocked by presidential
                                                                                order.
----------------------------------------------------------------------------------------------------------------
1995                               China National Non-   Magnequench Inc.      The initial takeover of
                                    Ferrous Metals                              Magnequench, producer of high-
                                    Import & Export                             tech magnets from rare-earth
                                    Corp, San Huan,                             minerals, by a Chinese-led
                                    Sextant                                     consortium and the following
                                                                                acquisition of Ugimag Inc. in
                                                                                2000, received regulatory
                                                                                approval from the Clinton
                                                                                Administration. However, the
                                                                                deal drew widespread criticism
                                                                                in the U.S public for the
                                                                                transfer of technology and jobs
                                                                                to China when the firm's
                                                                                facilities in the United States
                                                                                were shut down in 2002 and 2006,
                                                                                respectively.
----------------------------------------------------------------------------------------------------------------
1999                               China Ocean Shipping  Long-term lease of    Congress banned COSCO from
                                    (Group) Company       former Naval Base,    leasing a formal naval base in
                                    (COSCO)               Long Beach, CA *      Long Beach through a provision
                                                                                in the 1998-1999 defense
                                                                                authorization bill. Legislators
                                                                                cited national security concerns
                                                                                as a reason for blocking the
                                                                                deal through ad hoc legislative
                                                                                action.
----------------------------------------------------------------------------------------------------------------
2005                               China National        Unocal Corp.          The deal was rejected by
                                    Offshore Oil                                shareholders before a CFIUS
                                    Corporation (CNOOC)                         determination was made. The 2005
                                                                                bid attracted significant
                                                                                opposition from domestic
                                                                                interest groups and Members of
                                                                                Congress. After Congress
                                                                                threatened to enact an amendment
                                                                                that would have imposed
                                                                                significant additional costs and
                                                                                risks for the buyer (the Pombo
                                                                                Amendment: CFIUS would be
                                                                                prohibited from concluding its
                                                                                national security review of an
                                                                                ``investment in energy assets of
                                                                                a United States domestic
                                                                                corporation by an entity owned
                                                                                or controlled by the government
                                                                                of the PRC'' until after a
                                                                                period of 141 days--or 51 days
                                                                                longer than the maximum of 90
                                                                                days established under the Exon-
                                                                                Florio Amendment), CNOOC
                                                                                abandoned the bid. The U.S.
                                                                                competitor Chevron ultimately
                                                                                acquired Unocal.
----------------------------------------------------------------------------------------------------------------
2005                               Lenovo                IBM's personal        Domestic interest groups, the
                                                          computer division     security community, and Members
                                                                                of Congress voiced concerns
                                                                                after Lenovo's plans to purchase
                                                                                IBM's personal computer unit
                                                                                became public. The deal was
                                                                                cleared by CFIUS after the
                                                                                company signed extensive
                                                                                security agreements.
----------------------------------------------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * This project is included, although a lease would technically not 
be counted as direct investment.


        Addendum I:  Select Controversial Chinese Investments in the  United States, 1990-2013--Continued
----------------------------------------------------------------------------------------------------------------
               Year                      Investor               Target                      Summary
----------------------------------------------------------------------------------------------------------------
2008                               Huawei, Bain Capital  3Com                  CFIUS signaled a negative
                                                                                recommendation based on national
                                                                                security risks posed by the sale
                                                                                of network gear. Huawei and Bain
                                                                                Capital withdrew the bid.
----------------------------------------------------------------------------------------------------------------
2009                               Northwest Nonferrous  Firstgold Corp.       CFIUS signaled a negative
                                    International                               recommendation based on national
                                    Investment Co.                              security risks due to
                                                                                Firstgold's proximity to Fallon
                                                                                Naval Air Station, among other
                                                                                concerns. Northwest Nonferrous
                                                                                withdrew the bid.
----------------------------------------------------------------------------------------------------------------
2010                               Tangshan Caofeidian   Emcore                CFIUS expressed concerns over
                                    Investment Co. Ltd                          TCIC's acquisition of Emcore, a
                                    (TCIC)                                      provider of photovoltaic and
                                                                                fiberoptic technology. TCIC
                                                                                withdrew its bid.
----------------------------------------------------------------------------------------------------------------
2010                               Far East Golden       Nevada Gold           After investigating the
                                    Resources             Holdings, Inc.        transaction in 2012, CFIUS
                                    Investment Ltd.                             proposed that Hybrid Kinetic
                                    (FEGRI)                                     Group Ltd (the ultimate
                                                                                controlling entity of FEGRI)
                                                                                divest or break up its interests
                                                                                in Nevada Gold as related to the
                                                                                Tempo mine site in north central
                                                                                Nevada, located in proximity to
                                                                                U.S. Naval Air Station Fallon.
                                                                                Hybrid Kinetic and its
                                                                                subsidiaries agreed to divest
                                                                                all their interests in Nevada
                                                                                Gold.
----------------------------------------------------------------------------------------------------------------
2011                               Huawei                3Leaf                 CFIUS asked Huawei to submit its
                                                                                purchase of assets from bankrupt
                                                                                3Leaf, which created technology
                                                                                for cloud computing. Huawei
                                                                                agreed to divest its 3Leaf
                                                                                assets after CFIUS signaled a
                                                                                negative recommendation.
----------------------------------------------------------------------------------------------------------------
2012                               Ralls Corp.           Terna Energy Holding  Ralls bought four Oregon wind
                                                          USA Corp.             farm assets without reporting
                                                                                the transaction to CFIUS. The
                                                                                U.S. Navy objected to the
                                                                                project's proximity to the
                                                                                restricted Naval Weapons Systems
                                                                                Training Facility airspace,
                                                                                where the U.S. government tests
                                                                                drones. CFIUS asked Ralls to
                                                                                submit for review; upon review,
                                                                                CFIUS recommended that Ralls
                                                                                stop operations. Ralls
                                                                                challenged the CFIUS
                                                                                determination, so the president
                                                                                had to formally block the deal
                                                                                by executive order. Ralls
                                                                                challenged the rejection with a
                                                                                lawsuit alleging that the
                                                                                president acted
                                                                                unconstitutionally.
----------------------------------------------------------------------------------------------------------------


        Addendum I:  Select Controversial Chinese Investments in the  United States, 1990-2013--Continued
----------------------------------------------------------------------------------------------------------------
               Year                      Investor               Target                      Summary
----------------------------------------------------------------------------------------------------------------
2012                               Wanxiang              A123                  Wanxiang purchased the bankrupted
                                                                                A123 at auction for $256.6
                                                                                million, and the deal was
                                                                                approved by CFIUS despite
                                                                                significant opposition from some
                                                                                Members of Congress. Wanxian
                                                                                excluded A123's defense
                                                                                contracts (A123's defense
                                                                                division, which supplied cutting
                                                                                edge batteries to the U.S.
                                                                                military) from its bid at the
                                                                                auction. Those were sold
                                                                                separately to Illinois-based
                                                                                Navitas Systems for $2.25
                                                                                million. A123 has never turned a
                                                                                profit and received a $249
                                                                                million grant from the U.S.
                                                                                Department of Energy to develop
                                                                                lithium-ion batteries, although
                                                                                only about half of the money was
                                                                                used.
----------------------------------------------------------------------------------------------------------------
2012                               CNOOC, Ltd.           Nexen Inc. (U.S.      In 2012 CNOOC agreed to buy Nexen
                                                          assets)               Inc. (a Canadian company) for
                                                                                $15.1 billion as China's largest
                                                                                foreign deal. The Canadian
                                                                                government's Investment Canada
                                                                                Act was used to determine if the
                                                                                sale provides a ``net benefit''
                                                                                to Canada. In December 2012, the
                                                                                sale was approved by the
                                                                                Canadian federal government. In
                                                                                addition to Canadian
                                                                                authorities, CFIUS needed to vet
                                                                                the deal because Nexen has U.S.
                                                                                interests. CFIUS approval came
                                                                                in February 2013.
----------------------------------------------------------------------------------------------------------------
2013                               Shuanghui             Smithfield Foods      In June 2013, Shuanghui, China's
                                    International         Inc.                  largest meat processor, made an
                                    Holdings Ltd.                               offer for Smithfield, the U.S.'s
                                                                                biggest pork producer, for $4.7
                                                                                billion in cash (including debt,
                                                                                the deal values Smithfield at
                                                                                $7.1 billion). Smithfield and
                                                                                Shuanghui submitted the deal for
                                                                                CFIUS review, even though the
                                                                                food industry has not been
                                                                                traditionally among those
                                                                                relevant to national security.
                                                                                The proposed deal attracted
                                                                                opposition from some Members of
                                                                                Congress as well as farm,
                                                                                producer, consumer, and rural
                                                                                organizations, due to worries
                                                                                over food safety and the
                                                                                protection of U.S. technologies
                                                                                and intellectual property. CFIUS
                                                                                approved the sale in early
                                                                                September 2013. Smithfield
                                                                                shareholders approved the deal
                                                                                on September 24, 2013.
----------------------------------------------------------------------------------------------------------------
Source: Rhodium Group; various media reports.

                     ENDNOTES FOR SECTION 2

     1. For a deeper look at the evolution of China's outbound FDI, see 
Nargiza Salidjanova, ``Going Out: Overview of China's Outward Foreign 
Direct Investment'' (Washington, DC: USCC Staff Research Report, March 
30, 2011). http://origin.www.uscc.gov/sites/default/files/Research/
GoingOut.pdf.
     2. Edward M. Graham and David M. Marchick, U.S. National Security 
and Foreign Direct Investment (Washington, DC: Peterson Institute for 
International Economics, May 2006), p. 100.
     3. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
written testimony of Derek Scissors, May 9, 2013.
     4. Ting Xu, ``Destination Unknown: Investment in China's `Go Out' 
Policy,'' China Brief XI: 17 (September 16, 2011).
     5. Zhao Huanxin, ``China Names Key Industries for Absolute State 
Control,'' China Daily, December 19, 2006. http://
www.chinadaily.com.cn/china/2006-12/19/content_762056.htm.
     6. Huang Webin and Andreas Wilkes, ``Analysis of China's overseas 
investment policies'' (Bogor, Indonesia: Center for International 
Forestry Research, CIFOR Working Paper 79, 2011) pp. 12-13.
     7. Daniel H. Rosen and Thilo Hanemann, ``The Rise of Chinese 
Overseas Investment and What It Means for American Businesses,'' China 
Business Review, July 5, 2012. http: // rhg.com / articles / the-rise-
in-chinese-overseas-investment-and-what-it-means-for-american-
businesses.
     8. Laurie Burkitt, ``Smithfield Deal: Past Chinese Acquisitions 
Bode Well,'' 
Wall Street Journal, May 30, 2013. http://online.wsj.com/article/
SB100014241278873 
24682204578515043950586274.html#project % 3DCBRANDS0531 % 26articleTabs 
% 3D article.
     9. Linda Yueh, ``China Buying Up the World?'' BBC News, May 30, 
2013. http://www.bbc.co.uk/news/business-22717939.
    10. For more on China's outward FDI approval process, see Andrew 
Lumsden, ``Chinese Outbound Investment--The Growing Sophistication of 
China's `Go Global' Policy'' (Sydney, Australia: Corrs Chambers 
Westgarth, Thinking, March 18, 2013). http: // www.corrs.com.au / 
thinking / insights / chinese-outbound-investment-the-growing-
sophistication-of-china-s-go-global-policy/.
    11. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
written testimony of Thilo Hanemann, May 9, 2013.
    12. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
written testimony of Thilo Hanemann, May 9, 2013.
    13. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implication of Chinese Investment in the United States, 
written testimony of Derek Scissors, May 9, 2013.
    14. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implication of Chinese Investment in the United States, 
written testimony of Andrew Szamosszegi, May 9, 2013.
    15. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implication of Chinese Investment in the United States, 
written testimony of Andrew Szamosszegi, May 9, 2013.
    16. Shruti Date Singh, ``Smithfield Receives U.S. Approval for 
Biggest Chinese Takeover,'' Bloomberg, September 6, 2013.
    17. Luzi Ann Javier and Michelle Yun, ``Smithfield Embodies China's 
Record Hunger for Farm Assets,'' Bloomberg, June 12, 2013.
    18. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Thilo Hanemann, May 9, 2013.
    19. For more information about China's investment vehicles, see 
U.S.-China Economic and Security Review Commission, 2008 Annual Report 
to Congress (Washington, DC: U.S. Government Printing Office, 2008), 
pp. 43-68. http://origin.www.uscc.gov/sites/default/files/
annual--reports/2008-Report-to-Congress--0.pdf.
    20. Lingling Wei and Carolyn Cui, ``China is Seeking U.S. Assets,'' 
Wall Street Journal, May 20, 2013.
    21. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Andrew Szamosszegi, May 9, 2013.
    22. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Derek Scissors, May 9, 2013.
    23. Usha C.V. Haley and George T. Haley, Subsidies to Chinese 
Industry: State Capitalism, Business Strategy, and Trade Policy (New 
York, NY: Oxford University Press, 2013).
    24. Jamil Anderlini, ``Chinese Industry: Ambitions in Excess,'' 
Financial Times, June 16, 2013.
    25. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
written testimony of Elizabeth J. Drake, May 9, 2013.
    26. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
written testimony of Elizabeth J. Drake, May 9, 2013; U.S.-China 
Economic and Security Review Commission, Hearing on Trends and 
Implications of Chinese Investment in the United States, written 
testimony of Andrew Szamosszegi, May 9, 2013.
    27. For a list of FOCI mitigation instruments, see http://
www.dss.mil/isp/foci/foci--mitigation.html.
    28. Standard Form 328: ``Certificate Pertaining to Foreign 
Interests.'' http://www.dtic.mil/whs/directives/infomgt/forms/eforms/
sf0328.pdf.
    29. Edward M. Graham and David M. Marchick, U.S. National Security 
and Foreign Direct Investment (Washington, DC: Peterson Institute for 
International Economics, May 2006), p. 105.
    30. For more on the Chinese government's ownership and control of 
the economy, see U.S.-China Economic and Security Review Commission, 
2012 Annual Report to Congress (Washington, DC: U.S. Government 
Printing Office, 2012), chapter 1, section 2. http://www.uscc.gov/
Annual--Reports/2012-annual-report-congress.
    31. Edward M. Graham and David M. Marchick, U.S. National Security 
and Foreign Direct Investment (Washington, DC: Peterson Institute for 
International Economics, May 2006), p. 107.
    32. U.S. House of Representatives, Permanent Select Committee on 
Intelligence, Investigative Report on the U.S. National Security Issues 
Posed by Chinese Telecommunications Companies Huawei and ZTE, 112th 
Cong., 2nd sess., October 8, 2012. http://intelligence.house.gov/sites/
intelligence.house.gov/files/documents/Huawei-
ZTE%20Investigative%20Report%20(FINAL).pdf. Roughly half a year after 
the committee's report, a senior executive from Huawei stated that his 
company was no longer interested in the U.S. market after failing 
repeatedly to sell its products to U.S. telecoms operators. Economist, 
``You Can't Fire Me, I Quit,'' April 24, 2013. http://
www.economist.com/blogs/schumpeter/2013/04/telecoms.
    33. Kasia Klimasinska, ``CIC Chief Gao Says China's Fund Treated 
Differently by U.S.,'' Bloomberg Businessweek, April 25, 2013. http://
www.businessweek.com/news/2013-04-25/cic-chief-gao-says-china-s-fund-
treated-differently-by-u-dot-s-do.
    34. Committee on Foreign Investment in the United States, Annual 
Report to Congress (Washington, DC: December 2012). http://
www.treasury.gov/resource-center/international/foreign-investment/
Documents/ 2012 % 20CFIUS % 20Annual % 20Report % 20PUBLIC.pdf.
    35. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Derek Scissors, May 9, 2013.
    36. Derek Scissors, ``A Better Committee on Foreign Investment in 
the United States'' (Washington, DC: The Heritage Foundation Issue 
Brief 3844, January 28, 2013).
    37. Derek Scissors, ``A Better Committee on Foreign Investment in 
the United States'' (Washington, DC: The Heritage Foundation Issue 
Brief 3844, January 28, 2013).
    38. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Mark E. Plotkin, May 9, 2013.
    39. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Elizabeth J. Drake, May 9, 2013.
    40. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Mark E. Plotkin, May 9, 2013.
    41. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Mark E. Plotkin, May 9, 2013.
    42. U.S.-China Economic and Security Review Commission, Hearing on 
Trends and Implications of Chinese Investment in the United States, 
testimony of Elizabeth J. Drake, May 9, 2013.
                       SECTION 3: GOVERNANCE AND

                       ACCOUNTABILITY IN CHINA'S

                            FINANCIAL SYSTEM

Introduction
    This section provides an overview of China's financial 
system, covering strains in the state banking system; the 
growth of the shadow banking sector and access to credit; 
market access issues and operational challenges for foreign 
financial services firms; and governance, transparency and 
accountability problems in China's financial sector. It is 
based on witness testimonies from the Commission's March 7, 
2013, hearing; information from the Commission's fact-finding 
trips to China, Japan, and Taiwan; and additional staff 
research.

China's Banking System and Access to Credit and Capital

    China's 12th Five-Year Plan (2011-2015) calls for less 
dependence on exports and state-funded infrastructure projects 
and more domestic consumption to support China's economy. This 
shift from government-led to private-led growth necessarily 
requires that Chinese families and private sector businesses 
have sufficient access to credit and capital. Private small- to 
medium-sized enterprises (SMEs) already contribute 60 percent 
of gross domestic product (GDP) and 80 percent of urban 
employment, according to some estimates.\1,2\ Yet bank lending, 
the traditional source of credit for entrepreneurs and startups 
in most countries, is largely inaccessible to Chinese 
individuals and SMEs, because China's financial system is 
dominated by large, state-owned banks that mainly service 
government-directed projects and state-owned enterprises. A 
shadow banking system of unofficial credit has sprung up to 
fill the gaps left by the big banks' lending practices, but it 
is largely unregulated, and the proliferation of shadow banking 
activity poses threats to the country's financial stability.*
---------------------------------------------------------------------------
    * A shadow banking system is comprised of the unregulated or 
loosely regulated lending institutions outside the more familiar model 
of depository commercial banks. The shadow banking system may include 
loans from insurance companies, private equity firms, hedge funds, 
money market funds, venture capital firms, microlending, crowd 
sourcing, off-balance sheet lending by commercial banks, and even loan 
sharking.

---------------------------------------------------------------------------
Chinese State Banks

    Chinese banks hold a unique position. ``In China, banks are 
everything,'' said Carl Walter, former chief operating officer 
of JP Morgan China and co-author of Red Capitalism, at a March 
7 hearing of the Commission.\3\ The banks provide the loans and 
underwrite the bonds that fund government investments in 
infrastructure and fixed assets, which have been ``the major 
force driving China's economic growth to near double-digit 
levels over the past twenty years,'' \4\ he said. Banks in 
China are even more important to the national economy than are 
banks in Europe or North America, where alternative sources of 
financing through equity and bond markets are available even to 
small startups. In China, banks provide over 75 percent of the 
nation's capital, according to the Financial Services Forum's 
John Dearie, a Commission witness. By contrast, in most 
developed economies, banks are a source of less than 20 percent 
of capital, and in other emerging economies, banks typically 
provide about 50 percent of total capital.\5\
    China's financial sector is dominated by five massive, 
state-owned commercial banks--the Bank of China; the Industrial 
and Commercial Bank of China; the China Construction Bank; the 
Agricultural Bank of China; and, to a lesser extent, the Bank 
of Communications. Though they are categorized as commercial 
lenders, they function more as an arm of the government. The 
Commercial Bank Law of 1994 commercialized the operations of 
these banks by transforming them into retail deposit and 
lending institutions. The country has a network of other 
commercial banks, both state owned and semiprivate, which 
includes ten secondary shareholding commercial banks (the 
government holds a majority of shares in most of these), a 
number of city commercial banks (originally founded on the 
basis of urban credit cooperatives), village and township banks 
(the primary shareholders of which are often city commercial 
banks), and rural credit cooperatives.* \6\ However, as Lynette 
Ong of the University of Toronto explained in her testimony, 
the five big, state-controlled commercial banks comprise the 
heart of the banking system, collectively accounting for about 
50 percent of all deposits and loans.\7\ In 2011, total assets 
of commercial banking institutions were valued at renminbi 
(RMB) 113.29 trillion ($16.54 trillion), with the biggest four 
banks alone holding nearly 60 percent of those assets.\8\
---------------------------------------------------------------------------
    * The major, second-tier shareholding commercial banks include the 
Bank of Communications, China CITIC Bank, China Everbright Bank, Hua 
Xia Bank, China Minsheng Bank, Guangdong Development Bank, Shenzhen 
Development Bank, China Merchants Bank, Shanghai Pudong Development 
Bank, and Industrial Bank.
---------------------------------------------------------------------------
    Three policy banks were established in 1994 to take over 
government-directed spending functions like financing of major 
development projects, which were previously the purview of the 
newly commercialized state banks. These state-owned policy 
banks are the Agricultural Development Bank of China, China 
Development Bank, and the Export-Import Bank of China. 
\9\ The Chinese Communist Party (CCP) and central government 
treat the policy banks as ``basic utilities'' that provide 
capital to the state sector of the economy.\10\ The borrowers 
are almost exclusively state sector entities undertaking state-
directed development projects, such as the construction of 
dams, highways, and airports. The People's Bank of China 
(PBOC), China's central bank, sets credit quotas for the big 
five commercial banks, and PBOC data confirm that loans made by 
these banks have also historically gone overwhelmingly to the 
state sector.\11\
---------------------------------------------------------------------------
     The three policy banks--the Export-Import Bank, the 
Agricultural Development Bank, and the China Development Bank--were 
respectively charged with promoting exports, assisting with food 
production, and financing infrastructure projects. In the last decade, 
the policy banks, particularly the Export-Import Bank, have expanded 
their undertakings. The Export-Import Bank provides development aid and 
preferential loans to foreign clients purchasing certain goods and 
services from China and distributes government-backed loans to foreign 
nations. Since 2007, it has had a formal, market-oriented division.
---------------------------------------------------------------------------
    A 2013 Brookings Institution report outlines broad 
rationales behind the big five commercial banks' lending bias, 
a combination of government directives requiring them to loan 
to the state sector and a greater sense of confidence on their 
own part in the credit risks presented by state-owned 
enterprises (SOEs). State sector borrowers often have ``strong 
business positions, resulting from monopolistic or 
oligopolistic power, superior business models or other 
factors;'' and it seems relatively unlikely that the government 
will allow a large, state-owned enterprise to default on its 
loans.\12\ On the other hand, private sector businesses are 
typically small, possess fewer assets that can serve as 
collateral, and do not enjoy the implicit backing of the 
government. As a result, the private sector enjoys almost no 
assistance from China's largest commercial lending 
institutions. According to an estimate by Citic Securities Co., 
only 3 percent of China's SMEs are able to get loans from these 
banks. Other estimates are even lower.\13\
    The policy banks and the big commercial banks are all 
regulated by the China Banking Regulatory Commission. The 
policy banks are funded primarily by selling bonds to the big 
commercial banks, and all are ultimately guaranteed by the 
Chinese government.\14\ The incestuous relationship between the 
government; the large, state-owned policy banks; and their 
state-owned commercial cousins provides borrowers a 
considerable benefit: artificially low interest rates. PBOC 
sets low interest rates for depositors as well as for 
borrowers. Rates are approved by the State Council and the 
CCP's Leading Group on Finance and Banking. By controlling 
rates rather than allowing the market to determine them, the 
government ensures that the mainly state sector borrowers are 
able to access inexpensive capital, which in turn encourages 
them to borrow. The banks' depositors, meanwhile, are paid very 
low rates, sometimes below the rate of inflation, to help hold 
down the rates charged to borrowers. Thus, the state-owned 
corporate sector receives a subsidy from the bank's depositors 
(Chinese households) in the form of low interest rates. 
Renminbi (RMB) 36.7 trillion ($6 trillion) of household savings 
are deposited into the state-owned commercial banks and receive 
a savings rate of only about 3 percent. Although this is higher 
than the average savings rate in the United States, the 
repressive impact on Chinese household savings is compounded by 
the fact that there are virtually no viable alternatives for 
the average Chinese person that offer higher yields.\15,16\
    Figure 1 demonstrates the outsized holdings of the large, 
state-owned commercial banks. Figure 2 shows shares of loans 
and deposits accounted for by various types of financial 
institutions in China, also underscoring the dominance of the 
five key state-owned commercial banks in China's financial 
system.

 Figure 1:  Chinese Bank Holdings of Financial Assets, Fiscal Year 2010



    * CGB--Chinese Government Bonds; MOF--Ministry of Finance; NBFI--
Nonbank financial institution; PBOC--People's Bank of China.
    Source: U.S.-China Economic and Security Review Commission, Hearing 
on Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Carl Walter, March 7, 2013.

    Figure 2:  Chinese Financial Institutions by Size of Loans and 
                             Deposits, 2010



    Figure 2:  Chinese Financial Institutions by Size of Loans and 
                       Deposits, 2010--Continued



    * New rural financial institutions include township and village 
banks, microcredit companies, and rural mutual aid funds.

    ** Others consist of nonbank finance companies and overseas banks.

    *** The government owns a majority of shares in most of the second-
tier shareholding commercial banks.

    Source: U.S.-China Economic and Security Review Commission, Hearing 
on Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Lynette Ong, March 7, 2013.

The Stock and Bond Markets

    Shareholder rights are limited in China, and many publicly 
traded firms are majority owned by the government. ``Lacking 
the ability to influence business choices and dividend levels, 
or to sell the firm as a whole, shareowners place less reliance 
on underlying firm value and focus more on likely stock price 
movements in the short run.'' \17\ As a result, Chinese markets 
are dominated by volatile speculative trading, and are often 
compared to casinos. The two Mainland stock exchanges, the 
Shanghai Stock Exchange and the Shenzhen Stock Exchange, have 
undergone significant development in recent years but are not 
comparable to the U.S. or European stock exchanges in scale, 
importance, or regulation and still largely exclude private 
Chinese enterprise. The Hong Kong exchange is the sixth-largest 
exchange globally and the most popular destination for Chinese 
companies seeking to list outside the Mainland, but it has a 
backlog of Chinese firms waiting for approval to list.\18\
    Like the state banks, China's stock markets most reliably 
generate capital for the state sector.\19\ The Chinese 
government uses the domestic stock markets ``to create 
oligopolies and monopolies--the so-called national champions--
run by high-ranking political appointees,'' said Dr. 
Walter.\20\ As with bank interest rates, the equity market 
system for initial public offerings (IPOs) is controlled by the 
government. The government ``literally sets the prices of new 
shares based on how much funding it needs to raise, then 
directs other government-controlled entities to invest.'' \21\
    Equity markets ``fail to serve as a venue for capital-
raising by the private entrepreneurial companies critical for 
the innovation and job creation that will be necessary for 
China's long-term economic health,'' Georgetown University law 
professor Paul Saulski told the Commission.\22\ An IPO is 
``fundamentally a bank loan from a state-controlled bank, not 
the result of a business owner selling a stake in his company 
to outside investors seeking the highest return on their 
capital, as we think of in the West,'' wrote Dr. Walter.\23\
    Compared to the banks, the stock markets play a less 
important financial role.\24\ Chinese equity financing raised a 
record $123 billion on domestic and foreign exchanges in 
prerecession 2007. Far larger was the $530 billion in new loans 
extended by Chinese banks that year and the $581 billion in 
total debt issues in the bond market.\25\ Current imbalances 
are even more striking. Total debt issuance in the bond market 
was approximately $1.2 trillion in 2011.\26\ Total new loans 
extended by Chinese banks in 2012 were approximately $1.1 
trillion.\27\ Meanwhile, IPO approvals ground to a virtual halt 
in 2012 as a result of new China Securities Regulatory 
Commission policies, underscoring the fact that ``IPOs in China 
remain not a function of market dynamics, but of political and 
institutional policies that can change both completely and 
suddenly.'' \28\
    One means of diversifying credit risk away from the banking 
system is to encourage companies to raise funds by issuing 
bonds. China's leadership seems to have recognized the 
potential utility of a strong bond market and has made rapid 
headway in developing one. The Chinese bond market is now the 
world's fourth largest in terms of value. At approximately 
$3.41 trillion (RMB 20.9 trillion), its size is surpassed only 
by the United States, Japan, and France.\29\ It is also 
increasingly diverse and includes both public and private debt. 
But while China's bond market possesses the superficial 
appearance of a modern bond market, most of the bonds issued 
and traded are actually issued by other banks rather than 
corporations. The corporate bond sector was valued at only RMB 
548 billion ($89.7 billion), or less than 3 percent of the 
Chinese bond market's total value, as of December 2012.\30\ 
China also has yet to develop a properly functioning municipal 
bond market, and it is only beginning to develop a market for 
high-yield bonds, both of which are important for attracting 
investment capital. In addition, Beijing restricts foreigners 
from investing in the bond markets.\31\

Strains on the Banking System

    Because lending by the state-owned banks is based on 
government policy decisions rather than commercial 
considerations, it is not surprising that the banks have 
accumulated large numbers of nonperforming loans from lending 
to poorly run or poorly chosen projects undertaken by SOEs.\32\ 
Chinese banks appear to be undergoing a resurgence of the self-
inflicted bad debt crisis that troubled them in the late 1990s 
and early 2000s.\33\
    In 1999, the key Chinese state-owned commercial banks held 
roughly RMB 2.5 trillion in nonperforming loans, or 31 percent 
of China's annual GDP at the time. Bad loans accounted for 39 
percent of Chinese banks' loans.* \34\ China's central 
government created four asset management companies to bail out 
the banks by disposing of their loans. The government's 
recapitalization of the big banks between 1999 and 2005 removed 
RMB 3 trillion ($400 billion) in bad loans, or 25 percent of 
total loans, from bank balance sheets in order to compensate 
for the missed loan repayments from mismanaged and unprofitable 
state sector projects.\35,36\ The banks' nonperforming loans 
were generally bought at full value by the asset management 
companies, paid for with ten-year bonds backed by the Ministry 
of Finance and loans issued to the asset management companies 
by China's central bank.\37\ The central government also 
launched a variety of other initiatives aimed at curbing the 
big banks' substandard lending and maintaining asset quality. 
By the end of 2008, the nonperforming loan ratios of commercial 
banks had dropped to 2.4 percent of the total.\38,39\
---------------------------------------------------------------------------
    * By comparison, Spanish banks' bad loan ratio reached a record 
high of 12 percent in 2013 as a result of the recession there. The 
average nonperforming loan ratio for all U.S. banks between 1999 and 
2009 was 1.67 percent, according to the Federal Reserve, and is 
currently 3.16 percent. At the height of the financial crisis, the 
average nonperforming loan ratio for all U.S. banks was nearly 6 
percent. ``Banking Brief for Pennsylvania, New Jersey and Delaware,'' 
Philadelphia Fed, First Quarter 2011. http://www.philadelphiafed.org/
research-and-data/publications/banking-brief/2011/BB1Q2011.pdf; Charles 
Penty & Emma Ross-Thomas, ``Spanish Banks' Bad Loans Ratio Climbs to 
Record 12.1%,'' Bloomberg, October 8, 2013. http://www.bloomberg.com/
news/2013-10-18/spanish-banks-bad-loans-ratio-climbs-to-record-12-
1-.html.
---------------------------------------------------------------------------
    With the Chinese government's response to the global 
financial crisis, however, the strain of nonperforming loans 
has returned. Although financial statements provided by 
international auditing companies show the banks' current 
nonperforming loan ratios at less than 1 percent, this figure 
only covers loans that are on the balance sheets, and it 
strains credulity in light of the banks' central role in 
carrying out the government's stimulus response to the global 
economic crisis.\40\ In November 2008, the central government 
announced a $652 billion (in current dollars) stimulus, the 
equivalent of 12.5 percent of China's GDP that year, and 
directed the banks to fund the bulk of it by granting loans for 
infrastructure projects.\41\ According to analysis by KPMG, a 
multinational accounting firm, ``Banks extended RMB 9.6 
trillion worth of new loans'' in 2009, ``more than twice the 
total lending in 2008,'' and RMB 8.0 trillion in 2010.\42\ As 
the Chinese economy responded, the banks kept boosting their 
lending. The International Monetary Fund (IMF) estimates that 
Beijing has relied on the big banks to issue at least $3.8 
trillion (RMB 23.4 trillion) in new loans since 2008 to help 
offset the impact of the global economic crisis on the Chinese 
economy. Dr. Walter estimated that the unofficial shortfall 
``could be anywhere from $1 trillion (RMB 6.2 trillion) to $2.3 
trillion (RMB 14.2 trillion) against bank capital of $400 
billion.'' \43\ As one financial journalist noted, ``Either the 
Chinese government has become extremely skilled at lending in a 
very short time, and Chinese borrowers have become even better 
at repaying, or the numbers are too good to be true.'' \44\ 
Meanwhile, there are questions about whether the asset 
management companies (AMC) could be used to aid another bank 
recapitalization. Though at least two of them claim to be 
profitable today, other evidence strongly suggests that they 
are still holding a significant amount of the debt they took on 
in 1999. According to one unnamed financial expert who spoke to 
The Economist, they ``seem to be virtual holding-tanks where 
the debt doesn't stay and doesn't depart either.'' There is 
speculation that they are insolvent.* \45\
---------------------------------------------------------------------------
    * The four asset management companies established to dispose of the 
banks' nonperforming loans are Orient AMC (which serviced the Bank of 
China), Great Wall AMC (which serviced the Agricultural Bank of China), 
Huarong AMC (which serviced the Industrial and Commercial Bank of 
China), and Cinda AMC (which serviced the China Construction Bank). It 
is not entirely clear how much the asset management companies have 
recovered, but in 2009 the ten-year bonds were extended an additional 
ten years to assist in continued recovery, indicating that the 1999 
bank bailout is very much an ongoing job. As of December 2012, Orient 
AMC had reportedly disposed of $37 billion of these nonperforming 
assets and recovered $8 billion, achieving a cash recovery ratio of 
21.90 percent. Both Huarong and Cinda claim to be making profits, but 
their claims are not verified.
---------------------------------------------------------------------------
    The lending binge has raised fears of impending inflation 
and ushered in a clampdown on lending in 2012 and 2013, ``with 
harsh quotas that have made credit available only to those SOEs 
least likely to default.'' \46\ For example, bank lending to 
local government financing vehicles has been curtailed. 
Local government financing vehicles are companies set up by 
local governments to facilitate borrowing from state banks, 
which allows them to spend beyond the limits of their budgets. 
There are currently more than 10,000 local government financing 
vehicles in China. These hidden and unregulated companies have 
been ``the unseen hand powering China's investment-led economic 
growth over the past decade.'' \47\ Bank lending to local 
government financing vehicles rose from ``RMB 1.7 trillion in 
outstanding loans at the beginning of 2008 to nearly RMB 5 
trillion just two years later.'' \48\ In December 2012, 
outstanding loans to local government financing vehicles 
reached an estimated RMB 9.2 trillion ($1.4 trillion). The 
China Banking Regulatory Commission and the Chinese Ministry of 
Finance began instituting limits on future issuances, first 
barring local governments from using public assets as loan 
guarantees on behalf of their financing vehicles and then 
announcing that new loans extended to local government 
financing vehicles must be covered by existing cash flows and 
that the projects they are used for must generate returns.\49\ 
Approximately one-third of the outstanding loans to local 
government financing vehicles are scheduled to come due in the 
next three years, and ``there are well documented concerns that 
many of the underlying projects offer insufficient cash 
generating ability to service the incumbent debt.'' \50\ To 
avoid potential defaults, banks have begun extending maturities 
for local governments.\51\
---------------------------------------------------------------------------
     Local governments are not permitted to borrow directly 
from state banks and also are generally not permitted to issue 
municipal bonds under the 1995 People's Republic of China algorithm law 
(Chapter 4, Article 28). Thus, in order to fund the infrastructure and 
development projects that the central government encouraged, local 
governments have used state-owned resources and assets, especially 
land, as collateral to set up local government financing vehicles that 
meet basic asset and cash flow lending requirements and then borrowed 
from the state banks through the local government financing vehicles.
---------------------------------------------------------------------------
    By directing the banks to extend so much cheap credit to 
local government financing vehicles and SOEs for state sector 
projects unlikely to generate revenue in the short term, the 
central government has encouraged SOEs and local governments to 
hold too much debt, increasing the likelihood that the banks 
will require another government bailout or restructuring due to 
an accumulation of nonperforming loans and a sudden drop in 
profits.\52\ Despite the high ratio of outstanding bad loans to 
capital, however, the stability of the banks may be relatively 
assured in the near term because the banks are undergirded by 
the central government and the central bank. Dr. Walter 
describes the backstops in the financial system as a shell game 
with three shells: the government itself, the banks, and the 
SOEs. ``You can move these bad loans anywhere you want,'' he 
says, to ensure that the banks remain solvent.\53\ But the 
central government's effort to rein in risky bank loans has 
fueled a boom in unofficial credit that presents more complex 
problems for authorities. As the challenges of obtaining bank 
credit have mounted, local governments and private sector 
businesses have increasingly relied on alternative, less 
regulated, and less transparent financing channels to fund 
investment projects.\54\ This explosion of unofficial credit 
complicates existing challenges for the government's efforts to 
rebalance the economy and maintain financial stability.

Strains on Rural Credit Cooperatives_The Big State Banks of the 
        Countryside

    Rural credit cooperatives are locality-based credit 
institutions important to banking and credit in rural China. 
Although they account for only 10 percent of total deposits and 
loans nationwide, 80 percent of rural deposits and loans are 
made using rural credit cooperatives. They are the primary 
providers of credit to rural households and the primary holders 
of rural household savings.\55\ As of 2010, the rural credit 
cooperative system included 2,646 rural credit cooperative 
county unions, 223 rural cooperative banks, and 85 rural 
commercial banks.\56\ Rural credit cooperatives have 
historically been ``first and foremost accountable to the 
party, rather than to depositors or shareholders,'' and they 
are frequently urged to support local government enterprises 
and projects.\57\ Since 2003, the rural credit cooperatives 
have been managed by provincial credit unions that report to 
provincial governments, but local party leaders also continue 
to influence loan allocations and decisions.\58\
    The financial performance and asset quality of rural credit 
cooperatives vary, but Dr. Ong notes in written testimony to 
the Commission that rural credit cooperatives are a 
longstanding weak link in China's fiscal system, because they 
are perpetually ``saddled with mountains of bad loans.'' \59\ 
In 2007, the PBOC provided RMB 168 billion in debt-for-bonds 
swaps and RMB 830 million in earmarked loans to assist rural 
credit cooperatives in disposing of bad assets and writing off 
historical losses.\60\ The stability of rural credit 
cooperatives improved after their bailout but, like the state-
owned banks, they heavily supported the 2008-2009 stimulus 
programs and are likely experiencing deteriorating asset 
values.
    Although the central government is not technically under 
any formal obligation to ensure the stability of the rural 
credit cooperatives, much like the big, state commercial banks, 
they are treated as if they are too big to fail. Most likely 
this is due to the risk of social unrest in the event of a 
rural financial collapse.\61\ Because rural credit cooperatives 
are locality specific, the collapse of a rural credit 
cooperative would be less likely to cause cross-regional 
economic panic and bank runs than would the collapse of one of 
the big state banks, but rumors of a collapse in one region 
could potentially incite panic and runs in another.\62\

Shadow Banking

    The ``shadow banking system'' can broadly be defined as 
lending that falls outside of the official banking system.* 
\63\ It can involve both traditional and nontraditional 
institutions and is best understood not in terms of the 
institutions engaged in the system but in terms of the 
activities that they undertake.\64\ It encompasses a ``broad 
range of bank-like activities (often using uninsured, short-
term funding) that are lightly scrutinized and only sometimes 
backed by private sector sources of liquidity.'' \65\ Since 
shadow banking activity occurs outside of formal banking 
channels, it does not appear on bank balance sheets and is far 
less transparent than official lending activity. Chinese shadow 
banking products include entrusted loans (loans made by a third 
party to a borrower where a bank or other financial institution 
serves as the intermediary), investment trusts, wealth 
management products, credit guarantees, trusts, money market 
products, and various types of microloans.\66\
---------------------------------------------------------------------------
    * The term ``shadow banking'' refers to ``the whole alphabet soup 
of levered up non-bank investment conduits, vehicles and structures'' 
that are either unregulated or less regulated than conventional bank 
loans. In the prefinancial crisis U.S. context, this meant money market 
funds, asset-backed securities, leveraged derivative products, and 
other nonbank assets in the capital market that featured prominently in 
the U.S.'s subprime mortgage crisis. Paul A. McCulley, ``Global Central 
Bank Focus: Teton Reflections'' (PIMCO, September 2007).
---------------------------------------------------------------------------
    Since shadow banking is dominated by lending to higher-risk 
borrowers, it is frequently characterized by high fees and high 
interest rates.\67\ Loans are often arranged by middlemen who 
are paid a fee, and borrowers sometimes pay interest as high as 
70 percent or more per year.\68\ Such high rates are charged 
despite the fact that the legal maximum interest rate is 
currently 23 percent and by law cannot exceed four times the 
benchmark lending rate, currently 6 percent for one-year 
loans.\69\ Commission witness Regina Abrami, Wharton's director 
of the Global Program at the Lauder Institute of International 
Studies and Management, points out that some non-bank-based 
financing in China, in the form of private money houses, 
pawnshops, and revolving credit associations, dates back 
centuries. This financing has long served much as it does today 
``to aid the economic transactions of firms and individuals who 
might not otherwise be able to obtain funding or resolve short-
term liquidity crises.'' \70\ Chinese demand for shadow banking 
is largely driven by the growth of China's private sector, a 
sector with limited access to official bank credit; and the 
Chinese government's tolerance of shadow banking in recent 
years has been tied to the reality that the private sector is 
the increasingly dominant source of the nation's employment. In 
1980, the state sector accounted for 76.2 percent of urban 
employment. But by 2012, official Chinese sources attributed 80 
percent of urban employment and at least 60 percent of China's 
GDP to the private sector.\71\
    According to written testimony prepared for the Commission 
by Bloomberg Businessweek's Sheridan Prasso, 97 percent of 
China's 42 million privately owned SMEs are unable to obtain 
officially sanctioned loans from the big state banks.\72\ 
According to the official Xinhua news agency, 19 percent of all 
bank lending went to small businesses in 2011, and KPMG 
estimates that the size of SME lending in the banking sector 
may now account for as much as 25 percent of total bank 
lending, but ``these figures are distorted by the lack of 
differentiation between state-owned and privately owned SMEs.'' 
\73\ Certainly the majority of China's private sector is 
comprised of SMEs, many of them unregistered businesses, but 
there are no data on the percentage of SMEs with significant 
ties to the state.\74\ Chinese businesses ``fall into a 
bewildering variety of legal categories and their respective 
contributions to GDP are not reported in official statistics,'' 
but China's National Bureau of Statistics estimates that 
enterprises not majority owned by the state now account for at 
least two-thirds of the country's industrial output.\75\
    Figure 3, below, shows Chinese state-owned enterprises' 
declining share of industrial output. Figure 4 depicts the 
growing market share of private industrial enterprises with 
revenues exceeding RMB 5 million.

     Figure 3:  Chinese State-owned Enterprises' Percent Share of 
            Industrial Assets, Sales and Profits, 2000-2009



    Source: ``Let a Hundred Flowers Bloom,'' Economist, March 10, 2011. 
http://www.-economist.-com/node/18330120, sourced from hedge fund 
Keywise Capital Finance.

  Figure 4:  Growth of Industrial Enterprises with Revenues Exceeding 
                        RMB 5 Million, 2000-2009



    Source: Economist, ``Let a Hundred Flowers Bloom,'' March 10, 2011. 
http://www.-economist.-com/node/18330120, sourced from New York City-
based research firm China Macro Finance.

    Although China's banks continue to control a significant 
percentage of the country's capital, their percentage of 
overall lending is shrinking as the private sector grows. 
Commercial banks accounted for 52 percent of the country's 
total financing in 2012, down from roughly 90 percent a decade 
ago.\76,77\ Shadow banking is filling in this gap. As a result 
of their limited access to official sources of credit, private 
sector businesses seek capital from the unofficial alternative 
channels in the shadow banking system. ``Helping them along on 
the supply side,'' Dr. Abrami noted, ``are hundreds of millions 
of Chinese savers, profitable private firms, and state-owned 
enterprises eager to see better returns on their earnings than 
is possible through standard deposits within the formal banking 
system'' or investment in the markets.\78\
    Successfully channeling credit to China's productive 
private sector is a necessary precondition for economic 
rebalancing and among the biggest financial challenges facing 
China's new leadership.\79\ Since the government has undertaken 
efforts to rein in the risky bank lending that proliferated 
with the 2008 economic stimulus, it has permitted a boom in the 
shadow banking system to help maintain the country's 
macroeconomic growth.\80\ In addition, Chinese regulators have 
regarded shadow banking as ``a byproduct of their attempts to 
unleash more market forces in the allocation of capital in 
China,'' a useful ``experiment in liberalized interest rates'' 
and ``an incubator for risk-based capital allocation and 
financial innovation.'' \81,82\ In the meantime, the ever-
tightening restrictions on access to official sources of credit 
have shifted more and more borrowers to shadow alternatives. 
Shadow banking meets important market demands, ensuring that 
the private sector businesses generating so many of China's 
jobs are able to access credit when they need it.\83\ The 
growing pool, says Dr. Abrami, has also now ``moved beyond 
small enterprises to include larger firms, local governments . 
. . and businesses within politically disfavored sectors, such 
as property development and mining,'' effectively circumventing 
the government's efforts to rein in lending to overdeveloped 
sectors.\84\
    No one knows with certainty the size of China's shadow 
banking system but, according to Chinese Central Bank estimates 
and much private sector analysis, it is valued at RMB 2 
trillion to 4 trillion ($325 billion to $630 billion), or 
approximately 7 percent of total lending, four times its 
estimated size in 2008.\85,86\ The China Banking Regulatory 
Commission has produced a higher estimate of RMB 7.6 trillion 
($1.2 trillion) for 2012, which is equal to 14.6 percent of 
China's 2012 GDP.\87\ Total off-balance-sheet banking activity 
in China, including ``credits to property developers, local-
government entities and small-and-medium size enterprises 
(SMEs), individuals and bridge-loan borrowers,'' has been 
estimated as high as RMB 17 trillion as of the end of 2012, or 
roughly one-third of GDP.\88\ Even by this largest and most 
expansive estimate, the shadow banking system is still smaller 
than China's commercial banking industry, which had an 
estimated $21 trillion in assets as of September 2012.\89,90\ 
And by comparison with the shadow banking systems of the West, 
China's shadow banking is also relatively small. According to 
the Financial Stability Board, shadow banking had $23 trillion 
in assets in the United States and $22 trillion in assets in 
the European Union in 2012. Nevertheless, the recent 
exponential growth of the Chinese shadow banking sector, 
combined with the continued growth and increasing economic 
importance of the private sector relative to the state sector, 
is driving a ``reduction in the use of the official banking 
system to perform basic functions of finance.'' \91\ In some 
parts of China, informal lending now exceeds official bank 
lending.\92\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Chinese Shadow Banking Terminology
 
Bank Trust Products
 
  Bank trust products are packaged by trusts and sold by banks,
frequently resulting in a lack of transparency as to whether the bank or
the trust is responsible for their performance.\93\
 
Entrusted Loans
 
  Entrusted loans are products that allow banks to serve as middlemen by
identifying high-net-worth individuals who can provide corporate loans.
According to Bloomberg News, entrusted loans last year accounted for
nearly 8 percent of the RMB 14.27 trillion ($2.3 trillion) raised in
private placements--loans and other funding sources, such as returns on
stocks and bonds--compared with 0.9 percent in 2002.\94,95\
 
Passageway Deals
 
  In passageway deals, trusts and brokerages cooperate with banks to act
as passive reservoirs for loans that banks originate but cannot keep on
their own balance sheets without exceeding lending quotas or
transgressing capital requirements or loan-to-deposit ratios. Investors
who have purchased wealth manage-
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Chinese Shadow Banking Terminology--Continued
 
ment products from the banks often bear the risk if borrowers default on
 the loans that the trust companies and brokerages have purchased from
 the banks.\96\ Industry executives say at least 50 percent of trust
 company assets and 80 percent of brokerages' entrusted funds are
 related to this so-called ``passageway business.'' \97\
 
Peer-to-Peer Lending
 
  Peer-to-peer lending is a form of microcredit, and the companies that
facilitate it online match borrowers with lenders able to offer small,
short-term loans. The peer-to-peer lending market is worth approximately
$3.2 billion and is comprised of approximately 2,000 online sites.\98\
Peer-to-peer loans can be as small as RMB 50. One of the better known
Chinese peer-to-peer lending companies, Creditease, reports that its
average loan is RMB 50,000 ($8,200), ``too small for banks but
attractive to online micro-financiers.'' \99\
 
Trust Companies
 
  There are 64 Chinese trust companies today, with assets valued
collectively at approximately $1.2 trillion.\100\ Trust companies have
surpassed the insurance industry in China in terms of the value of their
assets and are now second only to the banking industry.\101\ Bank of
America Merrill Lynch estimates that trust companies account for 8.9
percent of all bank loans.\102\
 
Wealth Management Products
 
  Wealth management products are the fastest-growing investment vehicle
in China. Banks funnel money deposited by savers into these riskier
investments that are mostly held off of their balance sheets and sell
them to support their credit growth, since wealth management products
allow them to circumvent the China Banking Regulatory Commission's caps
on interest rates for bank loans. These are highly nontransparent
products because of a lack of disclosure requirements.\103\ Total
outstanding issuance of wealth management products was approximately RMB
6.7 trillion ($1.1 trillion) in the third quarter of 2012, an increase
of 47 percent from the end of 2011.\104\ Bank of America Merrill Lynch
estimates that wealth management products comprise 8 percent of all bank
loans.\105\ Fitch Ratings Agency recently estimated that these products
now account for approximately 16 percent of all commercial bank
deposits.\106\ Wealth management products generally offer 4 to 5 percent
yields, roughly 1 percent higher than the ceiling on deposit rates. The
China Banking Regulatory Commission was initially supportive of the
growth of wealth management products offered by banks, but amid recent
concerns over defaults, regulators have cracked down on the
practice.\107\
 
------------------------------------------------------------------------


Shadow Banking Risks
    According to recent analysis by the Federal Reserve Bank of 
Dallas, ``Shadow banks are [now] at the center of our global 
market-based financial intermediation system, conducting 
maturity, liquidity, and credit transformation without explicit 
public sector credit guarantees or liquidity access.'' \108\ 
The explosion of new financing vehicles presents risks that 
investors may not understand and that appear to outstrip 
government regulatory capacities. In the aftermath of the 2008 
financial crisis, there has been a push among regulators, both 
in the United States and abroad, to increase scrutiny of these 
financial intermediaries in order to reduce risks in the global 
financial system as well as in domestic ones.
    In December 2012, the IMF released an assessment 
identifying shadow banking as one of the key risks to China's 
continued financial stability.\109\ According to Ms. Prasso, 
``The primary risk to the [Chinese] government lies in its 
potential inability to intervene if a large number of 
underground loans suddenly go bad in a crisis; there is no 
centralized place to put the money, as in a bank bailout.'' 
\110\ Dr. Abrami also notes that the Chinese government may not 
be able to sufficiently regulate the risks posed by the rapid 
proliferation of private lending activities.\111\
    A particular cause for worry is the extent to which 
traditional Chinese banks may be exposed to the risks of the 
shadow banking system. Fitch Ratings Agency estimates that 
about 80 percent of new shadow banking credit is tied to the 
big commercial banks and that an even bigger percentage of 
outstanding shadow banking loans is linked to these banks.\112\ 
The banks are moving undesirable assets into the shadow banking 
system ``on an unprecedented scale, reinforcing suspicions that 
bank balance sheets reflect only a fraction of the actual 
credit risk lurking in the financial system.'' \113\ Trust 
companies and brokerages are a vital source of credit for banks 
seeking to ``arrange off-balance-sheet refinancing for maturing 
loans that risky borrowers cannot repay from their internal 
cash flow.'' \114\ As the Financial Times' Kate Mackenzie 
explains:

        The elephant in the room is that the shadow 
        institutions are the co-dependent evil twins to the 
        commercial banks . . . banks are reliant on the shadow 
        institutions to supply their liquidity, and shadow 
        institutions get a lot of their capital from the banks. 
        . . . Not only does the shadow market fund the banks, 
        but banks fund the shadow market: banks are the 
        ultimate source of many `non-standard' financial 
        products. . . . The whole market is running on the rate 
        arbitrage between official channels, which lend at 6.5-
        9.5 percent, and gray channels, which lend at 12-60 
        percent.\115\

    Whenever the central government eases monetary policy, the 
big banks tend to lend excessively, but when it tightens 
monetary policy, the shadow banking system steps into the gaps. 
With the banks so closely tied to the shadow banking system, it 
appears that tighter official lending rules not only fuel the 
growth of unofficial lending but also specifically encourage 
the banks to engage in more risky, less transparent 
lending.\116\ Banks are increasingly pressing customers to 
shift money from the older, regulated parts of their operations 
to newer, off-the-books products. ``The key question is no 
longer how much risk banks are carrying,'' but how many risky 
loans have been shifted to lightly regulated, shadow banking 
products offered by the banks and to ``lightly regulated shadow 
banking institutions--mainly trust companies, brokerages and 
insurance companies.'' \117\
    Figure 5, below, illustrates one means by which banks 
create and issue off-balance sheet loans.

    Figure 5:  Example of Off-Balance Sheet Lending by Chinese Banks



    Source: The New York Times, ``Questionable Lending in China,'' July 
1, 2013. http://www.-ny-times . com / interactive / 2013 / 07 / 02 / 
business / Questionable-Lending-in-China.html ? ref = global. As 
noted in The New York Times article, this is but one example of how shad
ow banking might work.

    China's leadership is turning a sharper eye toward the 
risks in the shadow banking system.\118\ Regulators have, for 
instance, begun issuing prohibitions against certain types of 
lending.\119\ In December 2012, the Ministry of Finance, the 
National Development Reform Commission, the People's Bank of 
China, and the China Banking Regulatory Commission issued a 
communique on curbing illegal financing by local governments, 
banning local government borrowing from individuals or 
nonfinancial institutions such as trust companies and fund 
management companies.\120\ In June 2013, PBOC dramatically 
tightened credit in the interbank market, where banks have been 
lending money to each other and to large shadow financiers to 
fund higher-yield offerings. Despite signs of a liquidity 
crunch, the central bank delayed injecting more money into the 
markets, insisting that ``overall bank liquidity conditions are 
at a reasonable level'' and that banks should ``prudently 
manage liquidity risks that have resulted from rapid credit 
expansion.'' \121\ China's official Xinhua news agency said on 
June 23 that the cash crunch was engineered to curb risky bank 
funding of shadow banking activities.\122\
    On April 26, the Chinese government announced that more 
than 1,400 people had been sentenced to prison terms of at 
least five years for illegal shadow banking activities. A total 
of 4,170 people have reportedly been convicted of violating 
shadow banking rules since 2011.\123\ People charged in the 
most recent crackdown were convicted of violations such as 
illegal fundraising, public advertising to find lenders, and 
promising excessively high rates of return.* \124\ Legal 
experts complain, however, that the central government has not 
sufficiently clarified what is and is not legal for lenders and 
borrowers. They argue that many of those netted in crackdowns 
and sweeps are engaged in practices that have not been 
explicitly prohibited.\125,126\ Another problem in cracking 
down on shadow banking in the absence of increased access to 
official lines of credit is that it threatens to starve China's 
entrepreneurial companies of capital, which in turn may hinder 
China's indigenous innovation.\127\
---------------------------------------------------------------------------
    * China's Supreme Court website defines ``illegal fundraising'' as 
applying to individuals who receive more than RMB 200,000 ($32,000) of 
informal loans or cause losses to lenders of RMB 100,000 ($16,000) or 
more. ``Enterprises can face charges if they receive RMB 1 million 
($160,000) or cause losses of RMB 2.5 million ($400,000).'' Joe 
McDonald, ``China jails more than 1,400 in lending crackdown,'' 
Associated Press, April 26, 2013.

Market Conditions and Access Issues for Banking, Investment, Insurance, 
---------------------------------------------------------------------------
        and Other Services Firms

    Expanding access to traditional bank lending for China's 42 
million SMEs would be a key way for Beijing to allow the 
private sector to thrive without compromising the government's 
regulatory powers. U.S. financial services firms say China 
should provide them with greater market access and operating 
capacity so that they can help to develop the Chinese financial 
sector. They note that, in contrast with China's bank-dominated 
financial system, in the United States, more credit is provided 
by financial markets and nonbank lenders than by banks, and 
they argue that they offer knowledge, experience, and products 
that China needs.\128\ Though China has taken some steps to 
expand foreign firms' access to its financial markets since 
joining the World Trade Organization (WTO) in 2001, this access 
remains quite limited (see Chinese Rationales for Market 
Barriers later in this section).
    China's economy has long been heavy on manufacturing and 
light on services, but the services sector is growing. 
Manufacturing accounted for 45.3 percent of China's GDP in 
2012, while the services sector (transport, wholesaling, 
retailing, hotels, tourism, financial services, real estate, 
scientific research, and other services) accounted for 44.6 
percent, according to official statistics.\129\ Strengthening 
this sector is a key goal of China's 12th Five-Year Plan for 
Economic and Social Development, as its expansion promises the 
creation of new jobs, increased domestic consumption and 
decreased dependence on exports and state investment projects 
for economic growth--all vital to the economic rebalancing 
needed to reduce the U.S.-China bilateral trade deficit.\130\ 
Unfortunately, the financial services subsector has not been 
growing as quickly as services overall, despite the fact that 
the development of this subsector is particularly crucial to 
China's achievement of its rebalancing goals. As Mr. Dearie 
told the Commission, ``Capital is the lifeblood of any 
economy's strength and well-being, enabling the investment, 
research, and risk-taking that fuels competition, innovation, 
productivity, and prosperity.'' \131\ An obvious way to 
increase access to capital is to spur development of the 
financial services sector in China. Fundamentally, the 
financial services sector struggles to thrive because of the 
extent of government intervention in the overall financial 
system. While the explosion of the shadow banking sector and 
the government's tolerance of it indicate the leadership's 
recognition of the need for financial liberalization, the 
government has been slow to embrace financial liberalization. 
This foot dragging continues even as the risks attendant in 
shadow banking underscore the importance of developing more 
comprehensive and well-regulated financial services than the 
informal shadow banking trend offers. The shortage of financial 
services inhibits the very consumption that China's leaders 
have committed to cultivate. While domestic consumption per 
capita continues to grow, it has actually fallen as a 
percentage of GDP from more than 60 percent to less than 50 
percent between 2000 and 2013, and more than half of the wealth 
in Chinese households today is still held in the form of low 
interest rate savings.\132\
    Empowering the Chinese consumer requires the broad 
availability of financial products and services, including 
personal loans, credit cards, mortgages, pensions, insurance 
products and services, and retirement security products. This 
would in turn persuade Chinese citizens to reduce their 
precautionary savings.\133\ U.S. financial services firms have 
long argued that if China would open its market to more 
investment, they could grow their own business. China has taken 
some steps to further open its financial services market in 
recent years. Foreign direct investment in financial services 
increased 122 percent between 2007 and 2010, but foreign access 
to China's financial markets more broadly remains heavily 
restricted, and this apparent high growth rate belies the fact 
that investment grew from a very small market share.\134\ 
Foreign ownership in the Chinese banking system, for example, 
currently amounts to less than 2 percent.\135\ And, according 
to Steve Simchak, director of International Affairs at the 
American Insurance Association, foreign property-casualty 
insurers in China currently hold only a 1.2 percent market 
share as a result of significant market entry barriers and a 
lack of national treatment.* \136\
---------------------------------------------------------------------------
    * National treatment is a principle of international law by which 
states guarantee that they will not favor their own citizens or 
businesses with treatment better than what they afford to those of 
their trading partners.
---------------------------------------------------------------------------
    U.S. financial services companies complain that even as the 
United States has taken steps to allow increased Chinese access 
to its financial services market, China is not reciprocating. 
The Wall Street Journal reported that China's state-run Citic 
Securities is applying for a license with U.S. regulators, 
making it the latest Chinese firm to expand into the United 
States as the Chinese government continues to encourage its 
financial services companies to invest more of the nation's 
foreign exchange reserves in foreign markets. Yet within China, 
foreign banking, securities, and insurance affiliates all 
continue to be subject to ownership restrictions and regulatory 
approval processes for their investments that are far more 
stringent than those that apply to domestic competitors. 
China's minimum capital requirements for foreign banks seeking 
to operate in the Chinese market exceed international norms, 
and foreign banks also cannot open new branches without 
permission from regulators and face cumbersome and lengthy 
approval processes.\137\ Foreign-owned securities and asset 
management firms are limited to joint ventures in which foreign 
ownership is capped at 49 percent, while foreign life insurance 
companies remain limited to 50 percent ownership in joint 
ventures and to 25 percent equity ownership of existing 
domestic companies; and, until a 2012 WTO dispute settlement 
panel ruling, market access for foreign electronic payment 
providers was virtually nonexistent.\138\
    In his testimony to the Commission, Professor Saulski noted 
that studies by the Organization for Economic Cooperation and 
Development and the World Bank ranked China as ``one of the 
most restrictive markets for financial services among the 
G20.'' China is also far more restrictive than its fellow major 
developing economies: Brazil, Russia, and India.\139\ Professor 
Saulski further explained that ``the current lack of 
significant competition in China's financial sector hinders 
efficiency, limits investor choice, and restricts access to 
capital by non-state-owned firms. Furthermore, the lack of 
competition in China's financial markets facilitates 
destructive rent seeking behavior by special interest groups 
and well-connected individuals. In its most pernicious form, 
this creates a perfect environment for fraud, insider dealing, 
and corruption.'' \140\

Chinese Rationales for Market Barriers: The General Agreement on Trade 
        in Services (GATS) and the Global Economic Crisis

    Though China's restrictions on market access to the 
financial services sector are significant, they are compatible 
with the country's 2001 WTO accession agreement, which was 
largely negotiated by the United States acting on behalf of 
other WTO members. Under the WTO's General Agreement on Trade 
in Services, Most Favored Nation (MFN) status and national 
treatment apply only as specified in a member country's 
schedule and MFN exemption list.* \141\ WTO members are 
explicitly allowed to provide non-MFN treatment if they record 
the exemptions in their WTO schedule of services commitments, 
though these exceptions are subject to negotiation in future 
multilateral trade talks. Members also are not obligated to 
provide national treatment except for the service categories 
that they choose and only to the extent recorded in their 
schedule of WTO services commitments. Agreements to gradually 
eliminate or reduce limitations to market access are also 
voluntary, ``applying only to those service categories included 
in a Member's schedule and only to the extent specified.'' 
\142\ Because many of the obligations under GATS are voluntary, 
most WTO members, including China, were selective about the 
service sector categories 
for which they undertook obligations in their accession 
agreements.\143\
---------------------------------------------------------------------------
    * Most Favored Nation treatment is a means of establishing equality 
of trading opportunity between states by ensuring that all nations 
accorded MFN status are treated equally by any given trading partner. 
An importing country cannot discriminate against the goods from one MFN 
country in favor of another MFN country's goods. If an importing 
country grants any type of concession to one MFN trading partner, this 
concession must also be given to all other countries with MFN status.
---------------------------------------------------------------------------
    At the ten-year review of China's WTO accession agreement 
in 2011, the United States criticized China's lack of progress 
in fully implementing its financial services obligations, 
honing in on continued restrictions on foreign ownership of 
Chinese banks and insurance companies. The Office of the U.S. 
Trade Representative (USTR) noted in its 2012 report to 
Congress on China's WTO compliance problems that ``China has 
continued to maintain or erect restrictive or cumbersome terms 
of entry in some sectors.'' USTR also underscored problems with 
``informal bans on new entry, high capital requirements, 
branching restrictions or restrictions taking away previously 
acquired market access rights.'' \144\ The Chinese claimed that 
their refusals to fully open the financial services sector were 
justified by the 2008 financial crisis, which cast developed 
nations' financial systems in an unfavorable light. As a senior 
official at the Shanghai Stock Exchange reportedly put it in 
2009, ``The master has been proven to be a fool.'' \145\ Mr. 
Dearie noted in his testimony that a major increase in negative 
Chinese perceptions of the U.S. financial system due to the 
global economic crisis damaged the ability of U.S. financial 
services firms to access the Chinese market and of USTR to 
negotiate greater access.\146\
    In June 2010, China proposed new WTO financial services 
discussions aimed at examining ``the gains and pains'' of 
financial liberalization and financial regulatory practices 
suited to developing countries. China reportedly noted:

        While many see liberalization of trade in financial 
        services as an essential contributing factor towards 
        the development of the sector, others regard excessive 
        and premature liberalization of the financial sector as 
        a key ingredient for financial instability. . . . This 
        is a particularly relevant subject in the post-crisis 
        era, as many countries are now concerned about how to 
        develop their financial sector so that it generates 
        real economic growth rather than asset bubbles. . . . 
        There is increasing evidence that the developed Members 
        may also have taken excessive liberalization 
        commitments. Before the financial crisis, deregulation 
        was the main trend in the domestic financial market of 
        the developed countries, and in the international 
        arena, the developed countries pushed for more 
        liberalization commitments to gain greater financial 
        deregulation in the markets of their trade partners. 
        The financial crisis has brought a sharp turn in the 
        way we think about financial deregulation, and now the 
        most popular word for the financial regulators is 
        `reregulation.' \147\

    China also warned that foreign services firms would 
dominate the most profitable sectors of the Chinese market, 
impeding the development and success of domestic firms. In 
addition, China worried that foreign firms might act as 
conduits for household savings to be funneled out of the 
country rather than invested domestically and that the 
increased linkages with the global financial system could leave 
China more susceptible to volatilities in the global 
market.\148\

China's Financial Sector--Foreign Investors Experience Problems with 
        Governance, Transparency, and Accountability

    Even if foreign service firms were given access to 
household savings in China, weak corporate governance, 
regulatory oversight, and accounting practices in China create 
problems for potential foreign investors. Investor confidence 
in China's securities markets and in Chinese companies trading 
on U.S. and other foreign exchanges is important to the Chinese 
government's economic rebalancing efforts. Selling shares of 
Chinese companies to foreign investors has become an 
increasingly significant means of raising capital. However, 
China's traditional banking system and its publicly traded 
corporations are hobbled by poor audit quality and unreliable 
financial statements. Investor confidence depends on 
transparent and reliable accounting and audit regimes--to which 
the Chinese government has shown resistance. Improvements in 
the governance of China's companies and its capital markets are 
critical to protecting American shareholders and American 
investments in China.

China's Corporate Governance Creates Challenges for Investors and 
        Regulators

    Demand for credit has led Chinese companies to seek capital 
overseas even as its shadow banking system has expanded. In the 
late 1990s, Chinese companies began raising capital on major 
international stock exchanges. This trend has been driven by 
large Chinese companies, many state owned, that have sought to 
broaden their shareholder base, increase the liquidity of their 
shares, and enhance the visibility of their brand names. In 
part, it has also been driven by small- and medium-sized 
private Chinese companies seeking alternative capital options 
beyond the state-controlled banks that dominate China's 
financial system, and the limited domestic exchanges.
    U.S. stock markets are among the most popular alternate 
global exchange destinations for Chinese firms. According to 
Commission witness Paul Gillis, professor at Peking University 
and Standing Advisory Group member of the Public Company 
Accounting Oversight Board (a quasi-public entity established 
by the Sarbanes-Oxley Act that polices auditors and reports to 
the U.S. Securities and Exchange Commission (SEC)), there are 
more than 200 Chinese companies that have offered shares of 
stock on the New York Stock Exchange and NASDAQ in recent 
years, and hundreds more have entered U.S. over-the-counter 
markets.\149\ However, many of the Chinese companies listing in 
the United States have proved to be poor investments.
    Initially, U.S. investors purchased stock in U.S.-listed 
Chinese companies in hopes of profiting from China's rapid 
growth rate. However, investors in U.S.-listed Chinese 
companies have increasingly found that insufficient corporate 
governance standards make these companies high-risk 
investments. Many have been implicated in frauds and accounting 
scandals, and U.S. regulators have deregistered about 50 
Chinese companies in the past two years following fraud 
probes.\150\ The stigma attached to U.S.-listed Chinese 
companies as a result of this regulatory scrutiny has lowered 
returns for nearly all of them. The 82 companies in the 
Bloomberg Chinese Reverse Mergers Index lost 52 percent of 
their market value between June 2011 and July 2012.\151\ U.S.-
listed Chinese companies are ``deserting U.S. stock markets in 
record numbers as regulatory scrutiny mounts and the advantages 
of a U.S. listing slip away.'' \152\ Six U.S.-listed Chinese 
companies announced plans to go private through buyouts in 
2010, but by 2012, 27 Chinese companies had announced they 
would go private. In addition, approximately 50 mostly smaller 
U.S.-listed Chinese companies deregistered with the SEC, ending 
their requirements for public disclosures, in 2012.\153\ In 
addition, far fewer Chinese companies are listing on U.S. 
exchanges. Only three Chinese companies successfully went 
public on U.S exchanges in 2012, down from 41 in 2003.\154\
    Two types of Chinese companies in particular have sought 
access to U.S. capital markets: smaller enterprises with 
limited ability to use Chinese capital markets, and some of the 
largest state-owned enterprises in industries such as petroleum 
and telecommunications.\155\ Larger Chinese state-owned 
enterprises have primarily entered the U.S. markets by openly 
filing IPOs on the New York Stock Exchange and NASDAQ in the 
form of American Depository Receipts (ADRs) or ordinary 
shares.* \156\ In 1993, state-owned Sinopec Shanghai 
Petrochemical was the first Chinese company to list on a U.S. 
exchange by issuing an IPO in the form of ADRs.\157,158\
---------------------------------------------------------------------------
    * An ADR is a certificate representing one or more shares of a 
foreign firm's stock, denominated in U.S. dollars.
---------------------------------------------------------------------------
    Smaller private Chinese companies have most commonly sought 
access to U.S. markets because they lack sufficient domestic 
sources for capital and have entered the markets by merging 
with existing, registered U.S. shell companies in reverse 
mergers. Reverse mergers do not require approval from the China 
Securities Regulatory Commission (the Chinese counterpart of 
the U.S.'s Public Company Accounting Oversight Board) and 
involve much less regulatory scrutiny by the SEC than do IPOs. 
A reverse merger involves a private company purchasing a 
publicly traded company and shifting its management into that 
company. This allows the private company to become publicly 
traded without going through the regulatory and financial 
disclosure processes associated with an IPO. Most Chinese 
reverse mergers are traded on the over-the-counter market until 
they satisfy various requirements, such as size and 
capitalization level, that qualify them to list on the New York 
Stock Exchange or NASDAQ. Between 2000 and 2011, approximately 
443 Chinese companies entered U.S. markets via reverse mergers, 
but relatively few of these have made it off of the over-the-
counter market and onto the New York Stock Exchange or 
NASDAQ.\159\
    As of May 2012, there were approximately 112 Chinese 
companies traded on the New York Stock Exchange or NASDAQ in 
the form of ADRs, 21 traded in the form of ordinary shares, and 
79 that listed via reverse merger transactions.\160\ Large 
Chinese companies entering U.S. markets via IPOs, including 
state-owned enterprises, have accounted for the greatest share 
of Chinese companies' market capitalization, but they have been 
greatly outnumbered by smaller Chinese companies entering U.S. 
markets via reverse mergers. This latter group has also 
generated a sizeable portion of Chinese companies' market 
capitalization. According to the Public Company Accounting 
Oversight Board, between January 2007 and March 2010, 159 
Chinese companies entered the U.S. securities markets using 
reverse mergers and generated market capitalization of $12.8 
billion. In the same period, 56 Chinese companies, including a 
number of very large, state-owned enterprises, completed U.S. 
IPOs and had an aggregate market capitalization of $27.2 
billion.\161\

Chinese Reverse Mergers Skirt Oversight

    Chinese reverse merger transactions have attracted the bulk 
of the critical attention from U.S. regulators. Companies that 
enter the U.S. market via reverse mergers are riskier 
investments, because they do not go through the disclosure 
processes associated with traditional IPOs and thus offer less 
information to investors. In response to increasing complaints 
involving foreign reverse mergers, the SEC issued a bulletin in 
June 2010 warning investors of the risks of fraud and other 
abuses involving reverse merger companies. The SEC also set up 
a task force to investigate the foreign company reverse merger 
trend and associated investor risks. In November 2011, the SEC 
approved new NASDAQ, New York Stock Exchange, and American 
Stock Exchange rules that impose more stringent listing 
requirements for reverse mergers. Under the new rules, a 
reverse merger company cannot apply to list on the New York 
Stock Exchange, NASDAQ, or the American Stock Exchange until it 
has completed a one-year ``seasoning period'' of trading on the 
U.S. over-the-counter market or on another regulated U.S. or 
foreign exchange following its reverse merger. It also must 
file all required reports with the SEC, including audited 
financial statements, and maintain a minimum share price of 
$2.00 to $4.00 for at least 30 of 60 trading days immediately 
prior to filing its listing application.\162,163\
    An ABC News investigation in January 2013 found that since 
2010, more than 70 Chinese companies have been removed from or 
left NASDAQ and the New York Stock Exchange after reports of 
alleged fraud and financial irregularities.\164\ In 2008 and 
2009, there were very few U.S. federal securities class actions 
filed against companies domiciled in China. In 2010, Chinese 
companies were the target of 15 such suits, and by 2011, that 
number had risen to 38 suits--accounting for 17 percent of the 
224 U.S. federal securities class actions filed in 2011 and 
nearly 66 percent of the 60 such suits targeting non-U.S. 
companies.\165\ At least 42 of the Chinese companies targeted 
by U.S. securities class actions to date were listed on U.S. 
stock markets via reverse mergers and have been subjects of SEC 
investigations of financial schemes that former SEC Chairman 
Mary Schapiro described as ``brazen.'' \166\ According to 
analysis by the Harvard Law School Forum on Corporate 
Governance and Financial Regulation, ``Over 85 percent of U.S. 
securities class actions filed against Chinese issuers from 
2008 to mid-2012 have included accounting-related 
allegations.'' \167\
    In order to be publicly traded on the U.S. capital markets, 
companies have to make public certain information about their 
business strategies, operations, material risks, and financial 
results. The financial statements contained in companies' 
annual reports filed with the SEC are required to have an 
independent external audit for consistency with U.S. accounting 
standards. These standards are the same for all companies 
notwithstanding where they are registered. In its 2010 Annual 
Report to Congress, the Commission noted that SEC standards for 
assessing material risks may benefit from singling out certain 
nations for special scrutiny, based on their domestic 
accounting standards. For example, there is no reporting 
requirement that takes note of the unique and politicized role 
that the CCP plays in the selection of Chinese corporate 
leadership.
    The House Financial Services Committee sent a letter to the 
Public Company Accounting Oversight Board and the SEC on 
September 9, 2010, complaining of the quality of auditing of 
U.S.-listed Chinese companies. The Big Four accounting firms 
(PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu, and 
Ernst & Young) audit 88 percent of all U.S.-listed Chinese 
companies, including a number of the companies named as 
defendants in U.S. government-filed law suits.\168\ Public 
Company Accounting Oversight Board standing advisory group 
member and Commission witness Paul Gillis noted in a recent 
report that fraud and accounting issues associated with U.S.-
listed Chinese companies have brought mounting pressure for 
these accounting firms to verify that they have conducted their 
audits properly.\169\

SEC Cracks Down on Accounting Firms of Chinese Companies

    During recent probes, the SEC has sought audit work papers 
from the accounting firms, a common request during fraud 
investigations. To date, the firms have refused to produce 
these documents, arguing that doing so would put them in 
violation of Chinese state secrets laws. In China, sharing 
accounting information with foreign regulators and removing 
audit papers from the country violates state secrets laws. 
Chinese authorities also do not permit non-Chinese regulators 
to conduct investigations in China.\170\ Chinese law 
``prohibits firms from producing audit working papers directly 
to any foreign regulator and requires those foreign regulators 
to seek such documents through the China regulator,'' according 
to Commission testimony by Cynthia Fornelli, executive director 
of the Center for Audit Quality.\171\ China has several times 
amended its Law on Guarding State Secrets to be more inclusive 
of a variety of information, including economic 
statistics.\172\ China is also applying its State Secrets Law 
to private companies. In the SEC's investigation of Deloitte 
Touche Tohmatsu's auditing of China-based Longtop Financial 
Technologies, for instance, Deloitte said Chinese regulators 
had warned them that turning over working papers to the SEC 
could lead to sentences of life imprisonment for the partners 
involved and to the banishment of their firm from conducting 
further business in China.\173\ In the United States, however, 
withholding foreign public accounting paperwork of U.S.-traded 
companies violates both the Securities Exchange Act and the 
Sarbanes-Oxley Act, which require foreign audit firms to 
produce documents concerning U.S.-listed clients at the SEC's 
request.\174\
    In December 2012, the SEC charged five firms with breaking 
U.S. securities laws by refusing to turn over the requested 
audit work papers. The defendants in the case are Beijing-based 
BDO China Dahua, Ernst & Young Hua Ming, KPMG Huazhen, 
Shanghai-based Deloitte Touche Tohmatsu Certified Public 
Accountants, and PricewaterhouseCoopers ZhongTian. China-based 
affiliates of these accounting firms face the possibility of 
losing both their right to practice and their registration with 
the Public Company Accounting Oversight Board.
    Initially, U.S. audit firms entered the Chinese market as 
joint ventures with Chinese partners. The Big Four in most 
countries are owned by local partners, operating more like a 
franchise than a typical multinational corporation. China has 
required the Big Four to convert into limited liability 
partnerships as their 20-year joint venture terms began to 
expire in late 2012. In May 2012, the Chinese government 
announced that by December 31, 2017, the Big Four must evolve 
into partnerships in which Chinese-qualified accountants are a 
majority of the firm's accountants. The new regulation will cap 
the level of foreign-qualified accountants at the firms at 40 
percent initially and at 20 percent by the end of 2017. In 
addition, the regulation will limit the voting rights of all 
partners with foreign qualifications and require that all 
senior partners be Chinese citizens. This change will limit 
U.S. corporate opportunities to manage audit operations, 
further complicating SEC enforcement efforts in China.\175,176\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Accounting Fraud Impacts U.S. Companies Operating in China
 
  Fraud and accounting problems associated with China are not limited to
U.S.-listed Chinese companies. U.S. companies have directly invested $54
billion in Chinese businesses, factories, and property, most of it in
the past decade, according to the Department of Commerce. U.S.
corporations' China operations are facing increasing problems. For
example, on January 18, Caterpillar disclosed ``deliberate, multi-year,
coordinated accounting misconduct'' at a unit of ERA Mining Machinery
Ltd., a company it paid $654 million to acquire in June 2012.
Caterpillar has disclosed inventory discrepancies, inflated profits, and
improperly recorded costs and revenue at the ERA Siwei unit, located in
Zhengzhou, China. The Caterpillar experience and the growing catalog of
smaller instances of deception and abuse involving U.S. companies' China
corporations indicate that U.S. companies' Chinese investments
experience unique accounting and governance challenges. The financial
and legal advisors for Caterpillar and ERA included Citigroup,
Freshfields Bruckhaus Derringer LLP, Blackstone, and DLA Piper. It
appears that they did not detect the fraud prior to the deal
closing.\177\
 
------------------------------------------------------------------------


Risk Management and Bilateral Cooperation
    All accounting firms that audit U.S.-traded public 
companies and their employees must register with the Public 
Company Accounting Oversight Board. The Public Company 
Accounting Oversight Board sets auditing standards and rules 
for U.S.-listed companies and is charged with inspecting and 
regularly reviewing the audits of all public accounting firms 
that audit U.S.-listed companies, including those firms that 
audit foreign-domiciled, U.S.-listed companies and are 
themselves domiciled outside of the United States.\178\ 
According to Ms. Fornelli, as of June 2011 there were 54 
Chinese mainland auditing firms and 55 Hong Kong firms 
registered with the Public Company Accounting Oversight Board, 
and the board had performed more than 200 inspections of non-
U.S.-domiciled accounting firms in over 35 jurisdictions, 
including Brazil, India, Japan, and Russia.\179,180\
    Recognizing a need to improve U.S. financial regulators' 
ability to gauge the financial health of companies domiciled in 
other jurisdictions, Congress empowered the Public Company 
Accounting Oversight Board to negotiate agreements for 
reciprocal inspections with audit regulators outside the United 
States as well as the confidential exchange of information with 
other regulators. This was part of the Dodd-Frank Wall Street 
Reform and Consumer Protection Act of 2010. Such cooperation 
between the board and foreign auditing oversight bodies was 
intended to encourage jurisdictions to better harmonize 
auditing standards and requirements. The goal was to eliminate 
such conflicts as the SEC's requests for documents that U.S. 
accounting firms cannot produce under Chinese law but must 
produce under U.S. law.\181\ Ms. Fornelli testified that the 
Public Company Accounting Oversight Board now has cooperation 
agreements with 16 nations and that after the 2010 Strategic 
and Economic Dialogue, the United States and China announced 
their intent to negotiate such an agreement on the sharing of 
confidential information for regulatory purposes.\182\ However, 
the Public Company Accounting Oversight Board and the China 
Securities Regulatory Commission have yet to achieve that goal.
    The inability of the Public Company Accounting Oversight 
Board to inspect in China creates a gap in investor protection. 
This lack of an information-sharing agreement with China does 
not just limit U.S. regulators' ability to ensure proper 
conduct at the Big Four accounting firms. It also limits their 
ability to ensure proper conduct at the Chinese-domiciled 
accounting firms that audit or play a substantial role in 
auditing U.S.-listed Chinese companies and the Chinese 
operations of U.S. companies. Though U.S. securities law 
requires overseas auditing firms that audit U.S.-listed 
companies to undergo inspection by the Public Company 
Accounting Oversight Board to ensure that they are following 
U.S. standards, China wants the United States to allow the 
China Securities Regulatory Commission and the Chinese Ministry 
of Finance to conduct and control all investigations of 
accounting firms in China, via an audit oversight agreement 
similar to the one it struck with the European Union. According 
to a statement by Mr. Gillis:

        In a 2009 letter commenting on the PCAOB's [Public 
        Company Accounting Oversight Board] proposed delay in 
        the deadline for foreign inspections, the CSRC [China 
        Securities Regulatory Commission] said that any 
        oversight of Chinese accounting firms should rely 
        solely on the CSRC. In 2011, the European Union 
        recognized the equivalence of the audit oversight 
        systems in 10 third countries, including China. The 
        third countries and EU [European Union] member states 
        can now mutually rely on each other's inspections of 
        audits. Chinese regulators want the same treatment from 
        the United States, but U.S. laws do not permit the 
        PCAOB to rely on foreign regulators.\183\

    Chinese regulators have been reluctant to offer joint 
inspections, as they view such access as a breach of national 
sovereignty. If they do agree to some form of joint inspections 
between Chinese and U.S. regulators, they will likely insist on 
retaining full control over punishment of violations by Chinese 
auditors. The Public Company Accounting Oversight Board has 
been in negotiations with Chinese regulators since 2010 to try 
to work out an agreement and previously set a December 31, 
2012, deadline to complete inspections of Chinese accounting 
firms. With this deadline passed, failure to reach a 
breakthrough in negotiations in the near future ``could lead to 
the deregistration of Chinese accounting firms and a mass 
delisting of Chinese stocks,'' since U.S.-listed Chinese 
companies would no longer have a registered auditor and thus 
would have to delist.\184\
    On May 24, 2013, the United States and China announced a 
deal for limited information-sharing between their regulatory 
agencies when there are questions regarding audits of U.S.-
listed Chinese companies. Under the agreement, the U.S. Public 
Company Accounting Oversight Board will be permitted access to 
audit documents from Chinese accounting firms to use in board 
investigations. This deal to facilitate information-sharing 
during investigations related to possible sanctions is a step 
in the right direction, but it does not resolve the board's 
challenges with regard to regular inspections of Chinese 
auditing firms, and it is inspections, rather than 
investigations, that are the Public Company Accounting 
Oversight Board's main function. Under U.S. law, ``firms that 
issue reports on public companies are to be inspected at least 
every three years'' to ensure that they are in compliance with 
U.S. auditing standards, but Chinese law still prohibits 
auditors from providing documents to the Public Company 
Accounting Oversight Board for such inspections.\185\ At the 
July meeting of the Strategic and Economic Dialogue, U.S. 
Treasury Secretary Jack Lew announced that Chinese regulators 
had agreed to turn over to the SEC certain requested audit work 
papers of some Chinese companies listed on U.S. stock 
exchanges, a move that will assist the SEC in ongoing 
investigations.* However, no further progress has been made 
toward achieving more general direct access to documents for 
U.S. regulators conducting investigations or inspections. The 
May deal also permits China to withhold documents from the 
Public Company Accounting Oversight Board ``on grounds of 
public interest or essential national interest.'' \186\ As Mr. 
Gillis explained in a May 2013 Op-Ed for the Wall Street 
Journal, failure to resolve these issues more fully could lead 
the SEC and the Public Company Accounting Oversight Board to 
ban Chinese accounting firms from auditing U.S.-listed 
companies, which could in turn lead to Chinese companies being 
delisted from U.S. exchanges. However, this is a ``nuclear 
option'' that U.S. regulators are likely reluctant to 
pursue.\187,188\
---------------------------------------------------------------------------
    * Achieving direct access to documents that the Big Four auditing 
firms have refused to turn over will aid the SEC in moving forward with 
its investigations into certain Chinese companies listed on U.S. 
exchanges, including specifically the Deloitte-audited company, Longtop 
Financial. As of the drafting of this Report, the SEC's administrative 
trial against Chinese affiliates of Deloitte and the other Big Four 
audit firms in response to their refusals to turn over audit documents 
is ongoing. The presiding judge has reportedly requested a 100-day 
extension in the case, pushing the due date for a decision to January 
7, 2014.

---------------------------------------------------------------------------
Implications for the United States

    The rate of China's economic growth over the last 30 years, 
and its integration of a fifth of the world's population into 
the global economy, has profound implications for economic 
growth and job creation in the United States. China is 
currently America's third-largest export market and its 
fastest-growing export destination. U.S. exports to China have 
increased sixfold since 2001, with 48 states experiencing at 
least triple-digit growth in their exports to China and 20 
states experiencing quadruple-digit growth. That is seven times 
the pace at which U.S. exports to the rest of the world have 
increased over the same time period.\189\ However, the growth 
of U.S. imports from China still far surpasses this growth in 
exports to China. (For further discussion of the deficit, see 
chap. 1, sec. 1, of this Report.) A more consumption-driven 
Chinese economy would mean an expansive growth in Chinese 
demand for American products and services. But China lacks the 
modern and sophisticated financial sector needed to accomplish 
the shift to greater domestic consumption.\190\ Without a more 
open and market-oriented financial system, China cannot deliver 
on its promised economic rebalancing, and the costs of the 
imbalances in the U.S.-China economic relationship will 
continue to accrue.
    While available measures indicate that China's shadow 
banking sector remains smaller than that of the United States, 
its size relative to China's formal banking sector continues to 
expand, and Beijing's efforts to curb the risky lending in this 
sector to date may perversely be fueling it. Expressing 
concerns about wealth management products in January 2013, Xiao 
Gang, former chairman of the Bank of China and current head of 
the Chinese Securities Regulatory Commission, reportedly 
characterized the shadow banking sector as ``a potential source 
of systemic financial risk,'' whose model is ``fundamentally a 
Ponzi scheme.'' \191\ In September, the G20 echoed this view 
when it endorsed new global rules for shadow banking issued by 
the Financial Stability Board.\192\ While the potential risks 
of China's shadow banking sector are not fully understood, to 
the extent that it poses systemic risks to China, it is fair to 
surmise that it poses risks for international financial 
stability more broadly. It is in the interest of the United 
States for Beijing to succeed in its efforts to curb risky, 
off-balance-sheet lending and establish greater regulatory 
control over nonbank financial institutions.
    China's opaque policies and practices with regard to 
corporate accountability present serious challenges for U.S. 
companies and U.S. investors seeking information on the risks 
entailed in their transactions.

Conclusions

 LThe Chinese economy weathered the first few years of 
the global economic downturn by doubling down on its time-
tested strategy of funneling capital into domestic development 
projects. But five years on, global demand for Chinese exports 
remains too weak to sustain the country's factories, much less 
new ones, and the merits of massive infrastructure projects 
have more than run their course. The policy decisions that kept 
the Chinese economy chugging over the last few years have also 
sped it closer to a reckoning that economists have long 
forecast would eventually be necessary.\193\ If a rebalancing 
of the U.S.-China economic relationship is to be achieved, 
China must reform its financial system to support newer, 
nonstate sources of economic growth, which will require that 
China's banks better service its private sector.

 LAs long as China's official, regulated channels of 
credit do not possess the flexibility to meet the needs of the 
Chinese economy's main job creators, China will be at risk of 
depressed economic growth, which in turn may limit the growth 
of U.S. exports to China and the prosperity of U.S. investments 
in China, slowing economic recovery here at home. The shadow 
banking system that Beijing has allowed to step into this 
credit gap is insufficiently regulated and, if left unchecked, 
will pose an increasingly serious threat to Chinese and global 
economic stability.

 LThe opacity of Chinese corporate governance and 
accountability policies, as well as conflicts with U.S. 
securities laws and regulations, hurts investor confidence in 
Chinese companies trading on U.S. exchanges. The current 
situation threatens U.S. investors with unforeseeable and 
unmanageable losses and may lead to a broad delisting of 
Chinese companies. China's lack of sophisticated banking, 
corporate governance, and auditing policies and practices also 
hinders much-needed growth and opportunity for the very U.S. 
financial services firms that could help China to restructure 
its system if they were allowed greater access to the Chinese 
market.

 LInsufficient transparency and accountability in 
China's financial sector put U.S. firms at risk of violating 
laws in both China and the United States; pose unreasonable 
hazards for U.S. investors with shares in Chinese companies; 
and render some U.S. laws and regulations unenforceable. 
Without greater regulatory transparency and assurance of 
China's regulatory, oversight, and enforcement capabilities, 
Chinese firms also risk curtailment or even revocation of 
access to the U.S. market.

                     ENDNOTES FOR SECTION 3

      1. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Sheridan Prasso, March 7, 2013.
      2. Dezan Shira & Associates, ``Shadow Banking Poses Hidden Risks 
to China's Financial Sector,'' January 2012.
      3. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Carl Walter, March 7, 2013.
      4. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, testimony of Carl Walter, March 7, 2013.
      5. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of John Dearie, March 7, 2013.
      6. Lucy Hornby and Coco Li, ``China should sell state shares in 
mid-tier banks--Minsheng vice chairman,'' Reuters, March 11, 2013. 
http://uk.reuters.com/article/2013/03/11/china-banks-govt-stakes-
idUKL3N0C31HS20130311.
      7. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Lynette H. Ong, March 7, 2013.
      8. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Carl Walter, March 7, 2013.
      9. Caijing, ``China's policy banks,'' September 2009.
     10. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Carl Walter, March 7, 2013.
     11. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, testimony of Carl Walter, March 7, 2013.
     12. Douglas J. Elliot and Kai Yan, ``The Chinese Financial System: 
An Introduction and Overview'' (Washington, DC: The John L. Thornton 
China Center at The Brookings Institution, July 2013).
     13. Bloomberg, ``China Shadow Bankers Go Online as Peer-to-Peer 
Sites Boom,'' July 24, 2012.
     14. Leland Miller, ``The Crisis Ahead for China's Policy Banks: 
Part 2,'' Seeking Alpha, January 3, 2012.
     15. Bloomberg, ``China Shadow Bankers Go Online as Peer-to-Peer 
Sites Boom,'' July 24, 2012.
     16. Deposits.org, ``Bank Deposit Rates in China,'' http://
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An Introduction and Overview'' (Washington, DC: The John L. Thornton 
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Companies to the U.S. Market'' (Albany, NY: State University of New 
York at Albany, May 17, 2012).
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Wall Street,'' Foreign Policy, February 4, 2013.
     20. Carl Walter and Fraser Howie, ``Why China Will Never Have a 
Wall Street,'' Foreign Policy, February 4, 2013.
     21. Carl Walter and Fraser Howie, ``Why China Will Never Have a 
Wall Street,'' Foreign Policy, February 4, 2013.
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China's Financial System: Rules and their Ramifications for U.S. 
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economics/21584021-china-still-dealing-mess-left-previous-bank-bail-
outs-lipstick.
     46. Dezan Shira & Associates, ``Shadow Banking Poses Hidden Risks 
to China's Financial Sector,'' January 2012.
     47. Henry Sanderson and Michael Forsythe, China's Superbank: Debt, 
Oil and Influence--How China's Development Bank Is Rewriting the Rules 
of Finance (Singapore: Bloomberg Press, John Wiley and Sons, 2013), p. 
3.
     48. Henry Sanderson and Michael Forsythe, China's Superbank: Debt, 
Oil and Influence--How China's Development Bank Is Rewriting the Rules 
of Finance (Singapore: Bloomberg Press, John Wiley and Sons, 2013).
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     53. U.S.-China Economic and Security Review Commission, Hearing on 
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China's Financial System: Rules and their Ramifications for U.S. 
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financing: Fitch,'' April 10, 2013.
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China's Financial System: Rules and their Ramifications for U.S. 
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     77. Fox Business, ``China banks `significantly exposed' to shadow 
financing: Fitch,'' April 10, 2013.
     78. U.S.-China Economic and Security Review Commission, Hearing on 
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lending risks lurk in the shadows,'' Reuters, April 9, 2013.
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Financial Times, February 26, 2013.
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lending risks lurk in the shadows,'' Reuters, April 9, 2013.
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22, 2013.
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2012).
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China's Financial System: Rules and their Ramifications for U.S. 
Investors, testimony of John Dearie, March 7, 2013.
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    149. U.S.-China Economic and Security Review Commission, Hearing on 
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China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Paul L. Gillis, March 7, 2013.
    150. Dena Aubin and Olivia Oran, ``Chinese Companies Retreat from 
U.S. Listings as Scrutiny Mounts,'' Reuters, January 14, 2013.
    151. Bloomberg, ``Chinese Stocks Flee U.S. Exchanges,'' July 19, 
2012.
    152. Dena Aubin and Olivia Oran, ``Chinese Companies Retreat from 
U.S. Listings as Scrutiny Mounts,'' Reuters, January 14, 2013.
    153. Dena Aubin and Olivia Oran, ``Chinese Companies Retreat from 
U.S. Listings as Scrutiny Mounts,'' Reuters, January 14, 2013.
    154. Dena Aubin and Olivia Oran, ``Chinese Companies Retreat from 
U.S. Listings as Scrutiny Mounts,'' Reuters, January 14, 2013.
    155. Lewis H. Ferguson, Investor Protection through Audit Oversight 
(California State University 11th Annual SEC Financial Reporting 
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    156. Kun-Chih Chen, Ying Chou Lin, and Yu-Chen Lin, Does Foreign 
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    158. NYSE EURONEXT Listings Directory, Sinopec Shanghai 
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    159. Yingjie Zhang, ``The Study on the Entry Mechanisms by Chinese 
Companies to the U.S. Market'' (Albany, NY: State University of New 
York at Albany, May 17, 2012).
    160. Yingjie Zhang, ``The Study on the Entry Mechanisms by Chinese 
Companies to the U.S. Market'' (Albany, NY: State University of New 
York at Albany, May 17, 2012).
    161. Lewis H. Ferguson, Investor Protection through Audit Oversight 
(California State University 11th Annual SEC Financial Reporting 
Conference, Irvine, CA, September 21, 2012).
    162. SecuritiesLawyer101.com, Reverse Mergers 101, Hamilton & 
Associates.
    163. U.S. Securities and Exchange Commission, ``SEC Approves New 
Rules to Toughen Listing Standards for Reverse Merger Companies'' 
(Washington, DC: November 9, 2011).
    164. Matthew Mosk, ``Chinese Deny Turning Blind Eye to Investment 
Scams,'' ABC News, January 10, 2013.
    165. Elaine Buckberg, ``Recent Trends in U.S. Securities Class 
Actions Against Non-U.S. Companies'' (The Harvard Law School Forum on 
Corporate Governance and Financial Regulation, November 20, 2012).
    166. Matthew Mosk, ``Chinese Deny Turning Blind Eye to Investment 
Scams,'' ABC News, January 10, 2013.
    167. Elaine Buckberg, ``Recent Trends in U.S. Securities Class 
Actions Against Non-U.S. Companies'' (The Harvard Law School Forum on 
Corporate Governance and Financial Regulation, November 20, 2012).
    168. Paul Gillis, ``Who Audits China?'' China Accounting Blog, 
November 22, 2011.
    169. Paul Gillis, ``Who Audits China?'' China Accounting Blog, 
November 22, 2011.
    170. Michelle FlorCruz, ``Standoff Between U.S., Chinese Over 
Audits of Chinese Firms Could Mean Delisting from U.S. Exchanges for 
Many Chinese Companies,'' International Business Times, December 4, 
2012.
    171. U.S.-China Economic and Security Review Commission, Hearing on 
Corporate Accountability, Access to Credit, and Access to Markets in 
China's Financial System: Rules and their Ramifications for U.S. 
Investors, written testimony of Cynthia Fornelli, March 7, 2013.
    172. Michelle FlorCruz, ``Standoff Between U.S., Chinese Over 
Audits of Chinese Firms Could Mean Delisting from U.S. Exchanges for 
Many Chinese Companies,'' International Business Times, December 4, 
2012.
    173. Megan Mcardle, ``Accounting War,'' The Daily Beast, December 
13, 2012.
    174. Kathy Chu, Michael Rapaport, and Ben Dummett, ``SEC Probe Puts 
China Listings in Doubt,'' Wall Street Journal, December 4, 2012.
    175. Wang Yuqian, ``Big Four Accounting Firms Face New Regulatory 
Challenges in China,'' China Briefing, March 2, 2012.
    176. Wang Yuqian, ``Big Four Auditors Get Rules for 
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    177. Ernest Scheyder, ``Caterpillar Writes Off Most of China Deal 
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    178. Patrick Chovanec, ``Clash of the Balance Sheets,'' Foreign 
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    180. Lewis H. Ferguson, ``Investor Protection through Audit 
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Reporting Conference, Irvine, CA, September 21, 2012).
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Trading Markets'' (Center for Professional Education, Inc., SEC 
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    182. Cynthia Fornelli, ``Financial Reporting and Confidence in 
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Wall Street Journal, May 29, 2013.
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Wall Street Journal, May 29, 2013.
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China's Financial System: Rules and their Ramifications for U.S. 
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    193. Xu Qiyuan, ``China needs to set its services free,'' Financial 
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11e2-b7dc-00144feabdc0.html-#-ax-zz-2-Rot4eLM6.
                 SECTION 4: CHINA'S AGRICULTURE POLICY,

                  FOOD REGULATION, AND THE U.S.-CHINA

                           AGRICULTURE TRADE

Introduction
    China's World Trade Organization (WTO) accession in 2001 
was a watershed event for U.S. agriculture. China is now the 
primary export market for U.S. agriculture products.\1\ While 
the United States ran a $315 billion trade deficit in goods 
with China in 2012, it achieved a $21 billion surplus in 
agriculture.\2\ Since full implementation of the WTO accession 
in 2005, China's agriculture imports from the United States 
have risen by an average of $2.5 billion each year, exceeding 
the U.S. Department of Agriculture's (USDA) initial estimate of 
$2 billion.\3\
    A prime beneficiary of this farm trade boom is Iowa, one of 
the nation's largest agricultural states.\4\ Twenty years ago, 
China and Taiwan accounted for 6 percent of Iowa's agricultural 
exports. By 2012, they accounted for over 20 percent. That has 
helped sales of Iowa's agricultural products triple to $30 
billion in just a decade.\5\ Iowa farm real estate is now worth 
three times the national average.\6\ Moreover, Iowa has 
enhanced the U.S.'s agriculture diplomacy with China. Iowa 
officials claim a ``special relationship'' with China's new 
president, Xi Jinping, who spent time in the state as a young 
official.\7\ U.S. Agriculture Secretary Tom Vilsack in February 
2012 hosted Mr. Xi and Agriculture Minister Han Changfu at the 
first U.S.-China Agricultural Symposium in Des Moines. The two 
countries signed the first U.S.-China Plan of Strategic 
Cooperation in Agriculture (2012-2017).\8\ Weeks after the 
symposium, the USDA led the largest ever agricultural trade 
mission to the Mainland.\9\
    The Commission consequently chose Iowa State University in 
Ames as the location for an April hearing on China's 
agriculture policy and the U.S.-China trade in agriculture 
products. Among the witnesses was Iowa Secretary of Agriculture 
William Northey. The Commissioners also traveled to China in 
July to meet with Chinese officials, researchers, and producers 
as well as U.S. food companies. These activities complemented 
the Commission's 2008 hearing in New Orleans, which examined 
the economic and safety impacts of China's seafood exports to 
the United States.\10\
    The hearing and trip illustrated the potential for 
deepening U.S.-China agriculture ties. China must feed a fifth 
of the world's population with less than a tenth of its arable 
land and potable water.\11\ As China transforms into an urban 
society with a growing middle class, per capita food 
consumption is rising and, with it, the demand for higher-
protein diets--a demand that U.S. farmers are well positioned 
to fill. China also seeks to make its farmers more productive, 
and U.S. agencies, companies, and universities are helping 
China to do that. The United States, with its distinct 
advantages in resources, productivity, and quality, should 
benefit from a free market in farm goods.
    However, the Commission takes note of serious problems in 
the bilateral relationship. These problems are detailed in this 
section. Many in the U.S. agriculture industry lobbied Congress 
in 2000 to grant China permanent normal trade relations, 
because they expected China to become a major purchaser of U.S. 
food products once it joined the WTO.* But yesterday's farm 
belt advocates have been disappointed that China has 
concentrated its purchases on bulk commodities, such as 
soybeans used as animal feed for China's outsized livestock 
industry (see figures 1 and 2). China's agriculture policy 
favors domestic production, even when it is unsustainable and 
nonessential to food security. In trade, China has used 
nontariff barriers to restrict imports of higher value-added 
products from the United States. Of particular concern are 
antidumping duties on U.S. broiler chickens; a ban on U.S. 
beef; and zero tolerance for even the small amounts of growth-
inducing chemicals used in U.S. pork feed lots. For the bulk 
goods that China does import, such as soybeans, cotton, and 
corn, value-added processing largely takes place in China, 
costing the United States opportunities to create new jobs.
---------------------------------------------------------------------------
    * Granting China permanent normal trade relations, also known as 
Most Favored Nation status, was a precursor to China's admission to the 
WTO the following year. President Bill Clinton also pushed for 
permanent normal trade relations as a way to widen access for U.S. 
agricultural exports to China. The White House, ``Clinton Says U.S. Has 
Key Role in China'' (Washington, DC: Office of the Press Secretary, 
February 24, 2000). For a comprehensive forecast of market access by 
product, see Jonathan R. Coleman, Jonathan T. Fry, and Devry S. 
Boughner, ``The Impact of China's Accession to the WTO on U.S. 
Agricultural Exports'' (Washington, DC: U.S. International Trade 
Commission, September 2002).

Figure 1:  Value and Composition of U.S. Agricultural Exports to China, 
                               2002-2012

                              US$ billions



    Source: USDA (Washington, DC: Foreign Agricultural Service, 2013).

Figure 2:  Basic Composition of U.S. Agricultural Exports to China and 
                           to the World, 2012

                               Share (%)



    Notes: Due to a rounding error, totals may not add up to 100.
    Under the USDA's classification system, ``bulk commodities'' refer 
to crops shipped in raw form, such as wheat, coarse grains, rice, 
soybeans, and cotton; ``intermediate goods'' refer to processed crops, 
such as flour, soybean meal, and feeds and fodders as well as products 
not directly for consumer use, such as live animals, planting seeds, 
hides and skins, and sweeteners; ``consumer-oriented products'' 
include, among others, meat and dairy products, fruits and vegetables, 
and snack foods.

    Source: USDA (Washington, DC: Foreign Agricultural Service, 2013).

    The emerging trade relationship with China also poses risks 
to the food industry on U.S. shores. China has not done enough 
to promote food safety for its own people but maintains a trade 
surplus with the United States in consumer foods. U.S. 
consumers eat large amounts of fish, fruits, and vegetables, as 
well as vitamins and food supplements, produced in China.* U.S. 
government food safety inspectors have been unable to 
sufficiently monitor the safety of these imports and have been 
restricted, too, in their access to food production sites 
within China. At the same time, Chinese food companies, led by 
pork producer Shuanghui Group, are beginning to acquire 
productive assets in the U.S. food sector. Such investments 
could improve China's food production by helping its companies 
to adopt best practices. For the United States, they also have 
implications for net economic benefits, intellectual property, 
and reciprocal market access.
---------------------------------------------------------------------------
    * For more information, see U.S.-China Economic and Security Review 
Commission, Hearing on China's Enforcement of Intellectual Property 
Rights and the Dangers of the Movement of Counterfeited and Pirated 
Goods into the United States (Washington, DC: June 7-8, 2006).

---------------------------------------------------------------------------
China's Changing Consumption Needs

    China's economic development over the past 30 years has 
caused a structural shift in the country's dietary habits. In 
1980, China consumed 68 percent less meat per capita than the 
world average; today, it consumes 19 percent more.\12\ There is 
still room for additional meat consumption. Although economic 
growth is slowing, China's population of 1.3 billion is seeing 
a faster rise in real wages than previously, and just over half 
of the population now lives in cities. Urbanization and higher 
incomes tend to correlate with protein-based diets.* Owing to 
income inequality among regions, rural and urban areas, and 
individual households, meat is enjoyed mostly by a small 
segment of China's population.
---------------------------------------------------------------------------
    * A more technical explanation of this phenomenon is the income 
elasticity of demand, or how much demand for a given product rises or 
falls with increases in income. Income elasticities in China, as in 
many other countries, have been negative for rice, wheat, and coarse 
grain, such that China consumes less of these products as it becomes 
wealthier. By contrast, its consumption of pork, poultry, and 
especially beef and fish will continue to rise rapidly with added 
income. Scott Rozelle, ``Overview of China's Agricultural Development 
and Policies'' (Center for Chinese Agricultural Studies, January 2010).
---------------------------------------------------------------------------
    Chinese consumers could also diversify their dietary 
intake. China currently consumes around half of the world's 
pork, equivalent to 30 kilograms of pork per capita each year, 
far higher than the rest of the world. In contrast, its 
consumption of beef and poultry is relatively low. Poultry 
consumption per capita is about ten kilograms per year, 
compared to 42.4 kilograms in the United States (see figure 3). 
Poultry is a lower-cost option for increasing protein intake. 
Speaking on behalf of the U.S. Poultry and Egg Export Council, 
which represents 95 percent of the U.S. poultry industry, DTB 
Associates' Kevin Brosch forecast the impact that China would 
have on world markets if it increased its annual per capita 
consumption of poultry: at Japan's modest level of 17 kilograms 
per annum, China would require an amount equal to all current 
world exports of poultry.\13\

Figure 3:  Per Capita Meat Consumption: China vs. Other Countries, 2012

                     Kilograms per capita per year



    Source: Organization for Economic Cooperation and Development 
(OECD)/Food and Agriculture Organization (FAO), Agriculture Outlook, 
June 2013, via U.S. Meat Export Federation (Denver, CO).

    China's distinct dietary preferences provide additional 
opportunities to U.S. producers. The United States has a 
surplus of exactly those parts of the animal, such as pork 
offal and chicken paws, that Chinese consumers prize. These 
products can be sold at a much higher price in China than the 
United States.\14\ The U.S. meat products exported to China are 
predominantly in these categories.\15\ As Dermot Hayes of Iowa 
State University told the Commission, if U.S. producers could 
sell the other half of the carcass in China at a premium, they 
could double their revenue without significant production cost 
increases.\16\
    As Chinese consumers change their diets, they are seeking 
safer food as well. Some of this vigilance has resulted in 
suspicion of new technologies, such as genetically modified 
foods.* A spate of food safety scandals in China has also made 
consumers justifiably worried about what they are eating. 
China's food production industry is highly fragmented. Many 
producers at the farming, processing, and distribution levels 
forgo safe practices in order to cut costs.\17\ Food is 
adulterated, among other things, by the excessive use of 
fertilizers and pesticides; growth-enhancing antibiotics for 
livestock; and toxic chemicals that artificially enhance the 
freshness, appearance, or nutritional value of food. Due to 
false or incomplete labeling, harmful ingredients are often not 
disclosed.\18\
---------------------------------------------------------------------------
    * The Chinese public remains very divided about genetically 
modified (GM) foods. Some critics, inspired by Japan and the European 
Union, maintain that GM foods are not safe for either production or 
consumption. Oddly, China has yet to legalize the planting of GM crops, 
even though it has invested large amounts in developing its own 
biotechnology. China does, however, import GM crops, such as soybeans 
and corn, which are fed to China's livestock. Some argue that this 
intermediate form of GM food consumption is less obvious to consumers 
and hence less controversial. Jikun Huang et al., ``A Consumer 
Segmentation Study with Regards to Genetically Modified Food in Urban 
China,'' Food Policy 35 (2010): 456-62.
---------------------------------------------------------------------------
    In response, Chinese citizens, with the aid of new social 
media, are seeking more information about food safety beyond 
government sources. Many have voiced grievances about a 
``special food supply'' that caters to government 
officials. Chinese consumers are also transitioning 
from wet markets to supermarkets,= in the process becoming more 
attentive to third-party labeling, traceability, and trusted 
brands.\19\ Those with more disposable income are turning to 
premium food products to ensure safety. Interest in organic 
food is spreading, ranging from farmers' markets to community 
farming and organic food clubs.\20\ On the outskirts of Xi'an 
in western China, the Commission visited a company that 
combines a vegetable seed business with organic food 
production. Members of the company's organic food service pay 
an annual fee of around $800 to have organic food shipped to 
their homes.\21\
---------------------------------------------------------------------------
     ``Special food supply'' refers to food for Chinese 
officials grown at special production sites. The system was first 
established under Soviet influence in the 1930s as a means to protect 
the Communist Party leadership against famine. Today, special food 
supply sites in China are associated with organic food production. 
While the precise quantity and nature of these production sites is 
unclear, articles in the Chinese media indicate that the ``special food 
supply'' has caused some consternation among ordinary Chinese. Barbara 
Demick, ``In China, What You Eat Tells Who You Are,'' Los Angeles 
Times, September 25, 2011, via Factiva database; Jiang Gaoming, ``Jiang 
Gaoming: Shipin tegong jidi pinxian tuxian shipin jianguan ganga'' 
(Jiang Gaoming: The Appearance of New Special Food Supply Sites Is an 
Embarrassment to China's Food Regulators), Guangming Wang (Guangming 
Net), February 25, 2013. http://health.gmw.cn/2013-02/25/
content-_-6800842-.-htm; Nandu online, ``Hu Xingdou: Jianyi quxiao 
tegong zhidu, jiejue tequan fubai'' (Hu Star: Recommendations on 
Eliminating the Special Food Supply System, and Resolving the 
Corruption of Special Privilege), May 14, 2013. http://
ndnews.oeeee.com/html/201305/14/59741.html; and Fazhi Ribao (China Law 
Daily), ``Tegong shangpin wushi zhengce, xuezhe cheng bufen guojia 
jiguan tan xiaoli,'' (Special Supply Products Unregulated, Scholars 
Ascribe It to Greed in Some Government Agencies), February 2, 2012. 
http://politics-.-people-.-com-.-cn/BIG5/16998050.html.
    = A wet market is a fresh food market commonly found in Asian 
countries. It often sells live animals and raw meat.
---------------------------------------------------------------------------
    Worries about food safety are also boosting food imports. A 
striking example is the dairy sector. The adulteration of 
infant formula with melamine, a toxic industrial solvent, 
caused China's dairy imports to grow at an annualized rate of 
45 percent between 2009 and 2012--more than double the previous 
rate and double the rate of increase in total food imports.\22\ 
Mainland Chinese are buying baby formula and ultra-high-
temperature milk from the shelves of supermarkets in other 
countries, where retailers have been compelled to ration sales 
to limit hoarding.\23\
    Reacting to the rise in consumer demand, the Chinese 
government has begun to allow some imports of U.S. premium 
consumer foods bearing the ``USDA approved'' logo. U.S. pear 
farmers, for example, received import licenses from Beijing in 
early 2013 and plan to focus on wealthy consumers concerned 
about the safety of domestic pears.\24\ These U.S. products 
often directly compete with goods produced in China.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Examples of Food Safety Scandals in China
 
  In recent years, food safety scandals in China have affected a variety
of consumer food items:
 
Dairy Products
 
  Melamine mimics the nutritional values of protein. It has been used in
China to mask the low protein content of dairy products, such as milk
powder and infant formula. In 2008, six infants were killed, and more
than 12,000 were hospitalized with kidney and other organ damage from
adulterated formula. The scandal led to the execution of two producers
and prison terms for dairy company executives. In February 2011, reports
emerged of another milk contamination scandal involving leather-
hydrolyzed protein. The toxic additive has also been found in such
processed products as candy, hot cocoa, and flavored drinks, some of
which are exported from China to other countries.
 
Fruits, Vegetables, and Tea
 
  Police in the northeastern city of Shenyang seized 40 tons of bean
sprouts in 2011 that had been treated with sodium nitrite, urea,
antibiotics, and plant hormones. Wholesale vegetable dealers in Shandong
Province in 2012 were found spraying cabbages with formaldehyde to
preserve them during transport without refrigeration. Chinese media in
2012 reported that fruit from 16 companies contained excessive pigments,
bleaching agents, and preservatives. Testing by Greenpeace found at
least three different kinds of pesticides in each of 18 varieties of
tea.
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Examples of Food Safety Scandals in China--Continued
 
Meat and Fish
 
  Pork is sometimes adulterated with clenbuterol, a lean meat additive
that can cause dizziness, heart palpitations, and diarrhea. Other
reports have identified pork contaminated by phosphorescent bacteria,
while rat meat has been substituted for lamb sold on skewers in Beijing.
A 2012 report revealed that fish vendors in Beijing were using a
chemical ordinarily meant for temporary dental fillings in order to
tranquilize fish during transport.\25\
 
------------------------------------------------------------------------


China's Unsustainable Agriculture Policy

The Focus on Self-Sufficiency and Domestic Production
    China has seen the fastest growth in agricultural output of 
any major economy over the past 30 years. In the Maoist period 
(1949-76), agronomists feared that China would place a strain 
on the world food system by being unable to feed itself. Today, 
China produces over 20 percent of the world's cereal grains, 25 
percent of the world's meat, and 50 percent of the world's 
vegetables.\26\ Based on a common definition of arable land, 
the United States has more than twice the cropland of China, 
yet China's output is two-and-a-half times that of the United 
States.* China feeds not only its own population of 1.3 
billion--it is also the world's largest exporter of numerous 
foods, including apple juice, farm-raised fish, garlic, and 
vitamin C.\27\
---------------------------------------------------------------------------
    * China has achieved greater agricultural output than the United 
States with a smaller share of arable land. As outlined in this 
section, this phenomenon is mainly attributable to the intensive and 
unsustainable use of labor, resources, and land. Dense livestock 
production, double-cropping, overuse of fertilizers and pesticides, and 
land reclamation in arid regions are some examples of intensive farming 
methods. Relative to the United States, the productivity of China's 
farming sector remains very low. U.S.-China Economic and Security 
Review Commission, Hearing on China's Agriculture Policy and U.S. 
Access to China's Market, testimony of Dermot Hayes, April 25, 2013.
---------------------------------------------------------------------------
    Beijing's agriculture policy has played a role in enhancing 
China's food productivity. Until the late 1970s, the government 
mostly procured agricultural goods from farmers at below-market 
rates. Reforms in the 1980s allowed farmers to sell some 
production on the open market at a higher return and 
established a land contracting system that permitted the 
leasing of land for several decades. Beginning in the 1990s, 
China's opening to world markets led to more export-oriented 
production, inbound foreign direct investment, and 
international development support from aid agencies such as the 
United Nations and the World Bank.\28\
    The government is seeking ways to further modernize the 
agriculture sector. Crop yields, for instance, are still below 
potential due to poor planting techniques and postharvest 
waste. The government has responded with ambitious 
measures. Since joining the WTO, China has increased its 
research and development (R&D) spending on agriculture more 
rapidly than any other country.\29\ China's 12th Five-Year Plan 
(2011-2015) for the first time shifts the explicit focus of 
agriculture policy from rural development to boosting 
agricultural output. It lays out a blueprint for consolidating 
industry, modernizing production facilities, and promoting 
regional specialization.\30\ The 12th Five-Year Plan has been 
complemented by the No. 1 Document--China's first policy 
document each year, which since 2004 has been devoted to 
agriculture. The most recent No. 1 Document, issued in January 
2013, summarizes a comprehensive set of policies, including 
incentives for new farming operations; corporate investment in 
agriculture; food grain security measures; and credit for 
farmers.\31\ During the Commission's July 2013 trip to China, 
participants met with top scientists at the Chinese Academy of 
Agriculture Sciences who are exploring ways to boost 
productivity through farmer training, satellite mapping, 
biotechnology, and reclamation of arid and polluted soils.\32\
---------------------------------------------------------------------------
     Postharvest waste refers to the loss in the process of 
storing grain after it is harvested. In China, grain crops are often 
exposed to adverse natural elements due to the lack of adequate storage 
facilities. Shannon Herzfeld (vice president, Archer Daniels Midland), 
telephone interview with Commission staff, Washington, DC, August 9, 
2013.
---------------------------------------------------------------------------
    However, many of China's agricultural policies are 
inefficient and unsustainable. These policies are driven, in 
part, by the government's emphasis on attaining self-
sufficiency across a broad spectrum of food products, when a 
more rational policy would be to import products for which 
China lacks a comparative advantage. Beijing keeps official 
targets of 95 percent self-sufficiency for corn, wheat, and 
rice. In practice, it also maintains near self-sufficiency for 
pork, poultry, and beef (see table 1). According to a typically 
optimistic forecast by Huang Jikun, a top researcher at the 
government's Chinese Academy of Science's Center for Chinese 
Agricultural Policy, China by 2025 will have no trade deficit 
in either meat products or wheat and rice and will continue to 
be a net exporter of fruits, vegetables, and farm-raised 
fish.\33\


 Table 1:  China's Self-Sufficiency in Beef, Pork, and Broiler Chickens,
                                2009-2012
                       1,000 metric tons per year
------------------------------------------------------------------------
                                    2009      2010      2011      2012
------------------------------------------------------------------------
Beef
      Production                    5,764     5,600     5,550     5,540
      Consumption                   5,749     5,589     5,524     5,597
      Surplus/deficit                  15        11        26      (57)
      Surplus/deficit share of       0.3%      0.2%      0.5%     -1.0%
 consumption
------------------------------------------------------------------------
Pork
      Production                   48,905    51,070    49,500    52,350
      Consumption                  48,823    51,157    50,004    52,275
      Surplus/deficit                  82      (87)     (504)        75
      Surplus/deficit share of       0.2%     -0.2%     -1.0%      0.1%
 consumption
------------------------------------------------------------------------
Broiler chickens
      Production                   12,100    12,550    13,200    13,700
      Consumption                  12,210    12,457    13,015    13,543
      Surplus/deficit               (110)        93       185       157
      Surplus/deficit share of      -0.9%      0.7%      1.4%      1.2%
 consumption
------------------------------------------------------------------------
Source: USDA, ``Livestock and Poultry: World Markets and Trade,''
  (Washington, DC: Foreign Agricultural Service, April 2013). http://
www.fas.usda.gov/psdonline/circulars/livestock--poultry.pdf.


Misallocation of Resources for Meat Production

    A central problem of China's agriculture policy is its 
concentration on livestock production. China accounts for half 
of the world's pork output. It is also the world's largest 
producer of farm-raised fish, second-largest producer of 
poultry, and third-largest producer of beef.\34\ Meat is an 
inefficient way to deliver calories, as it requires land- and 
water-intensive production of grain crops to feed animals 
instead of humans. For example, 1,799 gallons of water may be 
required over the life of a cow before it is slaughtered.\35\ 
China's low productivity, coupled with its lack of resources, 
exacerbates these inefficiencies.
    China lags far behind the United States in its ability to 
convert livestock into meat. China last year bred 15 percent 
more cattle than the United States--104 million head--but 
produced less than half as much beef. China produced five times 
more pork than the United States but required seven times as 
many hogs.\36\ Nor is productivity necessarily improving over 
time. China's hog herd grew by 0.6 percent per annum in the 
2000s, compared to 2.7 percent in the 1990s. China's pork 
output slowed even more over the two decades, from 5.9 percent 
to 2.2 percent per year.\37\ Following an outbreak of blue ear 
pig disease * that killed off much of the herd, China's pork 
production actually contracted by 7.8 percent in 2007.\38\ In 
contrast, the United States is achieving record pig herds and 
pork output, due to improved genetics and swine management 
techniques that have had more baby pigs survive to 
maturity.\39\
---------------------------------------------------------------------------
    * Blue ear pig disease, also known as porcine reproductive and 
respiratory syndrome, is a pandemic disease that causes reproductive 
failure in breeding stock and respiratory tract illness in young pigs. 
It was first reported in North America in the 1980s.
---------------------------------------------------------------------------
    As a consequence of livestock production, China is using 
scarce resources to produce grain crops for animal feed. In the 
1990s, China began to devote more acreage to horticulture cash 
crops. Yet over the past decade, that reallocation of land has 
slowed, such that grain crops still account for 68 percent of 
sown land (see figure 4). Within the grain sector, corn has 
overtaken rice as China's most widely planted and produced 
crop--reflecting the booming demand for corn feed.\40\
    China's focus on grain crops has also diverted valuable 
water resources to what is a less profitable crop. According to 
Dr. Hayes, it has been bad business for China's farmers:

        Consider the human resource waste when a skilled farmer 
        spends an entire year growing three acres of corn in a 
        world where a single U.S. farmer can grow three 
        thousand acres. If China were to allow the market to 
        incentivize these farmers to grow high value crops such 
        as flowers, fruits, vegetables and ornamental plants, 
        total farm income and the value of farm output would 
        soar.'' \41\

        Figure 4:  Distribution of Sown Area in China, 2002-2012

                               Share (%)



    Note: Due to a rounding error, totals may not add up to 100.
    Source: National Bureau of Statistics, via CEIC database.

    In spite of China's commitment to planting grain crops, 
domestic crops have not sufficed to feed all of the country's 
livestock. The government in the late 1990s began to sanction 
imports of soybeans as an alternative source of animal feed. 
China now imports four-fifths of the soybeans it consumes (see 
figure 5).\42\ But even soybean imports are proving too little 
to meet China's need for feed grains. In 2010, China for the 
first time imported large quantities of corn. A recent Iowa 
delegation to China testified that corn imports will keep 
rising.* While these developments may bode well for U.S. corn 
farmers, the fact is that China is tacitly abandoning its 95 
percent self-sufficiency policy for corn, even as it promotes 
its own large-scale corn production.
---------------------------------------------------------------------------
    * When traveling to southern China in March 2013, a group from the 
Iowa Soybean Association heard an estimate from a private trader that 
China would be importing 20 million metric tons of corn in five years, 
up from small amounts of net corn imports today. U.S.-China Economic 
and Security Review Commission, Hearing on China's Agriculture Policy 
and U.S. Access to China's Market, testimony of William Northey, April 
25, 2013.

    Figure 5:  Import Penetration of Major Crops in China, 2002-2012

                    Imports/Domestic Utilization (%)



    Source: Food and Agriculture Organization, Agricultural Market 
Information System (Rome, Italy: Agricultural Information System: 
Secretariat). http://www.amis-outlook.org/.

The Impact of Food Production on China's Environment and Public Health
    China's land and resources face rapid decline. It is 
doubtful whether the central government's target of maintaining 
120 million hectares under cultivation can be met in the 
future. According to Dr. Hayes, China will continue to lose 
about 2.5 million acres, or up to 4 percent of its farm land, 
each year to urban development.\43\ The remaining arable land 
is also becoming less useful. China's intensive fertilizer use 
per acre, the highest in the world, reduces soil fertility, 
causing a vicious cycle of ever more fertilizer application to 
achieve higher yields. Meanwhile, agriculture irrigation 
accounts for 65 percent of China's water withdrawal, compared 
to 40 percent in the United States.\44\ Water tables in arid 
regions are being depleted.\45\
    Pollution of China's water, soil, and climate directly 
impact food quality. Only 6 percent of China's agricultural 
products were considered pollution free in 2005, according to 
figures compiled by the USDA. A study released in February 2011 
found that 10 percent of all rice sold in China was 
contaminated with heavy metals.\46\ Agriculture is a victim, 
but also a cause, of pollution. China's first national 
pollution census, released in February 2010, found that 
agriculture is a bigger source of water pollution than 
industry.\47\ In order to produce vast quantities of pork, 
poultry, and farm-raise fish on limited land, China's breeders 
have resorted to high livestock density. For instance, China 
has kept five times the number of breeding sows--50 million--as 
the United States on much less farmland.\48\ Consequently, 
livestock farms in China currently produce about four billion 
tons of manure annually. Manure could be used as nitrogen 
fertilizer for cornfields, but in China manure more often ends 
up as waste, because corn is planted in other regions of the 
country.* That creates oxygen-depleting algae blooms and 
nutrient overloads in waterways, including the Yangtze and 
Yellow rivers. Not least, manure contributes to climate change 
by emitting methane gas into the atmosphere.\49\
---------------------------------------------------------------------------
    * China has been trying to diversify its hog production out of the 
Yangtze Delta into other parts of the country, particularly the North, 
where China's grain crops are grown. However, these efforts have had 
limited success. Northern China's hog production has remained around 
one-quarter of hog production since 1995. Kevin Chen and Wang Jimin, 
``Hog Farming in Transition: The Case of China'' (paper presented at 
Asian Livestock: Challenges, Opportunities and the Response, Proceeding 
of an International Policy Forum, Bangkok, Thailand, August 16-17, 
2012), p. 77; Mindi Schneider, ``Feeding China's Pigs: Implications for 
the Environment, China's Smallholder Farms, and Food Security'' 
(Minneapolis, MN: Institute for Agriculture and Trade Policy, May 
2011), p. 3.
---------------------------------------------------------------------------
    Dense livestock production has increased the incidence of 
animal diseases as well. In 2013, thousands of diseased pig 
cadavers were found floating in the river near Shanghai, dumped 
by illegal pork producers seeking to evade local food 
inspectors.\50\ Similarly, in the poultry sector, the density 
of fowl has turned China into a breeding ground for avian 
influenza, with the most recent H7N9 outbreak occurring earlier 
in 2013.\51\ According to Fred Gale of the USDA, these animal 
disease outbreaks should ``drive the [Chinese] leadership to 
acknowledge that the production of livestock has really grown 
beyond the carrying capacity of the country.'' \52\
    In contrast, U.S. meat production is more environmentally 
sustainable than in China. In Iowa, where corn and pork are 
produced side by side, manure is used as nitrogen fertilizer, 
and corn is harvested at the source where it is needed, forming 
a localized, low-cost, and self-sustaining production cycle. 
Said David Miller of the Iowa Farm Bureau:

        From an environmental perspective, there is significant 
        room for Iowa to increase pork production. Currently, 
        Iowa farmers apply about one million tons of nitrogen 
        from commercial fertilizer on Iowa farms and about 
        250,000 tons of nitrogen from manure. About 70 percent 
        of the manure-based nitrogen is from hog production. If 
        all of the commercial nitrogen for corn were to be 
        replaced by nitrogen from hog manure, the Iowa hog herd 
        would need to be currently five times as large as it is 
        for increased production.\53\

The Cost of Domestic Production for Chinese Consumers
    In addition to the food safety risks discussed above, 
China's consumers worry about prices. Food has been the main 
driver of consumer inflation, which reached historic highs in 
the 2000s (see figure 6). Said Dr. Hayes, ``They joke over 
there that the CPI [consumer price index] means consumer pig 
index, because if you spend 40 to 50 percent of your income on 
food, the thing you want to do is to upgrade to meat, and when 
that goes high, the Chinese government senses insecurity.'' 
\54\ Periods of unrest, such as the 1989 Tiananmen Square 
protests, have been accompanied by high inflation.\55\ The 
Great Famine in 1958-1961, which killed an estimated 15 million 
to 40 million people on account of faulty government policy, is 
etched in China's national psyche.\56\

     Figure 6:  Annual Consumer Price Inflation in China, 1996-2012

                            Year-on-year (%)



    Source: National Bureau of Statistics via CEIC database.

    A policy of domestic meat production further raises costs. 
According to Dr. Hayes, feed costs alone make China's pork 
production and farm-level livestock 40 percent more expensive 
than in the United States. Soy meal prices are typically $100 
per ton and corn $3 per bushel higher in China than in the 
United States, owing to shipping costs.\57\ In view of China's 
widening income gaps, the burden of higher prices is especially 
harmful to low-income households that are forced to spend more 
on meat products.\58\

Lack of Support for Rural Livelihoods
    An underlying rationale for China to favor domestic 
production is to support the nation's farmers. According to the 
Central Intelligence Agency, one in three Chinese workers is 
still active in agriculture.* Agriculture net output accounts 
for 10 percent of China's GDP--compared to 1 percent in the 
United States. China's market reforms have not done 
nearly as much to improve the well-being of the rural 
population as they have for the urban sector. Wages have risen 
much faster in cities, widening rural-urban disparities. Young 
people are leaving villages in droves to earn higher wages in 
factories.\59\ China's National Bureau of Statistics estimates 
that China has 170 million migrant workers.\60\
---------------------------------------------------------------------------
    * Due to China's large migrant population, off-farm employment in 
the rural sector, and subpar demographic data, there are varying 
estimates of the total population economically 
active in agriculture. See Central Intelligence Agency, World Factbook 
(McLean, VA). https://www.cia.gov/library/publications/the-world-
factbook/fields/2048.html; Scott Rozelle, ``Overview of China's 
Agricultural Development and Policies'' (Center for Chinese 
Agricultural Studies, January 2010); and Peter Hooper et al, 
``Demographics and GDP Growth in China'' (Frankfurt, Germany: Deutsche 
Bank, November 16, 2012).
     Net output refers to ``agriculture, value added,'' which 
the World Bank defines as ``the net output of a sector after adding up 
all outputs and subtracting intermediate inputs. It is calculated 
without making deductions for depreciation of fabricated assets or 
depletion and degradation of natural resources.'' World Bank Indicators 
(Washington, DC: World Bank). http://data.worldbank.org/indicator/
NV.AGR.TOTL.ZS.
---------------------------------------------------------------------------
    Maintaining rural livelihoods became a top priority for the 
Chinese leadership under the administration of President Hu 
Jintao and Premier Wen Jiabao (2003-2012). A document released 
at a central work meeting on rural development in December 2005 
stated: ``Only when the problems relating to agriculture, rural 
areas, and the farmers have been solved properly, can China's 
economy develop in the correct direction.'' \61\ The government 
enshrined these initiatives in the 11th Five-Year Plan for 
Agriculture (2006-2010), under the theme of ``building a new 
socialist countryside.'' \62\ In 2006, all farmers were exempt 
from an agricultural tax that had been in place for 
millennia.\63\ These policies built on the agricultural reforms 
initiated by Deng Xiaoping under the so-called ``three rural 
issues,'' shorthand for the need to raise agricultural 
productivity, boost rural incomes, and provide welfare to rural 
migrants.\64\
    The leadership under Xi Jinping is now changing tack by 
encouraging an ambitious urbanization strategy. The goal is to 
fully integrate 70 percent of the country's population, or 
roughly 900 million people, into city living by 2025.\65\ With 
a smaller rural population, agriculture could be concentrated 
around a core of wealthier farmers. Fewer farm laborers would, 
in theory, also make farmland more productive. Mechanization of 
cropland, for instance, could raise planting density, while 
larger pork feed lots would enhance efficiency and safety.\66\
    Nonetheless, a policy of urbanization and agricultural 
modernization will be difficult to realize. For one, China's 
successes in food production have relied heavily on labor 
intensity. Chinese farmers have planted multiple crops on the 
same land each year. A large portion of the country's livestock 
has been fed on manually collected food scraps and waste from 
restaurants. Low-wage farm workers have reclaimed land in rocky 
areas and hillsides that would not be considered arable in the 
United States.\67\ In areas where bees have become extinct, 
farmers have pollinated trees by hand.* As farm labor declines, 
China will have to find means to mechanize and scale up 
production.
---------------------------------------------------------------------------
    * In line with a global trend, bees in China are becoming extinct. 
China's farmers therefore pollinate many horticultural crops by hand 
using artificial pollen substitutes. Stephen Holden, ``In Fields and 
Hives, Zooming In On What Ails Bees,'' New York Times, June 11, 2013. 
http://movies.nytimes.com/2013/06/12/movies/more-than-honey-a-
documentary-by-markus-imhoof.html.
---------------------------------------------------------------------------
    To this end, the government is experimenting with models to 
consolidate land. Yet, the institutional structures currently 
in place are not conducive to a U.S.-style system of 
production. China's average farm size is just 1.5 acres, down 
from 1.7 acres 20 years ago.\68\ U.S. farms average 600 acres. 
The few large farms that are being established make only a 
small dent in overall production; in the pork sector, for 
instance, backyard farmers and small, specialized farms account 
for four-fifths of output.\69\ Further, China's complex system 
of land distribution, whereby rural collectives led by local 
officials reserve the right to allocate land to farmers, rural 
enterprises, and urban developers, is politically contentious 
and has frequently led to expropriation. The government 
took a step forward in 2003 by banning large reallocations of 
land and permitting farmers to lease land to locals and 
nonlocals. That gave rise to a rental market that allowed less 
productive farm workers to relocate to cities. But to this day, 
land is owned at the village level and cannot be mortgaged.\70\ 
Farmers' cooperatives in the United States help farmers to 
coordinate and scale up their production, but in China, only 
one in four villages hosts a cooperative. In an authoritarian 
system that restricts freedom of organization, local officials 
can curb the independence of cooperatives as well.*
---------------------------------------------------------------------------
     The policy that land should be contracted for 30 years 
with no adjustments became law when the Land Management Law was revised 
in 1998. Samuel P.S. Ho and George C.S. Lin, ``Emerging Land Markets in 
Rural and Urban China: Policies and Practices,'' China Quarterly 175 
(September 2003): 689-707.
    * The technical term for China's cooperatives is ``farmers' 
professional economic cooperative.'' Data from a 2009 survey by the 
Center for Chinese Agricultural Policy. Scott Rozelle, ``Overview of 
China's Agricultural Development and Policies'' (Beijing, China: Center 
for Chinese Agricultural Policy, January 2010).
---------------------------------------------------------------------------
    The absence of a functioning welfare state in China poses a 
further obstacle to modernizing agriculture. The government has 
yet to reform the system of residence permits (hukou) in urban 
areas that would grant all rural migrants access to urban 
welfare provision (For more on urbanization, see chap. 1, sec. 
1, of this Report.). Independent surveys show that younger 
family members are migrating to cities temporarily, while the 
elders stay behind to tend the land.\71\ Farmland, leased for 
30 years, remains an important form of personal insurance that 
many migrants are reluctant to give up.

The Impact of China's Agriculture Policy on U.S. Exports
Measuring the Impact of China's WTO Violations
    Prior to its WTO accession, China's trade barriers included 
exorbitant tariffs, quotas, state trading monopolies, and 
outright bans on some agricultural products. China agreed to 
eliminate most of these barriers. In 2002-2006, China lowered 
tariffs on agricultural goods of greatest importance to U.S. 
farmers and ranchers from a 1997 average of 31 percent to 14 
percent. The last tariff reductions occurred in 2008. As 
Stanford agricultural economist Scott Rozelle has shown, the 
reduction in tariff rates allowed prices for many commodities 
in China to converge with world markets. China's average 
tariffs and supports for agriculture are now below those of 
several other WTO members, including the European Union, Japan, 
and South Korea.\72\
    The effects of China's trade liberalization are evident in 
its trade balance. China's net imports of food have surged from 
near zero to more than $40 billion since 2004. As Colin Carter, 
professor of Agricultural & Resource Economics at University of 
California-Davis, told the Commission, China maintains an 
export-oriented horticulture industry, but imports of these 
products are outpacing exports.\73\ Although China remains 
largely self-sufficient, a small adjustment in its imports has 
a disproportionate effect on global markets. Based on 
unofficial estimates that include Hong Kong, China is already 
the world's top importer of beef and pork.\74\
    Nonetheless, China keeps numerous nontariff barriers in 
place to restrict U.S. imports. They include excessive 
subsidies; government control over import quotas; 
discriminatory taxes; and sanitary and phytosanitary 
restrictions that are not based on proper scientific analysis.* 
These measures have contributed to a very imbalanced food trade 
between the United States and China. U.S. soy farmers have 
reaped a windfall, accounting for three-fifths of U.S. 
agriculture exports to the Mainland in 2012.\75\ China buys up 
to seven times more soybeans from the United States than Japan, 
the next-largest customer.\76\ Yet other crops have not enjoyed 
fair and stable access. With the exception of dried distillers 
grains, a corn-based byproduct of U.S. ethanol 
production, value-added products based on crops have 
also had limited success.
---------------------------------------------------------------------------
    * Sanitary and phytosanitary regulations restrict or prohibit 
imports and marketing of certain animal species, or products, to 
prevent the introduction or spread of pests or diseases that these 
animals may be carrying. World Trade Organization, ``Introduction to 
the SPS [Sanitary and Phytosanitary] Agreement'' (Geneva, Switzerland: 
2013). http: // www.wto.org/english/tratop----e/sps----e/
sps----agreement----cbt----e/c1-s3-p1----e.htm.
     Distillers' grains are a cereal byproduct of the 
distillation process. There are two main sources of these grains. The 
traditional sources were from brewers. More recently, ethanol plants 
are a growing source. Corn based distillers grains from the ethanol 
industry are commonly sold as a high protein livestock feed that 
increases efficiency and lowers the risk of sub-acute acidosis in beef. 
U.S.-China Economic and Security Review Commission, Hearing on China's 
Agriculture Policy and U.S. Access to China's Market, testimony of 
Julius Schaaf, April 25, 2013.
---------------------------------------------------------------------------
    Worse still, U.S. consumer foods have entered China at a 
slower rate than total trade (see figure 7). China has banned 
U.S. beef for a decade. Although China is currently a top 
market for U.S. pork, China's pork purchases have been erratic 
due to unpredictable food safety-related bans. The U.S. Meat 
Export Federation claimed in 2012 that sanitary barriers posed 
``the single largest constraint to the expansion of U.S. beef, 
pork and lamb exports over the next five years.'' \77\ After 
China placed antidumping duties on U.S. broiler chickens in 
2010, poultry exports plummeted as well.

  Figure 7:  Annualized Growth of U.S. Agricultural Exports to China,

                               2002-2012

                    Compound Annual Growth Rate (%)



    Source: USDA (Washington, DC: Foreign Agricultural Service).

    China's nontariff barriers are often protectionist 
measures. According to Dr. Gale of the USDA, China's self-
sufficiency policy is based on an exaggerated alarm about the 
risks of import reliance. Beijing presumably worries that the 
volume of potential Chinese demand is so large that food 
imports would outstrip the capability of world markets to 
supply the country. There are also strategic concerns that 
reliance on imports of any particular commodity will leave 
China vulnerable to global price fluctuations and manipulation 
of prices by other countries or multinational companies.\78\ In 
addition, China's agriculture policy manifests the government's 
broader industrial policy. In numerous industries, from 
furniture to textiles and steel, China imports raw materials 
for value-added processing. That policy frequently entails 
heavy subsidies for land, labor, and capital; selective market 
barriers for imports and foreign investment; and, increasingly, 
support for strategic enterprises and outbound investment in 
productive assets overseas.

Sanitary and Phytosanitary Barriers to U.S. Meat Exports

    The WTO sets out clear obligations for member states to 
only use sanitary and phytosanitary restrictions that do not 
``arbitrarily or unjustifiably discriminate between WTO 
members' agricultural and food products, and are not disguised 
restrictions on international trade.'' \79\ China has applied 
numerous food safety-based restrictions on trade that 
contravene these principles.
    China has persistently banned U.S. meat products following 
epidemic outbreaks. In the interest of public health, countries 
customarily impose bans on imports if there is a related 
epidemic outbreak in the exporting country. China's bans, 
however, have frequently exceeded any necessary safety 
precautions. The most egregious case is the beef sector. China 
joined other countries in closing its market to U.S. beef 
imports in 2003 due to one discovered case of BSE (bovine 
spongiform encephalopathy, or ``Mad Cow Disease'').* But China 
kept its ban in place even after the United States was 
classified as a ``controlled risk'' country by the World 
Organization of Animal Health in July 2007 and as a ``minimal 
risk'' in May 2013.\80\ Likewise, U.S. pork was subject to 
unjust bans in April 2009, under the pretext of an H1N1 virus 
outbreak, even though the virus is not transmitted by 
consumption of food products. China's Ministry of Agriculture 
and the General Administration of Quality Supervision, 
Inspection and Quarantine only removed the bans in December 
2009.\81\
---------------------------------------------------------------------------
    * BSE (bovine spongiform encephalopathy) is a progressive 
neurological disorder of cattle that results from infection by an 
unusual transmissible agent called a ``prion.'' The nature of the 
transmissible agent is not well understood. According to the USDA, the 
United States has registered four cases of BSE in 2003-2012. The case 
that first caused the bans on U.S. beef was recorded in December 23, 
2003, in an adult Holstein cow from Washington State. On June 24, 2005, 
the USDA announced receipt of final results from the Veterinary 
Laboratories Agency in Weybridge, England, which confirmed the first 
endemic case of BSE in a 12-year-old Texas cow. On March 15, 2006, the 
USDA confirmed BSE in a ten-year-old cow in Alabama. On April 24, 2012, 
the USDA confirmed a BSE case in a ten-year-old dairy cow in 
California. U.S. Department of Health and Human Services, ``BSE (Bovine 
Spongiform Encephalopathy, or Mad Cow Disease)'' (Atlanta, GA).http://
www.cdc.gov/ncidod/dvrd/bse/.
---------------------------------------------------------------------------
    Another form of sanitary restrictions relates to residue 
levels. It is common for food products to contain some residual 
level of antibiotics, pesticides, or other potentially harmful 
substances. In order to facilitate trade, most trade partners 
agree on allowable maximum residue levels. Residues at low 
levels pose minimal health risks, according to international 
agreements. But China has adopted a zero-tolerance approach to 
ractopamine, a feed ingredient that significantly enhances 
yield and efficiency in pork production. The U.S. Food and Drug 
Administration (FDA) approved ractopamine as early as December 
1999, and it is now approved by 26 countries, including several 
countries in Asia.* The Codex Alimentarius Commission 
reaffirmed the safety of ractopamine by adopting maximum 
residue level standards in July 2012.\82\ Given that codex 
determinations serve as a basis for the WTO rules on dispute 
resolution, China's zero-tolerance policy is inconsistent with 
its WTO commitments. China began blocking shipments from 
individual U.S. pork plants after it detected ractopamine in 
2006. The issue was raised in 2009-2011 at working group 
meetings of the Joint Commission on Commerce and Trade, one of 
the main bilateral dialogue mechanisms between the United 
States and China. The United States requested that China adopt 
an interim maximum residue level for ractopamine. Still, China 
refused, and following the 2012 codex ruling did not take any 
steps to address its zero-tolerance policy.\83\
---------------------------------------------------------------------------
    * As a part of the Codex Alimentarius process, ractopamine 
hydrochloride has three times been reviewed by the Joint FAO/WHO Expert 
Committee on Food Additives (JECFA), which has recommended safety 
standards that align with those within the approved use countries. The 
most recent review was for consideration of studies conducted and 
submitted by China. The JECFA scientific statement noted that: ``The 
Committee concluded that, based on the data provided, including those 
from the three breeds of pigs in the studies undertaken by the People's 
Republic of China, and corresponding dietary information, the 
recommended MRLs [maximum residue levels] are compliant with the ADI 
[acceptable daily intake] as regards consumption of pig tissues of 
muscle, liver, kidney and fat. The estimated daily intake is 
approximately 50% of the upper bound of the ADI for a 60 kg person.''
---------------------------------------------------------------------------
    Sanitary restrictions have had a considerable impact on 
U.S. livestock producers. The U.S. Meat Export Federation 
estimated in 2012 that the decade-old ban on U.S. beef cost 
producers as much as $350 million a year.\84\ The blow has been 
mitigated somewhat by huge gray markets that transship U.S. 
beef products through Hong Kong and other neighboring 
jurisdictions into China, to be sold at a markup price to 
wealthy diners and shoppers. But that has not made up 
for the loss in market share. Australia, a U.S. competitor that 
is allowed to export its beef to China, saw its exports rise an 
incredible 1,948 percent year-on-year in the first half of 
2013.=
---------------------------------------------------------------------------
     The presence of this gray market was confirmed by numerous 
parties during the Commission's July 2013 trip to China. Beef is 
exported legally to Hong Kong, Vietnam, and the Philippines, then 
recontainerized and shipped to China. Exporters are allegedly willing 
to pay an additional fee for this transshipping. Because U.S. storage 
facilities operators in China refuse to harbor illegal imports, the 
U.S. beef often ends up stored in Chinese facilities, potentially 
making the product less safe. Many restaurants in Shanghai that serve 
U.S. beef carry two sets of books in case the authorities come to check 
on the beef's country of origin.
    = Although Australia is a major beef exporter, it did not send much 
beef to China until recently. Australia's traditional markets have been 
Japan, South Korea, the Middle East, and the United States. In the 
first half of 2013, however, China imported 62,421 tons of Australian 
beef, up from 3,048 tons a year earlier. Almost overnight, China became 
Australia's third-largest export destination for beef. Presentation by 
the U.S. Meat Export Federation (Shanghai, China, July 26, 2013).
---------------------------------------------------------------------------
    The barriers have also hurt pork producers, who rely on 
fixed rearing and slaughtering cycles and hope for predictable 
demand and prices. For instance, China's decision in March 2012 
to disallow third-party audits of ractopamine in U.S. pork 
suddenly prevented a host of U.S. pork exports from going to 
China. According to Mr. Miller, that effectively cut the price 
of Iowa's 30 million hogs by $10 per head.\85\ Another factor 
that makes compliance with the ractopamine ban difficult is 
that it interferes with the complex segmentation of pork 
products. As Secretary Northey noted, the United States sends 
more pork pieces, such as offal, to China than whole hog 
carcasses. By not using ractopamine in the breeding process, 
U.S. pork producers incur a higher cost of production for the 
whole pig. That puts them at a competitive disadvantage when 
they sell muscle cuts and other parts in the U.S. market.\86\
    China's sensitivity to food safety for imports is partly a 
reaction to the country's internal safety problems. The Chinese 
government has argued in its defense that it lacks the 
technology to distinguish harmful from less harmful additives. 
It has also requested additional research on feed additive 
residues in the internal organs of pigs, since those parts of 
the animal are more widely consumed in China than the United 
States.\87\ Still, as Dr. Gale asserted, China's stringency 
results in double standards. Although the Chinese government 
outlaws ractopamine, as well as a dangerous alternative, 
clenbuterol, countless Chinese pork producers continue to use 
these additives to increase feed efficiency. According to Dr. 
Gale, ``This brings up an issue of a much tighter enforcement 
of standards and regulations for imports than in the domestic 
market,'' a violation of basic trade principles.\88\ Mr. Brosch 
argued that ``China's strict, and sometimes unsupportable 
decisions to impose limitations on U.S. imports are driven 
primarily by internal pressures on its government as a result 
of past domestic food safety mistakes. In our view, Chinese 
health officials are now under a tremendous amount of internal 
pressure and scrutiny and want to appear to their domestic 
constituents to be increasingly vigilant.''\89\

Antidumping Duties and the Tradeoff between Market Access and Food 
        Safety

    Antidumping (AD) and countervailing duties (CVD) disputes 
have been a point of contention in U.S.-China bilateral trade. 
The agriculture sector is no exception. China's Ministry of 
Commerce (MOFCOM) imposed AD and CVD duties on U.S. chicken 
broiler products in August and September 2010, respectively. 
The AD duties ranged from 50.3 percent to 53.4 percent for the 
U.S. producers who responded to MOFCOM's investigation notice, 
while MOFCOM set an ``all others'' rate of 105.4 percent. In 
the CVD investigation, MOFCOM imposed countervailing duties 
ranging between 4.0 percent and 12.5 percent for the 
participating U.S. producers and an ``all others'' rate of 30.3 
percent. According to the Office of the U.S. Trade 
Representative, American exports to China of broiler products 
fell by 80 percent following the application of the duties (see 
figure 8).\90\

           Figure 8:  U.S. Poultry Exports to China, 2002-12

                              US$ millions



    Source: USDA (Washington, DC: Foreign Agricultural Service).

    The United States complained to the WTO in September 2011 
and was vindicated in August 2013 when a WTO dispute settlement 
panel found that China's AD/CVD actions against U.S. broiler 
chickens violated its WTO commitments.* The panel supported 
nearly all of the U.S. claims, including substantive errors in 
MOFCOM's calculations and procedures.\91\ China decided not to 
appeal the ruling by the September 10, 2013, deadline.\92\ As a 
next step, China will have to demonstrate that it has complied 
with the ruling by repealing the duties. At a September 25 WTO 
Dispute Settlement Body meeting with Chinese officials, U.S. 
officials said they hoped the decision would force Beijing to 
fundamentally re-evaluate how it proceeds in AD and CVD 
investigations.\93\
---------------------------------------------------------------------------
    * Broiler products include most chicken products, with the 
exception of live chickens and a few other products such as cooked and 
canned chicken.
---------------------------------------------------------------------------
    Although the WTO decision marked a victory, the AD/CVD 
actions against broiler products are emblematic of a broader 
conflict in bilateral trade that is unresolved. China's actions 
against broiler products coincided with an escalation in other 
trade disputes. Beijing threatened to impose the duties on 
chicken in September 2009, weeks after the United States 
applied a 35 percent tariff on Chinese-made tires. 
Within a week of the U.S.'s announcement that it would 
challenge the tariffs on broiler products, China applied 
dumping duties on U.S. automobiles and auto parts.= The United 
States also angered China by filing an AD case against Chinese 
honey in 2000. China's share of U.S. honey imports was around 
30 percent when the AD case was initiated, and today that 
market share is near zero.\94\
---------------------------------------------------------------------------
     On September 11, 2009, the president imposed additional 
duties on imports of certain passenger vehicle and light truck tires 
from China for a period of three years in order to remedy the market 
disruption caused by those imports, as determined by the U.S. 
International Trade Commission (USITC). China challenged the imposition 
of the duties, alleging that the USITC's determination regarding market 
disruption and the level and duration of the additional duties were 
inconsistent with the Protocol of Accession and the General Agreement 
on Tariffs and Trade (GATT) 1994. A WTO panel later rejected all of 
China's claims, and the Appellate Body rejected all of China's claims 
on appeal. Office of the U.S. Trade Representative, ``United States 
Prevails in WTO Dispute about Chinese Tire Imports'' (Washington, DC: 
USTR Press Release, September 2011). http: // www.ustr.gov/about-us/
press-office/press-releases/2011/september/united-states-
prevails-wto-dispute-about-chinese.
    = This is now a separate WTO complaint by the United States. See 
WTO, ``China--Certain Measures Affecting the Automobile and Automobile-
Parts Industries'' (Geneva, Switzerland: Dispute DS450). http://
www.wto.org/english/tratop----e/dispute----/cases-_-e/ds450-_-e.htm.
---------------------------------------------------------------------------
    Furthermore, the broiler duties were implemented less than 
two years after Congress passed the DeLauro Amendment, a piece 
of legislation introduced by Representative Rosa DeLauro (D-
OH), chair of the House Appropriations agriculture 
subcommittee, to the 2008 Farm Bill. The amendment prohibited 
funding the USDA Food Safety Inspection Service (FSIS) 
inspection of processed poultry imports from China. China soon 
challenged the ban in the WTO. The U.S. Trade Representative 
and the USDA worked with Congress to soften the language of the 
DeLauro Amendment in the fiscal year 2010 agriculture 
appropriations bill, opening the door to funding inspections of 
Chinese-processed poultry if certain conditions could be met by 
the USDA. * \95\ Nonetheless, China did not withdraw its WTO 
complaint and a year later won the case.\96\ The United States 
subsequently repealed the amendment. Some U.S. agriculture 
officials and advocates argue that it left a negative legacy 
for market access negotiations, particularly in regard to 
China's bans on U.S. beef. Owing to the USDA's dual functions 
as a trade negotiator and food safety inspector, certain 
Chinese officials apparently believe that the agency is capable 
of influencing U.S. food safety legislation in return for 
greater market access in China.\97\
---------------------------------------------------------------------------
    * According to a spokesperson at the time, Rep. DeLauro agreed to 
the amended bill in part because it requires that the USDA: (1) 
increase inspections and audits of Chinese poultry processing plants 
once they are certified; (2) make public the list of eligible plants 
and the outcomes of audits of those plants; and (3) not rush to an 
equivalency determination for the safety of China's poultry slaughter 
operations, which are to be subject to a separate approval process from 
poultry processing. Inside U.S.-China Trade, ``Compromise Reached on 
Poultry Ban, Could End U.S.-China WTO Dispute,'' September 30, 2009, 
via Factiva database.
---------------------------------------------------------------------------
    U.S. interest groups are divided about the merits of 
curbing Chinese food imports through legislation such as the 
DeLauro Amendment. For Patty Lovera of Food & Water Watch and 
other food safety advocates, U.S. food consumers need to be 
protected from China's unsafe production and weak regulation. 
According to this argument, China does not deserve an 
``equivalence determination,'' under which its food safety 
process would be deemed equivalent to the USDA's standards. The 
USDA audits prospective meat processing plants in China and 
approves those that meet its standards but then only visits 
them on a periodic basis for auditing purposes.\98\ In the 
United States, a USDA inspector is always present at each 
plant. For food safety advocates, these regulatory procedures 
do not sufficiently guarantee the safety of Chinese poultry 
imports (See Food Safety section below for more discussion of 
food safety inspection.)\99\
    On the other hand, poultry industry advocates argue that 
the U.S. government has committed a grave error in interfering 
with bilateral poultry trade. U.S. agribusinesses have invested 
heavily in Chinese chicken production and processing--both to 
feed Chinese consumers and as a future export platform to U.S. 
consumers--and they have been working to get USDA approval for 
Chinese poultry exports to the United States. These advocates 
argue that USDA-FSIS approvals and equivalency procedures of 
Chinese exporting plants are sufficiently stringent, as the 
United States currently permits poultry imports from only three 
other countries--Costa Rica, Canada, and Chile. The DeLauro 
Amendment, they argue, refuses USDA-FSIS the funding to even do 
its job. By targeting China, it also violates the U.S.'s WTO 
commitments and sets a bad example for unilateral action 
against a single trade partner in the WTO system. They further 
assert that very little processed poultry will be imported, as 
China has no commercial advantage in this market segment.\100\
    On September 5, the USDA-FSIS reaffirmed the equivalence of 
China's food safety inspection system for processed poultry, 
which was originally established in 2006. That will enable 
China to certify plants to export processed poultry products to 
the United States. The raw poultry used for these products must 
originate in the United States and Canada, as the USDA-FSIS has 
yet to provide equivalency status for slaughtered poultry in 
China. Nevertheless, the decision lays the foundation for 
negotiating future exports of processed poultry using Chinese-
origin birds.\101\
State Trading and Domestic Supports
    Another means by which China has restricted the flow of 
trade in agriculture is by requiring state trading * and 
providing domestic supports. These policies have done 
particular damage to U.S. exports of land-intensive crops and 
meat products. State trading impacts the allocation of tariff-
rate quotas. Tariff-rate quotas function as a way of protecting 
a market from excessive imports and, at the same time, provide 
a means of liberalizing trade and breaking up monopolies by 
dividing up the quota among different traders and passing on 
unfilled quotas. Following WTO accession, China's trading 
monopoly China National Cereals, Oils and Foodstuffs Corp. 
agreed to reduce its exclusive rights by allocating some quotas 
to other traders in a transparent manner.\102\
---------------------------------------------------------------------------
    * State trading enterprises are defined as governmental and 
nongovernmental enterprises, including marketing boards, which deal 
with goods for export and/or import. Article XVII of the General 
Agreement on Tariffs and Trade (GATT) 1994 is the principal article 
dealing with state trading enterprises (referred to as ``STEs'') and 
their operations. It sets out that such enterprises--in their purchases 
or sales involving either imports or exports--are to act in accordance 
with the general principles of nondiscrimination and that commercial 
considerations only are to guide their decisions on imports and 
exports. It also instructs that members are to notify their state 
trading enterprises to the WTO annually. World Trade Organization 
(Geneva, Switzerland). http://www.wto.org/english/tratop----e/
statra----e/statra----e.htm.
---------------------------------------------------------------------------
    However, China has been reluctant to comply with these 
commit- ments. In 2002, the National Development 
and Reform Commission, the Chinese agency in charge of 
implementing the regulations, refused to provide details on 
amounts and recipients of allocations. It also reserved a 
significant portion of tariff-rate quotas for the processing 
and reexport trade instead of the import-competing sector. By 
2004, tariff-rate quotas improved after considerable U.S. 
pressure through the Joint Commission on Commerce and Trade 
negotiations. Nevertheless, state-owned enterprises still 
dominate bulk commodity trading, accounting for an estimated 90 
percent of the wheat quota, 60 percent of the corn quota, 50 
percent of the rice quota, 70 percent of the sugar quota, and 
33 percent of the cotton quota. One way that China achieves 
this is by maintaining stringent licensing requirements to 
limit the pool of eligible nonstate firms.\103\
    Further, Beijing has leveraged its extensive state control 
over commodity import decisions as a tool of economic 
diplomacy. In December 2003 and February 2012, then Premier Wen 
Jiabao and then Vice President Xi Jinping negotiated landmark 
soybean acquisition deals during state visits to the United 
States. In both cases, the acquisitions were timed as a ``feel-
good'' deliverable to offset U.S. concerns about the bilateral 
trade deficit.\104\
    While China has agreed to minimize subsidies to meet its 
WTO commitments, it has found ways to support farmers and 
processors by subverting the rules. One example is its 
discriminatory use of the value-added tax (VAT) levied on 
industry. China signed on to the Article III of the General 
Agreement on Tariffs and Trade (GATT), which explicitly states, 
``WTO members shall not be subject, directly or indirectly, to 
internal taxes or internal charges of any kind in excess of 
those applied directly or indirectly to [a] like domestic 
product.'' In fact, China has not complied with this 
commitment. In 2009, USDA-funded research found that China 
imposes a 13 or 17 percent VAT on food and agriculture imports, 
while China's own farmers and meat producers use a complex 
rebate system in order to pay almost no VAT at all.* Stated 
Veronica Nigh of the American Farm Bureau Federation: ``The 
effect of many of China's VAT rebate adjustments is to make 
larger quantities of primary and intermediate products in a 
particular sector available domestically at lower prices than 
the rest of the world, giving China's downstream producers the 
finished products using these inputs a competitive advantage 
over foreign downstream producers.'' \105\
---------------------------------------------------------------------------
    * Slaughterhouses and food processors, for example, are given major 
deductions from the nominal VAT, as they are permitted to ``impute'' a 
VAT paid at prior stages of production. The differential VAT rates 
charged for domestic producers and imports thus constitute a clear 
violation of Article III of the General Agreement on Tariffs and Trade 
(GATT) 1994. U.S. Trade Representative, Hearing on China's Compliance 
with World Trade Organization Commitments, written testimony of 
National Pork Producers Council, September 24, 2012; and U.S. Grains 
Council, National Trade Estimates Report Submission (Washington, DC: 
October 12, 2012), p. 17.
---------------------------------------------------------------------------
    The VAT tax is one of the reasons why value-added 
production has been transferred from the United States to 
China. Soybeans, the top U.S. agricultural export, are shipped 
primarily in bulk form instead of processed feed. According to 
Iowa Secretary of Agriculture William Northey, China's domestic 
soybean crushing industry has expanded rapidly, to the extent 
that it now has 40 to 50 percent overcapacity.\106\ Foreign 
investment has contributed to this capacity buildup--foreign 
agribusiness firms, including Archer Daniels Midland, Bunge, 
and Cargill, own about 70 percent of China's soybean crushing 
industry.\107\ Some of this production is also ending up on 
world markets: statistics compiled by the United Nations (UN) 
Food and Agriculture Organization show that China's exports of 
feed, meal, and gluten increased by 63 percent a year in 2001-
2011, while U.S. exports declined by 8 percent per annum over 
the same period. U.S. market share in this trade category 
declined from 79 percent to 43 percent in 2001-2011.\108\
    The Office of the U.S Trade Representative affirms that 
agriculture is just one of several sectors in which China has 
used discriminatory taxation to gain a competitive edge:

        China's economic planners attempt to manage the export 
        of many primary, intermediate and downstream products 
        by raising or lowering the value-added tax (VAT) rebate 
        . . . these border tax practices have caused tremendous 
        disruption, uncertainty and unfairness in the global 
        markets for the affected products--particularly when 
        these practices operate to incentivize the export of 
        downstream products for 
        which China is a leading world producer or exporter .\10
        9\

    China has also been able to provide billions of dollars in 
agriculture subsidies through a series of loopholes. One such 
loophole is how China defines the ``value of production.'' Farm 
support under the WTO's de minimis provision is measured as a 
share of total production value. Agricultural production, 
according to the Chinese government's questionable 
statistics,\110\ has been expanding at a significant 12 percent 
a year. Thus, subsidies can be very large in nominal terms but 
appear small relative to production.\111\
    A related form of farm support is China's procurement and 
stockpiling of commodities to subsidize domestic producers and 
offset market prices.\112\ For nearly all major staple crops, 
China holds an outsized share of global stockpiles (see figure 
9).\113\ China has adopted a particularly aggressive 
stockpiling policy toward three of the largest U.S. exports to 
China: soybeans, corn, and cotton. The stockpiles are derived 
not only from imports but also domestic production. In 2008, in 
view of the rapid price increases and fluctuations of soybeans 
on the global market, the National Development and Reform 
Commission began to procure domestic soy at above the world 
market price, thus establishing a reserve stockpile and also 
boosting the income of its soy farmers. China announced last 
year that it would stockpile soybeans for a fifth year 
running.\114\ China's latest No. 1 Document, released in 
January 2013, lays out policies to raise the minimum purchase 
prices for wheat and rice; stockpile corn, soybeans, and other 
crops; and adjust export and import duties as necessary to 
achieve food (grain) security.\115\

Figure 9:  China, U.S., and Japan's Share of Surplus Stockpiles of Key 
                           Commodities, 2012

                               Share (%)



    Note: Stockpiles are calculated based on what a country produces, 
consumes, and trades. The surplus left over at the end of each year is 
the stockpile.

    Source: Food and Agriculture Organization, Agricultural Market 
Information System (Rome, Italy: Agriculture Market Information System 
Secretariat). http://statistics.amis-outlook.org/data/index.html#.

    According to testimony from Mark Lange, the president of 
the U.S. National Cotton Council, China's subsidies to its 
domestic cotton industry are having a negative impact on U.S. 
cotton exports, which account for 14 percent of U.S. 
agricultural exports to China. China in recent years began 
procuring cotton from its domestic producers for a rate far 
above world market prices. That has actually hurt China's 
textile mills, which are forced to buy expensive cotton and are 
barred by import licensing quotas from increasing imports of 
cheaper cotton from the United States. The mills are thus 
turning to manmade synthetic fibers, in turn boosting China's 
chemical industry. This policy has affected U.S. cotton exports 
to China, as well as introducing considerable uncertainty into 
the industry, as cotton prices could plummet once China 
releases its stockpiles onto the world market.\116\
    In the pork sector, the U.S. National Pork Producers 
Council recently estimated that U.S. pork exports to China 
would increase by 50 percent if China eliminated its domestic 
pork subsidies. Pork subsidies rose substantially following an 
outbreak of swine disease that reduced China's pork production 
in 2007 and 2008. In January 2009, the Chinese government 
introduced a price support scheme for pork called the 
``National Price Alert and Subsidy Program.'' The program is 
based on the ratio between China's live hog and corn prices: 
when the hog-corn price ratio falls below a certain range--
either because pork is too cheap or corn too expensive--the 
government procures pork from the domestic market at generous 
prices to support pork farmers. Related policies include hog 
and pork stockpiling; a sow insurance program; and a cash 
subsidy scheme for large-scale breeding farms.\117\

China's Agribusiness Development and Regulation of Foreign Investment

Restricted Access for U.S. Firms in China's Agriculture Sector
    The United States has helped China in diverse ways to 
develop its agriculture sector. During its July 2013 trip, the 
Commission met with representatives of Archer Daniels Midland 
Company, Cargill China, Preferred Freezer Services, and other 
U.S. companies that have built state-of-the-art production, 
processing and storage facilities on the Mainland. Cargill 
China and OSI Group have recently established vertically 
integrated poultry breeding facilities by consolidating land 
from local farmers. U.S. companies hire thousands of employees 
in China and, in some cases, finance training at their 
facilities in the United States.\118\ U.S. food retailers, led 
by Yum! Brands, Inc. and McDonald's Corp., have transferred 
best practices in the food service industry. These private 
sector efforts are being reinforced by technical assistance 
programs administered by U.S. government agencies and U.S. 
universities. The United States and China have launched more 
than 500 science and technology exchange programs since they 
established the working group on agricultural science and 
technology cooperation in 1980, with around 3,000 experts 
involved. In 2011, the two sides held the fourth meeting of the 
China-U.S. Joint Commission on Agriculture, which developed 
guidance to the two working groups on agricultural sciences and 
biotechnology.*
---------------------------------------------------------------------------
    * The Commission, on its July 2013 China trip, met with faculty 
from the Northwest Agriculture and Forestry University, one of China's 
top agronomics faculties based in Shaanxi Province, who discussed their 
partnerships with the University of California-Davis and other U.S. 
universities. Xinhua China Economic Information Service, ``China to 
Deepen Agricultural Cooperation with U.S.,'' February 12, 2012, via 
Factiva database.
---------------------------------------------------------------------------
    However, in spite of these supportive efforts, U.S. 
companies have not been granted fair market access in China. A 
pervasive problem is regulatory uncertainty, in the form of 
state-run media campaigns targeting foreign brands; stricter 
oversight than for domestic companies; and corrupt practices by 
officials at the local level. U.S. companies are 
required to enter into joint ventures with Chinese companies as 
a condition for investing in certain sectors.= Although this 
requirement per se does not violate China's WTO commitments, it 
often benefits China's state-owned enterprises. For example, 
Coca-Cola's joint venture partner in China is a subsidiary of 
China National Cereals, Oils and Foodstuffs Corp., the same 
conglomerate that dominates China's state trading of 
commodities.\119\ And although restrictions on foreign 
investment have been relaxed, major investments still require 
approval from the Chinese government. In 2009, for instance, 
China invoked its new antitrust law to prevent Coca-Cola from 
purchasing the juice maker Huiyuan Juice.\120\ Several sectors 
of China's economy are in fact off-limits to foreign companies; 
in the agriculture sector, foreign companies are prohibited 
from buying land; investing in the production of transgenic 
plant seeds; and constructing and operating large-scale 
wholesale markets for agricultural products.\121\
---------------------------------------------------------------------------
     A more optimistic assessment of these problems, voiced by 
some businesses, is that foreign companies serve as models for the rest 
of industry and are chosen by Chinese officials to experiment with new 
policies, such as environmental and food safety standards. U.S. 
companies, meetings with Commissioners, Shanghai, China, July 25-26, 
2013.
    = The relevant rules for joint ventures are laid out in the 
Catalogue of Industries for Guiding Foreign Investment that was first 
introduced by the State Council in 1995 and last revised in 2011. The 
catalogue comprises over 450 industries. In nearly 100 of those 
industries, foreign investment is subject to ownership restrictions. 
About half of those restrictions require foreign investors to form 
joint ventures--equity, cooperative, or contractual--with Chinese 
partners. State Council, ``Waishang touzi chanye zhidao mulu (2011 nian 
xiuding)'' (Catalogue of Industries for Guiding Foreign Investment--
2011 Revisions) (Beijing, China: 2011). http://www.gov.cn/flfg/2011-12/
29/content_2033089.htm.
---------------------------------------------------------------------------
    U.S. companies are also anxious about guarding their 
intellectual property in China. Barbara Glenn, vice president 
of Science and Regulatory Affairs at CropLife America, told the 
Commission that U.S. agrochemical and seed companies in China 
have encountered counterfeit goods as well as unauthorized 
misappropriation of trade secrets that are used to produce 
infringing products. These practices discourage U.S. 
agrochemical firms from investing in research and development 
in China and from deploying their most cutting-edge products 
there.\122\
    Further, U.S. developers of biotechnology are concerned 
about China's regulatory approval process. For the majority of 
these companies, which invest heavily in genetically modified 
seeds, China has become central to their business model, 
because their customers produce crops for export to China. At 
present, China only begins the approval process for a foreign 
biotechnology event when that event has already been approved 
in the exporting country. Ideally, both countries would conduct 
the approvals at the same time in order to expedite the 
process. This system of ``asynchronous approvals'' has become a 
pressing concern for U.S. agribusinesses.\123\ Julius Schaaf, 
vice chairman of the U.S. Grains Council, told the Commission:

        Among the most important factors affecting the near 
        term evolution of U.S. exports of corn is the 
        regulatory treatment of biotechnology. . . . As the 
        importance of biotech crops continues to increase 
        globally, potential disruptions due to inconsistent and 
        sometimes unpredictable national treatment have become 
        a recurring concern. With regard to China, the 
        asynchronous approval process for biotech events is of 
        particular importance.\124\

China's Agribusinesses and Outbound Investment
    In parallel to restricting market access for foreign 
agribusinesses, Beijing is fostering its own ``state 
champions'' to consolidate the agriculture sector. China's 
leading state-owned agribusiness, China National Cereals, Oils 
and Foodstuffs Corp., has extended its business from the grain 
trade to diverse activities along the value chain, from grain 
crushing to livestock production and beverage making. 
Meanwhile, quasi-private firms are expanding, especially in the 
livestock industry. These include Shuanghui Group, China's 
largest pork producer. The company began as a meat processing 
plant under a municipal government in Henan Province, in the 
interior of China. As recently as 2004, Shuanghui Group was 
taken over by a municipal branch of the government's State-
Owned Asset Supervision and Administration Commission, an 
agency charged with restructuring state-owned enterprises. In 
2006, the government divested its interest in Shuanghui Group, 
selling to a consortium led by Goldman Sachs and CDH, a Chinese 
private equity fund. Nonetheless, Shuanghui's current chairman, 
Wan Long, has stayed in charge throughout this 
``privatization'' process. He is a longtime member of China's 
Communist Party and National People's Congress. Through a 
management buyout in 2010, he has been able to exercise 
majority control over the company's shares and voting 
rights.\125\ The Chinese private equity firm New Horizon 
Capital--cofounded by former premier Wen Jiabao's son Wen 
Yunsong--is a minority shareholder of Shuanghui. * \126\
---------------------------------------------------------------------------
    * New Horizon is a private equity group cofounded by Wen Yunsong, 
the only son of former premier Wen Jiabao. According to the Financial 
Times, Wen Yunsong ``has been an active participant in Chinese 
investment since earning an MBA at Kellogg management school at 
Northwestern University in the US.'' New Horizon's first fund was 
incorporated in the Cayman Islands in 2005 with $100 million. A primary 
contributor to that first fund was Temasek, Singapore's sovereign 
wealth fund. New Horizon closed its second fund in May 2007 with $500 
million. The Financial Times reported in January 2010 that New Horizon 
was close to raising $1 billion from foreign investors for a fund that 
will invest in Chinese enterprises on the Mainland. Among the 
contributors to the latest fund are U.S. and European institutions. In 
addition to Shuanghui, New Horizon's equity investments include 
Xinjiang Goldwind, China's largest wind power equipment maker, and 
Zoomlion, China's second-largest construction machinery maker. Jamil 
Anderlini, ``China Premier's Son Nears $1bn Target for Fund,'' 
Financial Times, January 27, 2010, via Factiva database; U.S. Senate 
Committee on Agriculture, Nutrition, and Forestry, Hearing on 
Smithfield and Beyond: Examining Foreign Purchases of American Food 
Companies, testimony of Usha Haley, 113th Cong., 2nd sess., July 10, 
2013.
---------------------------------------------------------------------------
    China's agribusinesses have pursued outbound investment in 
several countries and sectors (see figure 10). According to Dr. 
Gale, government policy influences these outbound investments. 
Of note is what Dr. Gale refers to as the ``two markets, two 
resources'' strategy, which ``calls for control of overseas 
farm production, processing and logistics by Chinese companies 
for commodities that cannot be supplied domestically.'' The 
premise is that supply chain control will give Chinese 
companies a greater cost and price advantage in global markets. 
The ``two markets, two resources'' strategy is manifest in a 
plan, issued by the National Development and Reform Commission, 
that designates companies for overseas ventures. The two 
flagship companies chosen to shore up vegetable oil supplies, 
for instance, are Chongqing Grain Group and Beidahuang, an 
agribusiness company created by the Heilongjiang Province state 
farm system. These two companies have plans to invest in 
soybean and rapeseed production, processing, and logistics in 
Brazil, Russia, and Canada. Reportedly, Chongqing Grain Group 
has already begun importing soybeans from its Brazil project. 
Similarly, China National Cereals, Oils and Foodstuffs Corp. 
and other state-owned enterprises are to invest in soybean, 
cassava, rubber, and sugar projects. The strategy is financed 
by earmarked loans from state banks and public offerings in 
equity markets.\127\ Tax breaks have supported agribusiness 
growth as well: Article 27 of China's Enterprise Income Tax Law 
provides that income generated from agriculture, forestry, 
husbandry, or fisheries may be exempted from the tax.\128\


                                     Figure 10:  Outbound Investments by Chinese Firms in the Food Sector, 2008-2012
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                       Investment                                                                 Land
                   Year                       Month      Investor          ($       Subsector    Country      Type     Share    Partner/Target   Acqui-
                                                                       millions)                                        Size                     sition
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                           Dec.            Yili        $210         Dairy        New     Equity     100%    Oceania Dairy        No
                                                         Industrial                              Zealand
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                           Nov.        Shanghai        $730         Sugar       Aus-     Green-       --               --       Yes
                                                            Zhongfu                               tralia      field
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                          Sept.         Synutra        $120         Dairy     France      Joint       --          Sodiaal        No
                                                                                                            venture
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                           Aug.                Complant$170         Sugar    Jamaica     Equity     100%      State-owned       Yes
                                                                                                                                 sugar plants
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                            May    Bright Foods      $1,940              ConsBritain     Equity      60%         Weetabix        No
                                                                                        foods
--------------------------------------------------------------------------------------------------------------------------------------------------------
2012                                           Apr.        Shanghai        $170         Dairy        New     Equity     100%                 Crafar Yesms
                                                            Pengxin                              Zealand
--------------------------------------------------------------------------------------------------------------------------------------------------------
2011                                           Aug.    Bright Foods        $390              ConsumeAus-     Equity      75%   Manassen Foods        No
                                                                                        foods     tralia
--------------------------------------------------------------------------------------------------------------------------------------------------------
2011                                           July                COFCO   $140         Sugar       Aus-     Equity      99%      Tully Sugar       Yes
                                                                                                  tralia
--------------------------------------------------------------------------------------------------------------------------------------------------------
2011                                           June    Heilongjiang      $1,510      Soybeans     Argen-      Joint       --                 Cresud Yes
                                                         Beidahuang                                 tina    venture
                                                            Nongken
--------------------------------------------------------------------------------------------------------------------------------------------------------
2011                                          March                Chongq$1,410      Soybeans     Brazil     Green-       --               --       Yes
                                                              Grain                                           field
--------------------------------------------------------------------------------------------------------------------------------------------------------
2010                                           Oct.        Sinochem      $1,440         Agro-     Israel     Equity      60%   Makhteshim-Agan       No
                                                                                    chemicals
--------------------------------------------------------------------------------------------------------------------------------------------------------
2009                                           July                CIC     $370              ConsBritain     Equity       1%           Diageo        No
                                                                                        foods
--------------------------------------------------------------------------------------------------------------------------------------------------------
2008                                           June                China Na$140al        Pork        USA     Equity       5%       Smithfield        No
                                                                   Cereals,                                                             Foods
                                                           Oils and
                                                         Foodstuffs
 
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: ``China Global Investment Tracker'' (Washington, DC: Heritage Foundation, July 2013). http://www.heritage.org/research/projects/china-global-
investment-tracker-interactive-map; various media sources.


    In the United States, China's outbound investments came 
into focus in June 2013, when Shuanghui International Holdings 
Limited, a subsidiary of Shuanghui Group, proposed to acquire 
Smithfield Foods Inc., the largest U.S. pork producer. The 
deal, valued at $7.1 billion, is the largest-ever acquisition 
of a U.S. company by a Chinese company. It raises several 
critical issues. First, Smithfield is the market leader in the 
U.S. pork industry, and thus acts as a strategic node in the 
---------------------------------------------------------------------------
U.S. pork supply chain (see table 2).


             Table 2:  Top-Ten Pork Producers in the United States by Sows and Slaughtering Capacity
----------------------------------------------------------------------------------------------------------------
                                            Sows (2012)                                      Daily slaughter
                                     ------------------------                                capacity (2009)
                                                                                        ------------------------
                                          Sows       Market                                Slaughter     Market
                                                     share                                 capacity      share
----------------------------------------------------------------------------------------------------------------
 1 Smithfield                            862,000      28.4%               1 Smithfield       126,300      28.4%
 2 Triumph                               378,500      12.5%                    2 Tyson        74,550      16.8%
 3 Seaboard                              217,000       7.1%                    3 Swift        47,000      10.6%
 4 Maschhoffs                            196,000       6.4%                    4 Excel        38,500       8.7%
 5 Prestage Farms                        165,000       5.4%                   5 Hormel        37,000       8.3%
 6 Iowa Select Farms                     160,000       5.3%                 6 Seaboard        19,200       4.3%
 7 Pipestone System                      145,000       4.8%                    7 Excel        19,000       4.3%
 8 Cargill                               136,000       4.5%      8 Indiana Packing Co.        16,500       3.7%
 9 Carthage System                       103,500       3.4%                 9 Hatfield        10,600       2.4%
10 AVMC Management Services               82,000       2.7%              10 J.H. Routh         4,200       0.9%
   Other                                 593,800      19.5%                      Other        52,075      11.7%
     TOTAL                             3,038,800                                  TOTAL      444,925
----------------------------------------------------------------------------------------------------------------
Source: Top U.S. Pork Powerhouses, 2012. http://www.agriculture.com/uploads/assets/promo/external/siteimages/
PP2012.pdf.


    Second, the deal is not guaranteed to improve overall 
market access for U.S. pork in China. China is unlikely to 
abandon its policy of self-sufficient meat production. A more 
likely result is a closed market of intracompany trade between 
Shuanghui and Smithfield, combined with U.S. soybean and corn 
imports to feed China's hogs. Given Smithfield's massive 
output, it could supply the bulk of China's limited imports of 
U.S. pork. Indeed, Smithfield has developed a special 
relationship with Shuanghui over several years. At its plant in 
North Carolina, the largest of its kind in the world, 
Smithfield already switched over to ractopamine-free pork 
production at Shuanghui's request, prior to the proposed 
acquisition.\129\ Meanwhile, other pork plants in the United 
States could still find it tough to export to China, either 
because the costs of complying with ractopamine restrictions 
are too high or because they do not enjoy the privileges of a 
firm owned by a Chinese parent company.
    Third, even if China does import more U.S. pork, U.S. meat 
slaughterers and processors could lose out. Under the 12th 
Five-Year Plan (2011-2015), China has begun to consolidate and 
industrialize its meat industry. It is shutting down backyard 
farms in favor of large, vertically integrated operations. 
Although technically in private hands, Shuanghui is crucial to 
the government's efforts to enact this policy. The problem for 
Shuanghui is that it has built large industrial facilities to 
slaughter and process pork but lacks the hogs to fill them. 
Without direct control over hog farms, it sources meat from 
smaller producers, which leads to erratic quality and output. 
Importing pig carcasses from Smithfield appears to be an 
expedient solution. Shuanghui might use Smithfield mainly as a 
supplier of hog carcasses. Usha Haley told the U.S. Senate 
Committee on Agriculture, Nutrition, and Forestry:

        Extrapolating from what has occurred in steel, paper, 
        glass, auto parts and solar, the United States will 
        become an exporter of the commodity of pork to China, 
        and an importer of higher-value-added processed foods 
        from China. . . . Although U.S. exports to China of 
        pork will rise, U.S. imports of processed foods from 
        China will rise even faster, contributing to the trade 
        deficit and loss of manufacturing capacity. . . . U.S. 
        companies would be unable to compete domestically and 
        in exports against a Shuanghui-Smithfield that does not 
        pursue profits but is heavily subsidized and aims for 
        industry domination.\130\

    Fourth, while Smithfield could become a ``raw material'' 
supplier to Shuanghui, it would also transfer substantial 
intellectual property and branding power to its Chinese parent. 
Technology transfer * is a salient trend in China's pork 
industry. Along with consolidation and capacity expansion, the 
Chinese government is seeking better technologies to improve 
the productivity of its livestock. According to Delta Farm 
Press, a respected agriculture publication in the United 
States, China is ``capitalizing on decades of cutting-edge U.S. 
agricultural research.'' \131\ Chinese producers are especially 
looking to forge uniform herds based on the most efficient 
breeds, like Duroc, Yorkshire, and Landrace.\132\ From 2002 to 
2007, China imported a total of 13,000 head of swine; from 2008 
to 2011, live swine imports totaled 39,000 head--15,000 in 2011 
alone.\133\ In 2002-2012, China increased its share of U.S. 
live swine exports from 5 percent to 51 percent.\134\
---------------------------------------------------------------------------
    * Owing to its vertically integrated operations, Smithfield has 
played a pioneering role in modernizing breeding techniques for U.S. 
hog farms, competing head-on with dedicated genetics and breeding 
companies. The Smithfield Lean Generation Pork \TM\ Program has been 
among the nation's leading fresh pork programs, with dozens of branded 
items in its product line. Already in the 1990s, Smithfield acquired 
long-term rights for the NPD hog, a breeding line developed by National 
Pig Development Co., a British firm. In 2000, it bought out the U.S. 
branch of NPD, forming an in-house unit to undertake research and 
development. This intellectual property will be transferred to 
Shuanghui.
---------------------------------------------------------------------------
    Finally, an irony not lost on opponents of the Smithfield 
acquisition is that, if the situation were reversed, China's 
laws on foreign acquisitions would allow the government to 
block the sale on economic and commercial grounds rather than 
just national security, as is the case with the U.S. laws. 
Stated Dr. Haley: ``As the Chinese government views pork-
processing as a strategically important industry, the country 
is unlikely to open this market to U.S. companies.'' \135\
    Shuanghui and Smithfield submitted their proposed 
transaction for approval to the Committee on Foreign Investment 
in the United States (CFIUS) in June. On September 6, the 
companies received clearance from CFIUS.\136\ The shareholders 
voted September 24 to approve the sale. The transaction is 
expected to become final toward the end of 2013.\137\

Food Safety: China's Penetration of the U.S. Food Chain
The Safety of U.S. Food Imports from China

    China's WTO accession was primarily envisaged as an 
opportunity for U.S. exporters. But U.S. food imports from 
China have surged as well, part of a greater reliance on 
imported food by U.S. consumers. Food imports from 
China tripled to 4.1 billion pounds in 2001-2012 and have 
reached a high level of penetration for specific products (see 
figure 11). The majority of imports consists of consumer-
oriented products. For these products, the United States 
accumulated a trade deficit of $5 billion with China in 2008-
2012. About a third of U.S. food imports from China are fresh, 
frozen, and processed fish and seafood products. Another 41 
percent is comprised of fruits and vegetables, products that 
often compete directly with U.S. producers.\138\
---------------------------------------------------------------------------
     The U.S. Government Accountability Office (GAO) reports 
that from 2000 through 2011, the percentage of food consumed in the 
United States that was imported rose from 9 percent to over 16 percent, 
and food imports increased by an average of 10 percent each year for 
seven years. ``According to the U.S. Department of Agriculture's 
Economic Research Service, the food groups with the highest share of 
imports are fresh fish and shellfish (85 percent in 2009) and fruits 
and nuts (38 percent in 2009).'' U.S.-China Economic and Security 
Review Commission, Hearing on China's Agriculture Policy and U.S. 
Access to China's Market, testimony of Patty Lovera, April 25, 2013.

      Figure 11:  Imports from China as Share of U.S. Consumption

                Four-Year Average, 2008-2011, share (%)



    Sources: USDA, GATS [General Agreement on Trade in Services] 
Database (Washington, DC: Foreign Agricultural Service); USDA, 
Vegetable and Melon Yearbook 2011 and Fruit and Tree Nut Outlook 
(Washington, DC: Economic Research Service, 2012); and U.S. National 
Fisheries Institute, ``Top 10 Consumed Seafoods,'' 2012, via U.S.-China 
Economic and Security Review Commission, Hearing on China's Agriculture 
Policy and U.S. Access to China's Market, testimony of Patty Lovera, 
April 25, 2013.

    Imports from China also comprise a host of processed foods 
and food ingredients whose provenance may be less obvious to 
U.S. consumers. Food ingredients include xylitol, used as a 
sweetener in candy; ascorbic acid, a preservative; and vitamin 
ingredients, like folic acid and thiamine, frequently added to 
food products. Processed food imports, in turn, include vitamin 
C, candy, condiments, pet food, and pasta and baked goods, as 
well as food supplements and even gel capsules and nonactive 
pill binders for pharmaceuticals.\139\
    For the United States, these imports from China present 
significant food safety risks. Over the past decade, China's 
major trade partners have repeatedly banned its food shipments 
on the basis of food safety. The earliest actions centered on 
seafood--the European Union and the FDA temporarily blocked 
imports of shrimp, crayfish, and crabmeat from China in 2002-
2004 after discovering high residue levels of chloramphenicol, 
a broad spectrum antibiotic drug used to treat life-threatening 
infections in humans.\140\ China's food product safety garnered 
wider attention in 2007, when excessive antibiotic and 
pesticide residues led several countries, including South 
Korea, Japan, and the European Union, to impose renewed 
bans.\141\ The most imminent threat to the United States at the 
time was pet food from China that contained a harmful 
industrial solvent, melamine. The FDA received reports of 
17,000 pet illnesses, including 4,000 dog and cat deaths, 
believed to be the result of melamine contamination in imported 
Chinese gluten used to make pet food. Sixty million packages of 
melamine-contaminated pet food were recalled. That did not 
prevent a portion of melamine-contaminated products from ending 
up in other U.S. food products; there were reports that 56,000 
hogs ate melamine-tainted pet food and were processed into 
pork, which was then sold at supermarkets.\142\ The melamine 
threat did not end there. In the fall of 2008, the FDA also 
recalled candy made by U.S. companies in China due to concerns 
of melamine contamination in Chinese milk.\143\ The FDA in June 
2012 and June 2013 twice extended bans on milk products from 
China, which included chocolate products.\144\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
China's Organic Food Exports to the United States
 
  China has become a supplier of organic foods to the U.S. market.
According to the USDA's National Organic Program, from 1995 to 2006, the
value of organic food exported from China rose from $300,000 to $350
million annually. By 2010, 649 operations in China were certified by the
USDA as meeting U.S. organic standards.\145\ Ironically, these imports
now include organic soybeans. Because organic livestock producers in the
United States cannot use the genetically modified soybeans harvested at
home, they are turning to China's nongenetically modified beans
instead.\146\
  Organic foods are generally characterized by methods of farming that
do not involve synthetic inputs such as chemical fertilizers. In China
bureaucratic infighting has led to the emergence of two competing
standards for organic food. The Ministry of Agriculture has promoted a
less rigorous ``green food'' standard since the early 1990s, which
comprises foods that have very low levels of chemical residues. The
Environment Ministry, in turn, adheres to a more rigorous ``organic
food'' standard, which requires that food products contain no chemical
residues at all. To encourage organic food exports, China has lobbied to
make these standards equivalent with those of developed country markets
like the United States, the European Union, and Japan. At present,
however, neither standard has achieved international recognition.\147\
  The USDA issues its own approvals for organic food produced in China.
It does so by accrediting private, third-party certifiers. Once these
certifiers approve a Chinese production facility, that facility's
products are ``USDA certified'' and can be sourced by Whole Foods and
other organic food retailers in the United States. Some experts assert
that the USDA has exhibited a lack of due diligence in issuing certain
approvals. USDA officials three years ago visited China to conduct an
audit of four of the ten companies it had accredited as organic food
certifiers. The officials reported that conditions ``pose challenging
oversight duties andresponsibilitiesfor certifyingagentsoperatingin
China.''They
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
China's Organic Food Exports to the United States--Continued
 
discovered, for instance, that a certifier had used Chinese government
 employees to inspect state-controlled farms, suggesting a direct
 conflict of interest among different actors in China's government.\148\
 
------------------------------------------------------------------------


---------------------------------------------------------------------------
Inadequate Food Safety Regulation in China

    Current regulation of food entering the United States from 
China is insufficient. First of all, the Chinese government's 
own food safety regulation is inadequate. Multiple agencies 
oversee the food safety regulation process, including the 
Ministry of Health; the Ministry of Agriculture; the Ministry 
of Commerce; and importantly, the General Administration of 
Quality Supervision, Inspection, and Quarantine, which has 
separate jurisdiction over customs inspections. In the United 
States, there is no separate agency for customs. The various 
Chinese agencies also have central and local branches, forming 
a fragmented and decentralized system of regulation.\149\
    The Chinese government in 2009 introduced a comprehensive 
Food Safety Law to establish a modern framework for food safety 
regulation. The law was partially successful in handing more 
oversight power to the Ministry of Health and creating an 
intraministerial working group. This regulatory consolidation 
was reinforced in March 2013, when the government created a new 
China Food and Drug Administration, which took on certain 
responsibilities from the State Food and Drug Administration; 
the Ministry of Agriculture; the State Council's Food Safety 
Committee; and the General Administration of Quality 
Supervision, Inspection, and Quarantine.\150\ The 2009 law also 
made progress in specifying guidelines for hazard analysis and 
risk management, in order to track food safety ``from farm to 
plate.'' \151\ During its trip to China, the Commission met 
with officials from the China Food and Drug Administration to 
learn more about their activities.\152\
    However, it is uncertain whether these reforms will make a 
substantial difference. The consolidation of agencies has 
stopped short of full integration. For instance, farm-level 
production and slaughter is still overseen by the Ministry of 
Agriculture.* Further, the China Food and Drug Administration 
has just a few hundred staff at the central government level in 
charge of overseeing tens of thousands of less-capable 
inspectors in local agencies.\153\ Due to extreme fragmentation 
of production--with an estimated 450,000 companies in food-
processing alone--traceability of food products remains a stiff 
task.\154\
---------------------------------------------------------------------------
    * The China Food and Drug Administration will apparently handle the 
safety of food production as well as distribution, in contrast to its 
predecessor, the State Food and Drug Administration, which supposedly 
handled only safety in the food service industry. In spite of this 
regulatory integration, the General Administration of Quality 
Supervision, Inspection, and Quarantine Department remains responsible 
for customs inspections, while the Ministry of Agriculture remains in 
charge of overseeing ``primary'' production, including livestock 
slaughter. Brady Sidwell (vice president, corporate development, OSI 
Group), e-mail to Commission staff, July 31, 2013.
---------------------------------------------------------------------------
    Academic research has shown that the 2009 Food Safety Law 
has done little so far to hold producers and officials 
accountable. According to John Balzano of Yale Law School, 
Chinese consumers still have difficulty filing coordinated 
lawsuits against food companies, and the courts rarely 
investigate public officials.\155\ Other experts have argued 
that illegal food production occurs in China because local 
officials are responsible for both economic growth and food 
safety and, in many cases, prioritize the former.\156\ As a 
result, safe and high-quality food production is not 
consistently rewarded, while unsafe and low-quality production 
is not consistently punished.\157\ The Chinese government has 
resorted instead to public displays of enforcing food safety 
rules, inspecting food facilities, and punishing people 
connected with tainted food, especially in high-profile cases. 
In July 2007, for example, the former head of the State Food 
and Drug Administration was executed on conviction of receiving 
$850,000 in bribes.\158\ The melamine scandal in 2009 led the 
authorities to close down half the country's dairies.\159\ Two 
years later, a concerted crackdown on food safety violations 
resulted in 2,000 arrests and 4,900 businesses being closed. 
These actions were widely reported in the state media.\160\

Problems with U.S. Food Safety Inspection

    In the absence of effective regulation by the Chinese 
government, U.S. consumers depend on U.S. food safety 
inspectors to do their jobs. And yet, there are numerous 
problems with U.S. food regulation. The system is fragmented, 
underfunded, and heavily reliant on third-party verification--
structural flaws documented through extensive congressional 
hearings and government reports.\161\ The FDA and the USDA 
divide up food safety inspection by product group, with most 
seafood, horticulture, and processed foods coming under the 
jurisdiction of the FDA. Patty Lovera of Food & Water Watch 
testified: ``The USDA is in charge of meat and poultry. The FDA 
is in charge of basically everything else. We spend a lot of 
time in this context thinking about the FDA because those are 
the products that are coming in at this point from China.'' 
\162\
    Relative to its broad oversight role, the FDA's 
capabilities are limited. At the Commission's 2008 hearing on 
food safety in the seafood industry, the FDA's director of the 
Center for Food Safety and Applied Nutrition acknowledged that 
the surge of Chinese food imports has ``outstretched and 
outgrown the regulatory system for imports in the [United 
States].'' \163\ Based on expert testimony received by the 
Commission in 2008 and 2013, the FDA inspects less than 2 
percent of the food that passes through U.S. borders.\164\ 
Inspection rates in Japan and the European Union are several 
times higher.\165\ Nor does the agency always act forcefully 
when it discovers a problem; shipments are turned away by the 
FDA but not destroyed, so that products can potentially reenter 
the country through another port, a phenomenon known as ``port-
shopping.'' \166\
    According to Ms. Lovera, weak regulation at the border is 
compounded in China's case by a lack of cooperation between the 
two countries' authorities. During the melamine-tainted pet 
food crisis in 2007, for example, it took the FDA one month to 
identify and communicate with its regulatory counterparts in 
China.\167\ A USDA Economic Research Service report from 2009 
asserts that the Chinese government guards the food safety data 
it collects, making it difficult to impartially evaluate 
China's food safety performance.\168\ Kelli A. Giannattasio, 
the FDA's deputy country director in China, told the Commission 
that some progress has been made since then to widen channels 
of communication. Nonetheless, China's balkanized system of 
regulation, in which food production and distribution is 
overseen by different agencies at the central and local levels, 
has made it difficult to identify the right counterparties once 
a risk is identified.\169\
    The FDA has made substantial efforts to improve its border 
inspections. These were outlined by the FDA's associate 
director for Global Operations and Policy, Steven M. Solomon, 
at a May 2013 hearing of the Congressional-Executive Commission 
on China. Mr. Solomon pointed out that the 2011 Food Safety 
Modernization Act, the most wide-reaching reform of U.S. food 
safety laws in 70 years, lays the foundation for a more 
prevention-based approach to regulating imports. He also noted 
that, while the FDA does not ``physically inspect all imports'' 
that enter the country, it does ``electronically screen all 
imports using an automated risk-based system to determine if 
shipments meet identified criteria for physical examination or 
other review.'' To enhance its ability to target high-risk 
products, the agency recently developed the Predictive Risk-
based Evaluation for Dynamic Import Compliance Targeting 
application, a screening system that uses intelligence from 
many sources to provide the entry reviewer with risk scores on 
every import line.\170\
    The FDA is also trying to involve U.S. importers more 
directly in food safety oversight. Under the Foreign Supplier 
Verification Program, introduced in August, food importers in 
the United States must assess which types of safety risks are 
posed by the food they are importing and obtain documentation 
from the exporter that show how those risks are being 
mitigated. Importers will be required to conduct or obtain 
results of annual on-site audits of the exporter's facility. 
One loophole in the new regulations is that they do not apply 
to aquaculture products, one of the U.S.'s top imports from 
China. Aquaculture products are subject only to the less 
stringent Hazard Analysis and Critical Control Points program, 
under which importers are not required to retain detailed 
documentation to show how their foreign suppliers are 
controlling risks.\171\
    To supplement the efforts to improve food regulation at 
home, U.S. food safety inspectors have attempted to step up 
their on-the-ground presence in China. According to Ms. Lovera, 
the FDA visited just 46 food firms on the Mainland in 2001-
2008--less than six a year.\172\ Since then, the agency has 
devoted more resources to its food safety oversight in China. 
Initial budget increases were enacted in 2009. The fiscal year 
2013 Continuing Resolution added $10 million to the FDA's base 
to fund the addition of seven food and nine drug inspectors 
permanently posted in China.\173\ Under a memorandum of 
agreement that the U.S. Department of Health and Human Services 
signed with China in December 2007, the Chinese government 
permitted more FDA inspectors to enter the country and allowed 
the FDA to open offices in Beijing, Shanghai, and 
Guangzhou.\174\ Commission witness William Westman, who served 
as agricultural attache to the U.S. embassy in Beijing in the 
mid-2000s, noted that 11 FDA attaches were installed at the 
various U.S. consulates by the end of his tenure.\175\ 
According to the FDA's fiscal-year 2013 appropriations report, 
its inspections in China increased from 16 in 2009 to 55 in 
2011, a tangible improvement.\176\
    Still, U.S. food safety regulation in China has many 
shortcomings. Even with additional inspectors on the Mainland, 
the agency may find it difficult to monitor China's vast and 
fragmented food processing industry.\177\ Regulatory barriers 
imposed by Chinese authorities have added to the problem. 
Stated Ms. Giannattasio:

        Currently, our main challenge stems from delays in 
        issuance of visas for additional FDA staff in China. . 
        . . To date, China's Ministry of Foreign Affairs has 
        not issued diplomatic visas that would enable the 
        deployment of these inspectors to China on a full-time 
        basis. In order to continue its inspection efforts, 
        FDA's China Office is working with FDA's Office of 
        Regulatory Affairs to deploy inspectors on temporary 
        assignment to carry out the inspections FDA needs to do 
        in China.\178\

    Another impediment is China's reluctance to grant access to 
plants. Under the memorandum of agreement signed with the 
United States in 2007, the Chinese government promises FDA 
inspectors better access to Chinese facilities but reserves the 
right to control their movements and access.\179\ These 
restrictions appear to still be in place--during August 2012 
visits to Chinese processing plants that export pet treats to 
the United States, U.S. inspectors were not permitted to 
collect samples for independent analysis.\180\
    The United States and China are working together to improve 
food safety. Examples of collaboration include:

     LThe USDA and the FDA, along with major U.S. 
companies, participate in the China State Council's annual 
China International Food Safety and Quality Conference and 
Expo, inaugurated in 2007.\181\

     LA working group on economically motivated 
adulteration meets on a regular basis by video, linking 
Washington-based experts with the China Food and Drug 
Administration's key decision-makers.\182\

     LIn November 2012 and May 2013, the FDA and 
China's General Administration of Quality Supervision, 
Inspection and Quarantine held workshops for members of Chinese 
industry to address concerns regarding aquaculture practices 
for fish farms. These workshops have significantly enhanced the 
FDA's understanding of China's oversight system for aquaculture 
products and have provided Chinese industry with a clearer 
understanding of the FDA's requirements and practices.\183\

     LThe China-U.S. Plan of Strategic Cooperation in 
Agriculture (2012-2017), signed in February 2012 by the USDA 
and China's Ministry of Agriculture, states that the two 
countries will develop ``mutually beneficial international 
standards on food safety''; ensure implementation of science-
based laws, regulations, policies, and standards; ensure 
transparency of the regulatory decision-making process and food 
safety initiatives; and improve institutions and working 
mechanisms of emergency response. To this end, both sides 
``propose to more actively engage'' in bilateral and 
international meetings.\184\

Implications for the United States

    China is now the top market for U.S. agricultural exports, 
but not everyone in the U.S. farming community is benefitting 
equally. China's imports from the United States have been 
concentrated in bulk commodities, a trade pattern quite 
different from U.S. agricultural exports to the rest of the 
world. U.S. soybean exporters have gained disproportionately, 
to the extent that they have become quite dependent on the 
Chinese market. A problem for all bulk commodity exporters to 
China is that nation's policy of using taxes and subsidies, in 
combination with stockpiling and state trading, to control 
commodity trade flows. Therefore, much of the value-added 
processing of commodities is taking place in China rather than 
in the United States, which is hurting U.S. manufacturers and 
contributing to U.S. unemployment.
    Among consumer foods, U.S. meat products have the most to 
gain in China. Chinese consumers are shifting to a higher-
priced, protein-heavy diet, while China's domestic livestock 
industry is reaching its capacity limits. The United States 
enjoys a comparative advantage in resources, productivity, and 
quality for meat production. And yet, U.S. beef and pork 
producers have been affected by China's heavy subsidization of 
domestic production and, even more, by its stringent sanitary 
barriers. Many sanitary measures appear designed either to 
protect domestic producers or to shift the blame for domestic 
food safety lapses onto foreign products. A complicating factor 
for the United States is that China is not alone in abusing 
health and safety measures. Some of the U.S.'s best beef export 
markets have been slow to lift BSE-related restrictions. Japan, 
South Korea, and Taiwan will only accept U.S. beef from animals 
less than 30 months of age.\185\ The European Union and Taiwan 
ban imports of U.S. pork treated with ractopamine.\186\ By the 
same token, the intensifying competition from other 
agricultural exporters, such as Australia, Brazil, and 
Argentina, allows China to hedge its import strategy in ways 
that can damage U.S. interests.\187\
    A key challenge for the United States is to treat China as 
a major market rather than a developing country in need of 
development assistance. The United States and China are 
engaging in extensive bilateral cooperation in agriculture. The 
USDA has signed a Plan of Strategic Cooperation with its 
Chinese counterparts on agricultural science, trade, and 
education. U.S. universities and companies are also actively 
engaged in China. But this outreach is not always conducive to 
improving market access for U.S. exporters and foreign 
investors, who view China as a strategic market for their 
business.
    Another challenge is to reconcile different interests in 
U.S. trade policy. In regional terms, Iowa has profited the 
most from trade with China, given its extensive production of 
crops to feed China's livestock. The Iowa state government has 
been very proactive in fostering bilateral diplomacy. 
Conversely, specialty crop growers in the Pacific Northwest, 
beef producers in the Central Plains, and cotton and poultry 
producers in the South have been more critical of the evolving 
relationship. There is also a need to recognize the actors in 
China that might be for and against trade with the United 
States. For example, the Ministry of Agriculture, which 
prioritizes the interests of Chinese farmers, and the Ministry 
of Commerce, which seeks to implement China's WTO commitments, 
do not always share common interests.
    The case of poultry illustrates the tradeoffs of 
negotiating bilateral trade deals. U.S. poultry producers have 
been the unfortunate targets of Chinese retaliation in a 
broader trade dispute involving auto parts and tires. U.S. 
government efforts to support domestic producers and protect 
consumers in the food sector have not always achieved to their 
intended effects and, in some cases, have worked at cross 
purposes. Food safety advocates argue that allowing China to 
export processed poultry to the United States is too high a 
price to pay for greasing the wheels of bilateral trade deals.
    WTO accession has allowed China to export vast amounts of 
fruits, vegetables, fish, and processed foods to the United 
States, causing health scares and overstretching the U.S. food 
inspection regime. In the future, the U.S. government will have 
to strike a balance between expanding a rules-based trading 
regime that favors exporters and taking action to block Chinese 
imports if safety cannot be assured. It will also need to 
enhance the capacities of the USDA and the FDA to screen food 
imports at the border and on the ground in China. That will 
require better cooperation from the Chinese authorities--the 
U.S. State Department last October formally notified the 
Chinese Ministry of Foreign Affairs about obtaining visas for 
additional FDA inspectors, but as of September 2013, the visas 
had not been granted.\188\
    The proposed acquisition of Smithfield by a Chinese pork 
producer, Shuanghui, was approved by CFIUS and by Smithfield's 
shareholders in September. The case illustrates that Chinese 
companies can make major acquisitions of U.S. companies in the 
agriculture sector without being blocked on national security 
grounds. At the same time, the case elicits important questions 
about U.S. policy toward foreign investors from China. 
Smithfield is the largest pork producer in the United States 
and hence a strategic supplier of food to U.S. consumers. While 
Shuanghui is a quasi-private company, it maintains strategic 
ties to the Chinese government. The case also has a bearing on 
intellectual property protection, net economic benefits, and 
reciprocal market access.

Conclusions

 LFor the past three years, China has been the largest 
export market for U.S. agricultural goods. However, trade is 
far from free, and enormous opportunities are being withheld. 
China's WTO accession has not been as productive to the United 
States as initially expected. In contrast to U.S. agricultural 
exports to the rest of the world, most U.S. exports to China 
are bulk commodities, particularly raw soybeans that supply 
China's outsized livestock sector. Conversely, processed 
commodities, meat products, consumer foods, and other higher 
value-added products have not kept pace with the overall growth 
in bilateral trade.

 LSince the 1980s, China has developed into the world's 
largest agricultural economy, producing a fifth of the world's 
grains, a quarter of its meat, and half of its vegetables. But 
demand in China is beginning to outstrip supply. As more people 
move to cities and earn higher incomes, China's population is 
demanding safer food and a more diverse, protein-rich diet at 
an affordable cost. The United States is well-positioned to 
meet that demand. U.S. farmers enjoy a comparative advantage in 
resources, productivity, and quality, particularly in meat 
production.

 LChina's agriculture policy favors domestic production 
over imports. China maintains ambitious self-sufficiency 
targets that are unsustainable and unjustifiable in terms of 
food security. This policy is now being challenged by the 
decline in China's farm labor surplus, deteriorating land and 
resource endowments, and fragmented producer and land use 
systems. A related problem is that efforts to modernize 
agriculture conflict with rural welfare aims. Millions of rural 
migrants continue to rely on farmland and smallholder 
agriculture for insurance in the absence of a functioning 
welfare state.

 LChina has failed to fully perform its obligations 
under the WTO. It has erected a series of nontariff barriers 
that include state trading; excessive domestic subsidies and 
stockpiling of commodities; discriminatory taxes; uncalled-for 
antidumping duties; and slow approvals of biotechnology 
applications for U.S. crops. Damaging to U.S. interests as well 
are sanitary and phytosanitary restrictions, especially BSE-
based bans on beef and zero tolerance for ractopamine in pork. 
Although China has significantly lowered its tariffs and 
increased its agricultural imports since accession, numerous 
trade restrictions remain in place.

 LU.S. companies, universities, and government agencies 
are helping China to improve the quantity and quality of its 
food output. In a sign of deepening bilateral ties, the United 
States and China signed the first U.S.-China Plan of Strategic 
Cooperation in Agriculture (2012-2017) in February 2012, and in 
March of that year the largest-ever U.S. agricultural trade 
mission visited China. However, U.S. companies operating in 
China are hamstrung by regulatory uncertainty, restricted 
market access, and weak intellectual property enforcement.

 LChina is fostering globally competitive 
agribusinesses, in the process becoming an active acquirer of 
agricultural assets overseas. In June 2013, China's largest 
pork producer, Shuanghui, proposed a $7.1 billion acquisition 
of Smithfield, the leading pork producer in the United States. 
While the deal has been approved by CFIUS and Smithfield's 
shareholders, it raises critical issues regarding net economic 
benefits, intellectual property, reciprocal market access, and 
the treatment of quasi-private Chinese companies that maintain 
links to the Chinese government.

 LChina accounts for a large share of the fruits, 
vegetables, fish, and processed foods that Americans consume, 
but the United States has little assurance that the food 
imports coming into the United States from China are safe. 
China's own food safety regulation is still ineffective, in 
spite of recent efforts to consolidate agencies and improve 
legislation. U.S. consumers rely on U.S. food safety inspectors 
to do their jobs, but U.S. regulation is also fragmented and 
underfunded. U.S. regulators have increased their presence 
within China but have struggled to obtain work visas and to 
gain access to food production facilities. Although the United 
States does not permit raw meat imports from China, the USDA 
has granted equivalence status to Chinese poultry processors, 
which will permit them to process poultry raised in the United 
States and Canada and ship it to the United States.

                     ENDNOTES FOR SECTION 4

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Into Cities,'' New York Times, June 15, 2013. http: // 
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     66. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Dermot Hayes, April 25, 2013.
     67. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Dermot Hayes, April 25, 2013.
     68. Scott Rozelle, ``Overview of China's Agricultural Development 
and Policies'' (Beijing, China: Chinese Academy of Sciences Center for 
Chinese Agricultural Policy, January 2010).
     69. Kevin Chen and Wang Jimin, ``Hog Farming in Transition: The 
Case of China'' (paper presented at Asian Livestock: Challenges, 
Opportunities and the Response, Proceeding of an International Policy 
Forum, Bangkok, Thailand, August 16-17, 2012), p. 78.
     70. Mamta Badkar, ``Why China Has the Worst Farms in the World,'' 
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(Frankfurt, Germany: Deutsche Bank, November 16, 2012), pp. 7-9.
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and Policies'' (Beijing, China: Center for Chinese Agricultural Policy, 
January 2010).
     73. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Colin Carter, April 25, 2013.
     74. Presentation by the U.S. Meat Export Federation (Shanghai, 
China, July 26, 2013).
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(Washington, DC: Foreign Agricultural Service).
     76. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Northey, April 25, 2013.
     77. Presentation by the U.S. Meat Export Federation (Shanghai, 
China, July 26, 2013).
     78. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Fred Gale, April 25, 2013.
     79. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), pp. 
89-93.
     80. Beef Producer, ``OIE Approves U.S. BSE Status Upgrade,'' May 
30, 2013. http://beefproducer.com/story-oie-approves-bse-status-
upgrade-0-98705.
     81. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), pp. 
89-93.
     82. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Westman, April 25, 2013.
     83. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), p. 
92.
     84. U.S. Meat Export Federation, ``Re: Request for Comments on 
China's Compliance with Its WTO Commitments,'' Docket No. USTR-2012-
0020 (Washington, DC: September 24, 2012).
     85. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of David Miller, April 25, 2013.
     86. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Northey, April 25, 2013.
     87. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Westman, April 25, 2013.
     88. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Fred Gale, April 25, 2013.
     89. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Kevin Brosch, April 25, 2013.
     90. Office of the U.S. Trade Representative, ``United States Wins 
Trade Enforcement Case for American Farmers, Proves Export-Blocking 
Chinese Duties Unjustified Under WTO Rules'' (Washington, DC: USTR 
Press Release, August 2, 2013).
     91. World Trade Organization, ``China--Anti-Dumping and 
Countervailing Duty Measures on Broiler Products from the United 
States'' (Geneva, Switzerland: Dispute DS427). http: // www.wto.org/
english/tratop----e/dispu----e/cases----e/ds427----e.htm#bkmk 427r.
     92. Inside U.S. Trade, ``U.S., China Agree to Refrain from 
Appealing WTO Panel in Chicken Duties Dispute,'' September 13, 2013, 
via Factiva database.
     93. Inside U.S. Trade, ``U.S. Seizes on WTO Poultry Win to Press 
China for AD, CVD Changes,'' September 27, 2013, via Factiva database.
     94. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Colin Carter, April 25, 2013.
     95. Inside U.S.-China Trade, ``Compromise Reached on Poultry Ban, 
Could End U.S.-China WTO Dispute,'' September 30, 2009, via Factiva 
database.
     96. Helena Bottemiller, ``No WTO Appeal on Chinese Chicken 
Dispute,'' Food Safety News, October 27, 2010. http://
www.foodsafetynews.com/2010/10/us-does-not-seek-wto-appeal-on-chinese-
chicken-dispute/#.-Uk-20-EST-BN-8E.
     97. USDA, telephone interview with Commission staff, February 
2013.
     98. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Kevin Brosch April 25, 2013.
     99. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    100. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Kevin Brosch, April 25, 2013.
    101. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013; Poultry Times, ``FSIS Reaffirms 
Equivalence of China's Poultry Processing System,'' September 5, 2013. 
http://poultrytimes.net/?p=6939.
    102. Donald MacLaren and Steve McCorriston, ``The Trade and Welfare 
Effects of State Trading in China with Reference to COFCO,'' World 
Economy 33:4 (April 2010): 616-632.
    103. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), pp. 
85-86; U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Veronica Nigh, April 25, 2013; and Donald MacLaren and Steve 
McCorriston, ``The Trade and Welfare Effects of State Trading in China 
with Reference to COFCO,'' World Economy 33:4 (April 2010): 616-632.
    104. Kirk Johnson, ``For the Vice President of China, Tea Time in 
Iowa,'' New York Times, February 15, 2012. http: // www.nytimes.com/
2012/02/16/world/asia/xi-jinping-of-china-makes-a-return-
trip-to-iowa.html?----r=0; Patrice Hill, ``China Seeks Currency with 
Wall Street; Leader Says More Trade, Not Tariffs, Is Answer,'' 
Washington Times, December 9, 2003, via Factiva database; Scott Hillis, 
``China Premier to Target Textiles, TVs in Trade Talks,'' Reuters, 
December 4, 2003, via Factiva database; and Nick Macfie, ``China to Buy 
U.S. Soybeans as Trade Spat Fizzles,'' Reuters, December 12, 2003, via 
Factiva Database.
    105. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Veronica Nigh, April 25, 2013.
    106. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Northey, April 25, 2013.
    107. Mindi Schneider, ``Feeding China's Pigs: Implications for the 
Environment, China's Smallholder Farms, and Food Security'' 
(Minneapolis, MN: Institute for Agriculture and Trade Policy, May 
2011), p. 3.
    108. Food and Agriculture Organization, FAOStat (Rome, Italy: FAO 
Secretariat). http://faostat.fao.org/site/.
    109. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), p. 
45.
    110. Zhang Hongzhou, ``Behind China's ``Grain Miracle'': More than 
Meets the Eye?'' (Singapore: Nanyang Technological University, S. 
Rajaratnam School of International Studies (RSIS), RSIS Commentaries 
No. 028/2013, February 2013). http://www.rsis.edu.sg/publications/
Perspective/RSIS0282013.pdf.
    111. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Fred Gale, April 25, 2013; U.S.-China Economic and Security Review 
Commission, Hearing on China's Agriculture Policy and U.S. Access to 
China's Market, testimony of Veronica Nigh, April 25, 2013.
    112. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Fred Gale, April 25, 2013.
    113. Food and Agriculture Organization, Agricultural Market 
Information System (Rome, Italy: Agriculture Market Information System 
Secretariat). http://www.amis-outlook.org/.
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to Help Farmers,'' November 8, 2012. http://www.bloomberg.com/news/
2012-11-08/china-said-to-buy-soybeans-from-domestic-harvest-to-help-
farmers.html.
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Agricultural Service, Global Agricultural Information Network, March 
20, 2013). http://gain.-fas.-usda.-gov/Recent%20GAIN%20Publications/
China%20No.-%20-1-%20-Document-%20-2013-_-Beijing-_-China-%20--
-%20-Peoples-%20-Republic-%20-of-_-3-20-2013.pdf.
    116. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Mark Lange, April 25, 2013.
    117. Fred Gale, Daniel Marti, and Dinghuan Hu, ``China's Volatile 
Pork Industry'' (Washington, DC: USDA, Economic Research Service, 
February 2012), pp. 15-20.
    118. Cargill, meeting with Commissioners, Shanghai, China, July 26, 
2013.
    119. China National Cereals, Oils and Foodstuffs Corp. company 
data. http://www.-cofco.-com.
    120. Forbes, ``What Coca Cola Did Wrong, and Right, in China,'' 
March 24, 2009. http:/--/www.forbes.com/2009/03--/24/--coca---cola---
china---leadership-citizenship---huiyuan.html.
    121. State Council, ``Waishang touzi chanye zhidao mulu (2011 nian 
xiuding)'' (Catalogue of Industries for Guiding Foreign Investment--
2011 Revisions) (Beijing, China: 20--1--1). http:/--/www--.gov.cn/
--flfg--/20--1--1---------1--2/29--/--content----_-2033089.htm; Baker 
McKenzie, ``Client Alert: Revisions to the Catalogue for Guiding 
Foreign Investment in Industry 2011'' (Beijing, China: January 2012), 
pp. 3-4. http://www.bakermckenzie.com/files/Uploads/Documents/ China % 20 Update % 20 2012 / 
al _ china _ foreign-investment-catalogue-_-jan12.pdf.
    122. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Barbara Glenn, April 25, 2013.
    123. Office of the U.S. Trade Representative, 2012 USTR Report to 
Congress on China's WTO Compliance (Washington, DC: December 2012), pp. 
88-89; U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Veronica Nigh, April 25, 2013; and U.S.-China Economic and Security 
Review Commission, Hearing on China's Agriculture Policy and U.S. 
Access to China's Market, testimony of Julius Schaaf, April 25, 2013. 
http://www.ndrc.gov.cn/zcfb/zcfbl/2011ling/W020111229379511927834.pdf.
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China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Julius Schaaf, April 25, 2013.
    125. Henan Shuanghui Investment & Development Company Limited, 2010 
Annual Report (Luohe, Henan, China, 2011), p. 9. http://
disclosure.szse.cn/m/finalpage/2012-03-02/60612313.PDF ; Shuanghui 
Group, ``Fazhan Licheng'' (Development History) (Luohe, Henan, China: 
date?). http://www.shuanghui.net/html/category/about/fzlc; Shuanghui 
Group. ``Linghangren Jieshao'' (Leadership Introduction) (Luohe, Henan, 
China: 2013). http://www.shuanghui.net/html/category/about/lhrjs; 
Shuanghui Group, ``Fazhan Licheng'' (Development History) (Luohe, 
Henan, China: 2013). http://www.shuanghui.net/html/category/about/fzlc; 
Henan Shuanghui Investment & Development Company Limited, 2004 Annual 
Report (Luohe, Henan, China: 2005), p. 6. http://www.shuanghui.net/
shfz/pdf/nb2006.pdf ; Henan Shuanghui Investment & Development Company 
Limited, 2006 Annual Report (Luohe, Henan, China: 2007), p. 4; http://
www.shuanghui.net/shfz/pdf/nb2006.pdf and Reuters, ``Goldman Sachs 
Gets Nod for China Shuanghui Purchase,'' December 12, 2006. http://
news.oneindia-.-in / 2006 / 12 / 12 / goldman - sachs - gets - nod - 
for - china - shuanghui-purchase-1165-905-597-.html.
    126. U.S. Senate Committee on Agriculture, Nutrition, and Forestry, 
Hearing on Smithfield and Beyond: Examining Foreign Purchases of 
American Food Companies, testimony of Usha Haley, 113th Cong., 2nd 
sess., July 10, 2013.
    127. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Fred Gale, April 25, 2013.
    128. U.S. Senate Committee on Agriculture, Nutrition, and Forestry, 
Hearing on Smithfield and Beyond: Examining Foreign Purchases of 
American Food Companies, testimony of Usha Haley, 113th Cong., 2nd 
sess., July 10, 2013.
    129. Financial Times, ``Shuanghui Hopes $7bn Deal Will Allay 
Produce Fears,'' May 29, 2013, via Factiva Database.
    130. U.S. Senate Committee on Agriculture, Nutrition, and Forestry, 
Hearing on Smithfield and Beyond: Examining Foreign Purchases of 
American Food Companies, testimony of Usha Haley, 113th Cong., 2nd 
sess., July 10, 2013.
    131. Darrell Ray and Harwood D. Schaffer, ``China's Agricultural 
Future: Adopt U.S. Developed Technologies,'' Delta Farm Press, May 11, 
2012, via Factiva database.
    132. Mindi Schneider, ``Feeding China's Pigs: Implications for the 
Environment, China's Smallholder Farms, and Food Security'' 
(Minneapolis, MN: Institute for Agriculture and Trade Policy, May 
2011), p. 18.
    133. Darrell Ray and Harwood D. Schaffer, ``China's Agricultural 
Future: Adopt U.S. Developed Technologies,'' Delta Farm Press, May 11, 
2012, via Factiva database.
    134. U.S. International Trade Commission, Interactive Tariff and 
Trade Dataweb (Washington, DC). http://hts.usitc.gov/. HTS code 0103.
    135. U.S. Senate Committee on Agriculture, Nutrition, and Forestry, 
Hearing on Smithfield and Beyond: Examining Foreign Purchases of 
American Food Companies, testimony of Usha Haley, 113th Cong., 2nd 
sess., July 10, 2013.
    136. Inside U.S.-China Trade, ``Shuanghui International and 
Smithfield Foods Receive CFIUS Clearance'' (Smithfield Foods and 
Shuanghui International joint press release). http://
chinatradeextra.com.
    137. Nasdaq, ``Smithfield Shareholders Approve Merger--Analyst 
Blog,'' September 25, 2013. http: // www.nasdaq.com/article/
smithfield-shareholders-approve-merger-analyst-blog-cm280385.
    138. U.S.-China Economic and Security Review Commission, Hearing on 
the Impact of U.S.-China Trade and Investment on Pacific Northwest 
Industries, testimony of Christian Schlect, January 13, 2005; USDA 
Foreign Agricultural Service Global Agriculture Trade System online. 
http://www.fas.usda.gov/gats/.
    139. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    140. US Fed News, ``FDA Seizes Adulterated Crabmeat in Louisiana,'' 
July 7, 2004, via Factiva database; Reuters, ``US Steps Up Seafood 
Testing for Banned Antibiotic,'' June 14, 2002, via Factiva database.
    141. Associated Press, ``China's Food Safety Affects Us All; Pet 
Food Crisis Reveals the Global Implications of Its Lax Regulations,'' 
April 13, 2007, via Factiva database; Andrew Walker, ``Red Alert Sounds 
on Contaminated Food from China's Archaic Plot System,'' Sunday 
Independent (Ireland), April 29, 2007, via Factiva database.
    142. David Barboza, ``An Export Boom Suddenly Facing a Quality 
Crisis,'' New York Times, May 18, 2007; USDA, ``Joint Update: FDA/USDA 
Update on Tainted Animal Feed'' (Washington, DC: USDA, Release No. 
0121.07, March 2, 2007); FDA, ``Hog Meat Safe to Eat, Testing Shows'' 
(Washington, DC: April 23, 2007). http://www.fda.gov/ForConsumers/
ConsumerUpdates/ucm061945.htm.
    143. Lisa Abraham, ``Halloween Confections from China on Shelves,'' 
Akron (Ohio) Beacon Journal, October 22, 2008, via Factiva database.
    144. The Times of India, ``FDA Warns of Action Against Sale of 
Chinese Milk Products,'' July 6, 2012, via Factiva database; The Times 
of India, ``FDA Extends Ban of Chinese Milk Products,'' June 30, 2013, 
via Factiva database.
    145. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    146. Mark Peters, ``A Gap in Organic Food Chain,'' Wall Street 
Journal, July 15, 2013, p. A3.
    147. Richard Sanders, ``A Market Road to Sustainable Agriculture? 
Ecological Agriculture, Green Food and Organic Agriculture in China,'' 
Development and Change 37:1 (2006): 201-224; Mark Godfrey, ``BRICs and 
Beyond: Organic Food's Identity Problem in China,'' Just-Food, February 
9, 2012. http://www.just-food.com/analysis/organic-foods-identity-
problem-in-china----id118210.aspx.
    148. Liu Chenglin, ``Is `USDA Organic' a Seal of Deceit?: The 
Pitfalls of USDA Certified Organics Produced in the United States, 
China, and Beyond,'' Stanford Journal of International Law 47 (2011): 
333-78.
    149. APCO Worldwide, ``Will China's Food Safety Law Make China's 
Food Safer?'' (Washington, DC: April 2009). http://
www.apcoworldwide.com/content/contactus.aspx; Fred Gale and Jean C. 
Buzby, ``Imports from China and Food Safety Issues'' (Washington, DC: 
USDA, Economic Research Service, Economic Information Bulletin 52, July 
2009).
    150. Brady Sidwell (vice president, corporate development, OSI 
Group), e-mail to Commission staff, July 31, 2013.
    151. APCO Worldwide, ``Will China's Food Safety Law Make China's 
Food Safer?'' (Washington, DC: April 2009). http://
www.apcoworldwide.com/content/contactus.aspx.
    152. China Food and Drug Administration, meeting with 
Commissioners, Beijing, China, July 22, 2013.
    153. China Food and Drug Administration, meeting with 
Commissioners, Beijing, China, July 22, 2013.
    154. Don Lee, ``Chinese Food Makers Learn to Swallow Scrutiny, 
Controls,'' Los Angeles Times, September 24, 2007. http://
articles.latimes.com/2007/sep/24/business/fi-chinafood24 ; Fred Gale 
and Jean C. Buzby, ``Imports from China and Food Safety Issues'' 
(Washington, DC: USDA, Economic Research Service, Economic Information 
Bulletin 52, July 2009).
    155. John Balzano, ``China's Food Safety Law: Administrative 
Innovation and Institutional Design in Comparative Perspective,'' 
Asian-Pacific Law & Policy Journal 13:2 (2012): 23-80.
    156. Cheng Hongming, ``A Sociological Study of Food Crime in 
China,'' British Journal of Criminology 52 (2012): 254-273.
    157. Patrick Woodall (Research Director and Senior Policy Advocate, 
Food & Water Watch), telephone interview with Commission staff, October 
8, 2013; Cheng Hongming, ``A Sociological Study of Food Crime in 
China,'' British Journal of Criminology 52 (2012): 254-273.
    158. Kirsty Barnes, ``China Carries Out Execution on Corrupt Drug 
Official,'' Outsourcing Pharma, July 10, 2007. http://www.outsourcing-
pharma.com/Commercial -Services/China-carries-out-execution-on-corrupt-
drug-official.
    159. Peter Foster, ``Top 10 Chinese Food Scandals,'' Telegraph 
(United Kingdom), April 27, 2011.
    160. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    161. U.S. Government Accountability Office, ``Food Safety: FDA Can 
Better Oversee Food Imports by Assessing and Leveraging Other 
Countries' Oversight Resources'' (Washington, DC: September 28, 2012). 
http://www.gao.gov/products/GAO-12-933.
    162. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    163. For all the above, see U.S.-China Economic and Security Review 
Commission, Hearing on Chinese Seafood: Safety and Trade Issues 
(Washington, DC: April 24, 2008).
    164. U.S.-China Economic and Security Review Commission, Hearing on 
Chinese Seafood: Safety and Trade Issues, testimony of Patrick Woodall, 
April 25, 2008; U.S.-China Economic and Security Review Commission, 
Hearing on China's Agriculture Policy and U.S. Access to China's 
Market, testimony of Patty Lovera, April 25, 2013.
    165. U.S.-China Economic and Security Review Commission, 2008 
Annual Report to Congress (Washington, DC: U.S. Government Printing 
Office, 2011), p. 92.
    166. U.S.-China Economic and Security Review Commission, Hearing on 
Chinese Seafood: Safety and Trade Issues, testimony of Kim Chauvin, 
April 25, 2008.
    167. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    168. Fred Gale and Jean C. Buzby, ``Imports from China and Food 
Safety Issues (Washington, DC: USDA Economic Research Service, July 
2009), p. 4.
    169. Kelli A. Giannattasio (deputy country director, U.S. Food and 
Drug Administration, People's Republic of China), e-mail to Commission 
staff, Washington, DC, September 6, 2013.
    170. Congressional-Executive Commission on China, Food and Drug 
Safety, Public Health, and the Environment in China, testimony of 
Steven M. Solomon, May 22, 2013.
    171. Inside U.S.-China Trade, ``FDA Proposes New Requirements for 
Importers to Show Food Is Safe,'' August 14, 2013.
    172. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    173. Kelli A. Giannattasio (deputy country director, U.S. Food and 
Drug Administration, People's Republic of China), e-mail to Commission 
staff, Washington, DC, September 6, 2013.
    174. U.S.-China Economic and Security Review Commission, 2008 
Annual Report to Congress (Washington, DC: U.S. Government Printing 
Office, 2011), pp. 93-94; Food and Drug Administration website. http://
www.fda.gov/InternationalPrograms/FDABeyondOurBordersForeignOffices/.
    175. U.S.-China Economic and Security Review Commission, Hearing on 
China's Agriculture Policy and U.S. Access to China's Market, testimony 
of William Westman, April 25, 2013.
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Food and Drug Administration: Justifications of Estimates for 
Appropriations Committees'' (Washington, DC).
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China's Agriculture Policy and U.S. Access to China's Market, testimony 
of Patty Lovera, April 25, 2013.
    178. Kelli A. Giannattasio (deputy country director, U.S. Food and 
Drug Administration, People's Republic of China), e-mail to Commission 
staff, Washington, DC, September 6, 2013.
    179. U.S.-China Economic and Security Review Commission, 2008 
Annual Report to Congress (Washington, DC: U.S. Government Printing 
Office, 2011), pp. 93-94.
    180. JoNel Aleccia, ``China Stiff-Arms FDA on Jerky Pet Treat 
Testing, Reports Show,'' NBCnews.com, August 22, 2012. http://
www.nbcnews.com/health/china-stiff-arms-fda-jerky-pet-treat-testing-
reports-show-957994.
    181. Homepage, ``China International Food Safety and Quality 
Conference + Expo.'' http://www.chinafoodsafety.com/.
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Safety, Public Health, and the Environment in China, testimony of 
Steven M. Solomon, May 22, 2013.
    183. Congressional-Executive Commission on China, Food and Drug 
Safety, Public Health, and the Environment in China, testimony of 
Steven M. Solomon, May 22, 2013.
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(2012-2017)'' (Washington, DC: February 2012). http://www.fas.usda.gov/
country/China/USDA-
MOA%20Ag%20Cooperation%20Plan%202012%20signed%20EN.pdf.
    185. Jess Peterson (executive vice president, U.S. Cattlemen's 
Association), telephone interview with Commission staff, March 8, 2013.
    186. National Pork Producers Council, ``Comments on National Trade 
Estimates Report: Sanitary and Phytosanitary Trade Barriers'' 
(Washington, DC, September 2011), pp. 7, 15.
    187. Presentation by the U.S. Meat Export Federation, (Shanghai 
China, July 26, 2013).
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Delaying Visas,'' August 20, 2013. http://
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                            RECOMMENDATIONS

Trends in Chinese Investment in the United States

The Commission recommends:

 LCongress assess the extent to which existing laws 
provide for inadequate or ineffective remedies against the 
anticompetitive actions of Chinese state-owned or state-
invested enterprises operating in the U.S. market. Additional 
remedies may be required to account for the fact that these 
enterprises may not be operating based on commercial 
considerations.

 LCongress assess whether to amend the Committee on 
Foreign Investment in the United States (CFIUS) statute to 
allow review of greenfield investments for threats to U.S. 
national security.

 LCongress direct the Department of Commerce to develop 
a comprehensive ongoing inventory of Chinese foreign direct 
investment (FDI) in the United States and, on an annual basis, 
update the inventory. The inventory should identify the 
ownership structure of the entity engaging in the investment. 
In preparing the inventory, the department should call on 
private sector entities engaged in monitoring Chinese 
investments in the United States and such other entities to 
ensure that its report is complete and accurate. The department 
should prepare a comprehensive report to Congress on an annual 
basis identifying the FDI by Chinese entities that were made in 
the previous calendar year. In its report, the department 
should indicate those investments that received any assistance 
from the ``Select USA'' program. The department should also 
identify, on an ongoing basis, the lines of commerce that each 
of the investments are engaged in.

Governance and Accountability in China's Financial System

The Commission recommends:

 LCongress direct the Administration to press China for 
more cooperation with the international community in order to 
address the global economic risks of unregulated and 
underregulated shadow banking and ask the Department of the 
Treasury to provide an annual report to Congress on the risks 
of shadow banking

 LCongress direct the Administration, in any bilateral 
investment treaty negotiations, to make fair and equitable 
market access and treatment for financial services firms a 
priority.

 LCongress direct the Administration to assist the 
Securities and Exchange Commission (SEC) and the Public Company 
Accounting Oversight Board by encouraging China to develop 
better regulatory oversight enforcement capabilities and more 
transparent markets, during annual and biannual bilateral 
dialogues, as well as multilateral dialogues.

 LCongress empower the SEC to set minimum standards for 
companies listing and maintaining listings on U.S. exchanges 
and enable the SEC to directly delist foreign companies not in 
compliance with these standards.

China's Agriculture Policy, Food Regulation, and the U.S.-China 
        Agriculture Trade

The Commission recommends:

 LCongress monitor the implementation of the U.S.-China 
Plan of Strategic Cooperation in Agriculture (2012-2017) to 
ensure that U.S. funding is being allocated in such a way as to 
improve the safety, sustainability, efficiency, and security of 
food production in China and the United States.

 LCongress require the U.S. Department of Agriculture 
(USDA) and the U.S. Trade Representative (USTR) to conduct a 
comprehensive review of China's agricultural subsidies, 
discriminatory taxes, state trading, and procurement practices; 
take account of the damages incurred by U.S. farmers and 
downstream industries; and suggest appropriate remedies.

 LCongress urge the Secretary of Agriculture to engage, 
as part of the Joint Committee on Commerce and Trade and the 
Strategic and Economic Dialogue, with his/her Chinese 
counterparts to address those Chinese policies and practices 
that limit U.S. exports of value-added products.

 LCongress direct the Interagency Trade Enforcement 
Center (ITEC) to conduct a review of the selective use of value 
added tax (VAT) rebates by China and determine whether they 
have a trade-distorting effect and whether the selective use of 
VAT rebates is consistent with the original intent of the 
General Agreement on Tariffs and Trade (GATT) provision 
allowing for VAT rebates. The ITEC should prepare a report for 
the U.S. Trade Representative and the relevant Committees of 
jurisdiction and identify what steps should be taken to address 
any GATT inconsistencies, should they be found.

 LCongress direct the USDA to negotiate with China to 
synchronize approvals of biotechnology to ensure stable and 
predictable market access for U.S. seed companies and crop 
growers in the Chinese market.

 LCongress require that the USDA prepare an annual 
report on competitive factors in the pork industry. In 
preparing such reports, the department shall evaluate the 
impact, if any, of the recent purchase of Smithfield Foods on 
the ability of other U.S. producers to export pork products to 
China. In addition, the report shall identify any changing 
pricing structures throughout the pork production chain to 
determine whether there is price or profit suppression as a 
result of the Smithfield transaction.

 LCongress direct the USDA to exercise extreme caution 
in negotiating equivalency status for Chinese exports of 
processed poultry using Chinese-origin birds. Congress should 
also increase its support of USDA's Food Safety and Inspection 
Service in its role as protector of meat and poultry food 
safety so that the United States serves as a world model for 
high-quality, science-based regulations.

 LCongress ensure that the Food and Drug Administration 
makes it a priority to increase the number of physical 
inspections of Chinese food imports at the border; to increase 
the rigor of those inspections to include testing for pathogens 
and chemical, pesticide, and drug residues, and processed food 
ingredients; and to conduct more frequent and thorough 
inspections in food facilities in China. Congress should also 
urge the USDA to permanently assign inspection personnel to 
China so that the exporting plants receive regular visits by 
USDA inspectors.

 LCongress require the Secretary of Agriculture to 
prepare a report to Congress identifying those organic food 
products being imported into the United States from China. The 
report should include a comprehensive evaluation of the 
different methodologies employed by the United States and China 
to certify that a product is organic and what steps, if any, 
are being taken to harmonize any discrepancies that might 
exist.

 LCongress evaluate whether a requirement that U.S. 
food importers purchase insurance against food-borne illnesses 
and pathogens from Chinese imports would improve food safety. 
Such a program would involve private sector risk insurance with 
insurance companies evaluating the safety of various sources 
and charging risk-based premiums based on the methods employed 
by Chinese exporters to address food-borne illnesses and 
pathogens.
                               CHAPTER 2

                           CHINA'S IMPACT ON

                        U.S. SECURITY INTERESTS

                    SECTION 1: MILITARY AND SECURITY

                             YEAR IN REVIEW

Introduction
    This section--based on a Commission hearing, discussions 
with outside experts and U.S. Department of Defense (DoD) 
officials, and independent research--examines China's late 2012 
national and military leadership transition, China's 2012 
defense white paper, China's 2013 defense budget, China's 
military modernization, security developments involving China, 
and the U.S.-China security relationship. The section concludes 
with a discussion of China's impact on U.S. security interests. 
See chapter 2, section 2 and chapter 2, section 3, for coverage 
of China's cyber activities and China's maritime disputes, 
respectively.

Leadership Transition

President Xi Jinping Assumes Central Military Commission Chairmanship

    China's late 2012 leadership transition brought the largest 
turnover to the Central Military Commission (CMC) * in a 
decade. Xi Jinping assumed the position of both CMC chairman 
and Chinese Communist Party (CCP) general secretary at the 
CCP's 18th Party Congress on November 15, 2012. President Xi 
then completed his accession as China's senior leader by 
becoming the People's Republic of China (PRC) president on 
March 14, 2013. Although President Xi was widely expected to 
eventually assume all three of China's top leadership posts, 
many observers were surprised by the speed of his elevation to 
CMC chairman. Official Chinese press described President Xi's 
early promotion as an ``unusual twist to China's leadership 
transition'' and praised outgoing CMC Chairman Hu Jintao for 
his decision to step down.\1\ Mr. Hu broke with the pattern 
established by his two predecessors, who retained the CMC 
chairmanship for two years after finishing their terms as CCP 
general secretary.
---------------------------------------------------------------------------
    * The CMC is China's highest military decision-making body. Its 
main responsibilities are to set military policy and strategy, 
interpret Chinese Communist Party guidance for the military, and 
oversee the People's Liberation Army's senior staff and service arms.
---------------------------------------------------------------------------
    Cheng Li, director of research and a senior fellow at the 
Brookings Institution's John L. Thornton China Center, 
testified to the Commission that Mr. Hu's decision to fully 
cede power signals a strengthening of CCP succession 
procedures.\2\ In addition, James Mulvenon, vice president of 
Defense Group Inc.'s Intelligence Division, told the Commission 
that President Xi's strong and enduring ties with senior 
military leaders likely contributed to his rapid promotion. 
President Xi served as an aide to former Defense Minister Geng 
Biao from 1979 to 1982. He also is the son of Xi Zhongxun, a 
former Politburo member and revolutionary leader.\3\
---------------------------------------------------------------------------
    * The PSC consists of the CCP's top-ranking leaders and is China's 
highest decision-making body. The PSC guides and oversees the work of 
the Politburo.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Factional Imbalance Emerges in China's  Senior Leadership
 
  During China's 2012 leadership transition, the ``elitist coalition''
of the CCP prevailed over the ``populist coalition'' in personnel
selections to China's highest decision-making body, securing six of
seven seats on the Politburo Standing Committee (PSC).* The elitist
coalition, which had been headed by former President Jiang Zemin and is
now led by President Xi, mainly consists of the children of Chinese
revolutionary leaders and former high-level officials. The populist
coalition, which had been headed by Mr. Hu and now is led by current
Chinese Premier Li Keqiang, primarily consists of former Chinese
Communist Youth League leaders.
  Dr. Li testified to the Commission, ``Although the CCP monopolizes
power in China . . . these two coalitions have been competing for power,
influence, and control over policy initiatives since the late 1990s . .
. This dynamic structure of `one Party, two coalitions' . . . has
created something approximating a mechanism of checks and balances in
the decision making process.'' \4\ Dr. Li then explained the ``landside
victory'' by Mr. Jiang and President Xi's camp upsets the ``roughly
equal balance of power between these two coalitions'' and signals a
``profound change in the power equation.'' He speculated scandals during
the runup to the leadership transition involving two prominent
populists--then Chinese Premier Wen Jiabao and then Secretary of the CCP
Central Secretariat Ling Jihua--bolstered the elitist coalition's
leverage in the PSC personnel negotiations.\5\
  The concentration of elitists on the PSC probably strengthens
President Xi's ability to pursue his policy agenda and allows Mr. Jiang
and his allies to continue to compete for influence. However, Dr. Li
stressed, ``This does not mean . . . the winner now takes all in Chinese
elite politics.'' He explained the ``balance between the two camps in
the 25-member Politburo, the Secretariat (the organization that handles
daily administrative affairs), and the CMC have largely remained
intact.'' \6\ Furthermore, prominent populist coalition leaders are well-
positioned for seats on the next PSC in 2017, as five of the seven
current PSC members can serve only one term before reaching mandatory
retirement age.
 
------------------------------------------------------------------------


    Since becoming CMC chairman, President Xi has used public 
speeches and visits to People's Liberation Army (PLA) units to 
reaffirm China's long-term military modernization goals; 
emphasize the importance of a strong military to the 
fulfillment of the ``China Dream,'' his new political slogan 
and party campaign; and signal his intent to focus on 
increasing combat readiness and reducing corruption in the PLA.

    ``China Dream'': In November 2012, President Xi introduced 
the ``China Dream'' concept, which envisions the ``great 
renewal of the Chinese nation'' and the advancement of an 
international system in which China's successful rise provides 
an attractive alternate political model to Western ones. 
Achieving the dream means building a ``moderately prosperous 
society'' by 2021 and a ``modern socialist society that is 
strong, democratic, cultured, and harmonious'' by 2049.\7\ 
Although President Xi has emphasized that ``peaceful 
development'' and a stable regional environment are essential 
to create the conditions for this vision, he linked its 
fulfillment to a strong military in a December 2012 speech 
while aboard a PLA Navy destroyer.\8\ In June 2013, official 
PLA media explained, ``To the armed forces, the China dream is 
the strong-army dream, the China dream leads the strong-army 
dream, and the strong-army dream supports the China dream.'' 
\9\ According to Daniel Hartnett, research scientist at the CNA 
Center for Naval Analyses, the PLA's role in the China Dream is 
a significant and ``potentially worrisome development.'' Mr. 
Hartnett explained:

        [The policy] reflects Xi's attempt to exert his control 
        over the military and establish a break between himself 
        and his predecessors. It also provides further 
        justification for resources for PLA modernization in 
        any internal `guns versus butter' debate among China's 
        leadership . . . It may also signify a harder turn in 
        China's military policy under Xi. If the PLA is being 
        required to improve its combat capabilities in response 
        to changes in China's security environment, it could 
        indicate that the Chinese leadership increasingly feels 
        that it may have to resort to force to counter what it 
        sees as growing national security concerns.\10\

    Combat readiness: During his first reported visit to a PLA 
base as CMC chairman in December 2012, President Xi called for 
the PLA to increase ``combat readiness'' through ``realistic 
training.'' \11\ Combat readiness has been a central theme of 
subsequent speeches to the military by President Xi and now 
features prominently in official PLA statements and documents. 
For example, official PLA media in January 2013 said the 
military needs to prevent and overcome the ``harmful'' practice 
of training ``for show.'' \12\ Furthermore, describing the 
PLA's 2013 training priorities, Xiao Yunhong, deputy director 
of the PLA's General Staff Department Military Training 
Department, said: ``The `scent of gunpowder' in the `fighting' 
will be stronger. The entire military will make `training like 
real war' . . . the main theme of the entire year's training, 
powerfully strengthening training of mission topics, ensuring 
that as soon as there is a situation, the military will be able 
to go forward and fight to victory.'' \13\
    As part of its effort to strengthen realism in training, 
the PLA in January 2013 announced it had designated a 
mechanized infantry brigade in the Beijing Military Region as 
its first dedicated ``blue force'' unit. The brigade is charged 
with simulating the ``combat methods and tactics'' of foreign 
forces during PLA training and exercises, according to official 
PLA media.\14\ The PLA has used ``blue force'' units in 
training since the 1980s,* but previously these units served on 
only a temporary basis and so did not have sufficient time to 
learn foreign combat methods and tactics. This new brigade is 
headquartered in northern China at Zhurihe Training Base, the 
PLA's largest training center and experimental site for joint 
operations and ``informationized''  warfare. Official 
Chinese media explained the blue force brigade has ``carefully 
selected classic cases of local warfare around the world in 
recent years, devoted itself to studying the advanced 
operational styles of foreign armed forces, and even 
[simulated] the armed forces . . . exactly in terms of 
personnel organization and issuance of oral commands.'' \15\
---------------------------------------------------------------------------
    * Official PLA press frequently refer to the U.S. National Training 
Center at Fort Irwin, California, in discussions about PLA ``blue 
force'' training, suggesting U.S. practices may have influenced the 
PLA's development and implementation of the concept. PLA officers have 
visited Fort Irwin to observe U.S. training on at least four occasions 
(1985, 1994, 1997, and 2011). Shirley Kan, U.S.-China Military 
Contacts, Issues for Congress (Washington, DC: Congressional Research 
Service, July 30, 2013).
     In Chinese military doctrine, ``informationization'' 
refers to the application of advanced information technology to 
military operations. The PLA views informationization as a required 
enabler of its goal to be able to win ``local wars under 
informationized conditions.''

    Corruption: In a meeting shortly after becoming the CMC 
chairman, President Xi urged senior PLA officers ``to take a 
firm stand against corruption'' and to maintain a ``strict work 
style'' and ``iron discipline.'' \16\ Since then, reducing 
corruption and waste in the PLA has been one of President Xi's 
most consistent messages in his public speeches to the 
military. In addition to rhetoric, President Xi has announced 
stronger anticorruption regulations for the PLA, including 
restrictions on military personnel holding banquets, drinking 
excessive alcohol, and using luxury hotels.
    President Xi's focus on combating corruption in the PLA is 
part of the CCP's larger national effort to boost its image to 
mitigate growing public disillusionment with politics and 
governance in China.\17\ He also is attempting to end practices 
such as paying for promotion and graft, which some observers 
have suggested reduces the quality of officers, perpetuates 
opposition to reforms, threatens PLA modernization and 
readiness, and undermines loyalty to the CCP. In an unusually 
candid December 2011 speech, PLA Logistics Department Political 
Commissar General Liu Yuan, son of former Chinese President Liu 
Shaoqi (1959-1968) and potential friend of President Xi 
Jinping,\18\ reportedly said, ``No country can defeat China . . 
. Only our corruption can destroy us and cause our armed forces 
to be defeated without fighting.'' \19\ General Liu in a later 
speech reportedly explained, ``Certain individuals exchange 
public money, public goods, public office, and public affairs 
for personal gain, flouting the law and party codes of conduct, 
even resorting to verbal abuse and threats, clandestine plots 
and set ups . . . They deploy all of the tricks of the mafia 
trade within the army itself.'' \20\
    Nevertheless, empirical evidence of PLA corruption remains 
limited. Only two high-profile PLA corruption cases have become 
known since 2005. Admiral Wang Shouye was sentenced to life in 
prison in 2006 for embezzling approximately $20 million. 
General Gu Junshan was removed from his post in 2012, and the 
investigation apparently is ongoing.\21\ Both Admiral Wang and 
General Gu had served as the deputy director of the PLA General 
Logistics Department, suggesting officers in logistics 
positions may be more susceptible to corruption, or corruption 
charges, due to their involvement in infrastructure and natural 
resources.
Uniformed Members of the Central Military Commission
    In the weeks prior to the CCP's 18th Party Congress, seven 
new uniformed PLA officers were appointed to the CMC. In his 
testimony to the Commission, Dr. Mulvenon speculated that 
``some of the choices were short-term compromises,'' as five of 
the seven appointees can serve only one term on the CMC before 
reaching mandatory retirement age. Dr. Mulvenon also noted the 
elevation of two vice chairmen with strictly operational 
backgrounds allows China observers to dispense with the popular 
misconception that one of the positions is set aside for a 
political officer.\22\ Roy Kamphausen, senior advisor for 
political and security affairs at the National Bureau of Asian 
Research, stressed to the Commission that the PLA remains a 
``party army'' * even without the presence of a political 
officer in one of the CMC's top positions, because all PLA 
officers interact extensively with CCP leaders and eventually 
serve on the CCP Central Committee after joining the CMC.\23\
---------------------------------------------------------------------------
    * The PLA is the armed branch of the CCP, not the military force of 
the PRC.
---------------------------------------------------------------------------
    The new uniformed CMC members likely are more professional 
than previous CMC officers due to their more diverse careers, 
advanced education, more sophisticated training, and increased 
exposure to foreign militaries. Their predecessors tended to 
have specialized careers, less education and training, and 
limited interactions with foreign militaries outside the Soviet 
Union. However, because China has not fought a major war since 
the Sino-Vietnam War in 1979, the new uniformed CMC members 
have limited combat experience. In contrast, most of their 
predecessors participated in long and large-scale campaigns 
during the Chinese Civil War (1946 to 1949) and Korean War 
(1950 to 1953).\24\
---------------------------------------------------------------------------
     CMC members are listed according to official protocol 
order. An asterisk indicates the officer is a new CMC member.
    = General Fan Changlong's promotion to CMC vice chairman surprised 
many observers. Not only did General Fan have a relatively low public 
profile until 2012, but also he was promoted from Military Region 
commander to CMC vice chairman without first serving as a CMC member. 
General Fan will reach mandatory retirement age at the CCP's 19th Party 
Congress, so will serve only one term. U.S.-China Economic and Security 
Review Commission, Hearing on China's New Leadership and Implications 
for the United States, written testimony of James C. Mulvenon, February 
7, 2013.

   Figure 1:  Members of the 18th Central Military Commission 
------------------------------------------------------------------------
          CMC Member                            Position
------------------------------------------------------------------------
Xi Jinping                                                             Chairman
------------------------------------------------------------------------
General Fan Changlong *                                           Vice Chairman
------------------------------------------------------------------------



  Figure 1:  Members of the 18th Central Military Commission --
                                Continued
------------------------------------------------------------------------
          CMC Member                            Position
------------------------------------------------------------------------
General Xu Qiliang                                                Vice Chairman
------------------------------------------------------------------------
General Chang Wanquan                      Minister of National Defense
------------------------------------------------------------------------
General Fang Fenghui *                        General Staff Department Chief
------------------------------------------------------------------------
General Zhang Yang *              General Political Department Director
------------------------------------------------------------------------
General Zhao Keshi *              General Logistics Department Director
------------------------------------------------------------------------
General Zhang Youxia *             General Armament Department Director
------------------------------------------------------------------------
Admiral Wu Shengli Sec.                                       PLA Navy Commander
------------------------------------------------------------------------
General Ma Xiaotian *                                    PLA Air Force Commander
------------------------------------------------------------------------
General Wei Fenghe *                                  Second Artillery Corps Commander
------------------------------------------------------------------------
Source: Open Source Center, OSC Graphic: Organizational Chart of China's
  Military Leadership 2013 (Washington, DC: May 22, 2013). OSC ID:
  CPF2013 0521017002. http://www.opensource.gov.


Defense White Paper

    In April 2013, China released the latest version of its 
biennial defense white paper.para. \25\ This is the first 
defense white paper published since President Xi became CMC 
chairman. Although Chinese military leaders likely began to 
draft the document before President Xi assumed the position, 
official Chinese press suggests it contains strategic 
priorities specific to him.\26\
---------------------------------------------------------------------------
    Sec. Admiral Wu Shengli, who has served as PLA Navy Commander since 
2006 and was a member of the 17th CMC, was widely expected to be 
elevated to CMC vice chairman or minister of defense. Dr. Mulvenon in 
his testimony to the Commission speculated Beijing may have considered 
Admiral Wu's role in leading the PLA Navy's modernization program--a 
top priority for Beijing--too critical to move him into a different 
position. U.S.-China Economic and Security Review Commission, Hearing 
on China's New Leadership and Implications for the United States, 
written testimony of James C. Mulvenon, February 7, 2013.
    para. Defense white papers--China's most authoritative statements 
on national security--are published by the State Council's Information 
Office and approved by the CMC, Ministry of National Defense, and State 
Council. Beijing primarily uses these documents as a public relations 
tool to help ease deepening international concern over China's military 
modernization and answer calls for greater transparency.
---------------------------------------------------------------------------
    Unlike previous iterations, which provided a comprehensive 
overview of Chinese military and security issues, the 2012 
defense white paper focuses on a theme--the PLA's growing role 
in military missions other than war. The current version also 
is shorter and less formal and ideological than previous ones. 
Major General Chen Zhou, a senior fellow at the PLA Academy of 
Military Science and the document's coordinating author, said 
China in the future plans to alternate between ``subject-
specific'' defense white papers, such as the 2012 iteration, 
and the traditional ``comprehensive'' format.\27\
    Official Chinese media hailed the 2012 defense white paper 
as a milestone in transparency, citing the ``declassification'' 
of military details.\28\ However, most of this was widely-known 
information that Beijing had never officially acknowledged, 
such as the designations of Group Armies under the Military 
Regions and the breakdown of how the PLA distributes personnel 
among its service arms. Furthermore, as in previous iterations, 
the 2012 defense white paper offers no substantive information 
on important defense issues, including the defense budget; 
nuclear weapons; and the types and numbers of weapon systems 
already fielded, being developed, or under consideration for 
acquisition.

Defense Budget
    In March 2013, China announced its official defense budget 
for 2013 rose 10.7 percent in nominal terms to 720.168 billion 
RMB (approximately $117.39 billion), signaling the new 
leadership's support for the PLA's ongoing modernization 
efforts. This figure represents 5.3 percent of total government 
outlays \29\ and approximately 1.3 percent of estimated gross 
domestic product (GDP).\30\ China's official annual defense 
budget now has increased for 22 consecutive years and more than 
doubled since 2006. Most Western analysts agree Beijing likely 
will retain the ability--even with slower growth rates of its 
GDP and government revenue--to fund its ongoing military 
modernization for at least the near term.\31\
    It is difficult to estimate China's actual defense spending 
due to a number of reasons, including (1) the uncertainty 
involved in determining how China's purchasing power parity 
affects the cost of China's foreign military purchases and 
domestic goods and services and (2) Beijing's omission of major 
defense-related expenditures--such as purchases of advanced 
weapons, research and development programs, domestic security 
spending, and local government support to the PLA--from its 
official figures. The Institute of International Strategic 
Studies assesses China's actual defense spending is 40 to 50 
percent higher than the official figure.\32\ DoD estimated 
China's actual defense spending in 2012 fell between $135 
billion and $215 billion, which was approximately 20 to 90 
percent higher than China's announced defense budget.\33\

Military Modernization
Aircraft Carrier Developments
    In September 2012, China commissioned its first aircraft 
carrier, the Liaoning, after approximately six years of 
renovation work on the former Soviet hull and one year of sea 
trials. China continues to develop a fixed-wing carrier 
aviation capability, which is necessary for the carrier to 
perform air defense and offensive strike missions. The PLA Navy 
conducted its first successful carrier-based takeoff and 
landing with the Jian-15 (J-15) in November 2012, certified its 
first group of aircraft carrier pilots and landing signal 
officers on the carrier's first operational deployment from 
June to July 2013, and verified the flight deck operations 
process in September 2013.\34\ The PLA Navy will continue to 
conduct short deployments and shipboard aviation training until 
2015 to 2016, when China's first J-15 regiment is expected to 
become operational.
    China plans to follow the Liaoning with at least two 
indigenously built aircraft carriers. The first likely will 
enter service by 2020 and the second by 2025. As China's 
aircraft carrier force expands and matures, Beijing will 
improve its ability to project air power, particularly in the 
South China Sea, and to perform a range of other missions, such 
as airborne early warning, antisubmarine warfare, helicopter 
support to ground forces, humanitarian assistance, search and 
rescue, and naval presence operations.\35\

Sea-based Nuclear Deterrent Nears Initial Operational Capability

    China's Julang-2 (JL-2) submarine-launched ballistic 
missile (SLBM) is expected to reach initial operational 
capability by late 2013.\36\ The JL-2, when mated with the PLA 
Navy's JIN-class nuclear ballistic missile submarine (SSBN), 
will give China its first credible * sea-based nuclear 
deterrent. The JIN SSBN/JL-2 weapon system will have a range of 
approximately 4,000 nautical miles (nm), allowing the PLA Navy 
to target the continental United States from China's littoral 
waters.\37\ China has deployed three JIN SSBNs and probably 
will field two additional units by 2020.\38\ China also is 
developing its next generation SSBN, the Type 096,\39\ which 
likely will improve the range, mobility, stealth, and lethality 
of the PLA Navy's nuclear deterrent.
---------------------------------------------------------------------------
    * The PLA Navy operates one SSBN/SLBM weapon system with the XIA-
class SSBN and the JL-1 SLBM. However, the status of this weapon system 
is unclear, and DoD does not consider it to be a credible threat. U.S. 
Department of Defense, Annual Report to Congress: Military and Security 
Developments Involving the People's Republic of China 2013 (Washington, 
DC: May 2013), p. 6; U.S. Office of Naval Intelligence, The People's 
Liberation Army Navy: A Modern Navy with Chinese Characteristics 
(Suitland, MD: 2009), p. 23.

---------------------------------------------------------------------------
Submarine and Surface Fleets Modernizing and Expanding

    The PLA Navy continues to steadily increase its inventory 
of modern submarines and surface combatants. China is known to 
be building seven classes of ships simultaneously but may be 
constructing additional classes.\40\ See figures 2-5 below for 
more information on PLA Navy orders of battle from 1990 to 
2020.

     LIn 2012, China began building four improved 
variants of its SHANG-class nuclear attack submarine (SSN). 
China also continues production of the YUAN-class conventional 
submarine (SS), some of which include an air-independent 
propulsion  system that allows for extended duration 
operations, and the JIN SSBN. Furthermore, China is pursuing 
two new classes of nuclear submarines--the Type 095 guided-
missile attack submarine (SSGN) and the Type 096 SSBN--and may 
jointly develop four advanced conventional submarines with 
Russia.\41\ The PLA Navy's growing inventory of modern nuclear 
and conventional submarines will significantly enhance China's 
ability to strike opposing surface ships throughout the Western 
Pacific and allow it to protect future sea-based nuclear 
deterrent patrollers and aircraft carrier task groups.\42\
---------------------------------------------------------------------------
     Air-independent propulsion (AIP) is a method of generating 
electrical power in a conventional submarine while it operates 
submerged. The use of an AIP system reduces the need for a submarine to 
surface or come to periscope depth--where it is easier to detect--to 
recharge its batteries.

     LIn 2012, China launched two new surface 
combatants--the LUYANG III-class guided-missile destroyer (DDG) 
and the JIANGDAO-class corvette--and resumed construction of 
the LUYANG II-class DDG after a brief hiatus. China also 
continues serial production of the JIANGKAI II-class guided-
missile frigate. Most of these units likely will be operational 
by 2015. The expanding and modernizing surface force will 
improve Beijing's ability to project power in the East and 
South China Seas and the Western Pacific. It also will help the 
PLA Navy fulfill its growing set of nontraditional missions 
beyond China's immediate periphery. These missions include 
defense of distant maritime trade routes, humanitarian 
---------------------------------------------------------------------------
assistance, and counterpiracy.\43\

     LIn 2012, the PLA Navy commissioned two YUZHAO-
class amphibious transport docks (LPD), bringing its LPD 
inventory to three. The YUZHAO LPD can carry a mix of air-
cushion landing craft, amphibious armored vehicles, 
helicopters, and marines. This will provide the PLA Navy with 
additional flexibility while performing missions such as 
amphibious assault, humanitarian assistance, and counterpiracy 
and improve China's ability to seize and hold Taiwan's offshore 
islands. China may build additional YUZHAO LPDs and probably 
will field a new landing helicopter assault ship, called the 
Type 081, by 2018.\44\

     LIn 2013, China added two upgraded FUCHI-class 
auxiliary replenishment oilers (AOR) to its fleet, raising its 
number of AORs from five to seven. The increased number of 
naval support ships better equips the PLA Navy's surface fleet, 
including future aircraft carrier task groups and expeditionary 
forces, to sustain high-tempo operations at longer ranges.\45\

    According to Chinese military experts Andrew Erickson and 
Gabe Collins, ``by 2015, China will likely be second globally 
in numbers of large warships built and commissioned since the 
Cold War's end . . . by 2020, barring a U.S. naval renaissance, 
it is possible that China will become the world's leading 
military shipbuilder in terms of numbers of submarines, surface 
combatants and other naval surface vessels produced per year.'' 
\46\ The Office of Naval Intelligence projects China will have 
between 313 and 342 submarines and surface combatants by 2020, 
including approximately 60 submarines that are able to employ 
submarine-launched intercontinental ballistic missiles or 
antiship cruise missiles and approximately 75 surface 
combatants that are able to conduct multiple missions or that 
have been extensively upgraded since 1992.\47\


                            Figure 2:  PLA Navy Submarine Orders-of-Battle 1990-2020
----------------------------------------------------------------------------------------------------------------
                       Type                          1990     1995     2000     2005     2010     2015     2020
----------------------------------------------------------------------------------------------------------------
Diesel Attack                                          88       43       60       51       54    57-62    59-64
----------------------------------------------------------------------------------------------------------------
Nuclear Attack                                          4        5        5        6        6      6-8      6-9
----------------------------------------------------------------------------------------------------------------
Nuclear Ballistic                                       1        1        1        2        3      3-5      4-5
----------------------------------------------------------------------------------------------------------------
Total                                                  93       49       66       59       63    66-75    69-78
----------------------------------------------------------------------------------------------------------------
Sources: Numbers from 1990 to 1995 are based on information from various editions of the International Institute
  for Strategic Studies' The Military Balance series, reprinted in Anthony H. Cordesman et al., Chinese Military
  Modernization and Force Development: A Western Perspective (Washington, DC: Center for Strategic and
  International Studies, 2013), pp. 157-163. Numbers from 2000 to 2010 and projections for 2015 and 2020 were
  provided by the U.S. Office of Naval Intelligence. U.S. Office of Naval Intelligence, PLA Navy Orders of
  Battle 2000-2020, written response to request for information provided to the U.S.-China Economic and Security
  Review Commission, Suitland, MD, June 24, 2013.



             Figure 3:  PLA Navy Submarine Orders-of-Battle 1990-2020, Approximate Percent Modern *
----------------------------------------------------------------------------------------------------------------
                       Type                          1990     1995     2000     2005     2010     2015     2020
----------------------------------------------------------------------------------------------------------------
Diesel Attack                                          0%       0%       7%      40%      50%      70%      75%
----------------------------------------------------------------------------------------------------------------
Nuclear Attack                                         0%       0%       0%      33%      33%      70%     100%
----------------------------------------------------------------------------------------------------------------
Sources: Approximate percentages from 1990 to 1995 are based on information from various editions of the
  International Institute for Strategic Studies' The Military Balance series, reprinted in Anthony H. Cordesman
  et al., Chinese Military Modernization and Force Development: A Western Perspective (Washington, DC: Center
  for Strategic and International Studies, 2013), pp. 157-163. Approximate percentages from 2000 to 2010 and
  projections for 2015 and 2020 were provided by the U.S. Office of Naval Intelligence. U.S. Office of Naval
  Intelligence, PLA Navy Orders of Battle 2000-2020, written response to request for information provided to the
  U.S.-China Economic and Security Review Commission, Suitland, MD, June 24, 2013.

      
---------------------------------------------------------------------------
    * Modern submarines are those able to employ submarine-launched 
intercontinental ballistic missiles or antiship cruise missiles. U.S. 
Office of Naval Intelligence, PLA Navy Orders of Battle 2000-2020, 
written response to request for information provided to the U.S.-China 
Economic and Security Review Commission, Suitland, MD, June 24, 2013.

                         Figure 4:  PLA Navy Surface Orders-of-Battle 1990-2020 
----------------------------------------------------------------------------------------------------------------
                       Type                          1990    1995    2000    2005    2010      2015       2020
----------------------------------------------------------------------------------------------------------------
Aircraft Carriers                                       0       0       0       0       0          1        1-2
----------------------------------------------------------------------------------------------------------------
Destroyers                                             19      18      21      21      25      28-32      30-34
----------------------------------------------------------------------------------------------------------------
Frigates                                               37      37      37      43      49      52-56      54-58
----------------------------------------------------------------------------------------------------------------
Corvettes                                               0       0       0       0       0      20-25      24-30
----------------------------------------------------------------------------------------------------------------
Amphibious Ships                                       58      50      60      43      55      53-55      50-55
----------------------------------------------------------------------------------------------------------------
Coastal Patrol
                                                      215     217     100      51      85         85         85
(Missile)
----------------------------------------------------------------------------------------------------------------
Total                                                 329     322     218     158     214    239-254    244-264
----------------------------------------------------------------------------------------------------------------
Sources: Numbers from 1990 to 1995 are based on information from various editions of the International Institute
  for Strategic Studies' The Military Balance series, reprinted in Anthony H. Cordesman et al., Chinese Military
  Modernization and Force Development: A Western Perspective (Washington, D.C: Center for Strategic and
  International Studies, 2013), pp. 157-163. Numbers from 2000 to 2010 and projections for 2015 and 2020 were
  provided by the U.S. Office of Naval Intelligence. U.S. Office of Naval Intelligence, PLA Navy Orders of
  Battle 2000-2020, written response to request for information provided to the U.S.-China Economic and Security
  Review Commission, Suitland, MD, June 24, 2013.

      
---------------------------------------------------------------------------
     Totals do not include all types and sizes of surface 
ships, such as mine warfare and auxiliary ships.

               Figure 5:  PLA Navy Surface Orders-of-Battle 1990-2020, Approximate Percent Modern
----------------------------------------------------------------------------------------------------------------
                       Type                          1990     1995     2000     2005     2010     2015     2020
----------------------------------------------------------------------------------------------------------------
Destroyers                                             0%       5%      20%      40%      50%      70%      85%
----------------------------------------------------------------------------------------------------------------
Frigates                                               0%       8%      25%      35%      45%      70%      85%
----------------------------------------------------------------------------------------------------------------
Sources: Approximate percentages from 1990 to 1995 are based on information from various editions of the
  International Institute for Strategic Studies' The Military Balance series, reprinted in Anthony H. Cordesman
  et al., Chinese Military Modernization and Force Development: A Western Perspective (Washington, D.C: Center
  for Strategic and International Studies, 2013), pp. 157-163. Approximate percentages from 2000 to 2010 and
  projections for 2015 and 2020 were provided by the U.S. Office of Naval Intelligence. U.S. Office of Naval
  Intelligence, PLA Navy Orders of Battle 2000-2020, written response to request for information provided to the
  U.S.-China Economic and Security Review Commission, Suitland, MD, June 24, 2013.

      
---------------------------------------------------------------------------
    = Modern surface ships are those able to conduct multiple missions 
or that have been extensively upgraded since 1992. U.S. Office of Naval 
Intelligence, PLA Navy Orders of Battle 2000-2020, written response to 
request for information provided to the U.S.-China Economic and 
Security Review Commission, Suitland, MD, June 24, 2013.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Sustaining the U.S. Military's ``Rebalance'' to Asia
 
  In June 2010, then U.S. Secretary of Defense Robert Gates announced
the ``U.S. defense posture in Asia is shifting to one that is more
geographically distributed, operationally resilient, and politically
sustainable.'' \48\ In January 2012, DoD's Defense Strategic Guidance
declared the U.S. military will ``of necessity rebalance toward the
Asia'' by emphasizing existing alliances, expanding its networks of
cooperation with ``emerging'' partners, and investing in military
capabilities to ensure access to and freedom to maneuver within the
region.\49\ The rebalance is a whole-of-government effort that also
includes diplomacy, trade, and development.
  However, there is growing concern in the United States and among U.S.
allies and partners that DoD will be unable to follow through on its
commitment to the rebalance due to declining defense budgets and
emerging crises elsewhere in the world. U.S. Defense Secretary Chuck
Hagel in July 2013 said Washington would have to choose between a
smaller, modern military and a larger, older one if sequester-level
funding continues.
 
     In the first approach, we would trade away size
 for high-end capability. This would further shrink
 the active Army[from570,000]50to
 between380,000to450,000troops, reduce the number of
 carrier strike groups from 11 to 8 or 9, draw down
 the Marine Corps from 182,000 to between 150,000
 and 175,000, and retire older Air Force bombers. We
 would protect investments to counter anti-access
 and area denial threats, such as the long-range
 strike family of systems, submarine cruise missile
 upgrades, and the Joint Strike Fighter, and we
 would continue to make cyber capabilities and
 special operations forces a high priority. This
 strategic choice would result in a force that would
 be technologically dominant, but would be much
 smaller and able to go fewer places and do fewer
 things, especially if crisis occurred at the same
 time in different regions of the world.
 
     The second approach would trade away high-end
 capability for size. We would look to sustain our
 capacity for regional power projection and presence
 by making more limited cuts to ground forces,
 ships, and aircraft. But we would cancel or curtail
 many modernization programs, slow the growth of
 cyber enhancements, and reduce special operations
 forces. Cuts on this scale would, in effect, be a
 decade-long modernization holiday. The military
 could find its equipment and weapons systems--many
 of which are already near the end of their service
 lives--less effective against more technologically
 advanced adversaries. \51\
 
  U.S. Chief of Naval Operations Admiral Jonathan Greenert explained the
U.S. Navy's role in the rebalance: ``as directed by the 2012 Defense
Strategic Guidance . . . the [U.S.] Navy formulated and implemented a
plan to rebalance our forces, their homeports, our capabilities, and our
intellectual capital and part- nerships toward the Asia Pacific.'' 52
Specifically, the U.S. Navy
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Sustaining the U.S. Military's ``Rebalance'' to Asia--Continued
 
aims to increase its presence in the Asia Pacific from about 50 ships in
 2013 to 60 ships by 2020 and ``rebalance homeports to 60 percent'' in
 the region by 2020.\53\ However, Admiral Greenert has warned
 constraints in the current budget environment could delay or prevent
 the U.S. Navy from achieving these objectives. In a September 2013
 hearing held by the U.S. House Committee on Armed Services, Admiral
 Greenert testified:
 
     . . . If fiscally constrained to the revised
 discretionary caps, over the long term (2013-2023),
 the Navy of 2020 would not be able to execute the
 missions described in the [Defense Strategic
 Guidance] . . . One potential fiscal and
 programmatic scenario would result in a `2020
 Fleet' of about 255-260 ships, about 30 less than
 today, and about 40 less than the [U.S. Navy's 2014
 budget] submission. It would include 1-2 fewer
 [carrier strike groups], and 1-2 fewer [amphibious
 readiness groups] than today. With regard to the
 [Defense Strategic Guidance] and presence, in this
 particular scenario the `2020 Fleet' would not
 increase presence in the Asia-Pacific, which would
 stay at about 50 ships in 2020. This would largely
 negate the ship force structure portion of [the
 U.S.] plan to rebalance to the Asia Pacific region
 directed by the [Defense Strategic Guidance] . . .
 Overall, in this scenario, development of our
 capabilities to project power would not stay ahead
 of potential adversaries' [anti-access/area denial]
 capabilities.\54\
 
------------------------------------------------------------------------


Developing Sea-based Land Attack Capability

    China currently does not have the ability to strike land 
targets with sea-based cruise missiles. However, the PLA Navy 
likely is developing a land attack capability for its Type-095 
SSGN and LUYANG III DDG. Modern submarines and surface 
combatants equipped with land attack cruise missiles (LACMs) 
will complement the PLA's growing inventory of air- and ground-
based LACMs and ballistic missiles, enhancing Beijing's 
flexibility for attacking land targets throughout the Western 
Pacific, including U.S. facilities in Guam.\55\

Antiship Ballistic Missile Update

    In 2010, China deployed the Dong Feng-21D (DF-21D) antiship 
ballistic missile (ASBM). The DF-21D, which has a range 
exceeding 810 nm, provides Beijing with the ability to threaten 
large surface ships, such as U.S. Navy aircraft carriers, 
throughout the Western Pacific. China is fielding additional 
DF-21D missiles and may be developing a longer-range 
variant.\56\

Possible Test of New Antisatellite Capability

    On May 13, 2013, China fired a missile into space from the 
Xichang Satellite Launch Center in western China.* The missile 
``appeared to be on a ballistic trajectory to nearly 
geosynchronous Earth orbit,'' according to DoD. 
Geosynchronous Earth orbit can be achieved at about 22,000 to 
23,000 miles above the Earth's equator.= This launch is the 
world's highest known suborbital launch since the U.S. Gravity 
Probe A in 1976 and China's highest known suborbital launch to 
date, according to Jonathan McDowell, a scientist at the 
Harvard-Smithsonian Center for Astrophysics.\57\
---------------------------------------------------------------------------
    * China's Academy of Sciences National Space Science Center issued 
the following statement regarding China's May missile launch: ``This 
test used a high altitude space probe rocket, which carried a payload 
of multiple scientific detectors such as Langmuir probes, high energy 
particle detectors, magnetometers, and barium powder release test 
devices, etc. to perform original state detection of high energy 
particles and electromagnetic field strength in the ionosphere and near 
earth space.'' Xinhua, ``China Successfully Carries out a High Altitude 
Scientific Measurement Test,'' May 14, 2013. OSC ID: 
CPP-2013-0514003004.
     DoD issued the following statement regarding China's May 
missile launch: ``We detected a launch on May 13 from within China. The 
launch appeared to be on a ballistic trajectory nearly to 
geosynchronous Earth orbit. We tracked several objects during the 
flight but did not observe the insertion of any objects into orbit and 
no objects associated with this launch remain in space. Based upon 
observations, we assess that the objects reentered the atmosphere above 
the Indian Ocean. We defer any further questions to the government of 
China.'' Jonathan McDowell, ``Kunpeng-7,'' Space Report, May 21, 2013. 
http://www.planet4589.org/pipermail/jsr/2013-May/000051.html.
    = For an overview of the different classes of orbit, see NASA Earth 
Observatory, ``Three Classes of Orbit.'' http://
earthobservatory.nasa.gov/Features/OrbitsCatalog/page2.php.
---------------------------------------------------------------------------
    U.S. defense agencies reportedly assess the launch was the 
first test of a new antisatellite (ASAT) capability, according 
to two U.S. press reports citing unnamed U.S. officials.\58\ 
Beijing, however, claims the launch was part of a high-altitude 
scientific experiment for China's National Space Science 
Center. A Chinese Ministry of Foreign Affairs spokesperson said 
he was ``not aware'' of an ASAT test and then reiterated 
China's ``longstanding stance to make peaceful use of the outer 
space and oppose weaponization and arms race in the outer 
space.'' \59\ DoD did not comment on the U.S. press reports or 
provide information on its assessment of the relationship 
between the May missile launch and China's ASAT program.
    Although it is difficult to draw a definitive conclusion 
about the nature of the missile launch without more information 
from China or DoD, available data suggest it was intended to 
test at least the launch vehicle component of a new high-
altitude ASAT capability.\60\ If the launch is part of China's 
ASAT program, Beijing's attempt to disguise it as a scientific 
experiment would demonstrate a lack of transparency about its 
objectives and activities in space. Furthermore, such a test 
would signal China's intent to develop an ASAT capability to 
target satellites in an altitude range that includes U.S. 
Global Positioning System (GPS) and many U.S. military and 
intelligence satellites.Sec.  In a potential conflict, this 
capability could allow China to threaten the U.S. military's 
ability to detect foreign missiles and provide secure 
communications, navigation, and precision missile guidance. 
Beijing's January 2007 destruction of an aging Chinese FY-1C 
weather satellite demonstrated it has the capability to target 
satellites in low Earth orbit (an altitude between about 100 to 
1,200 miles), such as remote sensing satellites.
---------------------------------------------------------------------------
    Sec. It is not clear from U.S. press reports which type of attack 
mechanism the potential new ASAT capability would employ. For example, 
it could use a ``kinetic kill vehicle'' to disable or destroy a 
satellite through the force of a direct collision. The new ASAT 
capability also could employ electronic warfare or directed energy 
weapons to temporarily degrade a satellite's capabilities without 
permanently destroying or damaging it. For an overview of the different 
types of ASAT attack methods and technologies, see David Wright, Laura 
Grego, and Lisbeth Gronland, The Physics of Space Security: A Reference 
Manual (Cambridge, MA: American Academy of Arts and Sciences and Union 
of Concerned Scientists, 2005). http://www.ucsusa.org/assets/documents/
nwgs/physics-space-security.pdf.

---------------------------------------------------------------------------
Developing Operationally Responsive Space Capability

    On September 25, 2013, China launched a satellite into 
space from the Jiuquan Satellite Launch Center in western 
China. Official Chinese press claims the satellite, carried on 
a missile called the ``Kuaizhou,'' will ``monitor natural 
disasters and provide disaster relief information'' for China's 
National Remote Sensing Center.\61\ However, Gregory Kulacki, 
China project manager and senior analyst at the Union of 
Concerned Scientists, explains that, in addition to orbiting a 
weather satellite, the launch served to test a new solid-fueled 
launch vehicle. Solid-fueled rockets are simpler to operate, 
cheaper, and have fewer logistical requirements than liquid-
fueled rockets, making them ideal for quick launches with 
minimal preparation. According to Dr. Kulacki, ``This 
capability would allow [the PLA] to rapidly replace satellites 
that might be damaged or destroyed in an anti-satellite attack 
with small but `good enough' satellites able to restore at 
least some of the functions of the satellites lost.'' The U.S. 
military has been developing a similar capability, which it 
refers to as ``Operationally Responsive Space,'' since at least 
2006.* \62\
---------------------------------------------------------------------------
    * DoD's Operationally Responsive Space Office, established in 2007, 
is charged with planning and preparing ``for the rapid development of 
highly responsive space capabilities that enable delivery of timely 
warfighting effects and, when directed, develop and support deployment 
and operations of these capabilities to enhance and assure support to 
Joint Force Commanders' and other users' needs for on-demand space 
support, augmentation, and reconstitution.'' U.S. Operationally 
Responsive Space Office, Mission Statement. http://ors.csd.disa.mil/
mission/.

---------------------------------------------------------------------------
Beidou Regional Satellite Navigation System Complete

    On December 27, 2012, China's Beidou regional satellite 
navigation system  became fully operational and 
available for commercial use. Using 16 satellites and a network 
of ground stations, Beidou provides subscribers in Asia with 
24-hour precision, navigation, and timing services, as well as 
the ability to send and receive text messages up to 120 Chinese 
characters.\63\ China plans to expand Beidou into a global 
satellite navigation system by 2020.\64\
---------------------------------------------------------------------------
     The regional Beidou system, which China refers to as 
Beidou-2, grew out of an earlier satellite constellation, known as 
Beidou-1. Beidou-1 provided limited precision, navigation, and timing 
services in China and a small portion of East Asia but served primarily 
as a developmental platform for future projects. For more information 
on China's civilian and military space activities, see U.S.-China 
Economic and Security Review Commission, 2011 Annual Report to Congress 
(Washington, DC: U.S. Government Printing Office, November 2011), pp. 
198-222.
---------------------------------------------------------------------------
    China's Satellite Navigation Office emphasized Beidou's 
importance to the PLA and Chinese commercial interests, stating 
the system meets the ``demands of China's national security, 
economic development, technological advances and social 
progress . . . safeguard[s] national interests . . . enhance[s] 
the comprehensive national strength . . . promote[s] the 
development of satellite navigation industry . . . make[s] 
contributions to human civilization and social development . . 
. [and] serve[s] the world and benefit[s] mankind.'' \65\

     LBeidou is a critical part of China's stated goal 
to prepare for fighting wars under ``informationized 
conditions,'' which includes an emphasis on developing the 
PLA's C4ISR * and electronic warfare capabilities. The PLA is 
integrating Beidou into its systems to improve its command and 
control and long-range precision strike capabilities and to 
reduce the PLA's reliance on foreign precision, navigation, and 
timing services, such as GPS.\66\
---------------------------------------------------------------------------
    * C4ISR refers to command, control, communications, computers, 
intelligence, surveillance, and reconnaissance.

     LBeijing seeks to use Beidou to gain 15-20 percent 
of China's domestic satellite navigation market share by 2015 
and 70-80 percent by 2020. GPS currently has about 95 percent 
---------------------------------------------------------------------------
of China's market.\67\

     LBeijing is marketing Beidou's services to 
countries throughout Asia and has already reached agreements 
with Thailand, Laos, Brunei, and Pakistan to provide precision, 
navigation, and timing services for government and military 
customers at heavily subsidized costs.\68\ These agreements 
include provisions allowing Beijing to build satellite ground 
stations outside of China, which will be used to increase 
Beidou's range and signal strength.\69\

Manned Space Program Reaches Milestone

    In mid-June 2013, three astronauts aboard China's Shenzhou-
10 space shuttle docked with the Tiangong-1, which is a small 
orbiting experimental space lab that China launched in 2011. 
Shenzhou-10 was China's fifth manned spaceflight, second manned 
mission to the Tiangong-1, and longest human spaceflight to 
date. Over the 15-day mission, the crew conducted both 
automatic and manual dockings, as well as medical, 
technological, and scientific experiments while aboard the 
Tiangong-1.\70\ China's second-ever female astronaut, Wang 
Yaping, gave a physics lesson from the space lab to more than 
60 million Chinese students via live broadcast.\71\ President 
Xi attended the Shenzhou-10 launch and later told the crew in a 
video conference: ``The space dream is a crucial part of our 
nation-building dream. With the rapid development of China's 
space industry, a great step forward will be made by the 
Chinese people in the exploration of space.'' \72\
    According to Vice Premier Zhang Gaoli, Shenzhou-10's 
multiple successful dockings with the Tiangong-1 mark the 
achievement of the second phase of China's three-phase manned 
space program. In phase one, China launched several unmanned 
missions to develop technologies necessary for its first manned 
spaceflight in 2003. In phase two, China honed its spacecraft 
rendezvous and docking capabilities. In phase three, scheduled 
for completion by 2023, China plans to launch a permanent 
manned space station into orbit.\73\
    Official Chinese statements emphasize the civilian aspects 
of China's space program and only implicitly refer to the PLA's 
role in China's space strategy. Beijing's 2011 Space White 
Paper states China's objectives in space are the following:

        to explore outer space and to enhance understanding of 
        the Earth and the cosmos; to utilize outer space for 
        peaceful purposes, promote human civilization and 
        social progress, and to benefit the whole of mankind; 
        to meet the demands of economic development, scientific 
        and technological development, national security and 
        social progress; and to improve the scientific and 
        cultural knowledge of the Chinese people, protect 
        China's national rights and interests, and build up its 
        national comprehensive strength.\74\

    However, the PLA has a significant role in most aspects of 
China's space activities. Scott Pace, director of the Space 
Policy Institute at George Washington University's Elliott 
School of International Affairs, testified to the Commission: 
``China's human space flight efforts are managed by elements of 
the PLA and require industrial capabilities that are the same 
as those used for military programs. Thus it might be more 
accurate to say that China has civil space activities, such as 
science and exploration, but does not have a civil space 
program.'' \75\ This suggests even ostensibly civilian 
projects, such as the Shenzhou missions and the Tiangong-series 
space labs, support the development of PLA space, counterspace, 
and conventional capabilities.

Indigenous Large Transport Aircraft Conducts First Flight Test

    In late January 2013, China conducted the first test flight 
of its indigenously developed cargo transport aircraft, the 
Yun-20 (Y-20). China previously was unable to build heavy 
transports, so it has relied on a handful of Russian Ilyushin-
76 (Il-76) aircraft for strategic airlift since the 1990s. 
Following the exposure of key shortcomings in the PLA's ability 
to conduct disaster relief after China's 2008 Sichuan 
earthquake, official Chinese media highlighted the PLA's lack 
of strategic airlift is an ``obvious insufficiency'' that 
``affects the overall elevation of [China's] core military 
capability.'' \76\
    Aircraft specifications provided by official Chinese media 
indicate the Y-20 can carry about twice the cargo load of the 
PLA's only operational transport, the IL-76, and about three 
times the cargo load of the U.S. C-130. Although the Y-20 
currently uses Russian engines, the plane's chief designer said 
China ultimately plans to replace these with Chinese engines 
that feature better fuel efficiency and thrust-weight 
ratio.\77\ China also may produce variants of the Y-20 aircraft 
for specialized missions, such as airborne refueling, airborne 
early warning, command and control, and electronic warfare.\78\
    Once large-scale deliveries of the new plane begin, the Y-
20 aircraft will be able to support a variety of domestic and 
international military operations. The Y-20 will enhance the 
PLA's ability to respond to internal security crises and border 
contingencies, support international peacekeeping and 
humanitarian assistance operations, and project power in a 
regional conflict.\79\

New Bomber Deployed

    In June 2013, the PLA Air Force began to receive new 
Hongzha-6K (H-6K) bomber aircraft.\80\ The H-6K--an improved 
variant of the H-6 (originally adapted from a late-1950s Soviet 
design)--has extended range and can carry China's new long-
range LACM. The bomber/LACM weapon system provides the PLA Air 
Force with the ability to conduct conventional strikes against 
regional targets throughout the Western Pacific, including U.S. 
facilities in Guam.\81\ Although the H-6K airframe could be 
modified to carry a nuclear-tipped air-launched LACM, and 
China's LACMs likely have the ability to carry a nuclear 
warhead, there is no evidence to confirm China is deploying 
nuclear warheads on any of its air-launched LACMs.\82\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Marketing New Armed Unmanned Aerial Vehicle
 
  At China's major biennial airshow in November 2012, the Chengdu
Aircraft Design Institute, which falls under the state-owned Aviation
Industry Corporation of China, presented for the first time a static
display of the Wing Loong armed unmanned aerial vehicle (UAV).\83\ The
Wing Loong appeared again at the Paris Air Show in June 2013, marking
China's first display of an armed UAV at an international defense
exhibition.\84\ A representative of China's largest defense aviation
exporter at the air show revealed that as many as six countries in
Africa and Asia are negotiating with China to purchase the Wing
Loong.\85\
  Press observers noted the Wing Loong's close resemblance to the MQ-9
Reaper, one of the U.S.'s chief attack UAVs, leading some analysts to
speculate Chinese espionage may have contributed to the Wing Loong's
development.\86\ Furthermore, U.S. cybersecurity company FireEye in
September 2013 exposed an extensive PLA cyber espionage campaign
targeting top aerospace and defense firms for information on U.S. drone
technology.\87\ FireEye attributed the campaign to a cyber threat group
known as ``Comment Group,'' which U.S. cybersecurity company Mandiant
has linked to the 2nd Bureau of the PLA General Staff Department's Third
Department.\88\ This suggests cyber espionage may have played a role in
the new UAV's design. For more information on China's cyber actors and
operations, see chapter 2, section 2, of this Report, ``China's Cyber
Activities.''
 
------------------------------------------------------------------------


Security Developments

Expanding Military Operations in Foreign Exclusive Economic Zones
    In 2012, the PLA Navy for the first time began to conduct 
maritime intelligence collection operations in foreign 
exclusive economic zones (EEZs) * without providing advance 
notification.\89\ In one instance, the PLA Navy operated near 
Hawaii during a major U.S.-led multilateral exercise.\90\ This 
activity runs counter to Beijing's insistence that foreign 
militaries provide notification and receive approval prior to 
operating in China's claimed EEZ. In June 2013, a senior PLA 
official confirmed China's naval deployments to foreign EEZs 
and said China is ``sort of reciprocating America's 
reconnaissance in our EEZ by sending our ships to America's EEZ 
for reconnaissance.'' The PLA official added China has done so 
only ``a few times,'' in contrast to the U.S. and Japan's 
``almost daily reconnaissance'' of China.\91\
---------------------------------------------------------------------------
    * According to the United Nations Convention on the Law of the Sea, 
a coastal state is entitled to an EEZ, a 200 nautical mile zone 
extending from its coastline within which that state can exercise 
jurisdiction to explore and exploit natural resources, but not full 
sovereignty.
---------------------------------------------------------------------------
    Although the United States and China agree on the basic 
role and right of a coastal state to explore, exploit, 
conserve, and manage natural resources within its EEZ, the two 
countries have conflicting views on a coastal state's right to 
regulate foreign military activity in its EEZ, whether they are 
exercises, military surveys, reconnaissance, or other military 
operations.\92\ Differences on this issue emerged in the 1970s 
during United Nations Convention on the Law of the Sea (UNCLOS) 
negotiations,\93\ reflecting the contrast in priorities between 
coastal states with interests in the control and security of 
their coastal waters and seagoing states with interests in the 
freedom of the seas. When UNCLOS negotiations concluded in 
1982, China was a coastal nation with a littoral navy, whereas 
the United States was a global maritime power with a blue water 
navy that operated regularly outside its coastal waters.*
---------------------------------------------------------------------------
    * China ratified UNCLOS in 1996. Although the United States has not 
ratified UNCLOS, it contends the binding principles of UNCLOS conform 
to customary international law.
---------------------------------------------------------------------------
    Today, China continues to assert its right to regulate 
foreign military activities in its claimed EEZ, a minority 
practice among the world's nations. China's position is 
based largely on its view that it has the right to prevent any 
activity that directly or indirectly threatens its security or 
economic interests. The United States, maintaining military 
vessels have high seas freedoms in EEZs, contends China must 
have due regard for the rights and duties of other states 
exercising those freedoms in a manner compatible with 
UNCLOS.\94\ Viewing its own position as one based on 
international norms, the United States ``encourage[s]'' similar 
operations by China, according to U.S. Pacific Command 
Commander Admiral Samuel Locklear.\95\
---------------------------------------------------------------------------
     According to the U.S. Navy, only 27 countries share this 
view, including China, Bangladesh, Burma, Cambodia, India, Malaysia, 
Maldives, North Korea, Pakistan, Sri Lanka, Thailand, and Vietnam. 
Ronald O'Rourke, Maritime Territorial and Exclusive Economic Zone (EEZ) 
Disputes Involving China: Issues for Congress (Washington, DC: 
Congressional Research Service, April 2013), p. 4.
---------------------------------------------------------------------------
    China also asserts jurisdiction of its domestic laws in its 
claimed EEZ. The 1998 Law of the People's Republic of China on 
the Exclusive Economic Zone and Continental Shelf requires 
foreign entities to obtain Chinese government approval prior to 
conducting fishing, natural resource exploitation, and marine 
scientific research in China's claimed EEZ.\96\ China 
classifies U.S. military and hydrographic surveys as marine 
scientific research falling under the jurisdiction of this 
law.= The United States considers both types of survey high 
seas freedoms.
---------------------------------------------------------------------------
    = UNCLOS also addresses marine scientific research in the EEZ and 
continental shelf. United Nations Convention on the Law of the Sea, 
``Article 246: Marine scientific research in the exclusive economic 
zone and on the continental shelf.'' http://www.un.org/depts/los/
convention----agreements/texts/unclos/part13.htm; U.S.-China Economic 
and Security Review Commission, 2008 Annual Report to Congress 
(Washington, DC: U.S. Government Printing Office, November 2008), pp. 
143-147.
---------------------------------------------------------------------------
    The different interpretations of maritime rights and 
freedoms in the past decade have led to bilateral tensions and 
occasionally incidents between U.S. and Chinese maritime and 
air forces.
    One Chinese scholar has suggested the PLA's acknowledgement 
of its foreign EEZ operations demonstrates that Beijing's 
``changing concept of maritime affairs'' is ``moving [China] 
towards international norms.'' \97\ Nevertheless, it is 
unlikely China will completely abandon its existing policy on 
military activities in EEZs, as doing so would undermine the 
legal foundation it has sought to build over time as an 
objector to the international norm. Therefore, in order to 
avoid being accused of holding contradictory positions, as well 
as to manage regional perception of its expanding naval 
activity, Beijing probably will seek to justify its activities 
using some of the following approaches:

     LContinue to rely on domestic law to legitimize a 
coastal state's authority to regulate foreign military 
activities in its EEZ. Under this view, which is at odds with 
state practice by an overwhelming majority of the world's 
nations, the PLA could justify operating in foreign EEZs absent 
a coastal state's legislation addressing this matter.

     LSeek to distinguish U.S. activity from its own by 
continuing to classify U.S. operations as marine scientific 
research that requires coastal state approval.

     LDifferentiate between U.S. activity off the coast 
of the Chinese mainland and Chinese operations along the outer 
reaches of the U.S. geographic periphery.

     LPortray such Chinese operations as mere 
reciprocation of similar U.S. activities.

     LContrast China's less frequent operations with 
what it describes as the U.S.'s ``almost daily 
reconnaissance.'' \98\

First Deployment of Infantry to Support UN Peacekeeping Operation
    In July 2013, the PLA began to deploy its first 
peacekeepers to the UN Multidimensional Integrated 
Stabilization Mission in Mali (MINUSMA).* \99\ The PLA 
contingent, which together consists of nearly 400 troops that 
were dispatched in two groups, includes what Beijing calls a 
``security force'' from the PLA's 16th Group Army.\100\ This 
marks the first time Beijing has deployed infantry to support a 
peacekeeping operation since it began participating in UN 
missions in 1990.\101\ The PLA's security force in Mali is 
responsible for providing force protection for ``MINUSMA 
headquarters and the living areas of peacekeeping forces.'' 
\102\ China previously had limited the PLA's participation 
 in peacekeeping operations to noncombat troops--mainly 
military observers; staff officers; and engineering, medical, 
and transportation personnel. For example, China in January 
2012 deployed a ``guard'' unit--consisting of about 50 PLA 
troops--to the UN Mission in South Sudan.\103\ However, the 
unit's mission was limited to protecting China's own noncombat 
troops. Beijing explained the guards were needed because the 
United Nations was not providing protection for Chinese 
peacekeepers.\104\
---------------------------------------------------------------------------
    * MINUSMA took over peacekeeping responsibilities from the African-
led International Support Mission in Mali (AFISMA) on July 1, 2013. 
AFISMA had been providing security since January 2013 when Islamic 
rebels were ousted from the country. United Nations, MINUSMA: United 
Nations Stabilization Mission in Mali. http: // www.un.org/en/
peacekeeping/missions/minusma/background.shtml.
     Since 2004, China has been contributing police units to UN 
missions. However, these police units consist of civilians--usually 
drawn from provincial-level border police units--and are not under the 
command of the PLA. Bates Gill and Chin-Hao Huang, China's Expanding 
Role in Peacekeeping: Prospects and Policy Implications (Stockholm, 
Sweden: Stockholm International Peace Research Institute, November 
2009), p. 8.
---------------------------------------------------------------------------
    Official Chinese statements have downplayed the PLA's 
deployment of infantry to Mali, likely to avoid raising 
international concerns about Beijing's intentions and the PLA's 
growing military capabilities. These statements also have 
emphasized that China's participation in MINUSMA is consistent 
with its long-espoused non-interference policy, because Mali 
requested military assistance. Beijing distinguishes between 
international action requested by a sovereign state and 
international action it perceives as designed to overthrow a 
sovereign state. Beijing fears the latter could legitimize 
regime change and external intervention and thus threaten 
China's own core interests of sovereignty and territorial 
integrity.

China and Russia Hold Large Naval Exercise

    In early July, the PLA Navy and the Russian Federation Navy 
held ``Joint Sea-2013'' in the Sea of Japan, outside of 
Vladivostok, Russia. Seven PLA Navy ships--six modern surface 
combatants and a replenishment ship--participated in the 
exercise, which included training for antisubmarine operations, 
antisurface operations, air defense, replenishment at sea, 
counterpiracy, and search and rescue and concluded with a 
maritime parade. Official Chinese media highlighted Joint Sea-
2013 as the largest deployment of Chinese forces in any joint 
foreign exercise and the first time the PLA Navy has 
participated in an ``overseas joint exercise far away from [a] 
naval base and without [a] support system.'' \105\
    China and Russia have conducted military drills bilaterally 
or under the auspices of the Shanghai Cooperation Organization 
since 2005, but this was only the second naval exercise between 
the two countries. The first exercise occurred in April 2012 in 
the Yellow Sea. According to a PLA Navy official, ``From now 
on, the friendly cooperation between Chinese and Russian navies 
will be further developed, and the exercise will gradually 
develop towards normalization and institutionalization.'' \106\ 
Furthermore, during an interview with an official Chinese 
television station, a Chinese commentator noted, ``The 
antisubmarine subject should be said to be an important subject 
of this China-Russia joint exercise because antisubmarine 
exercise has always been a top-secret exercise of various 
countries . . . this shows the military cooperation between the 
two countries has reached a certain high level of mutual 
trust.'' \107\
    Most Western observers maintain China and Russia are not 
entering a new stage in security cooperation. Jeffrey Mankoff, 
a fellow and deputy director of the Russia and Eurasia Program 
at the Center for Strategic and International Studies, said, 
``Sporadic cooperation between the Russian and Chinese 
militaries [does not] alter the fact that China's assertiveness 
worries Russia at least as much as it worries the United 
States. Russian military commanders acknowledge that they see 
China as a potential foe, even as official statements continue 
to focus on the alleged threat from the United States and [the 
North Atlantic Treaty Organization].'' \108\ Furthermore, two 
of Russia's largest military exercises since the Soviet era, 
held in July 2010 and July 2013, focused on its Far East region 
and were indicative of training for a conflict scenario 
involving China.\109\
    Nevertheless, most U.S. observers agree the United States 
should carefully monitor the status of the China-Russia 
relationship. Dean Cheng and Ariel Cohen, both senior research 
fellows at the Heritage Foundation, warned, ``If a close Sino-
Russian strategic relationship develops, it could limit the 
capacity of the U.S. to act abroad and undermine economic 
freedom, democracy, and human rights in Greater Eurasia.'' 
\110\

China-India Border Tensions Flare

    Border tensions between China and India flared after New 
Delhi claimed a contingent of 30 to 50 PLA soldiers crossed 
about 12 miles beyond the Line of Actual Control * between the 
two countries on April 15 and stayed there for three weeks. 
According to New Delhi, PLA soldiers frequently conduct border 
incursions (more than 600 times over the last three years) but 
do not usually cross more than a few miles over the Line of 
Actual Control nor stay there longer than several hours.\111\
---------------------------------------------------------------------------
    * The Line of Actual Control is the effective border between China 
and India. The 2,400 mile-long Line of Actual Control traverses the 
Aksai Chin, the northern part of the Sikkim State, and crosses the 
McMahon Line in Arunachal Pradesh State.
---------------------------------------------------------------------------
    Beijing denied Chinese troops had crossed into Indian 
territory. A Chinese Ministry of Foreign Affairs spokesperson 
said, ``China has always acted in strict compliance with 
relevant agreements and protocols between the two countries on 
maintaining peace and tranquility in the Line of Actual Control 
area along the border . . . Chinese patrol troops have never 
crossed the line.'' \112\ Chinese Premier Li Keqiang attempted 
to downplay the incident and the risk of conflict. During a 
state visit to India, he insisted that ``a few clouds in the 
sky cannot shut out the brilliant rays of our friendship.'' 
Premier Li did not directly address the alleged Chinese 
incursion, though he said ``both sides believe we need to 
improve various border-related mechanisms that we have put into 
place and make them more efficient, and we need to 
appropriately manage and resolve our differences.'' \113\
    Beijing and New Delhi resolved the April border impasse in 
May after a series of talks and agreed to pursue a formal 
agreement to build trust and confidence between the border 
troops. The two sides signed the agreement during the Indian 
prime minister's trip to China in October 2013.\114\
    Nevertheless, the potential for periodic low-level 
confrontations between border patrols to escalate likely will 
persist. Indian media have reported several additional albeit 
briefer incursions by Chinese troops since the April standoff. 
Furthermore, both China and India continue to boost their 
militaries' capabilities on the border, adding to mutual 
suspicion. This has left both sides sensitive to each other's 
border activities and disposed toward worst-case perceptions of 
the other sides' intentions and activities. Ely Ratner and 
Alexander Sullivan of the Center for a New American Security, 
warn: ``more intense strategic competition between India and 
China would reverberate throughout the continent, exacerbating 
tensions in Central Asia, the Indian Ocean, and Southeast Asia. 
Disruptions to the Asian engine of economic growth caused by 
these tensions could debilitate the global economy.'' \115\

``Subtle Shift'' in China's North Korea Policy?

    As has been discussed in previous Commission reports, China 
for decades has provided North Korea with economic and 
political support and shielded Pyongyang from harsh punishment 
by the international community for its destabilizing rhetoric 
and activities.\116\ However, North Korea's recent 
provocations--including its December 2012 long-range rocket 
launch and February 2013 nuclear test--have led to a ``subtle 
shift'' in China's policy toward North Korea, according to 
former U.S. Assistant Secretary of State for East Asian and 
Pacific Affairs Kurt Campbell.\117\ Observable manifestations 
of this ``subtle shift'' are Beijing's stronger and higher-
level public signals of its frustration with Pyongyang. Most 
notably, President Xi indirectly criticized North Korea in an 
April speech when he said, ``No one should be allowed to throw 
a region and even the whole world into chaos for selfish 
gains.'' \118\ This appears to be the first time a Chinese 
president has publicly reproached North Korea.
    Nevertheless, most U.S. analysts agree China has not 
fundamentally altered its North Korea strategy. Beijing's 
recent diplomatic moves have been temporary, limited, easily 
reversible, and more symbolic than substantive.

     LIn September 2013, several Chinese government 
ministries jointly issued a new 236-page list of technologies 
and materials to be banned from export to North Korea.\119\ The 
proscription list focuses on dual-use items that could be used 
to produce weapons of mass destruction or ballistic missiles. 
However, according to the Nautilus Institute, ``nothing 
indicates that by issuing tighter controls, China is 
fundamentally changing its policy toward North Korea, let alone 
abandoning it . . . The degree to which China enforces the 
prohibition of trade in items on this list will mostly 
determine the success of the program.'' \120\

     LAlthough China in March 2013 voted to approve new 
and strengthened UN Security Council sanctions on North 
Korea,\121\ Stephanie Kleine-Ahlbrandt, then North East Asia 
project director and China adviser for the International Crisis 
Group, in July noted that China's implementation of the 
sanctions had been ``underwhelming.'' \122\

     LIn May 2013, state-owned Bank of China Ltd. 
closed its account with North Korea's Foreign Trade Bank. 
However, 
Ms. Kleine-Ahlbrant explains, ``It is unclear whether there was 
any money in the Foreign Trade Bank's accounts when they were 
closed. For months already, North Koreans had been limiting 
their use of major Chinese banks to avoid scrutiny. Third 
countries are often used for such transactions, as well as 
provincial Chinese banks, which operate with considerably more 
autonomy than the larger state-owned banks. Furthermore, most 
of North Korean trade with China skirts the banking system 
altogether by engaging in cash transactions via trading 
companies in China, processing payments in the form of gold or 
gemstones, or even bartering.'' \123\

    Joel Wuthnow, analyst at the CNA Center for Naval Analyses, 
warns: ``this refrain is familiar. For instance, China's harsh 
rhetoric and vote in favor of UN sanctions after North Korea's 
2006 nuclear test was followed in 2007 by a push for dialogue; 
a similar pattern developed after China's approval of sanctions 
in response to [North Korean] provocations in 2009, with a more 
conciliatory approach in 2010.'' \124\

United States-China Security Relationship
China Seeking ``New Type of Major-Country Relationship'' with the 
        United States
    Throughout 2013, Beijing called for a ``new type of major-
country relationship'' * with the United States. Official 
Chinese statements claim the ``new type'' relationship is 
intended to promote more stable relations between the two 
countries and avoid or, if necessary, manage tensions that 
history suggests could occur as China rises. The concept, which 
was formulated by Beijing in 2011, has been referenced 
increasingly in official Chinese statements and press since 
February 2012, when then presumptive Chinese President Xi 
evoked it during a visit to the United States.\125\ The ``new 
type'' relationship was a central theme of the June 2013 summit 
between President Obama and President Xi in Sunnylands, 
California.\126\
---------------------------------------------------------------------------
    * Chinese statements also use the term ``new type of great power 
relationship.'' Both phrases refer to the same concept.
---------------------------------------------------------------------------
    The ``new type'' concept, like many Chinese policy slogans, 
is vaguely defined in order to provide Chinese officials with 
the flexibility to frame it in different ways for different 
circumstances and audiences. Chinese officials likely will 
attempt to use the concept to serve a number of Beijing's 
strategic objectives, including the following:

     LDevelop deeper and more frequent military 
communication to improve the two countries' abilities to manage 
crises if and when they arise.

     LPressure the United States to respect China's 
``core interests,'' which are to preserve China's political 
system and national security, protect Chinese sovereignty and 
territorial integrity, and sustain economic and social 
development.

     LPromote an image of China as a constructive actor 
seeking common solutions to regional and global issues.

     LConvince the United States that China is 
proactively seeking to build a peaceful and cooperative 
bilateral relationship.

     LPressure the United States to cease its military 
reconnaissance and survey operations in China's claimed EEZ, 
reduce U.S. arms sales to Taiwan, and relax restrictions on the 
military-to-military relationship, particularly those imposed 
in the 2000 National Defense Authorization Act. \127\
---------------------------------------------------------------------------
     Section 1201 of the 2000 National Defense Authorization 
Act prohibits DoD from authorizing any military-to-military exchange or 
contact with representatives of the PLA if that exchange or contact 
would create a national security risk for the United States. United 
States Congress, ``National Defense Authorization Act for Fiscal Year 
2000,'' Public Law 106-65, October 5, 1999. http://www.gpo.gov/fdsys/
pkg/PLAW-106publ65/pdf/PLAW-106publ65.pdf.

---------------------------------------------------------------------------
Select Military-to-Military Engagements

    DoD is seeking to expand and deepen its engagement with the 
Chinese military in nonsensitive areas of mutual interest. DoD 
contends a strong military-to-military relationship develops 
familiarity at the operational level, which reduces the risk of 
conflict through accidents and miscalculations; builds lines of 
communication at the strategic level that could be important 
during a crisis; contributes to better overall bilateral 
relations; and creates opportunities to obtain greater 
contributions from China to international security.
    From 2012 to 2013, the number of U.S.-China military-to-
military contacts--including high-level visits, recurrent 
exchanges, academic exchanges, functional exchanges, and joint 
exercises--more than doubled from approximately 20 to 40.\128\ 
In particular, contact between the U.S. Navy and PLA Navy 
increased significantly during this timeframe. In July 2013, 
U.S. Pacific Commander Admiral Locklear said, ``I think that 
the progress that we're making between our two militaries is 
quite commendable . . . because we are able to have very good 
dialogue on areas where we converge, and there are a lot of 
places where we converge as two nations, and we're also able to 
directly address in a matter-of-fact way where we diverge.'' 
\129\ Key military-to-military contacts in 2013 include the 
following:

     LIn April, U.S. Chairman of the Joint Chiefs of 
Staff General Martin Dempsey traveled to Beijing to meet with 
senior Chinese leaders, including President Xi, CMC Vice 
Chairman General Fan Changlong, and Defense Minister General 
Chang Wanquan. General Dempsey raised U.S. concerns about 
Chinese cyber espionage, reiterated U.S. treaty obligations to 
Japan encompass the Senkaku Islands, and explained the U.S. 
rebalance to Asia. After the trip, General Dempsey announced 
both militaries had agreed to a set of joint recommendations 
for their respective governments, including more frequent and 
regular military engagements at every level and the development 
of a code of conduct for interactions in the air, sea, and 
cyber domains.\130\

     LIn May, the USS Shiloh, a guided-missile cruiser 
based in Japan, called at Zhanjiang, China, to visit the PLA 
Navy's South Sea Fleet headquarters.\131\ This marked the first 
port visit by a U.S. Navy ship to China since 2009.\132\

     LIn May, then U.S. Pacific Fleet Commander Admiral 
Cecil Haney visited Beijing for talks with PLA Deputy Chief of 
General Staff General Qi Jianguo and PLA Navy Commander Admiral 
Wu Shengli.\133\ Admiral Haney then traveled to Zhanjiang to 
participate in the USS Shiloh's port visit.\134\

     LIn August, a group of two PLA Navy surface ships 
and a replenishment ship called at Pearl Harbor, Hawaii. This 
marked the first port visit by a Chinese ship to the United 
States since 2006.\135\ The PLA Navy ships then participated in 
a search and rescue exercise with ships from the U.S. Pacific 
Fleet. According to U.S. Navy Region Hawaii and Naval Surface 
Group Middle Pacific Commander Rear Admiral Rick Williams, the 
exercise included ``helicopters working together [for] airspace 
deconfliction . . . small boat operations back and forth . . . 
[and] communication drills.'' \136\

     LIn August, the U.S. Fifth Fleet and the PLA Navy 
conducted the second ever U.S.-China counterpiracy 
exercise.\137\ A U.S. guided-missile destroyer, a Chinese 
destroyer, and a Chinese replenishment ship participated in the 
two-day exercise in the Gulf of Aden. According to DoD press, 
the drill included ``simulated medical emergencies and hostage 
scenarios . . . a live-fire proficiency exercise . . . [and 
the] landing of a helicopter from each country aboard the deck 
of each other's ships.'' Paraphrasing a U.S. Fifth Fleet 
official, the DoD press report said the exercise marked a ``big 
step forward'' from the first U.S.-China counterpiracy exercise 
in 2012, which ``lasted only about six hours and was limited to 
a basic visit, board, search, and seizure and secure exercise, 
follow-on discussion, and crew lunch.'' \138\

     LIn August 2013, China's Defense Minister General 
Chang Wanquan traveled to the United States, where he visited 
the U.S. Pacific Command, the U.S. Northern Command, the North 
American Aerospace Defense Command, and the Pentagon. Defense 
Minister Chang met with U.S. Secretary of Defense Chuck Hagel 
at the Pentagon to discuss Asian security, U.S.-China cyber 
issues, and opportunities to enhance U.S-China military 
cooperation. During a joint press conference, Secretary Hagel 
and Defense Minster Chang gave an overview of recent and 
planned bilateral exercises; announced plans to establish a 
dialogue between the U.S. Strategic Plans and Policy 
directorate of the Joint Chiefs of Staff and the PLA's new 
Strategic Planning Department; and said the two sides continue 
to develop a notification mechanism for major military 
activities and rules of behavior for military air and naval 
activities.\139\

     LIn September, PLA Navy Commander Admiral Wu 
Shengli and Senior Captain Zhang Shen, the commanding officer 
of China's first aircraft carrier, traveled to San Diego, 
California, and Washington, DC. In San Diego, the PLA Navy 
delegation met with U.S. Chief of Naval Operations Admiral 
Jonathan Greenert; toured a NIMITZ-class aircraft carrier and a 
LOS ANGELES-class attack submarine; embarked on a Littoral 
Combat Ship at sea; and visited U.S. Marine Corps Base Camp 
Pendleton. In Washington, DC, the delegation had a series of 
talks with U.S. Navy leadership at the Pentagon and visited 
Walter Reed National Military Medical Center.\140\

    Additionally, China in March accepted the U.S. invitation, 
first extended by then U.S. Secretary of Defense Leon Panetta 
in September 2012, to participate in the U.S.-led multilateral 
Rim of the Pacific (RIMPAC) Exercise near Hawaii in 2014.\141\ 
According to U.S. Pacific Command Commander Admiral Samuel 
Locklear, this is ``a big step for the Chinese military . . . 
[the] Chinese navy [will] be entering a multinational three-
week-long exercise that's basically run by the U.S. from the 
3rd Fleet headquarters.'' \142\

Implications for the United States

    China's military modernization presents significant 
challenges to U.S. security interests in Asia. First and 
foremost, major elements of this program--such as the DF-21D 
antiship ballistic missile and increasing numbers of advanced 
submarines armed with antiship cruise missiles--are designed to 
restrict U.S. freedom of action throughout the Western Pacific. 
As the PLA's anti-access/area denial * capabilities mature, the 
costs and risks to the United States for intervention in a 
potential regional conflict involving China will increase.
---------------------------------------------------------------------------
    * ``Anti-access'' (A2) actions are those intended to slow 
deployment of an adversary's forces into a theater or cause the forces 
to operate from distances farther from the conflict than they would 
otherwise prefer. A2 affects movement into theater. ``Area denial'' 
(AD) actions are those intended to impede an adversary's operations 
within areas where friendly forces cannot or will not prevent access. 
AD affects movement within theater. U.S. Air-Sea Battle Office, Air Sea 
Battle: Service Collaboration to Address Anti-Access & Area Denial 
Challenges (Arlington, VA: May 2013), pp. 2-4.
---------------------------------------------------------------------------
    Furthermore, the PLA's rapidly advancing regional power 
projection capabilities enhance Beijing's ability to use force 
against Taiwan, Japan, and rival claimants in the South China 
Sea. This could embolden China to respond militarily to a 
perceived provocation or to consider preemptive attacks in a 
crisis involving Taiwan or China's maritime sovereignty claims. 
Many of these scenarios could require the U.S. military to 
protect U.S. regional allies and partners as well as to 
maintain open and secure access to the air and maritime commons 
in the Western Pacific.
    At the same time, rising unease over both China's expanding 
capabilities and increasing assertiveness is driving U.S. 
allies and partners in Asia to improve their own military 
forces and strengthen their security relationships with each 
other. These trends could support U.S. interests by lightening 
Washington's operational responsibilities in the region.
    Most Asian countries welcomed the U.S. rebalance to Asia 
when it was announced by the Obama Administration in 2011. The 
Philippines, for example, is considering granting the United 
States access to Subic Bay--a former U.S. naval base. 
The Philippines Department of Foreign Affairs Visiting Forces 
Agreement Director said, ``As the [United States] begins to 
implement [the rebalance to Asia], Subic will play an important 
role because it is one of the important facilities that can 
service its presence in the Pacific.'' \143\ However, there is 
growing concern among U.S. allies and partners that the United 
States will be unable to follow through on its commitment to 
the rebalance due to declining defense budgets and continuing 
security challenges elsewhere. Furthermore, some regional 
countries almost certainly began to question the willingness of 
the United States to restrain China's increasing assertiveness 
after China in 2012 gained de facto control of Scarborough 
Reef, territory also claimed by the Philippines, a U.S. treaty 
ally. This perception could lead some regional countries to 
increasingly accommodate China or pursue military capabilities 
that could be used offensively or preemptively. Either scenario 
could undermine U.S. interests in the region.
---------------------------------------------------------------------------
     Subic Bay--a natural harbor that is about 50 miles north 
of Manila--served as a major U.S. naval base until the early 1990s.

---------------------------------------------------------------------------
Conclusions

 LPLA modernization is altering the security balance in 
the Asia Pacific, challenging decades of U.S. military 
preeminence in the region.

 LThe PLA Navy is in the midst of an impressive 
modernization program. China's acquisition of naval platforms, 
weapons, and systems has emphasized qualitative improvements, 
not quantitative growth, and is centered on improving its 
ability to strike opposing ships at sea and operate at greater 
distances from the Chinese mainland. Today, the PLA Navy is 
able to conduct high-intensity operations in China's immediate 
periphery as well as low-intensity operations beyond the 
region. Trends in China's defense spending, research and 
development, and shipbuilding suggest the PLA Navy will 
continue to modernize. By 2020, China could have approximately 
60 submarines that are able to employ submarine-launched 
intercontinental ballistic missiles or antiship cruise missiles 
and approximately 75 surface combatants that are able to 
conduct multiple missions or that have been extensively 
upgraded since 1992.

 LThe PLA is rapidly expanding and diversifying its 
ability to strike U.S. bases, ships, and aircraft throughout 
the Asia Pacific region, including those that it previously 
could not reach, such as U.S. military facilities on Guam.

 LThe PLA's expanding involvement in real world 
missions allows it to field-test equipment and obtain hands-on 
experience in areas such as addressing unconventional threats 
in harsh and potentially hostile environments, satisfying 
expeditionary logistics requirements, and integrating into 
multilateral operations.

 LThe PLA is improving its day-to-day readiness levels 
and conducting longer-range and more frequent, robust, and 
realistic training. As these reforms continue, the PLA will 
become more proficient and confident operating its advanced 
platforms and weapon systems and better able to rapidly respond 
to regional contingencies.

 LThe PLA Navy's growing presence in foreign EEZs 
contradicts its longstanding policy on military activities in 
its own EEZ. Rather than resolve this inconsistency between its 
actions and policy, Beijing likely will continue to assert its 
authority to regulate U.S. military activities in its EEZ.

                     ENDNOTES FOR SECTION 1

      1. Yan Hao, ``Xinhua Insight: Hu praised for voluntarily 
resigning from top post,'' Xinhua, November 17, 2012. http://
news.xinhuanet.com/english/special/18cpc-nc-/2012-11/18/
c-_-131981526.htm.
      2. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of Cheng Li, February 7, 2013.
      3. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of James C. Mulvenon, February 7, 2013.
      4. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of Cheng Li, February 7, 2013.
      5. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of Cheng Li, February 7, 2013.
      6. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of Cheng Li, February 7, 2013.
      7. Xinhua, ``Xi pledges `great renewal of Chinese nation,' '' 
November 29, 2012. http://news.xinhuanet.com/english/china/2012-11/29/
c----132008231.htm.
      8. Jeremy Page, ``For Xi, a `China Dream' of Military Power,'' 
Wall Street Journal, March 13, 2013. http://online.wsj.com/article/
SB10001424127887324128504-5-7-8-3-4-8-7-74040546346.html.
      9. Xie Zhengxuan, ``Basic Adherences that Lead National Defense 
Construction and Army Building,'' Jiefangjun Bao (PLA Daily), June 15, 
2013. OSC ID: CPP-2013-0620088001. http://www.opensource.gov.
     10. Daniel Hartnett, ``Army Day Coverage Stresses Winning Battles 
with `Dream of a Strong Military,' '' China Brief 13:17 (Washington, 
DC: Jamestown Foundation, August 23, 2013). http://www.jamestown.org/
uploads/media/China----Brief----Vol----13----Issue----04.pdf.
     11. Cary Huang, ``Xi Jinping orders PLA to step up its `real 
combat' awareness,'' South China Morning Post (Hong Kong), December 13, 
2012. http://www.scmp.com/news/china/article/1103957/xi-jinping-orders-
pla-step-its-real-combat-awareness.
     12. Jiefangjun Bao (PLA Daily), ``JFJB Commentator on PLA Military 
Training Directive for 2013,'' January 14, 2013. OSC ID: 
CPP20130114787021. http://www-.-open-source-.-gov.
     13. CCTV-7, ``Deputy Training Chief Discusses PLA 2013 Military 
Training Plans,'' December 28, 2012. OSC ID: CPP20130105678001. http://
www-.-open-source-.-gov.
     14. CCTV-7, ``The PLA's New Specialized `Blue Force' Brigade 
Unveiled in Zhurihe,'' January 13, 2013. OSC ID: CPP20130122075005. 
http://www-.-open-source-.-gov.
     15. CCTV-7, ``The PLA's New Specialized `Blue Force' Brigade 
Unveiled in Zhurihe,'' January 13, 2013. OSC ID: CPP20130122075005. 
http://www-.-open-source-.-gov.
     16. Open Source Center, PRC Media Portray Xi Jinping as Actively 
Managing Military (Washington, DC: June 6, 2013). OSC ID: 
CPP20130606790021. http://www-.-open-source-.-gov.
     17. Willy Lam, ``Commander-in-Chief Xi Jinping Raises the Bar on 
PLA `Combat Readiness,' '' China Brief 13:2 (Washington, DC: Jamestown 
Foundation, January 18, 2013). http: // www.jamestown.org/programs/
chinabrief/ single / 
? tx _-ttnews[tt-_-news]=40329&cHash=d7a108eeb831585907e389ed5a637ada.
     18. James Mulvenon and Leigh Ann Ragland, ``Liu Yuan: Archetype of 
a `Xi Jinping Man' in the PLA,'' China Leadership Monitor No. 36, 
January 6, 2012. http://media.hoover.org/sites/default/files/documents/
CLM36JM.pdf.
     19. John Garnaut, ``Rotting from Within: Investigating the massive 
corruption of the Chinese military,'' Foreign Policy, April 16, 2012. 
http://www.foreignpolicy.com/articles/2012/04/16/
rotting----from----within.
     20. John Garnaut, ``Rotting from Within: Investigating the massive 
corruption of the Chinese military,'' Foreign Policy, April 16, 2012. 
http://www.foreignpolicy.com/articles/2012/04/16/
rotting----from----within.
     21. Wang Xiangwei, ``Time for Xi to clean up the sleaze pervading 
the PLA,'' South China Morning Post (Hong Kong), August 5, 2013. http:/
/www.scmp.com/news/china/article/1294329/time-xi-clean-sleaze-
pervading-pla.
     22. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of James C. Mulvenon, February 7, 2013.
     23. U.S.-China Economic and Security Review Commission, Hearing on 
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(London), June 27, 2013. http://www.ft.com/intl/cms/s/0/e46f3e42--defe-
-11e2--881f--00144feab7de.html#-axzz2XoBd-8ZtL.
    100. China Defense Blog, ``Photos of the Day: The first PLA combat 
elements to Mali,'' July 13, 2013. http://china-defense.blogspot.com/
2013/07/photos-of-day-first-pla-combat-elements.html.
    101. Ministry of National Defense (China), Transcript of PRC 
National Defense Ministry's News Conference on 27 June 2013 (Beijing, 
China: June 30, 2013). OSC ID: CPP20130627680001. http://
www-.-open-source-.-gov; Ministry of Foreign Affairs (China), Foreign 
Ministry Spokesperson's Regular Press Conference on 27 June 2013 
(Beijing, China: June 28, 2013). OSC ID: CPP20130628968145. http://
www-.-open-source-.-gov; and Kathrin Hille, ``China commits combat 
troops to Mali,'' Financial Times (London), June 27, 2013. http://
www.ft.com/intl/cms/s/0/e46f3e42-defe-11e2-881f-
00144-feab-7de.html#axzz2XoBd8ZtL.
    102. Xinhua, ``China to Send Security Forces for Peacekeeping 
Mission in Mali,'' June 27, 2013. OSC ID: CPP-2013-0627968233. http://
www.opensource.gov.
    103. Daniel Hartnett, China's First Deployment of Combat Forces to 
a UN Peacekeeping Mission--South Sudan (Washington, DC: U.S.-China 
Economic and Security Review Commission, March 13, 2012).
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Engineering Detachment to South Sudan Established,'' January 5, 2012. 
OSC ID: CPP-2012-010670-2003. http://www.opensource.gov.
    105. Zhao Shengnan and Pu Zhendong, ``China, Russia Begin Live Fire 
Navy Drill,'' China Daily, July 9, 2013. OSC ID: CHR2013070936047015. 
http://www-.-open-source-.-gov; Jiefangjun Bao (PLA Daily), ``Six 
Highlights of China-Russia Maritime Joint Exercise,'' July 5, 2013. OSC 
ID: CHO2013070821926494. http://www-.-open-source-.-gov.
    106. Jiefangjun Bao (PLA Daily), ``China-Russia Exercise `Joint Sea 
2013' in July,'' July 10, 2013. OSC ID: CHO2013071018775963. http://
www.opensource.gov; Jiefangjun Bao (PLA Daily), ``China-Russia Naval 
Joint Exercise to be Normalized and Insitutionalized,'' July 11, 2013. 
OSC ID: CHL-2013-071132470531. http://www-.-open-source-.-gov.
    107. CCTV-Xinwen, ``PRC Expert Views Joint Antisubmarine, Air 
Defense Drills in China-Russia Naval Exercise,'' July 10, 2013. OSC ID: 
CH-O-2013-071018085524. http://www.opensource.gov.
    108. Jeffrey Mankoff, ``The Wary Chinese-Russian Partnership,'' New 
York Times, July 11, 2013. http: // www.nytimes.com/2013/07/12/
opinion/global/the-wary-chinese-russian-partnership.html?----r=0.
    109. Zachary Keck, ``Russia Holds Massive Military Drill Aimed at 
China, Japan,'' Diplomat, July 17, 2013. http://thediplomat.com/
flashpoints-blog/2013/07/17/russia-holds-massive-military-drill-aimed-
at-china-japan/.
    110. Dean Cheng and Ariel Cohen, How Washington Should Manage U.S.-
Russia-China Relations (Washington, DC: Heritage Foundation, September 
12, 2013). http: // www.heritage.org/research/reports/2013/09/
how-washington-should-manage-us-russiachina-relations#----ftn16.
    111. Economist, ``India and China: Parsnips Unbuttered,'' May 25, 
2013. http://www--.--economist--.--com/news/--asia/
2--1--57--84--1--2---flowery---rhetoric---fails-hide-difficulties---
bilateral--relationship-parsnips-unbuttered; Open Source Center, 
Summary: India Protests PRC Troop `Intrusion' (Washington, DC: April 
23, 2013). OSC ID: FEA-2013-04-23-03-08-77. http://www.opensource.gov.
    112. Ministry of Foreign Affairs (China), Foreign Ministry 
Spokesperson Hua Chunying's Regular Press Conference on April 25, 2013, 
April 27, 2013. OSC ID: CPP-2013-0427968070. http://www.opensource.gov.
    113. Gardiner Harris, ``India and China Vow to Cooperate on 
Border,'' New York Times, May 20, 2013. http: // www.nytimes.com/
2013/05/21/world/asia/india-china-border-issues.html?----r=0.
    114. Vivek Raghuvanshi, ``India Sends Draft Border Cooperation 
Agreement to China,'' Defense News, August 20, 2013. http://
www.defensenews.com/article/2013-08-20/DEFREG03/308200026/India-Sends-
Draft-Border-Cooperation-Agreement-China.
    115. Ely Ratner and Alexander Sullivan, ``The Most Dangerous Border 
in the World: Why is China picking a fight with India?'' Foreign 
Policy, May 4, 2013. http://www.foreignpolicy.com/articles/20--13/05/
03/china----india----most----dangerous----border?-page=-0,0.
    116. U.S.-China Economic and Security Review Commission, 2012 
Annual Report to Congress (Washington, DC: U.S. Government Printing 
Office, November 2012), 
p. 11.
    117. Josh Rogin, ``Former top U.S. official: China getting fed up 
with North Korea,'' Foreign Policy, April 5, 2013. http://
thecable.foreignpolicy.com/posts/2013/04/05/
former----top----us----official----china----getting----fed----up----with----north
----korea.
    118. William Wan, ``Chinese President Xi Jinping expresses concern 
over North Korea's rhetoric,'' Washington Post, April 7, 2013. http://
articles.washingtonpost.com/2013-04-07/world/38354043----1----south-
china-sea-schumer-united-nations.
    119. Jane Perlez, ``China Bans Items for Export to North Korea, 
Fearing Their Use in Weapons,'' New York Times, September 24, 2013. 
http://www.nytimes.com/20--1--3/09/25/world/--asia/--china-bans-
certain---north---korean---exports-for---fear---of---weapons-
use-.-html.
    120. Roger Cavazos, Peter Hayes, and David von Hippel, ``Technical 
Bulletin #59 on Prohibition of Dual Use Exports to North Korea,'' 
Nautilus Institute for Security and Sustainability, September 26, 2013. 
http://nautilus.org/napsnet/napsnet-special-reports/technical---
bulletin-59-on-prohibition-of---dual---use-exports-to-north-korea/
#axzz2h-4-TE-Y8Zl.
    121. United Nations Security Council, ``Security Council 
Strengthens Sanctions on Democratic People's Republic of Korea, In 
Response to 12 February Nuclear Test,'' March 7, 2013. http://
www.un.org/News/Press/docs/2013/sc10934.doc.htm.
    122. Stephanie Kleine-Ahlbrandt, ``China's North Korea Policy: 
Backtracking from Sunnylands?'' 38North.org, July 2, 2013. http://
38north.org/2013/07/skahlbrandt-07-02-13--/.
    123. Stephanie Kleine-Ahlbrandt, ``China's North Korea Policy: 
Backtracking from Sunnylands?'' 38North.org, July 2, 2013. http://
38north.org/2013/07/skahlbrandt-07-02-13--/.
    124. Joel Wuthnow, ``How China Reads North Korea,'' National 
Interest, September 8, 2013. http://nationalinterest.org/commentary/
how-china-reads-north-korea-9009.
    125. Michael S. Chase, ``China's Search for a `New Type of Great 
Power Relationship,' '' China Brief 12:27 (Washington, DC: Jamestown 
Foundation, September 7, 2012), p. 14. http://www.jamestown.org/
uploads/media/cb----09----04.pdf.
    126. Xinhua, ``China, U.S. agree to build new type of relations,'' 
June 8, 2013. http: // news.xinhuanet.com / english / china / 2013-06 / 
08 / c _ 132442379.htm; Jeremy Page and Colleen McCain Nelson, ``U.S.-
China Summit Reveals Beijing's Drive,'' Wall Street Journal, June 2, 
2013. http://online.wsj.com/article/
SB100014241278873244-2-3-9-045785-211-61140840702.html; and Jamil 
Anderlini, ``Global Insight: China's `great power' call to the US could 
stir friction,'' Financial Times (London), June 4, 2013. http://
www.ft.com/intl/cms/s/0/80f4168a---ccca---11e2---9cf7---
-00144feab7de.html#-axzz2WfP-E-h45n.
    127. Zhao Xiaozhuo, ``The Building of a New-Type Military 
Relationship Between China and the United States Is Facing a Historic 
Opportunity,'' Jiefangjun Bao (PLA Daily), June 14, 2013. OSC ID: 
CPP20130614787003. http://www-.-open-source-.-gov.
    128. U.S. Department of Defense, Annual Report to Congress: 
Military and Security Developments Involving the People's Republic of 
China 2013 (Washington, DC: May 2013), pp. 69-71.
    129. Karen Parrish, ``U.S.-China Military Ties Growing, Pacom 
Commander Says,'' U.S. Armed Forces Press Service, July 11, 2013. 
http://www.defense.gov/news/newsarticle.aspx?id=120440.
    130. Karen Parrish, ``Leaving Asia, Dempsey Discusses Combined 
Defense, China Engagement,'' U.S. Armed Forces Press Service, April 27, 
2013. http: // www.-defense.gov/news/newsarticle.aspx?id=119894.
    131. N. Ross Taylor, ``USS Shiloh Sailors Visit Zhanjiang, China,'' 
U.S. Navy News Service, May 30, 2013. http: // www.navy.mil/submit/
display.asp?story _ id =-74477.
    132. Matthew White, ``USS Fitzgerald Arrives in Qingdao, China,'' 
U.S. Department of Navy, April 20, 2009. http: // www.navy.mil/
submit/display.asp ? story _ id =-44493.
    133. Renmin Ribao (People's Daily), ``Wu Shengli meets with U.S. 
Pacific Fleet commander,'' May 30, 2013. english.peopledaily.com.cn/
90786/8263856.html; Xinhua, ``China, US vow further naval 
cooperation,'' May 28, 2013. http://news-.-xinhua-net-.-com/english/
china/2013-05/28/c-_-132414858.htm.
    134. Grace Jean, ``USN Cruiser, US Pacific Fleet Commander Stop in 
China 
for Scheduled Port Visit,'' IHS Jane's Navy International, May 30, 
2013. http://www.janes.com/article/--1--2842/usn-cruiser-us-pacific-
fleet---commander-stop-in-china-for---scheduled-port-visit.
    135. U.S. Chief of Naval Operations, CNO Wraps up Weeklong Visit 
with PLA Navy (Washington, DC: August 16, 2013). http://www-.-navy.mil/
search/print.asp?story-_-id=76608&VIRIN=&imagetype=0&page=0.
    136. Cynthia Clark, ``Chinese Navy Ships Visit Hawaii,'' U.S. Navy 
News Service, September 7, 2013. http://www.navy.mil/submit/
display.asp?story----id=76402.
    137. Associated Press, ``Chinese ships head for search exercises 
with US Navy as Beijing ramps up military diplomacy,'' August 20, 2013. 
http://www-.-washington-post.-com / world / asia _ pacific / chinese - 
ships - depart - for - rare - drills- with- us- navy- as- beijing-
-ramps - up - military - diplomacy / 2013 / 08 / 20 / 4499d6c0 - 0a05 - 
11e3 - 89fe - abb4a5067014 _-story.html; U.S. Department of Defense, 
Department of Defense Press Briefing with Secretary Hagel and Gen. 
Chang from the Pentagon (Washington, DC: August 19, 2013). http://
www.defense.gov/transcripts/transcript.aspx?transcriptid=5289.
    138. Donna Miles, ``U.S., Chinese Navies Exercise Counterpiracy in 
Gulf of Aden,'' U.S. American Forces Press Service, August 26, 2013. 
http://www.defense.gov/news/newsarticle.aspx?id=120675.
    139. U.S. Department of Defense, Department of Defense Press 
Briefing with Secretary Hagel and Gen. Chang from the Pentagon 
(Washington, DC: August 19, 2013). http://www.defense.gov/transcripts/
transcript.aspx?transcriptid=5289.
    140. U.S. Chief of Naval Operations, CNO Wraps up Weeklong Visit 
with PLA Navy (Washington, DC: August 16, 2013). http://www.navy.mil/
search/print.asp?story----id=76608&VIRIN=&imagetype=0&page=0.
    141. Shirley Kan, U.S.-China Military Contacts: Issues for Congress 
(Washington, DC: Congressional Research Service, July 25, 2013).
    142. Karen Parrish, ``U.S.-China Military Ties Growing, PACOM 
Commander Says,'' U.S. American Forces Press Service, July 11, 2013. 
http://www.defense.gov/news/newsarticle.aspx?id=120440.
    143. James Hardy, ``Back to the Future: The U.S. Navy Returns to 
The Philippines,'' Diplomat, October 16, 2012. http://thediplomat.com/
2012/10/16/just-like-old-times-us-navy-returns-to-philippines/
?all=true.
                  SECTION 2: CHINA'S CYBER ACTIVITIES

Introduction
    Since the Commission's 2012 Annual Report to Congress, 
strong evidence has emerged that the Chinese government is 
directing and executing a large-scale cyber espionage campaign 
against the United States. This section--based on discussions 
with cybersecurity experts and U.S. Department of Defense (DoD) 
officials and independent research *--provides an overview of 
this evidence, examines developments in Chinese cyber policy, 
and explores potential U.S. actions and policies to deter and 
mitigate future Chinese cyber theft and improve U.S. cyber 
policy development and implementation.
---------------------------------------------------------------------------
    * In 2013 the Commission held a roundtable on U.S.-China 
cybersecurity issues on July 11 and sponsored a report on the economic 
and security implications of cloud computing development in China, 
which the Commission published on September 5. Leigh Ann Ragland et 
al., Red Cloud Rising: Cloud Computing in China (Vienna, VA: Defense 
Group Inc. for the U.S.-China Economic and Security Review Commission, 
September 2013). http://origin.www.uscc.gov/sites/default/files/
Research/
Red-%20-Cloud-%20-Rising----Cloud-%20-Computing-%20-in-%20-China.pdf.
     For discussion of China's cyber strategy and actors, see 
U.S.-China Economic and Security Review Commission, 2012 Annual Report 
to Congress (Washington, DC: U.S. Government Printing Office, November 
2012), pp. 147-151; Bryan Krekel et al., Occupying the Information High 
Ground: Chinese Capabilities for Computer Network Operations and Cyber 
Espionage (Falls Church, VA: Northrop Grumman Corporation for the U.S.-
China Economic and Security Review Commission, March 2012). http://
origin.www.uscc.gov/sites/default/files/Research/
USCC----Report----Chinese----Capabilities----for----Computer----Network----Oper
ations-_-and-_-Cyber-_-%20-Espionage.-pdf.

Mounting Evidence of the Chinese Government's Active Role in Cyber 
---------------------------------------------------------------------------
        Espionage

Detailed Technical Information Released on Chinese Cyber Activities
    In February 2013, Mandiant, a private U.S. cybersecurity 
firm, published a report providing detailed technical 
information regarding the activities of a cyber threat group, 
which Mandiant refers to as Advanced Persistent Threat 1. 
According to the report, the group likely is the 2nd Bureau of 
the People's Liberation Army (PLA) General Staff Department's 
Third Department, also known as Unit 61398. Mandiant assesses 
Unit 61398 since 2006 has penetrated the networks of at least 
141 organizations, including companies, international 
organizations, and foreign governments. These organizations are 
either located or have headquarters in 15 countries and 
represent 20 sectors, from information technology to financial 
services. Four of these sectors are among the seven strategic 
emerging industries the Chinese government prioritized for 
development in its 12th Five-Year Plan (2011 to 2015). 81 
percent of the targeted organizations were either located in 
the United States or had U.S.-based headquarters. Through these 
intrusions, the group gained access to ``broad categories of 
intellectual property, including technology blueprints, 
proprietary manufacturing processes, test results, business 
plans, pricing documents, partnership agreements, and e-mails 
and contact lists from victim organizations' leadership.'' \1\
    In its report, Mandiant states Unit 61398 is responsible 
for conducting computer network operations,* specifically the 
gathering of strategic and economic intelligence on targets in 
the United States and Canada, as well as targeting 
organizations whose primary language is English in other 
countries.\2\ Aside from Unit 61398, the Third Department has 
another 11 operational bureaus, three research institutes, four 
operations centers, and 16 technical reconnaissance 
bureaus. \3\ Not all of these organizations are 
directing their actions against the United States, and there 
are no public reports available about their role in China's 
cyber espionage campaign.\4\
---------------------------------------------------------------------------
    * Computer network operations are ``comprised of computer network 
attack, computer network defense, and related computer network 
exploitation enabling operations.'' Bryan Krekel et al., Occupying the 
Information High Ground: Chinese Capabilities for Computer Network 
Operations and Cyber Espionage (Falls Church, VA: Northrop Grumman 
Corporation for the U.S.-China Economic and Security Review Commission, 
March 2012), p. 115. http: // origin.www.uscc.gov/sites/default/
files/Research/
USCC-- Report_ Chinese_- Capabilities-_- for-_-Computer_ Network_ -Opera-
tions_- and_ -Cyber_ %20-Espionage.-pdf.
     Technical reconnaissance bureaus are administratively 
subordinate to the PLA General Staff Department's Third Department but 
are attached to the PLA's service arms and provide direct support to 
operational units through signals intelligence and computer network 
operations.
---------------------------------------------------------------------------
    According to the Wall Street Journal, on the same day 
Mandiant published its report, the U.S. Department of Homeland 
Security and the U.S. Federal Bureau of Investigation shared 
hundreds of Internet Protocol (IP) addresses used by Unit 61398 
with U.S. Internet service providers to help them defend their 
customers against cyber intrusions. Mandiant gave the U.S. 
government advance notice of the release of its report on Unit 
61398; this may have been a factor in the timing of the 
government's sharing of the IP addresses.\5\
    In April 2013, the Verizon RISK Team, a cybersecurity unit 
within private U.S. telecommunications company Verizon, 
published its annual Data Breach Investigations Report.\6\ The 
report presents analysis of 621 cases of ``confirmed data 
disclosure,'' which Verizon defines as ``any event resulting in 
confirmed compromise (unauthorized viewing or accessing) of any 
non-public information,'' that occurred in 2012. Eighteen 
governmental and private organizations from the United States, 
Europe, Malaysia, and Australia provided the information about 
these cases. Verizon categorized 19 percent of the intrusions 
as espionage carried out by ``state-affiliated actors.'' It 
identified 96 percent of the intrusions conducted by state-
affiliated actors as originating in China.\7\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
Chinese Cyber Espionage against U.S. Critical Infrastructure
 
  In July 2013, a threat researcher at Trend Micro, a private Japanese
cybersecurity firm, claimed he had detected a Chinese cyber intrusion,
commencing in December 2012, of a honeypot.
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    = A honeypot is part of a honeynet, which is a fake or diversionary 
computer network designed to draw in an adversary in order to identify 
the adversary or give the adversary false information. Honeynets can 
provide intelligence regarding adversaries' ``tools, tactics, and 
motives.'' The Honeynet Project, ``Short Video Explaining Honeypots.'' 
http://old.honeynet.org/misc/files/Honeynet Web.mov.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Chinese Cyber Espionage against U.S. Critical Infrastructure--Continued
 
He created the honeypot to resemble the industrial control system of a
 water plant in the United States. The researcher attributed the
 intrusion to Unit 61398, based on forensic analysis.\8\ If true, this
 suggests Unit 61398 is collecting intelligence on critical
 infrastructure in addition to other targets. Such activities are
 consistent with PLA doctrine, which explains that one function of
 wartime computer network operations is to ``disrupt and damage the
 networks of [an adversary's] infrastructure facilities, such as power
 systems, telecommunications systems, and educational systems.'' \9\
 Some PLA strategists also have suggested China should develop the
 capability to paralyze ports and airports by cyber or precision weapon
 attacks on critical infrastructure.\10\
 
------------------------------------------------------------------------


U.S. Department of Defense for the First Time Attributes Cyber 
        Espionage to China
    In May 2013, DoD for the first time directly accused the 
Chinese government and military of cyber espionage against U.S. 
networks. DoD's 2013 Annual Report to Congress: Military and 
Security Developments Involving the People's Republic of China 
states: ``In 2012, numerous computer systems around the world, 
including those owned by the U.S. government, continued to be 
targeted for intrusions, some of which appear to be 
attributable directly to the Chinese government and military.'' 
The report then states, ``China is using its computer network 
exploitation capability to support intelligence collection 
against the U.S. diplomatic, economic, and defense industrial 
base sectors that support U.S. national defense programs.'' 
\11\
    U.S. Secretary of Defense Chuck Hagel said addressing 
Chinese cyber espionage primarily requires dialogue between the 
U.S. and Chinese governments behind closed doors, but he added, 
``It has to be public as well.'' \12\ Publicly attributing 
cyber intrusions to the Chinese government and military in the 
DoD report is a significant step for the U.S. government. 
Previous DoD documents and statements had acknowledged cyber 
espionage ``emanated'' or ``originated'' from China but stopped 
short of attributing those operations to the Chinese government 
and military. For example, DoD's 2012 report to Congress 
stated: ``Computer networks and systems around the world 
continued to be targets of intrusions and data theft, many of 
which originated within China.'' \13\ In a press briefing 
following the release of the 2012 report, then acting Deputy 
Assistant Secretary of Defense for East Asia David Helvey said, 
``We have concerns about a number of computer network 
operations and activities that appear to originate from China 
that affect DoD networks.'' When asked whether he was referring 
to the Chinese government, he said, ``I didn't specify the 
attribution.'' \14\

------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Beijing Issues Routine Denials of the Allegations by Mandiant and DoD
 
  When confronted with public accusations from the United States about
its cyber espionage, Beijing attempted to refute the evidence, in part,
by pointing to the anonymity of cyberspace and the lack of verifiable
technical forensic data. The Chinese government's statements were
similar to its responses to previous foreign allegations of cyber
espionage.\15\
  In a press conference on the day after Mandiant released its report, a
spokesperson for China's Ministry of Foreign Affairs said, ``Groundless
speculation and accusations regarding hacker attacks, for various
purposes, is both unprofessional and irresponsible and it is not helpful
for solving the problem.'' He also emphasized cyber attacks are a
serious problem for China.\16\ In a press conference the next day, a
spokesperson for China's Ministry of National Defense denied that the
PLA supports hacking. He argued Mandiant's allegations are without
merit, because, among other reasons, hackers frequently use third-party
IP addresses to conduct cyber attacks.\17\
  In response to the allegations regarding China's cyber espionage
activities in DoD's 2013 report to Congress, a Ministry of Foreign
Affairs spokesperson said China is ``strongly against any form of
hacking activities'' and called the charges ``baseless.'' \18\
 
------------------------------------------------------------------------


Evidence of a Cyber Campaign against U.S. Press
    There is growing evidence the Chinese government is 
conducting a cyber espionage campaign against U.S. media 
organizations. China likely seeks to use information acquired 
through these intrusions to (1) shape U.S. press coverage of 
China by intimidating U.S. journalists' sources in China, and 
(2) gain warning about negative media coverage of China before 
it is published.\19\

     LIn January 2013, the New York Times reported 
Chinese cyber actors had gained access to its computer network 
in September 2012 and had conducted activities inside the 
network for the next four months. The intrusions appeared to 
focus on the e-mail account of a reporter investigating the 
assets of family members of outgoing Chinese Premier Wen 
Jiabao. The New York Times hired Mandiant to investigate the 
intrusion, which Mandiant attributed to a China-based cyber 
threat group it refers to as Advanced Persistent Threat 12. The 
New York Times reported, ``The attacks started from the same 
university computers used by the PLA to attack United States 
military contractors in the past.'' \20\

     LThe New York Times also reported Chinese cyber 
actors conducted an intrusion into computers at Bloomberg News 
in 2012 following Bloomberg's investigation of the assets of 
then Chinese Vice President Xi Jinping's relatives.\21\

     LFollowing the New York Times' revelations, the 
Wall Street Journal and the Washington Post reported their 
networks also had been penetrated by hackers, with evidence in 
both cases implicating cyber actors based in China.\22\ In the 
Wall Street Journal intrusion, the hackers targeted personnel 
reporting on China.\23\

New Information Emerges about 2009 Intrusion into Google's Network
    In May 2013, the Washington Post reported Chinese cyber 
actors in 2009 infiltrated a Google database containing 
information regarding Foreign Intelligence Surveillance Court 
orders Google had received.* The hackers seemed to be searching 
for names of Chinese intelligence operatives whom the U.S. 
government might be monitoring. Regarding this intrusion, a 
former U.S. government official said that were the Chinese 
government to become aware that its operatives were being 
monitored, it could ``take steps to destroy information, get 
people out of the country,'' and perhaps intentionally transmit 
incorrect information to the U.S. government.\24\ A former U.S. 
Department of Justice (DoJ) official said data breaches such as 
this one show ``the overall security and effectiveness of 
lawful interception and undercover operations is dependent in 
large part on security standards in the private sector,'' which 
``clearly need strengthening.'' \25\
---------------------------------------------------------------------------
    * The intruders also reportedly accessed Google's source code. 
Source code is the set of instructions that compose computer software 
programs. In addition, they attempted to access the e-mail accounts of 
Chinese human rights activists. This intrusion was part of a broader 
campaign targeting over 30 companies that U.S. cybersecurity company 
McAfee called ``Operation Aurora.'' Ellen Nakashima, ``Chinese Hackers 
Who Breached Google Gained Access to Sensitive Data, U.S. Officials 
Say,'' Washington Post, May 20, 2013. http://
articles.-washington-post.com/2013-05-20/world/39385755-_-1-_-chinese-
hackers-court-orders-fbi; Andrew Jacobs and Miguel Helft, ``Google, 
Citing Attack, Threatens to Exit China,'' New York Times, January 13, 
2010. http://www.nytimes.com/2010/01/13/world/asia/
13beijing-.-html-?-page-wanted-=-all-&-_-r-=-0; and Kim Zetter, 
``Google Hack Attack Was Ultra Sophisticated, New Details Show,'' 
Wired, January 14, 2010. http://www.wired.com/threatlevel/2010/01/
operation-aurora/.

Defense Science Board Points to Widespread Hacking of U.S. Defense 
        Designs
    The Defense Science Board  warns in Resilient 
Military Systems and the Advanced Cyber Threat, an unclassified 
report published in October 2012, ``The cyber threat is 
serious, with potential consequences similar in some ways to 
the nuclear threat of the Cold War.'' The Defense Science Board 
then assesses DoD ``is not prepared to defend against this 
threat.'' \26\ In May 2013, the Washington Post published an 
article describing a classified version of the report, which 
lists more than 24 U.S. weapon system designs the board 
determined were accessed by cyber intruders. The Washington 
Post reported, ``Senior military and industry officials with 
knowledge of the breaches said the vast majority were part of a 
widening Chinese campaign of espionage against U.S. defense 
contractors and government agencies.'' The list includes the 
Patriot Advanced Capability 3 air defense system, the Terminal 
High Altitude Area Defense system, the Aegis ballistic missile 
defense system, the F/A-18 fighter aircraft, the V-22 Osprey 
multirole combat aircraft, the Black Hawk helicopter, the 
Littoral Combat Ship, and the F-35 Joint Strike Fighter.\27\
---------------------------------------------------------------------------
     According to its charter, the Defense Science Board 
submits ``independent advice and recommendations on science, 
technology, manufacturing, acquisition process, and other matters of 
special interest to the DoD'' to the Secretary of Defense and other 
senior defense officials. Defense Science Board, ``Charter.'' http://
www.acq.osd.mil/dsb/charter.htm.

Update on U.S. Department of Justice Indictment of Chinese Company
    In another high-profile example of a Chinese company 
allegedly targeting a U.S. company's intellectual property 
through cyber espionage, the DoJ in June 2013 filed charges 
against Sinovel Wind Group, a Chinese energy firm, alleging 
Sinovel stole intellectual property from Massachusetts-based 
company American Superconductor (AMSC). DoJ charged Sinovel, 
the deputy director of Sinovel's research and development 
department, a technology manager at Sinovel, and a former 
employee of a subsidiary of AMSC with theft of trade secrets 
and related charges.\28\
    AMSC and Sinovel entered into a business relationship in 
2005, with AMSC selling software, components, and electrical 
systems to Sinovel for use in its wind turbines. In the 
following years, Sinovel became AMSC's largest client. However, 
the Chinese firm in 2011 stopped paying for products that had 
arrived in China and cancelled existing orders after allegedly 
stealing source code from AMSC to reproduce AMSC's 
software.\29\ Media reporting alleges Dejan Karabasevic, who 
was working as an engineer for AMSC Wintec GmbH in Austria at 
the time, remotely extracted the source code from a computer in 
Wisconsin and delivered it to Sinovel by e-mail.\30\ According 
to the company's chief executive officer, without sales to 
Sinovel, AMSC's revenue declined dramatically, and 50 percent 
of its 900 employees lost their jobs.\31\ In early 2012, the 
U.S. Federal Bureau of Investigation found software alleged to 
have been illegally copied from AMSC's software in a wind 
turbine the Massachusetts Water Resources Authority had 
purchased from Sinovel. This was a critical factor leading to 
Sinovel's indictment.\32\ AMSC has sought compensation from 
Sinovel through lawsuits in China, an effort that is ongoing 
and has resulted in legal fees for AMSC exceeding $6 
million.\33\

Chinese Cyber Policy Developments
United States and China Establish Cyber Working Group
    In April 2013, U.S. Secretary of State John Kerry announced 
the U.S. and Chinese governments would establish a working 
group to discuss cybersecurity.\34\ The Cyber Working Group 
convened for the first time in July immediately preceding the 
latest meeting of the U.S.-China Strategic and Economic 
Dialogue (S&ED). Christopher Painter, the U.S. Department of 
State's Coordinator for Cyber Issues, and Dai Bing, an official 
from China's Ministry of Foreign Affairs, were the senior 
representatives for their respective countries at the 
meeting.\35\ At the conclusion of the S&ED, the two sides 
announced they had ``decided to take practical measures to 
enhance dialogue on international norms and principles in order 
to guide action in cyber space and to strengthen CERT to CERT 
(Computer Emergency Response Team) * coordination and 
cooperation.'' \36\ James Lewis, director of the Technology and 
Public Policy Program at the Center for Strategic and 
International Studies (CSIS), testified to the House Foreign 
Affairs Committee's Subcommittee on Asia and the Pacific that 
the July S&ED and Cyber Working Group meetings ``are an 
important step that, if it succeeds, will make the situation in 
Asia more stable.'' He added, ``We are looking at a long effort 
and the S&ED process will need to be sustained and 
reinforced.'' \37\
---------------------------------------------------------------------------
    * A CERT is an organization that is devoted to preventing and 
resolving cybersecurity problems and provides information regarding 
cyber threats and vulnerabilities to government agencies, companies, 
and other organizations. For an example of a CERT, see US-CERT, ``About 
Us'' (Washington, DC: U.S. Department of Homeland Security). http://
www.us-cert.gov/about-us.

---------------------------------------------------------------------------
China Shifts on International Law and Cyberspace

    In what appears to be a break with the past, China in June 
2013 agreed in a United Nations (UN) report that international 
law, which includes the law of armed conflict,* extends to 
cyberspace. The report states, ``International law, and in 
particular the Charter of the United Nations, is applicable and 
is essential to maintaining peace and stability and promoting 
an open, secure, peaceful and accessible [information and 
communication technology] environment.'' \38\ In addition, 
China agreed that ``states must meet their international 
obligations regarding internationally wrongful acts 
attributable to them. States must not use proxies to commit 
internationally wrongful acts. States should seek to ensure 
that their territories are not used by non-state actors for 
unlawful use of [information and communication technologies].'' 
\39\ This statement is based on the contents of the UN's 
Articles on Responsibility of States for Internationally 
Wrongful Acts, also known as the law of state 
responsibility.\40\ The UN Group of Governmental Experts on 
Developments in the Field of Information and Telecommunications 
in the Context of International Security, which includes China, 
the United States, Russia, and 12 other countries, agreed on 
the report's contents when the group convened in New York.\41\
---------------------------------------------------------------------------
    * The law of armed conflict, which is also known as international 
humanitarian law, includes principles such as distinction between 
military and civilian targets, proportionality, military necessity, and 
limitation. International Committee of the Red Cross, ``The Law of 
Armed Conflict: Basic Knowledge,'' June 2002, pp. 12-14. http://
www.icrc.org/eng/assets/files/other/law1----final.pdf.
---------------------------------------------------------------------------
    James Mulvenon, vice president of Defense Group Inc.'s 
Intelligence Division, at the roundtable on U.S.-China 
cybersecurity issues held by the Commission on July 11, said, 
``The Chinese made a dramatic reversal on their view about how 
the laws of armed conflict did not apply to the cyber 
dimension, which was a showstopper for DoD about [the 
department] being involved in any confidence building measures 
[with China].'' \42\ While the Chinese government does not 
appear to have publicly asserted its stance on the 
applicability of the law of armed conflict and the law of state 
responsibility to cyberspace prior to the UN report, U.S. 
experts and media reports indicate that in the past Beijing has 
not agreed that these laws apply to activities in 
cyberspace.\43\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Impact of Snowden Leaks on U.S. Efforts to Stop Chinese Cyber Espionage
 
  In June 2013, Edward Snowden, a former contractor for the U.S.
National Security Agency (NSA) alleged NSA has conducted cyber
operations against hundreds of Hong Kong and mainland Chinese
targets.\44\ Addressing Mr. Snowden's allegations, a
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Impact of Snowden Leaks on U.S. Efforts to Stop Chinese Cyber Espionage--
 
spokesperson for China's Ministry of National Defense said, ``To, on the
 one hand, abuse one's advantages in information technology for selfish
 ends, while on the other hand, making baseless accusations against
 other countries, shows double standards that will be of no help for
 peace and security in cyberspace.'' \45\ Despite the Obama
 Administration's efforts to distinguish what it calls ``cyber-enabled
 economic espionage'' or ``cyber-enabled theft of trade secrets'' from
 government-to-government espionage,\46\ some observers expect Mr.
 Snowden's allegations to set back U.S. efforts on U.S.-China
 cybersecurity issues by at least six months. Dr. Mulvenon said, ``I
 don't really think we're going to make a lot of progress for a while. .
 . . I would say it's probably going to delay progress six to twelve
 months.'' \47\ However, an official at the U.S. embassy in Beijing told
 the Commission Mr. Snowden's allegations had not affected private
 discussions with the Chinese government on cyber theft of intellectual
 property.
 
------------------------------------------------------------------------


Developments Related to Chinese Information Technology Companies

    An October 2012 report by the U.S. House Permanent Select 
Committee on Intelligence (HPSCI) characterized China's two 
largest telecommunication equipment companies, Huawei and ZTE, 
as a risk to U.S. national security because they could 
facilitate intelligence collection by the Chinese government. 
The report advised U.S. companies against using products or 
services provided by Huawei and ZTE.* \48\ During an interview 
with the Australian Financial Review in July 2013, former 
director of the Central Intelligence Agency and NSA, General 
Michael Hayden (Retd.), confirmed and augmented the HPSCI's 
findings regarding Huawei. When asked to verify whether he 
believed ``it is reasonable to assume that hard evidence exists 
that Huawei has engaged in espionage on behalf of the Chinese 
state,'' General Hayden said, ``Yes, that's right.'' He then 
added, ``At a minimum, Huawei would have shared with the 
Chinese state intimate and extensive knowledge of the foreign 
telecommunications systems it is involved with. I think that 
goes without saying.'' \49\
---------------------------------------------------------------------------
    * For more details on the HPSCI report, see U.S.-China Economic and 
Security Review Commission, 2012 Annual Report to Congress (Washington, 
DC: U.S. Government Printing Office, November 2012), p. 164.
---------------------------------------------------------------------------
    Huawei and ZTE continue to issue public assurances that 
they do not pose a security threat.\50\ For example, Huawei's 
president Ren Zhengfei said during his first interview with a 
media organization in May 2013 that his company would not 
assist the Chinese government with collecting foreign 
intelligence if asked.\51\
    Despite widespread concerns about the national security 
risks posed by Huawei and ZTE, Bloomberg reported in August 
2013 that the U.S. General Services Administration (GSA) 
authorized U.S. government agencies to procure a 
videoconferencing system produced by ZTE and Prescient, a 
division within U.S. company CyberPoint International LLC, in 
November 2012. According to an executive at CyberPoint, 
Prescient produced hardware and software to enhance the 
security of the system, which was originally made by ZTE. He 
said, due to these alterations, it now was a ``Made-in-America 
product.'' \52\ However, in September 2013, U.S. Customs and 
Border Protection concluded the system should still be 
considered a Chinese product, because ``the Chinese-origin 
Video Board and the Filter Board impart the essential character 
to the video teleconferencing server.'' \53\ GSA subsequently 
took the system off the list of products agencies can buy. Even 
before the decision, no U.S. agencies had purchased this 
product.\54\
    In a meeting in May 2013, Commissioners and DoD officials 
discussed DoD's interpretation of U.S. law regarding 
procurement sources. DoD officials indicated a stricter 
procurement evaluation standard that includes sourcing concerns 
could be applied only to items on the United States Munitions 
List. Items outside this list are judged by a different 
standard, which some officials believe might preclude concerns 
about the origin of products. For example, items procured for 
C4ISR * maintenance facilities are not subject to stricter 
scrutiny. Commissioners raised concerns that this 
interpretation of the law was limiting the department's ability 
to address potential risks arising from certain procurement 
sources. Commissioners urged DoD to expand the purview of the 
stricter standard to items beyond the munitions list.
---------------------------------------------------------------------------
    * C4ISR refers to command, control, communications, computers, 
intelligence, surveillance, and reconnaissance.
---------------------------------------------------------------------------
    DoD is currently moving in this direction. Section 806 of 
the National Defense Authorization Act (NDAA) for Fiscal Year 
2011 is intended to address the problem, but it has yet to be 
fully implemented. Section 806 authorizes the Secretary of 
Defense and the secretaries of the Army, Navy, and Air Force to 
reject procurement sources for information technology on 
grounds of protecting supply chain security if they receive a 
recommendation to do so from DoD.\55\ According to a DoD 
Congressional liaison, as of May, ``DoD has proceeded to 
implement NDAA Section 806, beginning with a number of table-
top exercises involving department procurement, legal, 
acquisition, engineering, and intelligence experts to expose 
any underlying issues with 806 implementation.'' \56\ In 
addition, DoD wrote the Defense Federal Acquisition Regulation 
Supplement Rule implementing Section 806 and, as of May, the 
rule was in the process of interagency coordination.\57\ These 
changes to DoD procurement ultimately may provide officials 
with the flexibility they need to protect all DoD systems. 
However, progress has been slow and the problem the 
Commissioners highlighted will remain until the new policy is 
implemented, potentially posing a threat to national security.

Security Implications of Cloud Computing in China

    ``Cloud computing, often referred to as simply `the cloud,' 
is the delivery of on-demand computing resources--everything 
from applications to data centers--over the Internet and on a 
pay-for-use basis,'' according to IBM.\58\ In Red Cloud Rising: 
Cloud Computing in China, a report for the Commission published 
in 2013, Defense Group Inc. (DGI) describes several potential 
cybersecurity concerns related to China and cloud computing, 
including the following:

     LMicrosoft licensed 21Vianet, a Chinese data 
center services company, to provide Office 365 and Windows 
Azure, two cloud computing products, to customers in China. 
Microsoft currently plans to link 21Vianet's data centers in 
China to Microsoft's data centers in other parts of Asia, 
Europe, and North America. As a part of this plan, Windows 
Azure users outside China could choose to store their data in 
data centers in China, and Azure users in China could store 
their data in other countries. Domestic Chinese law authorizes 
the government to ``inspect the electronic communication 
instruments and appliances and other similar equipment and 
installations'' of organizations operating in China. If the 
Chinese government accesses 21Vianet's data centers, it might 
then potentially connect to foreign data centers through the 
network Microsoft is planning. DGI states, ``This risk can be 
mitigated by designing the network with appropriate data 
segregation and limits on network administrator privileges.'' 
\59\

     LChina's Ministry of State Security (MSS), the 
country's main foreign intelligence collection agency, is 
closely connected with the Chongqing Special Cloud Computing 
Zone. In addition to being one of the central government 
agencies to authorize the establishment of the zone, the MSS 
has stated it is giving the zone ``leading guidance and 
corresponding requirements.'' \60\ The agency's connection to 
this cloud computing zone represents a potential espionage 
threat to foreign companies that might use cloud computing 
services provided from the zone or base operations there.\61\

     LSince Chinese domain registrars and Internet 
service providers typically are not vigilant about users 
employing their services to carry out nefarious activities 
against computers outside China, DGI writes, ``One can 
speculate that malicious use of Chinese cloud services may 
eventually take place at a higher rate than the cloud computing 
industry's global norm.'' \62\

     LGiven the widely acknowledged security weaknesses 
in networking hardware developed by Chinese companies and the 
shift toward use of this equipment in Chinese cloud 
infrastructure, ``it logically follows that use of this 
equipment may constitute an additional vulnerability in some 
Chinese cloud infrastructure, beyond the standard `baseline' 
level of vulnerability.'' \63\

    In addition, cloud computing could improve the PLA's C4ISR 
capabilities. DGI writes that cloud computing ``could enable 
more effective and flexible development and deployment of 
military equipment, while at the same time improving the 
survivability of the PLA's information systems by endowing them 
with greater redundancy (allowing a system's capabilities to 
survive the disabling or destruction of any individual node).'' 
\64\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Deterring Chinese Cyber Theft against U.S. Companies
 
  There are no indications the public exposure of Chinese cyber
espionage in technical detail throughout 2013 has led China to change
its attitude toward the use of cyber espionage to steal intellectual
property and proprietary information. Mandiant's revelations merely led
Unit 61398 to make changes to its cyber ``tools and infrastructure,''
causing future intrusions to be harder to detect and attribute.65
Richard Bejtlich, chief security officer at Mandiant, said Unit 61398
decreased its activity for about one month following the publishing of
Mandiant's report in February.\66\ Former and current U.S. officials
said the U.S. government's sharing of IP addresses with Internet service
providers contributed to this reduction in activity.\67\ However, Mr.
Bejtlich said Unit 61398 remains active but at lower levels compared to
the period before Mandiant's report was released.\68\
  It is clear naming and attempting to shame will not be sufficient to
deter entities in China from engaging in cyber espionage against U.S
companies. Mitigating the problem will require a long-term and
multifaceted approach that centers on changing China's cost-benefit
calculus.\69\ Congress, the Obama Administration, and outside experts
are discussing a number of potential U.S. actions and policies,
including the following:
 
  Link Chinese economic cyber espionage to trade restrictions. An
example of such a measure is the Deter Cyber Theft Act (S. 884), a
bipartisan bill introduced in the Senate in May 2013. The bill requires
the U.S. intelligence community to identify goods it assesses to have
been ``manufactured or otherwise produced using technologies or
proprietary information'' that was ``developed by United States
persons'' and acquired through cyber espionage. It calls on the
President to block the import of these goods if the President deems it
necessary for safeguarding intellectual property rights or the DoD
supply chain.\70\
 
  Prohibit Chinese firms using stolen U.S. intellectual property from
accessing U.S. banks. In May 2013, the Commission on the Theft of
American Intellectual Property (hereafter ``the IP Commission''),*
released a report that examines the pilfering of U.S. intellectual
property and presents policy recommendations to address the problem. The
IP Commission recommends the U.S. government ``deny the use of the
American banking system to foreign companies that repeatedly benefit
from the misappropriation of American intellectual property.'' \71\ Roy
Kamphausen, senior advisor for political and security affairs at the
National Bureau of Asian Research and the deputy executive director for
the IP Commission, explained at the Commission's roundtable the U.S.
government could determine whether or not a foreign company should be
sanctioned based on a combination of information from commercial or
government sources, and well-defined bench-
 
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * The IP Commission was co-chaired by Dennis Blair, former U.S. 
director of national intelligence, and Jon Huntsman, former U.S. 
ambassador to China.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Deterring Chinese Cyber Theft against U.S. Companies--Continued
 
marks, such as the results of legal cases in the past involving the
 company.\72\
 
  Ban U.S. travel for Chinese organizations that are involved with cyber
espionage. Dr. Mulvenon suggested to the Commission the United States
needs ``to create a constituency of people in China who want to succeed
but are being harmed by government cyber espionage efforts that they had
nothing to do with.'' He believes placing Chinese companies and
universities involved with cyber espionage on a list of entities that
are barred from entry into the United States would help to build this
constituency. However, Dr. Mulvenon warned this policy would have to be
implemented carefully and deliberately, because sanctioning Chinese
companies that are connected to foreign multinational companies ``would
be self-defeating in some cases.'' \73\ For example, if a U.S. company
has a partnership with a Chinese company, such measures might hinder the
U.S. company's ability to do business with its Chinese partner.
 
  Use counterintelligence techniques, such as deliberately providing
incorrect information to cyber spies to ``poison the well.'' \74\ Dr.
Mulvenon explained to the Commission this could lead the Chinese
government ``to spend more and more resources actually figuring out
whether things are true or not.'' He argued, ``The more problems they
have in that system will lead them to begin to accelerate the trends
toward centralization of authority and decision-making, and . . . I
think the goal of our policy should be to make it as difficult to get a
computer network exploit operation approved in the Chinese system as it
is currently in our system.'' * \75\ However, David Merkel, Mandiant's
chief technology officer, doubts the effectiveness of this tactic. He
said, ``Those kinds of techniques can be effective in highly-targeted
ways, used by specialists to get some particular result like learning
more information about an adversary . . . but as some kind of broad-
based defense or mechanism to change the economics of stealing digital
information, I just don't see it.'' \76\ Mr. Merkel explained, ``When I
go take a look at a large organization and the challenges it has
managing its own legitimate information, and then you talk about
managing legitimate disinformation and being able to tell one from the
other and being able to make decisions based on what happens with it
seems pretty far fetched.'' \77\
 
  Encourage the U.S. government, military, and cleared defense
contractors to implement measures to reduce the effectiveness of Chinese
cyber operations and increase the risk of conducting such operations for
Chinese organizations. For example, the IP Commission recommends
measures such as ``meta-tagging, water-
 
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * Dr. Mulvenon said that in China there is a ``bottom up, 
grassroots, entrepreneurial sort of cyber espionage framework.'' He 
described U.S. cyber espionage as ``top down . . . and controlled,'' 
and involving a great deal of oversight. U.S.-China Economic and 
Security Review Commission, Roundtable: U.S.-China Cybersecurity Issues 
(Washington, DC: July 11, 2013).


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Deterring Chinese Cyber Theft against U.S. Companies--Continued
 
marking, and beaconing,'' \78\ because they can help identify sensitive
 information and code a digital signature within a file to better detect
 intrusion and removal.\79\ These tags also might be used as evidence in
 criminal, civil, or trade proceedings to prove data was stolen.
 
  Clarify the legal rights of companies, and the types of action that
are prohibited, regarding finding and recovering intellectual property
that is stolen through cyber intrusions. Mr. Kamphausen said U.S.
companies ``need the right tools that afford them the protections, legal
and otherwise, so that they can do what's in their own interest.'' \80\
 
  Pass legislation permitting U.S. companies to conduct offensive cyber
operations in retaliation against intrusions into their networks. Such
operations could range from ``actively retrieving stolen information''
to ``physically disabling or destroying the hacker's own computer or
network.'' The IP Commission explores this option in its report but
ultimately does not endorse it at the current time, because the
possibility that retaliatory actions could significantly impair neutral
computers or networks makes this option undesirable.\81\
 
  Improve opportunities for U.S. companies to pursue legal action in the
United States against Chinese commercial espionage. The IP Commission
recommends the Economic Espionage Act (18 U.S.C. Sec.  1831-1839) be
amended to ``provide a federal private right of action for trade secret
theft.'' \82\ Mr. Kamphausen explained, ``This essentially means you can
bring your own [law] suit. You don't have to wait for the government to
take one up on your behalf.'' \83\
 
  Shift jurisdiction for all appeals in Economic Espionage Act cases to
the Court of Appeals for the Federal Circuit. The IP Commission
recommends Congress ``make the Court of Appeals for the Federal Circuit
(CAFC) the appellate court for all actions under the [Economic Espionage
Act].'' \84\ At present, appeals in Economic Espionage Act cases are
handled by a court of appeals in one of the United States' 12 regional
circuits.\85\ The IP Commission writes, ``The CAFC serves as the
appellate court for nearly all IP-related cases, and thus has a high
degree of competency on IP issues. Making the CAFC the appellate court
for all [Economic Espionage Act] issues ensures a degree of continuity
in judicial opinion. Moreover, it helps support the federal circuit in
expanding extraterritorial enforcement.'' \86\
 
  Encourage U.S. companies and individuals to bring cases of cyber theft
of intellectual property to intellectual property courts in China.
According to Mr. Kamphausen, ``Enormous strides have been made within
the Chinese legal system with regard to protection of intellectual
property and then enforcement actions
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Deterring Chinese Cyber Theft against U.S. Companies--Continued
 
once cases are brought.'' \87\ In his comments, he indicated to the
 Commission these courts may become a viable option for U.S. companies
 seeking recourse when their intellectual property has been stolen.
  Furthermore, a variety of potential multilateral measures to deter
Chinese cyber theft are under discussion, including the following:
 
  Expand information sharing among countries regarding cyber threats.
For example, countries could create an international list of ``bad
players'' to which private companies could contribute information.\88\
 
  Include standards for safeguarding intellectual property in
negotiations of the Trans-Pacific Partnership (TPP) and the
Transatlantic Trade and Investment Partnership (T-TIP) agreements.\89\
Intellectual property rights is one of the issues partner countries are
discussing in these negotiations.\90\ However, the TPP negotiating
parties have yet to reach consensus on this issue. They met in Tokyo in
October 2013 to discuss the intellectual property chapter of the
TPP.\91\ The United States and the European Union only recently started
negotiating the T-TIP, thus discussions of intellectual property rights
in this forum are in the beginning stage.\92\
 
  Finally, some discussions focus on improving the U.S. government's
ability to develop and implement cyber policy as necessary steps to
address Chinese cyber theft. Suggestions include the following:
 
  Appoint a Cabinet-level official to oversee an interagency process
regarding the protection of intellectual property. According to the IP
Commission, this step is necessary, because executive branch ``efforts
to protect American intellectual property will involve literally
thousands of detailed actions--data gathering and research, interagency
coordination, work with the private sector, coordination with Congress,
and interactions with foreign government agencies.'' \93\ The IP
Commission adds this undertaking will involve ``expert officials across
many departments and agencies.'' \94\
 
  Enhance cooperation between the U.S. government and private companies.
During the Commission's roundtable, Bruce Quinn, vice president for
government relations with Rockwell Automation, stressed the importance
of improving cooperation between the U.S. government and the private
sector to protect U.S. intellectual property from cyber intrusions. Most
importantly, he said the government could provide companies with
information about threats to their intellectual property as well as
suggestions for protecting it. Mr. Quinn would like to see a model
whereby if a company shares information about a threat with the govern-
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Deterring Chinese Cyber Theft against U.S. Companies--Continued
 
ment, the government would later provide the company with a report
 detailing its understanding of that threat. He said the government
 should provide companies with a point-of-contact for information
 regarding cyber threats to intellectual property.* According to Mr.
 Quinn, this is particularly important for small- and medium-sized
 companies. He explained Rockwell has ``contacts with the government. .
 . . But these small- and medium-sized companies that funnel into us,
 that are critical to us being successful, they don't have that
 access.'' He suggested the U.S. Department of Commerce's Foreign
 Commercial Service could be this point-of-contact. Under such an
 arrangement, the Foreign Commercial Service would have access to threat
 information from other U.S. government agencies. He explained, ``It
 doesn't have to be detailed information, but it has to be enough that
 they can sensitize these small- and medium-sized manufacturers to the
 threat and make recommendations to them if they're looking at entering
 certain markets, how to best protect themselves, what to look for, what
 are the red flags.'' He also suggested, given the government's
 knowledge about cyber threats, the U.S. Defense Advanced Research
 Projects Agency could partner with U.S. companies to develop defensive
 technologies to combat cyber intrusions and then release those
 technologies for purchase by the public.\95\
 
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * This proposal differs from President Obama's February 2013 
executive order regarding cybersecurity, in that the executive order is 
focused on information sharing between the government and critical 
infrastructure providers. The White House, ``Executive Order--Improving 
Critical Infrastructure Cybersecurity'' (Washington, DC: February 12, 
2013). http://www.-whitehouse.-gov/the-press-office/2013/02/12/
executive-order-improving-critical-infrastructure-cybersecurity.

---------------------------------------------------------------------------
Implications for the United States

    China's cyber espionage against U.S. commercial firms poses 
a serious threat to U.S. business interests and competiveness 
in key industries. While it is clear the economic cost of cyber 
espionage to the United States is significant, precise numbers 
are impossible to calculate. A July 2013 interim report based 
on an ongoing study by McAfee and CSIS estimates the annual 
cost of both cyber crime  and cyber espionage targeting 
U.S. persons and entities is between $24 billion and $120 
billion. The report does not separate out the cost of cyber 
espionage, in particular, from the total amount or estimate the 
cost of cyber espionage originating from specific countries, 
such as China.\96\ The IP Commission Report assesses the damage 
to the U.S. economy due to the theft of intellectual property 
by all means to be around $300 billion a year. Using a range of 
estimates from prominent studies of this issue, the IP 
Commission states 50 to 80 percent of international 
intellectual property theft originates in China. The IP 
Commission Report lists what it appraises to be the numerous 
difficulties with calculating the cost of intellectual property 
theft, including using surveys of a sample of companies to draw 
conclusions about an entire sector or a variety of sectors.* 
\97\ General Keith Alexander, director of the NSA and commander 
of U.S. Cyber Command, assessed the cost to U.S. companies of 
intellectual property theft to be about $250 billion a year, 
although not all the losses are due to Chinese activity.\98\
---------------------------------------------------------------------------
     The McAfee and CSIS report defines cyber crime as the 
theft of financial assets, whereas the report's examination of cyber 
espionage is focused on the theft of intellectual property and 
confidential information from companies. James Lewis and Stewart Baker, 
The Economic Impact of Cybercrime and Cyber Espionage (Washington, DC: 
CSIS, July 22, 2013), pp. 8-11.
    * For the IP Commission's full assessment of the difficulties in 
calculating the cost of intellectual property theft, see The Commission 
on the Theft of American Intellectual Property, The IP Commission 
Report (Seattle, WA: The National Bureau of Asian Research, May 2013), 
pp. 23-30. http://www-.-ip-commission-.-org/report/
IP-_-Commission-_-Report-_-052213.pdf.
---------------------------------------------------------------------------
    The theft of trade secrets is a major concern for U.S. 
businesses with operations in China. The U.S.-China Business 
Council's 2013 survey of its members found they ``cited trade 
secrets as the intellectual property (IP) issue of most concern 
in China.'' \99\ If effective action to curb commercial 
espionage is not taken, this problem might worsen for U.S. 
companies. Dr. Lewis testified to the House Committee on Energy 
and Commerce's Subcommittee on Oversight and Investigations 
that although, ``for China, there has been a lag of several 
years, perhaps as many as ten, between successful acquisition 
through espionage and the ability to produce competing products 
(be they military or civil) . . . [the] lag time between 
acquisition and the appearance of a competing product based on 
stolen technology is decreasing, as China's ability to absorb 
and utilize technology has increased.'' \100\ This suggests the 
demand for U.S. intellectual property from within China could 
increase and with it the amount and value of intellectual 
property stolen.
    If Chinese companies are able to duplicate technology and 
products using intellectual property acquired by cyber theft 
from U.S. companies, they may be able to compete even more 
effectively with U.S. companies in markets worldwide. Stealing 
intellectual property could allow Chinese companies to forgo 
some of the time and expenditure necessary for research and 
development.\101\ Beyond theft of proprietary information 
regarding technology or products, the theft of corporate e-mail 
correspondence or internal documents can aid Chinese companies 
in competitive bidding for commercial contracts.\102\ In each 
of these cases, U.S. companies might lose revenue and lay off 
workers or even go out of business. The theft of intellectual 
property, if publicized, also might lead to a drop in a 
company's stock value.\103\ Moreover, the authors of the McAfee 
and CSIS report write, ``Cyber espionage and crime may slow the 
pace of innovation, distort trade, and create social costs from 
job loss. This larger effect may be more important than . . . 
[the] actual number [of dollars lost].'' \104\
    China's cyber espionage also has security implications. 
Information gained from intrusions into the networks of U.S. 
military contractors likely improves China's insight into U.S. 
weapon systems, enables China's development of countermeasures, 
and shortens China's research and development timelines for 
military technologies.\105\ In addition, the same intrusions 
Chinese cyber actors use for espionage also could be used to 
prepare for offensive cyber operations. Chinese cyber actors 
could place latent capabilities in U.S. software code or 
hardware components that might be employed in a potential 
conflict between the United States and China.

Conclusions

 LThe Chinese government is directing and executing a 
large-scale cyber espionage campaign against the United States 
and to date has successfully targeted the networks of U.S. 
government and private organizations, including those of DoD 
and private firms. These activities are designed to achieve a 
number of broad economic and strategic objectives, such as 
gathering intelligence, providing Chinese firms with an 
advantage over their competitors worldwide, advancing long-term 
research and development objectives, and gaining information 
that could enable future military operations.

 LChina has not reduced its cyber intrusions against 
the United States despite recent public exposure of Chinese 
cyber espionage in technical detail. This suggests Beijing has 
decided to continue its cyber campaign against the United 
States.

 LDevelopments in cloud computing in China may present 
cybersecurity risks for U.S. users and providers of cloud 
computing services. The relationship between China's Ministry 
of State Security and the Chongqing Special Cloud Computing 
Zone represents a potential espionage threat to foreign 
companies that might use cloud computing services provided from 
the zone or base operations there. In addition, the plan to 
link 21Vianet's data centers in China and Microsoft's data 
centers in other countries suggests the Chinese government one 
day may be able to access data centers outside China through 
Chinese data centers.

 LThere is an urgent need for Washington to take action 
to prompt Beijing to change its approach to cyberspace and 
deter future Chinese cyber theft. Actions and policies under 
discussion include the following: passing new legislation or 
modifying existing legislation; changing the cost-benefit 
calculus of Chinese cyber actors and China's leaders through 
sanctions and counterintelligence tactics; undertaking 
multilateral measures; appointing a Cabinet-level official to 
oversee an interagency process regarding the protection of 
intellectual property; and enhancing cooperation between the 
U.S. government and the private sector. These would be more 
effective if used in combination, as they probably would lead 
Beijing to make only temporary or minor changes to its cyber 
espionage activities if used in isolation.

                     ENDNOTES FOR SECTION 2

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     93. The Commission on the Theft of American Intellectual Property, 
The IP Commission Report (Seattle, WA: The National Bureau of Asian 
Research, May 2013), p. 63. http://www.ipcommission.org/report/
IP----Commission----Report----052213.pdf.
     94. The Commission on the Theft of American Intellectual Property, 
The IP Commission Report (Seattle, WA: The National Bureau of Asian 
Research, May 2013), p. 63. http://www.ipcommission.org/report/
IP----Commission----Report----052213.pdf.
     95. U.S.-China Economic and Security Review Commission, 
Roundtable: U.S.-China Cybersecurity Issues (Washington, DC: July 11, 
2013).
     96. James Lewis and Stewart Baker, The Economic Impact of 
Cybercrime and Cyber Espionage (Washington, DC: CSIS, July 22, 2013), 
p. 5. http://csis.org/files/publication/60396rpt----cybercrime-
cost----0713----ph4----0.pdf.
     97. The Commission on the Theft of American Intellectual Property, 
The IP Commission Report (Seattle, WA: The National Bureau of Asian 
Research, May 2013), pp. 2-3, 23. http://www.ipcommission.org/report/
IP----Commission----Report----052213.-pdf.
     98. Josh Rogin, ``NSA Chief: Cybercrime Constitutes the `Greatest 
Transfer of Wealth in History,' '' Foreign Policy, July 9, 2012. http:/
/thecable.foreignpolicy.com/posts/2012/07/09/
nsa--_-chief--_ cybercrime--_-constitutes--_-the--_ greatest--_-transfer
--_-of--_-wealth--_ in--_-history.
     99. U.S.-China Business Council, ``Shanghai: Battling Trade 
Secrets and Data Theft in China.'' http://www.uschina.org/battling-
trade-secrets-and-data-theft-china.
    100. House Committee on Energy and Commerce, Subcommittee on 
Oversight and Investigations, Hearing on Cyber Espionage and the Theft 
of U.S. Intellectual Property and Technology, written testimony of 
James A. Lewis, 113th Cong., 1st sess., July 9, 2013.
    101. Mike McConnell, Michael Chertoff, and William Lynn, ``Cyber 
Thievery is National Policy--And Must be Challenged,'' Wall Street 
Journal, January 27, 2012. http://online.wsj.com/article/
SB1000--14240529702037--18504577--178832338032--176.html.
    102. U.S.-China Economic and Security Review Commission, 
Roundtable: U.S.-China Cybersecurity Issues (Washington, DC: July 11, 
2013); James Lewis and Stewart Baker, The Economic Impact of Cybercrime 
and Cyber Espionage (Washington, DC: CSIS, July 22, 2013), p. 10. 
http://csis.org/files/publication/60396rpt----cybercrime-
cost----0713----ph4----0.pdf.
    103. The Commission on the Theft of American Intellectual Property, 
The IP Commission Report (Seattle, WA: The National Bureau of Asian 
Research, May 2013), p. 10. http://www.ipcommission.org/report/
IP----Commission----Report----052213.pdf.
    104. James Lewis and Stewart Baker, The Economic Impact of 
Cybercrime and Cyber Espionage (Washington, DC: CSIS, July 22, 2013), 
p. 5. http://csis.org/files/publication/60396rpt----cybercrime-
cost----0713----ph4----0.pdf.
    105. Ellen Nakashima, ``Confidential Report Lists U.S. Weapons 
System Designs Compromised by Chinese Cyberspies,'' Washington Post, 
May 27, 2013. http://www.washingtonpost.com/world/national-security/
confidential-report-lists-us-weapons--system-designs-compromised-by-
chinese-cyberspies/2013/05/27/a42c3e1c-c2dd-11e2-8c-3b--
0b5e9247e8ca----story.html.
                  SECTION 3: CHINA'S MARITIME DISPUTES

Introduction
    This section provides an overview of China's East China Sea 
and South China Sea disputes, covering the drivers of Beijing's 
approach to the disputed waters, the means by which China is 
asserting sovereignty in those areas, the risks of escalation 
or miscalculation at sea, and the consequential dangers of 
political or military escalation. It is based on witness 
testimonies from Commission hearings; information from the 
Commission's fact-finding trips to China, Japan, and Taiwan; 
and additional research. This section primarily focuses on the 
East China Sea; the South China Sea was covered in detail in 
chapter 3, section 1, of the Commission's 2012 Annual Report.

Maritime Dispute Overview
    Peter Dutton, professor and director of the China Maritime 
Studies Institute at the U.S. Naval War College, testified to 
the Commission that China's overall interests and objectives in 
the East and South China Seas include:

        . . . enhancing China's sense of national security, 
        acquiring control over the region's living and non-
        living maritime resources, and restoring China's place 
        of pre-eminence in the East Asian regional order . . . 
        Additionally, consolidating Chinese state power over 
        the offshore islands and regional seas serves the 
        Communist Party's interest in maintaining internal 
        political credibility by delivering to the Chinese 
        people what they believe is rightfully their own.\1\

    Although sovereignty disputes in the East and South China 
Seas are not new, China's growing diplomatic, economic, and 
military clout is improving China's ability to assert its 
interests. It is increasingly clear that China does not intend 
to resolve the disputes through multilateral negotiations or 
the application of international laws and adjudicative 
processes but instead will use its growing power in support of 
coercive tactics that pressure its neighbors to concede China's 
claims.

East China Sea Dispute Background
    The East China Sea dispute involves China, Japan, and 
Taiwan (see figure 1).* The dispute can be divided into two 
distinct issues: territorial sovereignty over the Senkaku 
Islands (known as Diaoyu Dao in China, and Diaoyutai in 
Taiwan), and demarcation of maritime zones, which has 
implications for natural resource rights.
---------------------------------------------------------------------------
    * For a discussion of Taiwan's role in China's maritime disputes, 
see chapter 3, section 2, of this Report, ``Taiwan.''
---------------------------------------------------------------------------
    China's most intense dispute in this area relates to 
territorial sovereignty over the Senkaku Islands, eight 
uninhabited islets that lie approximately 120 nautical miles 
(nm) northeast of Taiwan, and 240 nm southwest of Japan's 
Okinawa Island. China and Taiwan rely on a historical 
foundation as far back as the Ming Dynasty (1368-1644) to 
justify their claims to the islands. According to China's 
official narrative, Japan ``secretly `included' Diaoyu Dao in 
its territory at the end of the Sino-Japanese War of 1894-1895. 
Japan then forced China to sign the unequal Treaty of 
Shimonoseki,'' ceding the Senkaku Islands and Taiwan to 
Japan.\2\
    Japan administers the Senkaku Islands and asserts there is 
no territorial dispute over the islands. When Japan made an 
official declaration incorporating the Senkaku Islands into 
Japanese territory in 1895, it considered them uninhabited land 
without an owner. The United States administered the islands 
following the 1951 Treaty of San Francisco officially 
concluding World War II until the 1971 Okinawa Reversion Treaty 
came into force. This treaty transferred administrative rights 
over the Senkaku Islands to Japan while maintaining U.S. 
neutrality on the ultimate sovereignty of the islands.\3\ Japan 
argues China did not express an interest in the islands until a 
1968 United Nations (UN) study suggested the possibility of 
petroleum resources in the East China Sea.\4\
    The Japanese government's September 2012 purchase of three 
of the Senkaku Islands from a private Japanese owner angered 
China, sparking an escalation in tensions between China and 
Japan.* \5\ Beijing immediately responded by issuing a 
Government Statement, its highest-level diplomatic document, 
which for the first time includes map coordinates to its claims 
in the East China Sea. Later that month, China's State 
Council released a white paper on the Senkakus, its first ever 
on a territorial dispute, which stated the ``Diaoyu Dao is 
China's inherent territory in all historical, geographical, and 
legal terms, and China enjoys indisputable sovereignty over 
Diaoyu Dao.'' \6\
---------------------------------------------------------------------------
    * For more information on the background and domestic aftermath of 
the Senkaku Islands purchase in China, reference the East China Sea 
subsection in chapter 2, section 1, of the Commission's 2012 Annual 
Report, ``China's Impact on U.S. Security Interests, '' pp. 133-135.
     Government Statements represent China's highest-level, 
most authoritative message. Prior to this incident, China had only 
twice issued a Government Statement--once regarding the Sino-Vietnamese 
War and once regarding the 1999 destruction of China's embassy in 
Belgrade during U.S. bombing operations. Open Source Center, ``China 
Shows No Sign of Easing Tough Public Posture on Senkakus,'' September 
14, 2012. OSC ID: CPF-2012-0914534001. http://www-.-open-source-.-gov; 
J. Ashley Roach, ``China's Straight Baseline Claim: Senkaku (Diaoyu) 
Islands,'' American Society of International Law Insights, February 13, 
2013. http://www-.-asil-.-org/pdfs/insights/insight-130213.pdf.
---------------------------------------------------------------------------
    A separate but equally important dispute among China, 
Japan, and Taiwan is over rights and interests (including 
natural resource extraction) involving maritime demarcation of 
overlapping exclusive economic zones (EEZ) within the East 
China Sea. The dispute--which primarily concerns the Chunxiao 
(Shirakaba in Japanese) Gas Field--is mainly a result of 
differing interpretations of the United Nations Convention on 
the Law of the Sea (UNCLOS). Among many other provisions, 
UNCLOS allots nations an EEZ out to 200 nm from their coastal 
baselines.= Although a coastal nation cannot claim full 
sovereignty in an EEZ, it does have sovereign rights to 
explore, exploit, and protect natural resources, including 
fisheries, in this zone.\7\ UNCLOS also provides similar rights 
over natural resources, with the exception of fishing, in an 
extended continental shelf zone up to 150 nm beyond a country's 
EEZ, subject to certain restrictions based on seafloor 
geography.\8\
---------------------------------------------------------------------------
    = One nautical mile is approximately equal to 1.15 statute miles. 
Therefore, 200 nautical miles is roughly 230.16 statute miles.
---------------------------------------------------------------------------
    Because the maritime distance between China and Japan in 
the East China Sea is less than 400 nm, neither China nor Japan 
can claim a full EEZ in this region. Japan proposes a median 
line between the two countries as an attempt to divide EEZ 
rights evenly. China claims an extension of its continental 
shelf eastward past the median line to the Okinawa Trough and 
in December 2012 formalized its position in a claim submission 
to the United Nations.\9\

                     Figure 1:  The East China Sea



    Source: Mark Manyin, Senkaku (Diaoyu/Diaoyutai) Islands Dispute: 
U.S. Treaty Obligations (Washington, DC: Congressional Research 
Service, January 2013).

South China Sea Dispute Background

    Six parties claim the South China Sea in part or in full: 
China, Taiwan, Vietnam, the Philippines, Malaysia, and Brunei. 
Beijing denotes its claim on its South China Sea maps using a 
nine-dash line, with an additional dash off the coast of Taiwan 
to demonstrate its claim over Taiwan (see figure 2). Also in 
dispute are two sets of island groups: the Paracel Islands, 
located in the northern part of the sea, and the Spratly 
Islands, a widespread collection of approximately 200 islands, 
islets, rocks, and reefs located in the southern part of the 
South China Sea. China occupies the Paracel Islands, though 
Taiwan and Vietnam also lay claim to them. While all claimants 
except Brunei have established military outposts in the Spratly 
Islands, China and Vietnam occupy the greatest number of 
outposts.* For a comprehensive discussion of the South China 
Sea dispute, see chapter 3, section 1, of the Commission's 2012 
Annual Report, ``China and the South China Sea.''
---------------------------------------------------------------------------
    * For more information on Taiwan's claims and outposts and for 
another map depiction of the South China Sea, see chapter 3, section 2, 
of this Report, ``Taiwan.''

                     Figure 2:  The South China Sea



    Source: U.S. State Department. From U.S. Energy Information 
Administration, South China Sea (Washington, DC: February 2013). http:/
/www.eia.gov/countries/regions-topics.cfm?fips=SCS.

China's Overall Approach to Maritime Disputes

    At the Commission's hearing on China's maritime disputes, 
two longtime China watchers concluded that China is seeking to 
change the status quo in its favor in both the East and South 
China Seas. Rear Admiral Michael McDevitt, USN (Retd.), senior 
fellow at CNA Center for Naval Analysis, said in testimony to 
the Commission that China has taken a ``proactive approach 
toward creating a new, [more] favorable status quo'' with 
regard to its maritime disputes. He assessed Beijing has been 
more assertive since 2012, offering rival claimants the choice 
of either facing the brunt of Chinese power as a result of 
challenging Chinese claims or benefitting from economic and 
political rewards for moderating their positions or even 
acquiescing to China's claims.\10\
    Michael Swaine, senior associate at the Carnegie Endowment 
for International Peace, emphasized in his testimony that 
Beijing has in some instances ``responded in a deliberately 
escalatory manner'' to perceived attempts by China's rival 
claimants to secure territorial gains in the disputed waters, 
``seeking to create a new status quo in its favor or to 
undertake a more muscular or aggressive action in order to 
convey resolve and deter further escalation by others.'' \11\ 
For example, Beijing appears to have calculated that Japan's 
purchase of the Senkaku Islands provided a justification to 
deploy a regular maritime presence supporting a new status quo 
in China's favor.\12\
    Chinese official statements and use of maritime law 
enforcement rather than military forces suggest Beijing prefers 
to avoid direct military conflict over its maritime disputes 
and rely on the shift in the balance of regional power in its 
favor to resolve its maritime disputes in the long term.\13\ 
China probably judges that as a result of its growing power and 
influence vis-a-vis other claimants to the East and South China 
Seas, time is on its side with regard to consolidating control 
over its maritime claims.

Drivers of China's Approach to Maritime Disputes
Nationalism
    The new Chinese Communist Party (CCP) leadership has 
affirmed that it intends to continue governing China without 
resort to elections or other democratic processes, and the CCP 
has long been aware that the absence of democratic legitimacy 
tends to undermine the stability of its rule. As a result, the 
CCP places a high priority on legitimizing itself by convincing 
the Chinese people that it is delivering economic growth, a 
better quality of life, and an assertion of China's ascendance 
regionally and globally.
    In fact, Beijing has long used the education system and 
media to cultivate an awareness of China's victimization during 
what China calls its century of humiliation from the mid-19th 
to the mid-20th centuries.\14\ By promoting a sense of 
grievance among the Chinese people, and then aggressively 
asserting China's claims against its neighbors, the CCP shifts 
attention away from the authoritarian nature of its rule and 
toward its role as the champion of China's interests in the 
region.
    China not only takes an aggressive stance in the region to 
satisfy the nationalistic impulse it has promoted; it also uses 
nationalism domestically to support its regional claims. 
Jessica Chen Weiss, assistant professor of political science at 
Yale University, testified to the Commission: ``The Chinese 
government has allowed nationalist street demonstrations when 
it wants to demonstrate resolve to signal that China will not 
budge on [an] issue. Just as the [U.S.] president can point to 
Congress and say his hands are tied, so can the Chinese 
leadership point to nationalist fervor and say that they can't 
compromise or else protestors will turn against them.'' \15\
    For example, Beijing permitted large-scale, anti-Japanese 
demonstrations in the fall of 2012 following the Japanese 
government's purchase of several of the Senkaku Islands. 
Demonstrations in China's second- and third- tier cities even 
became destructive, damaging storefronts of Japanese companies, 
such as Toyota and Panasonic.\16\
    On the other hand, the Chinese government suppresses 
popular nationalism if it believes doing so will help it 
achieve its diplomatic objectives.\17\ For example, in a move 
attributed to Beijing, the Hong Kong government in August 2013 
prevented a group of anti-Japan activists from sailing to the 
Senkaku Islands as they did in 2012 to mark the anniversary of 
Japan's World War II surrender.\18\ Beijing likely judged 
popular Chinese animosity toward Japan threatened a potentially 
volatile public backlash that it might not be able to manage or 
exploit to its advantage. However, as Dr. Weiss testified, 
suppressing nationalist sentiment is ``costly for the Chinese 
government, which has often been accused [by its people] of 
being both unpatriotic and undemocratic in suppressing 
nationalist sentiment.'' \19\

Sovereignty and ``Core Interests''

    China's view of ``indisputable sovereignty'' over its 
maritime claims underlies its overall policy approach to the 
East and South China Seas.\20\ As tensions involving China's 
maritime disputes in the East China Sea and South China Sea 
have grown since 2009, official and unofficial Chinese sources 
indicate China views the East and South China Seas as central 
to its ``core interests,'' which authoritative Chinese speeches 
and documents define as (1) national security; (2) sovereignty 
and territorial integrity; and (3) economic and social 
sustained development.\21\ Beijing makes core interest 
declarations to signal to other countries that China is 
unwilling to compromise on particular policy issues and to 
imply that China would use force to defend its core interests. 
These declarations usually relate to matters regarding China's 
territorial sovereignty, such as Taiwan, Tibet, and 
Xinjiang.\22\
    China appears to have overtly linked the South China Sea 
and East China Sea to China's core interests in recent years.* 
\23\ Japanese commentators expressed concern that the 
designation of the Senkaku Islands as a core interest in April 
signaled a shift in Beijing's approach to the maritime dispute 
and indicated China ``will make no concessions on the islets.'' 
\24\ Subsequent official Chinese statements have not clarified 
the status of the islands, allowing Beijing to maintain 
flexibility in its approach to the dispute, prevent any 
domestic accusations that China is adopting a weaker stance, 
and deny that it is taking unilateral actions or escalating 
tensions.\25\
---------------------------------------------------------------------------
    * According to Japanese press reports, a Chinese Ministry of 
Foreign Affairs spokesperson stated in a regular press briefing that 
``[t]he Diaoyu [Senkaku] Islands are about sovereignty and territorial 
integrity. Of course, it's China's core interest.'' An official 
Ministry of Foreign Affairs transcript quotes the spokesperson as 
saying the issue of the contested islands ``touches on'' China's core 
interests. Kyodo, ``China Says Senkaku Islands are its `Core Interest,' 
'' April 26, 2013. OSC ID: JPP-2013-0426969071. http://
www-.-open-source-.-gov; Open Source Center, ``China-Japan--Video of 
PRC Remarks on Senkakus as `Core Interest' Differs from Official 
Transcript,'' May 7, 2013. OSC ID: CPP-2013-0507358001. http://
www-.-open-source-.-gov.

---------------------------------------------------------------------------
Economic Development

    China also views the East and South China Seas as central 
to its economic development, due to their resource potential 
and significant roles as maritime transit routes. Though 
nationalism has a stronger pull on China's foreign policy-
making levers with regard to its maritime disputes, natural 
resources are significant because they galvanize popular 
nationalist sentiment.\26\

    Oil and Gas Resources: China's surging economy has made the 
country increasingly dependent on oil and gas to supply its 
growing industrial and manufacturing base. However, hydrocarbon 
reserves in the East and South China Seas would provide only 
modest relief to the heavy energy demands of many of the 
surrounding Asian economies, according to Lloyd Thrall, project 
associate at the RAND Corporation.\27\ Additionally, the 
financial feasibility of exploiting oil and gas reserves in 
these areas is limited at best. In the South China Sea, the 
risk and cost of recovering deepwater oil and gas in contested 
waters prone to unusually strong currents and tropical storms 
heavily outweighs the minimal benefit of yet-to-be-proven 
hydrocarbons.\28\ Nevertheless, the speculation and perceived 
economic value of natural resources in both seas fuels the 
narrative of competition and sovereignty by the respective 
claimants.\29\

    Maritime Trade Routes: The East and South China Seas play 
central roles in the transport of oil and gas to China's 
coastal regions, which serve as the engines of China's economic 
growth.\30\ According to the U.S. Energy Information 
Administration, almost a third of the world's crude oil passes 
through the South China Sea, with about 15 percent of this 
volume moving on to Northeast Asia and the East China Sea.\31\ 
Additionally, over half of the world's traded liquefied natural 
gas (LNG) passes through the South China Sea. China's reliance 
on this trade route is projected to grow significantly in the 
coming two decades due to increasing LNG consumption. As Steven 
Lewis, fellow and professor at Rice University, testified to 
the Commission: ``The future economic growth of China's most 
prosperous cities and provinces is one heavily tied to massive 
fleets of LNG carriers (with four or five times the number of 
vessels used today)'' transiting the East and South China 
Seas.\32\

    Fisheries: According to Mr. Thrall, ``Fishermen in East and 
Southeast Asia are potent national symbols . . . to have 
fishermen denied their livelihood in areas perceived as 
historical fishing grounds, or, worse yet, detained or facing 
violence can strike deeply discordant notes'' within China. 
\33\ This dynamic helps explain the nationalist sentiment in 
China that followed the detention of the captain of a Chinese 
fishing trawler upon his collision with a Japanese Coast Guard 
(JCG) vessel in September 2010. Similar sentiments are 
prevalent across the region; the death of a Taiwan fisherman in 
May 2013, a result of the Philippine Coast Guard firing shots 
at a Taiwan fishing boat in disputed fishing grounds, set off 
nationalist outpourings across Taiwan. The incident led to 
three months of strained relations between Taiwan and the 
Philippines that ended only after Manila offered an official 
apology, agreed to pay compensation to the victim's family, and 
recommended homicide charges for the Philippine Coast Guard 
personnel who opened fire on the Taiwan fishing boat.\34\ See 
chapter 3, section 2, of this Report, ``Taiwan,'' for full 
coverage of the Taiwan-Philippine row.

Advancing Maritime Claims in Regional and Multilateral Organizations

    The multilateral nature of the South China Sea dispute, as 
opposed to the generally bilateral nature of the East China Sea 
dispute, diffuses negotiating power among multiple claimants, 
giving China relatively less influence in the multilateral 
dispute resolution process. China as a result seeks to ``divide 
and conquer'' by negotiating the issue on a bilateral basis 
rather than under the auspices of the Association of Southeast 
Asian Nations (ASEAN). At the ASEAN Regional Forum Foreign 
Ministers' Meeting in July 2013, Chinese Foreign Minister Wang 
Yi underscored this approach: ``The South China Sea issue is 
not an issue between China and ASEAN. It is only an issue 
between China and a small number of Southeast Asian 
countries.'' \35\ In 2013, there have been two significant 
efforts in multilateral venues seeking to resolve South China 
Sea disputes; China has stalled progress in one and refused to 
participate in the other.

    South China Sea Code of Conduct negotiations: Chinese 
obstructionism and efforts to exploit disunity among Southeast 
Asian nations was a factor in stalled progress toward a binding 
Code of Conduct in the South China Sea. China and ASEAN in 2002 
signed a Declaration on the Conduct of Parties in the South 
China Sea that laid the groundwork for an eventual Code of 
Conduct. However, despite agreeing to ``work, on the basis of 
consensus, towards the eventual attainment'' of a ``code of 
conduct in the South China Sea [that] would further promote 
peace and stability in the region,'' Beijing remains 
circumspect on ASEAN calls for formal, substantive Code of 
Conduct talks.* \36\ During an August 2013 multi-country visit 
to Southeast Asia, Foreign Minister Wang emphasized patience in 
what he described would be a long-term process toward 
concluding a Code of Conduct.\37\
---------------------------------------------------------------------------
    * For an additional discussion of the Declaration on Conduct and 
the Code of Conduct, reference chapter 3, section 1, of the 
Commission's 2012 Annual Report, ``China and the South China Sea,'' p. 
237.

    Philippines-initiated arbitration over South China Sea 
claims: Manila surprised many observers in January 2013 when it 
initiated UNCLOS-based arbitration challenging China's nine-
dash line and maritime claims in the South China Sea. Beijing 
has rejected the arbitral process as ``manifestly unfounded'' 
under UNCLOS and declined to participate.\38\ In an official 
Foreign Ministry statement responding to the arbitration, 
Beijing denounced the Philippines' ``illegal occupation'' of 
China's claimed islands and reefs and argued the arbitral 
process counteracts ongoing bilateral negotiations that would 
peacefully resolve the South China Sea issue.\39\ However, 
China's refusal to participate in the arbitration has not 
prevented the formation of an arbitral tribunal or delayed the 
proceedings. A five-judge tribunal in the Hague is expected to 
consider Manila's arguments following their submission in March 
2014 and is likely to conclude proceedings by mid-2015.* \40\
---------------------------------------------------------------------------
    * The selected arbitrators include Judge Thomas Mensah (Ghana), 
Judge Jean-Pierre Cot (France), Judge Stanislaw Pawlak (Poland), 
Professor Alfred Soons (the Netherlands) and Judge Rudiger Wolfrum 
(Germany). Judge Thomas Mensah is serving as the arbitral panel's 
president. According to Annex VII of UNCLOS, each of the parties in 
arbitration may select one judge. The remaining three judges are in 
normal circumstances to be selected by agreement between the parties. 
Because of China's refusal to participate, the Philippines selected 
Judge Wolfrum, and the president of the International Tribunal on the 
Law of the Sea appointed the four remaining arbitrators. Luke Eric 
Peterson, ``Philippines-China UNCLOS arbitration moving forward without 
Chinese participation,'' Kluwer Arbitration Blog, August 28, 2013. 
http://kluwer-arbitrationblog.com/blog/2013/08/28/an-update-on-the-
philippines-china-unclos-arbitration/.

    Political tension is particularly pronounced between China 
and the Philippines due to China's view that the Philippines 
has internationalized the South China Sea disputes.\41\ In 
August 2013, official Chinese press signaled displeasure with 
the Philippines, seemingly for instituting arbitration to draw 
international attention to the lack of progress on a Code of 
Conduct: ``. . . certain countries are deliberately creating an 
issue of the `Code of Conduct' and are not genuinely concerned 
about the `Code' but instead want to use this kind of hyping to 
multilateralize and internationalize South China Sea issues.'' 
---------------------------------------------------------------------------
\42\

Legal and Administrative Assertions of Maritime Sovereignty

    Since late 2012, China has stepped up its use of a number 
of legal and administrative methods to assert sovereignty over 
its claims in the East and South China Seas, including the 
following:

     LAfter the Japanese Senkaku purchase in September 
2012, Beijing published its claim to the disputed islands in an 
official Government Statement ``on the Baselines of the 
Territorial Sea of Diaoyu Dao and Its Affiliated Islands'' and 
submitted these claims to the UN.\43\ Japan, which does not 
officially recognize a dispute over the islands, countered with 
its position that China's submission was ``totally unacceptable 
and legally invalid.'' \44\ The United States also has 
protested China's claims, calling them ``improperly drawn.'' 
\45\

     LIn 2012, China introduced a new passport design 
that has a watermark of a national map that includes popular 
tourist sites in Taiwan, its nine-dash line around the South 
China Sea, and border areas disputed with India as part of its 
territory. Countries disputing the depiction of China's 
territory denounced China's new passports, and some are not 
stamping the new passports and instead are issuing separate 
visa sheets.\46\

     LHainan Province, China's southernmost province, 
issued new maritime regulations in late 2012. The regulations, 
which are applicable to the 12 nm territorial waters within 
Hainan Province's announced baselines, include a provision 
allowing China to board, inspect, and expel foreign vessels 
``illegally'' entering Chinese waters.\47\ According to Wu 
Shicun, director of the Hainan Foreign Affairs Office and 
president of China's National Institute for South China Sea 
Studies, the provision is designed to curb Vietnamese fishing 
activity near the Paracel Islands.\48\

     LChina's official Sinomaps Press issued a new 
national map in January 2013 that includes China's South China 
Sea claims. The new map depicts the entire South China Sea on 
the same scale as mainland China, rather than using insets to 
illustrate China's claimed island groups. The map also includes 
a dash southeast of Taiwan delineating China's claim over 
Taiwan, bringing China's well-known nine-dash line claim in the 
South China Sea to ten dashes. Although official Chinese maps 
have included the tenth dash for at least the past two years, 
its larger-scale incorporation into the newest version of an 
official Chinese map raised concerns among China's neighbors in 
both the East and South China Seas.\49\ One Sinomaps editor 
said the changes in presentation served to ``elevate the 
[Chinese] peoples' consciousness of national territory and 
safeguard China's maritime rights and interests.'' \50\

Maritime Law Enforcement Assertions of Maritime Sovereignty

    China's maritime law enforcement agencies since 2009 have 
played an increasing role as the frontline actors in staking 
and enforcing China's maritime claims.\51\ Beijing likely sees 
this approach as less provocative than the use of the PLA Navy 
and a means to demonstrate de facto governance over its 
territorial claims. Nevertheless, robust and near-constant 
deployments of increasingly capable maritime law enforcement 
vessels, with the PLA Navy often deployed nearby, effectively 
serve as coercive policy instruments in the East and South 
China Seas.\52\
    Since 2012, China has begun to ``[respond] to challenges to 
its claims with an enhanced physical presence to bolster 
China's position and deter any further challenges,'' according 
to M. Taylor Fravel, associate professor of political science 
at the Massachusetts Institute of Technology. ``These responses 
suggest an even greater willingness to pursue unilateral 
actions to advance its claims.'' Dr. Fravel further notes that 
this activity is a recent departure from what had for several 
decades been a pattern of Chinese restraint with regard to the 
presence of ships and aircraft in disputed waters.\53\ Several 
other analysts have observed this change in China's approach to 
island disputes since the 2012 Scarborough Reef standoff, which 
began with a confrontation between China and the Philippines 
over the fishing activities of several Chinese fishing vessels 
at the reef, located in the South China Sea.* \54\ Both 
countries had previously fished in Scarborough Reef despite 
disputing its territoriality. Over the course of the months-
long standoff, China established physical control over the reef 
by patrolling the vicinity with maritime law enforcement 
vessels and roping off the reef's entrance to prevent 
Philippine vessels from operating there.\55\ At the time of 
this Report's publication, China continues to maintain de facto 
control over the reef.\56\
---------------------------------------------------------------------------
    * For more information about the Scarborough Reef standoff, see 
chapter 3, section 1, of the Commission's 2012 Annual Report, ``China 
and the South China Sea,'' p. 231-233.
---------------------------------------------------------------------------
    China has applied similar tactics in Second Thomas Shoal, a 
coral reef in the South China Sea approximately 105 nm west of 
Palawan Island, Philippines. The Philippines in early May 2013 
reported a PLA Navy vessel escorting two Chinese maritime law 
enforcement ships and approximately 30 fishing boats in the 
shoal. The Philippines maintains a regular presence on Second 
Thomas Shoal of approximately 12 marines aboard the BRP Sierra 
Madre, a World War II-era U.S. tank landing ship that the 
Philippine Navy deliberately ran aground on the shoal in 1999 
to stake its territorial claim.\57\ China frames this ``illegal 
occupation'' of Chinese territory as justification for its 
enhanced patrols in the waters surrounding Second Thomas 
Shoal.\58\
    The Commission learned in meetings with the JCG that PLA 
Navy and Chinese maritime law enforcement activity near the 
Senkaku Islands, previously irregular and sporadic, increased 
sharply following Japan's Senkaku Islands purchase. Official 
Chinese press appears to confirm the purchase marked a turning 
point for China's maritime operations, after which Chinese 
government ships maintained a near-persistent presence near the 
disputed isles. (See figure 3 for a depiction of this 
operational state based on JCG data.)\59\

Figure 3:  Routes of Chinese Government Ships Near Senkaku Islands from 
                  January 19, 2013 to August 27, 2013



    Source: Asahi Shimbun (Tokyo), ``INSIGHT: Japan, China still far 
apart in mending ties 1 year after purchase of Senkakus,'' September 
11, 2013. http://ajw-.-asahi-.-com/article/behind-_-news/
AJ-2013-09110069.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Japan Reconsiders Self-Defense in the East China Sea
 
  The ongoing domestic debate over whether Tokyo should revise its
constitution to expand the circumstances for self-defense was a
prominent theme of the Commission's fact-finding trip to Japan this
year. Japan remains divided on the issue of revising a constitutional
provision renouncing war and preventing the maintenance of a military
force.\60\ In meetings with a group of retired Japan Self-Defense Force
and JCG senior officers, the Commission learned that such a revision
could, for example, allow the Japan Self-Defense Force to employ arms in
the event of intrusion into Japan's territorial waters by foreign
government vessels. The retired senior officers further explained that
under the current constitution, a lengthy legal process would precede
 
------------------------------------------------------------------------




------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Japan Reconsiders Self-Defense in the East China Sea--Continued
 
any decision by Tokyo to exercise self-defense. This would complicate
 Tokyo's ability to authorize a military response to a perceived Chinese
 escalation in the East China Sea, especially if such activity involves
 only Chinese maritime law enforcement--not naval--vessels.
 
------------------------------------------------------------------------


    Beijing has undertaken a number of steps since mid-2012 to 
address several shortcomings in its coordination of maritime 
policy to better align China's maritime activity with national 
policy. China's lack of a unified maritime strategy and 
multiple--sometimes overlapping--bureaucracies has previously 
been characterized as a model of inefficiency and an impediment 
to effective policymaking.\61\
    In mid-2012, China created a new, high-level advisory group 
for maritime security issues. In China's foreign policy-making 
apparatus, key Chinese security policy issues, such as Taiwan, 
foreign affairs, and national security traditionally have 
merited their own high-level advisory groups within the 
Politburo Standing Committee.\62\ However, this is the first 
time maritime security has been elevated to this level, 
signaling the rising importance of this issue to Chinese 
leadership. The designation of Xi Jinping, who at the time was 
the top contender to be China's next senior leader, as the 
group's head, also indicates high-level attention to the 
matter. Furthermore, upon Japan's 2012 purchase of the Senkaku 
Islands, Beijing reportedly formed an ``Office to Respond to 
the Diaoyu Crisis'' and again placed Mr. Xi at the helm.\63\
    China previously had six chief maritime law enforcement 
agencies, all with separate and sometimes overlapping missions. 
In June 2013, China officially consolidated four of these six 
agencies--China Marine Surveillance, China Coast Guard, 
Fisheries Law Enforcement Command, and Maritime Customs 
Service--into the new China Coast Guard. The Maritime Safety 
Administration and China Rescue and Salvage remain 
independent.\64\ The inaugural China Coast Guard patrol 
occurred near the Senkaku Islands, and was intended to 
``sternly declare the Chinese government's stance on its 
sovereignty over the Diaoyu Islands to Japanese vessels,'' 
according to an official Chinese statement.\65\
    While most of these ships previously had been unarmed, 
those subordinated to the China Coast Guard under the new 
structure could now be armed with mounted guns.\66\ 
Furthermore, the China Coast Guard's capabilities will continue 
to modernize and improve in the next three to five years as it 
receives at least 30 new ocean-going ships and more than 100 
smaller patrol boats. Most of these vessels will be larger and 
more capable than previous ones, and some will have the ability 
to embark helicopters. China's maritime law enforcement 
agencies also will continue to incorporate decommissioned ships 
from the PLA Navy into their own fleets--a practice that has 
increased in recent years.\67\

Military Assertions of Maritime Sovereignty
    The PLA Navy plays a powerful but indirect role in the East 
and South China Seas, backing up maritime law enforcement 
patrols from a distance; training, transiting, and conducting 
highly visible displays of presence in disputed waters; and 
resupplying Chinese-controlled islands in the South China Sea.* 
\68\
---------------------------------------------------------------------------
    * U.S. Navy Seventh Fleet senior officers told the Commission PLA 
Navy vessels generally supported maritime law enforcement patrols at a 
distance of about 50 to 75 nm.

     LIn March 2013, the PLA Navy sent a task force 
comprised of one large amphibious ship and three modern surface 
combatants to James Shoal, which is the southernmost point of 
China's maritime claim in the South China Sea and lies 
approximately 43 nm off the coast of Malaysia. According to 
official Chinese media, the crews of these vessels held a 
ceremony pledging to safeguard China's maritime interests upon 
reaching James Shoal. The task force then conducted training in 
---------------------------------------------------------------------------
the West Pacific before returning home.\69\

     LIn May 2013, the PLA Navy conducted a rare, 
multifleet exercise involving elements of all three PLA Navy 
fleets in the South China Sea. While China's Ministry of 
National Defense described the exercise as ``routine'' and 
``not aimed at any specific country or target,'' \70\ some 
commentators suggested the exercise was used for political 
signaling during the China-Philippines standoff at Second 
Thomas Shoal and the transit of the U.S. Navy's USS Nimitz 
aircraft carrier through the region.\71\

     LIn mid-July 2013, following a joint exercise with 
the Russian Navy, a PLA Navy task force for the first time 
passed through the La Perouse Strait (also known as the Soya 
Strait), dividing northern Japan and Russia. The group of five 
vessels then transited east of Japan through the Pacific Ocean 
and back around southern Japan through the Miyako Strait 
dividing Japan's Miyako and Okinawa Islands, before reaching 
its homeport in Qingdao.\72\ Japanese press portrayed the route 
as ``intended to demonstrate Chinese naval might to Japan and 
the United States and show Russia it means business in the 
region.'' \73\ Official Chinese press heralded the event as a 
demonstration of the PLA Navy's ability to gain access to the 
Pacific Ocean through narrow chokepoints and to ``cut the first 
island chain into several pieces,'' according to a PLA Navy 
official.\74\ Chinese strategists and academics assert that the 
United States and Japan use the first island chain to 
strategically encircle or contain China and to prevent China 
from operating freely in the Pacific. \75\
---------------------------------------------------------------------------
     The first island chain refers to the first chain of major 
archipelagoes east of the East Asian continent--from the Kuril Islands 
in the north, through the Japanese archipelago, Ryukyu Islands, Taiwan, 
the Philippines, and Borneo.

    The PLA Navy's regional power projection capability has 
advanced rapidly since the 1990s, boosting Beijing's ability to 
assert its maritime claims in the East and South China Seas and 
to respond forcefully to perceived challenges by rival 
claimants. See chapter 2, section 1, of this Report, ``Military 
and Security Year in Review,'' for full coverage of China's 
---------------------------------------------------------------------------
naval modernization.\76\

Risk of Unintended Escalation in the East and South China Seas
    While Beijing's efforts to streamline its decision making 
on maritime disputes may reduce the risk of unintended 
escalation or accidents stemming from poor policy coordination, 
this risk is unlikely to be completely eliminated for the 
following reasons.
    First, China's crisis management approach emphasizes 
demonstrating resolve to assert its sovereignty claims to rival 
claimants and domestic audiences. This characteristic, combined 
with China's tendency to view sovereignty in moralistic and 
absolutist terms, results in China's greater capacity to engage 
in escalatory actions in a foreign policy crisis.\77\
    Second, despite Beijing's efforts to consolidate its 
maritime bureaucracy, the fragmented nature of China's foreign 
policy structure could undermine Beijing's cohesiveness on 
maritime issues, particularly in the East China Sea. A major 
contributing factor is the limited authority of the Chinese 
Foreign Ministry. The Chinese Foreign Minister ranks several 
steps below the Politburo, whereas his Japanese counterpart 
occupies a much more influential position within the Japanese 
government. In some cases, this difference in protocol ranking 
between the two foreign ministries has prevented meaningful 
dialogue from taking place at the working level and could limit 
the capacity for crisis mitigation. For example, despite its 
limited authority, the Chinese Foreign Ministry was reportedly 
the only official channel open to Tokyo during the 2012 Senkaku 
Island crisis. Frequent turnover in Japanese leadership from 
2006 to 2012 has further hindered the establishment of 
consistent official and unofficial diplomatic channels between 
the two countries.\78\

------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
The Ministry of Foreign Affairs in PRC Foreign Policymaking
 
  Although China's Ministry of Foreign Affairs technically is
responsible for the formulation and implementation of China's foreign
policy, its influence has waned over the past decade. Due to China's
increased political, economic, and military interaction with the world
in recent decades, a wide array of actors has entered the Chinese
foreign policymaking process through their di-
rectdealingswithforeignentities, includingseveralnationalmin- istries,
most provincial governments, the PLA, and state-owned firms.\79\ As a
result, the Ministry of Foreign Affairs is but one of several Chinese
foreign policy actors that often have competing interests and goals. The
exclusion of the foreign minister from China's 25-member Politburo since
1998 has further weakened the Ministry of Foreign Affairs' position in
the foreign policymaking process. Though the opacity of the Chinese
political system makes it difficult to render a definitive assessment,
most analysts judge the Politburo and its seven-member Standing
Committee make most of China's important foreign policy decisions.\80\
  For more information on the proliferation of official and non-official
Chinese foreign policy actors, see chapter 3, section 2, of the
Commission's 2011 Annual Report, ``Actors in China's Foreign Policy.''
 
------------------------------------------------------------------------


    Finally, deficiencies in civil-military coordination could 
continue to hamper policy coordination in the East and South 
China Seas. Officials at Japan's National Institute for Defense 
Studies, a policy think tank under the Japanese Ministry of 
Defense, told the Commission that coordination between the PLA 
and the Foreign Ministry, an important nexus in the management 
of China's maritime disputes, remains weak.\81\ The position of 
the PLA in the party bureaucracy outweighs and outranks the 
Foreign Ministry, which is one of many ministries under the 
State Council. Therefore, ``for the Foreign Ministry to liaise 
with the PLA, it must report up to the State Council, which may 
have to report up further up to the Politburo in order to 
secure PLA cooperation,'' according to the Congressional 
Research Service.\82\ Such a structure does not lend itself to 
rapid or coordinated decision-making between the PLA and 
Foreign Ministry, which would be critical in a crisis in either 
the East or South China Seas.
    The apparent maturation since the mid-2000s of China's 
National Committee on Border and Coastal Defense, an entity 
under the ``dual leadership'' of the State Council and the 
Central Military Commission that ``coordinates China's border 
and coastal defense,'' suggests an effort to strengthen civil-
military coordination with regard to border defense. However, 
outsiders know little about the influence of this organization 
on Beijing's overall management of the East and South China Sea 
disputes.\83\
    China's civil-military relationship also poses risks for 
crisis in the East and South China Seas at the operational 
level. Because the PLA routinely enjoys autonomy for military 
affairs, operational military activities that could 
significantly impact foreign affairs may not be approved at the 
highest levels before their execution.\84\
    For instance, on two occasions in late January 2013, a 
Chinese PLA Navy frigate reportedly locked weapons-targeting 
radar onto a Japan Maritime Self-Defense Force platform--first 
a helicopter, and later a destroyer. Public information on both 
Japanese and Chinese rules of engagement for ships and aircraft 
in the area is limited; however, illuminating another military 
asset with radar suggests hostile intent under international 
norms and increases the risk of miscalculation in an 
operational environment.\85\
    When queried about the incidents at a press conference, 
China's foreign ministry spokesperson stated the foreign 
ministry was ``not aware of the matter'' and knew of the 
incidents only through press reports.\86\ Later in March, 
Japan's Kyodo News, citing unnamed high-level PLA officers, 
reported that the PLA admitted its frigates had locked its 
weapons-targeting radar onto the Japanese platforms. According 
to Kyodo, these PLA officers claimed the event, at least in the 
case of the destroyer, was reportedly due to an isolated 
``emergency decision'' of the frigate's commander based on the 
Chinese military's rules of engagement.\87\ China's Ministry of 
Defense dismissed the Kyodo report.\88\ Nevertheless, the 
disconnect among Chinese entities in these cases suggests, as 
Rear Admiral McDevitt testified to the Commission, ``that 
perhaps [the] ability [of Chinese leadership] to control the 
situation was not absolute.'' \89\
    Such close encounters are not limited to naval surface 
vessels. Japan also has reported an increasing number of 
Chinese aircraft within Japan's Air Defense Identification 
Zone. Between March 2012 and March 2013, the Japan Air Self-
Defense Force scrambled fighter jets against Chinese aircraft 
in 306 instances--the largest number on record, and the first 
time this number surpassed the number of similar Japanese 
responses against Russia.\90\ Furthermore, the Japanese 
Ministry of Defense in May 2013 reported three separate 
instances of PLA Navy submarine operations within Japan's 
contiguous zone in the East China Sea, an UNCLOS-defined band 
of water that stretches from 12 to 24 nm from Japan's coastal 
baselines.\91\ ``Innocent passage'' of submarines is lawful in 
contiguous zones and even in territorial waters, but the 
frequency and persistence of such operations at a time of 
ongoing tension was enough for Tokyo to raise the issue 
publically as a means to urge restraint.\92\
    These incidents, particularly the radar lock incident, 
``raise questions about . . . whether there's an appreciation 
[in China] for the degree to which [these were] escalatory 
act[s],'' as Roy Kamphausen, senior advisor for political and 
security affairs at the National Bureau for Asian Research, 
testified to the Commission.\93\ As interactions between 
Chinese forces and U.S. and Japanese forces become more 
regular, the adherence of international protocols at sea will 
become increasingly important for the safety of all air and 
maritime operations in the region as well as the stability of 
the security situation in the East and South China Seas.

Implications for the United States

    Beijing discourages and seeks to prevent the diplomatic 
involvement of the United States in the disputes, which Beijing 
considers a series of bilateral issues between China and each 
claimant. In response to interview questions on the role of the 
United States in the East China Sea, China's Ambassador to the 
United States Cui Tiankai stated, ``The most helpful thing the 
U.S. could do is to remain truly neutral, to take no side . . . 
When the United States talks to us, they say they'll take no 
side, but sometimes, when they talk to the Japanese or when 
they make public statements, we hear something different.'' 
\94\
    Although the United States does not take a position on the 
sovereignty of the disputed features and waters in the East and 
South China Seas, its treaty commitments bind it to the region 
in ways that link its security interests to the peaceful 
resolution of China's maritime disputes.
    In the East China Sea, the 1960 Treaty of Mutual 
Cooperation and Security between Japan and the United States of 
America provides for a U.S. commitment ``in accordance with its 
constitutional provisions and processes'' to defend Japan in 
the event of an armed attack ``against either Party in the 
territories under the administration of Japan.'' \95\ The 
official U.S. position includes the Senkaku Islands, which are 
under Japanese administration, in its treaty obligations.\96\ 
In the South China Sea, the United States maintains a treaty 
alliance with the Philippines based on the 1951 Mutual Defense 
Treaty between the United States and the Republic of the 
Philippines. Though the United States has affirmed its 
commitment to the Mutual Defense Treaty,\97\ it has not 
officially articulated the specific geographic areas that would 
trigger a mutual defense response to the Philippines. Some 
observers suggest this ambiguity regarding the Philippines' 
disputed land features has led Manila to misinterpret U.S. 
defense obligations, perhaps even emboldening Manila to 
challenge China.\98\
    Forward-deployed U.S. forces in East Asia are another 
element of U.S. security policy in the East and South China 
Seas. As Lt. Gen. Wallace ``Chip'' Gregson, USMC (Retd.), 
currently senior director for China and the Pacific at the 
Center for the National Interest, testified to the Commission, 
``Broad, active, widely distributed presence throughout the 
theater dampens sources of instability, deters conflict, gives 
substance to U.S. security commitments, and ensures continuing 
American access to the region.'' \99\ As defense budgets 
tighten, the United States will face difficult choices in 
implementing its policy ``rebalance'' to Asia. A major 
challenge ahead for Washington, therefore, will be to stand 
firm on its security commitments while resourcing its overall 
foreign policy and security goals in the Asia Pacific 
region.\100\ An integral part of this effort is evident in the 
deepening U.S. diplomatic and military engagement in the 
region, with an apparent emphasis on treaty alliances with the 
Philippines and Japan.\101\
    Finally, the U.S.-China relationship is central to 
Washington's interest in the East and South China Sea disputes. 
Despite a generally improving military-to-military 
relationship, mutual mistrust about one another's long-term 
intentions continues to pervade the overall security 
relationship.\102\ This strategic backdrop poses challenges for 
the operational environment at sea, especially as the maritime 
operating areas of the two countries increasingly overlap. 
China's growing naval and maritime law enforcement advantage 
over its neighbors will add to already high levels of 
confidence that China can and should take bolder actions to 
protect its maritime interests. As U.S.-China air and naval 
interactions become more frequent, China's adherence to and 
participation in multilateral regimes regulating mariner 
interactions, such as the Convention on the International 
Regulations for Preventing Collisions at Sea and the Western 
Pacific Naval Symposium's Code of Unalerted Encounters at Sea, 
will become increasingly critical.\103\
    Through its diplomatic actions and the rebalance to Asia, 
the United States has signaled its intent to strengthen its 
relationship with partners and allies in East Asia. However, 
China's military modernization, coupled with the potential 
decline in U.S. power caused by sequestration, is altering the 
balance of power in the region and reducing the deterrent 
effect of the rebalance policy. The risk is therefore 
increasing that China's coercive approach to its sovereignty 
claims will lead to greater conflict in the region.

Conclusions

 LChina relies on a coercive and persistent maritime 
law enforcement and naval presence to gain control of disputed 
territory in the East and South China Seas. A consolidated 
maritime policymaking bureaucracy and streamlined maritime law 
enforcement fleets could increase Beijing's confidence in its 
capability for coercion in the ongoing maritime disputes.

 LTwo key drivers shape China's approach to its 
maritime disputes: First, China encourages ardent popular 
nationalism, which it exploits to support its foreign policy 
aims in the East and South China Seas. Second, China views 
sovereignty over claims in the East and South China Seas as 
central to its national security, territorial integrity, and 
economic development.

 LChina uses legal and administrative measures to 
assert de jure governance over its disputed maritime regions; 
it deploys maritime law enforcement and naval vessels to its 
claimed waters to demonstrate and lay the groundwork for de 
facto governance.

 LBeijing's tendency to demonstrate resolve in its 
maritime disputes; its large and complicated political, foreign 
affairs, and military bureaucracy; and its inconsistent 
adherence to internationally accepted norms of air and maritime 
operations may contribute to operational miscalculations in the 
East and South China Seas. Unyielding positions on sovereignty 
and nationalist sentiment surrounding these maritime disputes 
increase the risk of escalation from a miscalculation at sea to 
a political crisis.

                     ENDNOTES FOR SECTION 3

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China's Maritime Disputes in the East and South China Seas, written 
testimony of Peter Dutton, April 4, 2013.
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An Inherent Part of the Territory of the Republic of China (Taiwan),'' 
(Taipei, Taiwan: April 2012). http://www.mofa.gov.tw/official/Home/
Detail/4ad52054-ebc--7---452c-a6c--1-d--182-b25-c800--1?arfid=2b7802ba-
--d5e8-4538-9ec2-4eb8--18--1--790--15&opno=02--7--ffe58-09dd-4b--7--c-
--a554--99def06b00a1; State Council Information Office (China), Diaoyu 
Dao, an Inherent Territory of China (Beijing, China: State Council, 
September 2012). http://www--.--china--.--org--.--cn/government/
whitepaper/2012-09/25/content-_-26628166.htm.
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U.S. Treaty Obligations (Washington, DC, Congressional Research 
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Island Controversy: A Crisis Postponed,'' Japan's Territorial Disputes: 
CNA Maritime Asia Project: Workshop Three (Alexandria, VA: CNA: June 
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Remo, Italy: International Institute of Humanitarian Law, November 
2009), pp. 22-23; Itsunori Onodera, ``Extra Press Conference by the 
Defense Minister'' (Tokyo, Japan: Ministry of Defense, February 5, 
2013). http://www.mod.go.jp/e/pressconf/2013/02/13-02-05a.-html.
     86. John Brinsley and Isabel Reynolds, ``Abe Calls China Radar 
Targeting of Japan Vessel Provocative,'' Bloomberg, February 6, 2013. 
http://www.bloomberg.com/news/2013-02-05/china-targeted-japanese-naval-
vessel-with-radar-nhk-reports.html.
     87. Kyodo, ``Chinese officials admit to MSDF [Maritime Self 
Defense Force] radar lock allegations,'' March 18, 2013. http://
www.japantimes.co.jp/news/2013/03/18 / national / chinese - officials - 
admit - to - msdf - radar - lock - allegations / # . Ue1JjndGXmk; 
Samuel Wade, ``Chinese Officials Said to Admit Radar Lock (Updated),'' 
China Digital Times, March 18, 2013. http: // chinadigitaltimes.net / 
2013 / 03 / chinese-officials-said-to-admit-radar-lock-incident/; and 
Satoshi Tomizaka, ``Who is Responsible for PLAN Radar Lock-On 
Incident?'' Shukan Bunshun (Tokyo), February 21, 2013. English 
translation at: http://jsw.newpacificinstitute.org/?p=10876.
     88. Zhang Yunbi, ``Beijing dismisses Japan's `radar lock' media 
report,'' China Daily, March 19, 2013. http://
english.peopledaily.com.cn/90883/8173056.html.
     89. U.S.-China Economic and Security Review Commission, Hearing on 
China's Maritime Disputes in the East and South China Seas, written 
testimony of Michael McDevitt, April 4, 2013.
     90. Ministry of Defense (Japan), ``Japan Details Scramble Mission 
Against PRC, Russian Aircraft Apr 2012--Mar 2013'' (Tokyo, Japan). OSC 
ID: JPP2013-04-18-0-1-4-0-01. http://www.opensource.gov; Asahi Shimbun 
(Tokyo), ``INSIGHT: China puts Japan on notice that its scrambles are 
now routine,'' July 30, 2013. http://ajw.asahi.com/article/
behind----news/politics/AJ2013-07-30-0099.
     91. Alexander Martin, ``Japan on Alert Over Unidentified 
Submarines,'' Wall Street Journal, May 14, 2013. http://online.wsj.com/
article/SB100014241278-8-7-3-2-3-7-1-6-3-0-4-5-7-8482331157168110.html; 
Sankei Shimbun (Tokyo), ``Defense Ministry Concludes Latest Chinese 
Yuan-Class Submarines Were Sailing in Contiguous Zones; Japanese, US 
Ocean Surveillance Ships Deployed To Detect Subs,'' May 26, 2013. OSC 
ID: JPP20130526033005. http://www.opensource.gov.
     92. Japan News (Tokyo), ``Sound Waves Used Against `Chinese' 
Sub,'' May 21, 2013. OSC ID: JPP20130521969092. http://
www.opensource.gov; Asahi Shimbun (Tokyo), ``Move to publicize 
submarine locations proves ineffective,'' May 21, 2013. http://
ajw.asahi.com/article/behind----news/politics/AJ201305210052; Peter A. 
Dutton, ``International Law and the November 2004 `Han Incident','' in 
Andrew S. Erickson et al., China's Future Nuclear Submarine Force 
(Annapolis, MD: U.S. Naval Institute, 2007), pp. 163-169.; UN 
Convention on the Law of the Sea, Part II: Territorial Sea and 
Contiguous Zone, ``Article 19: Meaning of innocent passage,'' http://
www.un.org/depts/los/convention----agreements/texts/unclos/part2.htm; 
and UN Convention on the Law of the Sea, Part II: Territorial Sea and 
Contiguous Zone, ``Arti- 
cle 20: Submarines and other underwater vehicles,'' http: // 
www.un.org/depts/los/convention----agreements/texts/unclos/
part2.htm.
     93. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, 
testimony of Roy Kamphausen, February 7, 2013.
     94. Jonathan Tepperman, ``Beijing's Brand Ambassador: A 
Conversation with Cui Tiankai,'' Foreign Affairs 92:4 (July/August 
2013): 16.
     95. ``Article V,'' Treaty of Mutual Cooperation and Security 
between Japan and the United States of America, January 19, 1960. 
http://www.mofa.go.jp/region/n-america/us/q&a/ref/1.html.
     96. U.S. Senate Foreign Relations Committee, Hearing on Maritime 
Territorial Disputes and Sovereignty Issues in Asia, testimony of Kurt 
Campbell, 112th Cong., 2nd sess., September 20, 2012.
     97. U.S. Senate Foreign Relations Committee, Hearing on Maritime 
Territorial Disputes and Sovereignty Issues in Asia, testimony of Kurt 
Campbell, 112th Cong., 2nd sess., September 20, 2012.
     98. Bonnie Glaser, ``Armed Clash in the South China Sea: 
Contingency Planning Memorandum No. 14,'' (New York, NY: Council on 
Foreign Relations, April 2012). http://www.cfr.org/world/armed-clash-
south-china-sea/p27883; U.S.-China Economic and Security Review 
Commission, Hearing on China's New Leadership and Implications for the 
United States, written testimony of David Lampton, February 7, 2013.
     99. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of Wallace Gregson, February 7, 2013.
    100. U.S.-China Economic and Security Review Commission, Hearing on 
China's New Leadership and Implications for the United States, written 
testimony of David Lampton, February 7, 2013; U.S.-China Economic and 
Security Review Commission, Hearing on China's New Leadership and 
Implications for the United States, written testimony of Michael 
Auslin, February 7, 2013.
    101. Jonathan Greenert, ``Sea Change: The Navy Pivots to Asia,'' 
Foreign Policy, November 14, 2012. http://www.foreignpolicy.com/
articles/2012/11/14/sea----change; U.S. Senate Foreign Relations 
Committee, Hearing on Maritime Territorial Disputes and Sovereignty 
Issues in Asia, testimony of Kurt Campbell, 112th Cong., 2nd sess., 
September 20, 2012.
    102. Kenneth Lieberthal and Wang Jisi, Addressing U.S.-China 
Distrust (Washington, DC: The Brookings Institution, April 2012). 
http://www.brookings.edu//media / research / files / papers / 2012 / 
3 / 30 % 20us % 20china % 20lieberthal / 0330 _ china _-lieberthal.pdf.
    103. For more information on these regimes, see Kimberly Hsu and 
Craig Murray, China's Expanding Operations in Foreign Exclusive 
Economic Zones (Washington, DC: U.S.-China Economic and Security Review 
Commission, June 2013). http: // www.uscc.gov/Research/ china % E2 % 80 % 99s - expanding - military - operations -foreign-
exclusive-economic-zones.
                            RECOMMENDATIONS

China's Cyber Activities

The Commission recommends:

 LCongress adopt legislation clarifying the actions 
companies are permitted to take regarding tracking intellectual 
property stolen through cyber intrusions.

 LCongress amend the Economic Espionage Act (18 U.S.C. 
Sec. 1831-1839) to permit a private right of action when trade 
secrets are stolen.

 LCongress support the Administration's efforts to 
achieve a high standard of protection of intellectual property 
rights in the Trans-Pacific Partnership and the Transatlantic 
Trade and Investment Partnership.

 LCongress encourage the Administration to partner with 
other countries to establish an international list of 
individuals, groups, and organizations engaged in commercial 
cyber espionage. The Administration and partner governments 
should develop a process for the list's validation, 
adjudication, and shared access.

 LCongress urge the Administration to continue to 
enhance its sharing of information about cyber threats with the 
private sector, particularly small- and medium-sized companies.

 LCongress direct the Administration to prepare an 
inventory of existing federal use of cloud computing platforms 
and services and determine where the data storage and computing 
services are geographically located. Such inventory should be 
prepared annually and reported to the appropriate committees of 
jurisdiction.

 LCongress urge the Administration to expedite progress 
in its implementation of Section 806 of the National Defense 
Authorization Act for Fiscal Year 2011 (Public Law 111-383), 
which was intended to enhance the Department of Defense's 
ability to address supply chain risks.

China's Maritime Disputes

The Commission recommends:

 LCongress fund the U.S. Navy's shipbuilding and 
operational efforts to increase its presence in the Asia 
Pacific to at least 60 ships and rebalance homeports to 60 
percent in the region by 2020 so that the United States will 
have the capacity to maintain readiness and presence in the 
Western Pacific, offset China's growing military capabilities, 
and surge naval assets in the event of a contingency.

 LCongress fund Departments of Defense and State 
efforts to improve the air and maritime capabilities of U.S. 
partners and allies in Asia, particularly with regard to 
intelligence, surveillance, and reconnaissance, to improve 
maritime domain awareness in the East and South China Seas.

 LCongress urge the Department of Defense to continue 
to develop the U.S.-China maritime security relationship in 
order to strengthen strategic trust. The relationship should be 
within the bounds of the National Defense Authorization Act for 
Fiscal Year 2000 (Public Law 106-65) and based on the 
principles of reciprocity and transparency.

 LCongress fund U.S. Coast Guard engagement efforts 
with coast guard and maritime law enforcement agencies in the 
Western Pacific to increase understanding among civilian 
maritime bodies in the Asia Pacific.
                               CHAPTER 3

                          CHINA AND THE WORLD

                  SECTION 1: CHINA AND THE MIDDLE EAST

                            AND NORTH AFRICA

Introduction
    This section, based on a Commission hearing and research 
conducted throughout the year, discusses China's relations with 
the Middle East and North Africa (MENA).* The section explores 
China's primary interests in MENA; Chinese engagement in the 
region; and the political, diplomatic, and security challenges 
China faces there. Finally, it examines how China's MENA 
policies impact U.S. interests.
---------------------------------------------------------------------------
    * For the purposes of this Report and unless otherwise noted, MENA 
refers to Algeria, Bahrain, Egypt, Iran, Iraq, Israel, Jordan, Kuwait, 
Lebanon, Libya, Morocco, Oman, the Palestinian territories, Qatar, 
Saudi Arabia, Syria, Tunisia, the United Arab Emirates, and Yemen.

---------------------------------------------------------------------------
China's Primary Interests in MENA

    Beijing's approach and policies related to MENA are driven 
by its broader national interests, which are to sustain China's 
economic growth, preserve China's political system, protect 
China's sovereignty claims, and expand China's global 
influence. These interests are reflected in China's primary 
objectives in the region: enhancing economic ties; supporting 
China's efforts to achieve energy security; fostering friendly 
relations with all MENA countries (as well as the Palestinian 
territories); ensuring domestic stability and control, 
particularly in Xinjiang Uighur Autonomous Region; and 
promoting regional stability in an effort to augment China's 
domestic economic and security priorities. These interests are 
discussed below.

Enhancing Economic Ties

    Since the 1990s, Beijing's main priority in MENA has been 
to safeguard China's domestic economic growth by expanding 
opportunities for Chinese exports and acquiring resources to 
enhance China's energy security.\1\ Dawn Murphy, then 
postdoctoral research fellow at the Princeton-Harvard China and 
the World Program, testified to the Commission that China 
likely will be the dominant economic actor in MENA by the 
2020s.\2\

    Trade: Between 2003 and 2012, China-MENA annual trade 
increased more than twelvefold, from $20.8 billion to $262.1 
billion.\3\ China in 2009 overtook the United States to become 
the world's largest exporter to MENA.\4\ Still, China's trade 
with the region constituted only 6.7 percent of its global 
trade in the first half of 2013.\5\
    Although China runs a trade deficit with MENA (due largely 
to its heavy reliance on energy imports from the Persian Gulf), 
the region increasingly is an important export market for 
China. Chinese exports to MENA grew from $6.47 billion to $121 
billion between 1999 and 2012.\6\ The majority of these exports 
are light manufactured goods, including home and office 
appliances, communications and acoustic equipment, lamps, 
furniture, toys, building materials, machinery, textiles, 
footwear, and stationery, among other items.\7\ MENA also is a 
large export market for Chinese services, particularly in the 
construction, telecommunications, and finance sectors.\8\ 
Chinese state-owned enterprises (SOEs) Sinohydro and China 
Railway Construction Corporation, the two largest Chinese 
construction companies in the region, have built dams, 
highways, mines, airports, housing, water distribution 
networks, stadiums, irrigation projects, power stations, and 
other facilities in Algeria, Iran, Libya, Oman, Qatar, and 
Yemen. Telecommunications companies Huawei and ZTE provide 
services in at least six countries in the region, including 
Algeria, Bahrain, Egypt, Iran, Tunisia, and the United Arab 
Emirates.\9\ Both companies in recent years reportedly sold or 
were associated with the sale of embargoed telecommunications 
equipment to Iran in violation of U.S. sanctions.* \10\
---------------------------------------------------------------------------
    * Huawei's contract with Iran's state-controlled mobile phone 
industry appears to have been marketed in part on the premise that the 
company could enable Tehran to censor and conduct surveillance on 
Iranian mobile phone users. Steve Stecklow, Farnaz Fassihi, and Loretta 
Chao, ``Chinese Tech Giant Aids Iran,'' Wall Street Journal, October 
27, 2011. http://online.wsj.com/article/
SB10001424052970204644504576651503577823210.html.
---------------------------------------------------------------------------
    China's trade with MENA is facilitated by the following:

     L``Strategic partnerships:'' China shares what it 
refers to as ``strategic partnerships'' with Algeria, Egypt, 
Saudi Arabia, and the United Arab Emirates. These partnerships 
vary in depth and nature of cooperation. While some have a 
security component, most emphasize economic cooperation, as 
with the Sino-Saudi ``strategic oil partnership,'' discussed 
below.\11\

     LCooperation fora: The China-Arab States 
Cooperation Forum (CASCF) and the Forum on China-Africa 
Cooperation (FOCAC) are China's primary multilateral venues for 
promoting its economic interests in the region, including but 
not limited to identifying and developing export markets.\12\ 
For example, the China-Arab States Economic and Trade Forum, 
established under CASCF in China's Ningxia Hui Autonomous 
Region in 2010, serves as a ``bridgehead'' for China to develop 
``an open inland economy, emphasizing . . . Arab League 
countries and Muslim regions.'' \13\

     LSpecial economic zones and trade fairs: Energy 
exports aside, much China-MENA trade is facilitated by trade 
zones and wholesale trade fairs. China and Egypt launched the 
Egypt Suez Cooperation Zone in 2009. The zone facilitates 
exports to the Middle East, Africa, and Europe. \14\ 
Dubai's DragonMart is the largest trading center for Chinese 
goods outside China and houses more than 3,900 Chinese 
wholesale and retail vendors.\15\ The Yiwu International Trade 
Mart in Yiwu, Zhejiang Province, claims to be the world's 
largest small commodities market and attracts around 200,000 
Arab traders each year.\16\
---------------------------------------------------------------------------
     China in 2006 also began plans for a special economic zone 
in Algeria, focused on automobile manufacturing. These plans have since 
been suspended. U.S.-China Economic and Security Review Commission, 
Hearing on China and the Middle East, written testimony of Dawn Murphy, 
June 6, 2013; Chris Alden and Faten Aggad-Clerx, Chinese Investments 
and Employment Creation in Algeria and Egypt (Tunis, Tunisia: African 
Development Bank, 2012), p. 20. http://www.-afdb.org/fileadmin/uploads/
afdb/Documents/Publications/Brochure%20China%20Anglais.pdf.

    China's trade ties with the region could expand with a 
planned free trade agreement with the Cooperation Council for 
the Arab States and the Gulf, which includes Bahrain, Kuwait, 
Oman, Qatar, Saudi Arabia, and the United Arab Emirates. The 
---------------------------------------------------------------------------
proposed agreement would cover trade in goods and services.\17\

    Investment: China's investment in MENA is growing.\18\ 
According to statistics from the Chinese Ministry of Commerce, 
Chinese foreign direct investment (FDI) flows to the region 
reached $1.5 billion in 2011. China's FDI stock in the region 
reached $6.14 billion in 2011, about 1.4 percent of China's 
global FDI stock that year. Iran, the United Arab Emirates, and 
Saudi Arabia, respectively, were the top three recipients of 
Chinese FDI (in terms of flows and stock) in the region in 
2011.\19\
    Much of China's investment in MENA is in the infrastructure 
and transportation sectors. Chinese companies are building, 
funding, or have agreed to build railways in Egypt, Iran, 
Israel, Libya, and Saudi Arabia. State-owned China Harbour 
Engineering Company is investing in port projects in Kuwait, 
Saudi Arabia, and Qatar.\20\ Investment in infrastructure helps 
China build goodwill in the region and increase its access to 
Middle Eastern, European, and African markets.

    Financial Services: China is active in financial services 
sectors throughout the region. Five regional banks have signed 
cross-border renminbi (RMB) trade settlement agreements, 
enabling MENA-based companies to settle payments with Chinese 
suppliers.\21\ China's four largest state-owned banks operate 
in Dubai, United Arab Emirates, which likely will become the 
first market for RMB conversion and clearing outside East 
Asia.\22\ Several non-Chinese banks in the United Arab Emirates 
offer RMB accounts to accommodate growing numbers of Chinese 
traders and investors.\23\

Promoting Energy Security

    China's engagement with MENA is driven primarily by its 
efforts to achieve energy security.\24\ In 2012 and the first 
eight months of 2013, the region accounted for about 54 percent 
of China's imported crude oil.\25\ Saudi Arabia is China's 
largest source of oil, both in the region and globally. Among 
Middle Eastern producers, Saudi Arabia, Iran, Oman, and Iraq, 
respectively, exported the most crude oil by volume to China in 
the period from January 2012 to August 2013.\26\ Qatar and 
Yemen are China's third- and fifth-largest sources of liquefied 
natural gas (LNG), providing 18 percent and 7 percent of 
China's LNG imports in 2011, respectively.\27\

                               Figure 1: 
    China's Crude Oil Imports by Volume, January 2012 to August 2013

           (Imports from MENA are noted in a darker gradient)



    Source: China National Bureau of Statistics, via CEIC database. 
http://www.ceicdata.com/en.

    China's reliance on oil imports from MENA likely will 
grow.\28\ Erica Downs, fellow at the Brookings Institution, 
testified to the Commission that China's oil imports from the 
region are estimated to grow from 2.9 million barrels per day 
in 2011 to 6.7 million barrels per day in 2035.\29\ In addition 
to imports, China's national oil companies (the state-owned 
``national champions'' of China's energy sector) have invested 
heavily in energy companies and projects in MENA, particularly 
in Iran and Iraq.*
---------------------------------------------------------------------------
    * For additional information on China's energy ties with the 
region, see the Commission's 2012 Annual Report to Congress. U.S.-China 
Economic and Security Review Commission, 2012 Annual Report to Congress 
(Washington, DC: U.S. Government Printing Office, November 2012), pp. 
333-334. http://origin.www.uscc.gov/sites/default/files/annual--reports/
2012-Report-to-Congress-.-pdf.
---------------------------------------------------------------------------
    Over the last decade, China's leaders increasingly have 
begun to view the country's growing reliance on energy imports, 
the majority of which originate in MENA, as a strategic 
vulnerability.\30\ Then Chinese President Hu Jintao in a 2003 
speech described China's dependence on seaborne energy imports 
as China's ``Malacca Dilemma,'' referencing the strait through 
which most of China's MENA crude oil imports flow.\31\ This 
sense of vulnerability appears to drive Beijing's efforts to 
strengthen its relations with the region's major producers. 
Beijing likely will enhance its overall engagement in MENA if 
China's reliance on the region's energy exports continues to 
grow as projected. According to a 2013 market outlook report by 
Norwegian multinational energy company Statoil, ``Given the 
rebalancing of global oil trade flows, most of [China's] 
imports must be covered by the Middle East, which suggest[s] 
that China probably will be forced to take a more 
interventionist approach in foreign policy, particularly 
towards the Middle East.'' \32\
    Beijing's energy insecurity and consequent drive for 
greater influence in the region are compounded by China's 
apprehension about U.S. primacy in the region and the U.S. 
Navy's near-total control over the sea lanes through which 
Chinese energy imports pass.\33\ According to a 2012 report by 
Scott Harold and Alireza Nader for the RAND Corporation, 
Beijing seeks to augment its energy trade ties with political 
ties to the Iranian government to ensure that in a potential 
scenario in which the United States may seek to disrupt China's 
oil supply, China could rely on a friendly oil-producing 
country to mitigate the disruption.\34\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Saudi Arabia, Iran, Iraq, and Oman: China's Major Energy Partners in
 
  Saudi Arabia: China and Saudi Arabia established a ``strategic oil
partnership'' in 1998, which has enabled close cooperation in the energy
sector.\35\ China's oil trade with Saudi Arabia has grown drastically in
the past decade, and in 2009 China overtook the United States as Saudi
Arabia's largest crude oil customer.\36\ Chinese national oil companies
have several investments in Saudi oil and natural gas projects, and
Saudi Aramco, the largest Saudi energy company, has several investments
in Chinese refineries.\37\
  Saudi Arabia's position as a dominant supplier and its ability to
calibrate production and drive oil prices make it an indispensable
partner for China. Beijing seeks assurances from Riyadh that Saudi
Arabia will maintain price stability in the event of severe supply
disruptions.\38\ China (and other importers of Iranian crude oil) relied
heavily on Saudi Arabia to compensate for sharp decreases * in Iranian
imports in 2012. Riyadh, recognizing China's growing importance
as an export market for Saudi oil, in turn has indicated its willingness
to help China achieve energy security. A 2006 joint memorandum on energy
cooperation states Saudi Arabia will assist China in developing its
strategic petroleum reserves.\39\During then President Hu's 2009 state
visit to
 
------------------------------------------------------------------------

      
---------------------------------------------------------------------------
    * Between 2011 and 2012, the volume of Chinese imports of Iranian 
crude oil decreased by about 20 percent, from about 27 million tons to 
about 22 million tons. China National Bureau of Statistics, via CEIC 
database. http://www.ceicdata.com/en.
     The United States also reportedly urged Saudi Arabia to 
increase oil exports to China to encourage Beijing to decrease its 
Iranian imports. Mohammed Turki Al-Sudairi, Sino-Saudi Relations: An 
Economic History (Geneva, Switzerland: Gulf Research Center, August 
2012), 
p. 26. http://grc.net/
index.php?frm----module=contents&frm----action=detail----book&pub----type-=-
16&sec-= Contents-&-frm-_-title=&book-_-id=79283&op-_-lang=en.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Saudi Arabia, Iran, Iraq, and Oman: China's Major Energy Partners in
 
Saudi Arabia, the two countries announced a ``gentleman's agreement''
 between Saudi Aramco and Chinese national oil company Sinopec for the
 continued export of Saudi crude oil to China. Later that year, Saudi
 Minister of Petroleum and Mineral Resources Ali Al-Naimi stated in a
 speech, ``China can rely on Saudi Arabia to provide it with the oil it
 will need to continue its projected growth for the coming decades.''
 \40\
 
  Iran: Energy interests are a primary driver of China's challenging and
problematic relationship with Iran.\41\ China is Iran's top crude oil
customer, and about 8 percent of China's oil imports (by volume) were
from Iran in the period from January 2012 to August 2013.\42\ Iran was
China's third-largest supplier of crude oil globally for much of the
2000s, but in 2012 and in the first eight months of 2013 Iranian exports
to China dropped significantly, likely due to U.S. sanctions on Iran's
energy sector and a pricing dispute between Chinese oil trader Unipec
and the National Iranian Oil Company in 2012.\43\
  Beijing seeks to balance its interest in securing energy from and
maintaining relations with Iran with its interests in promoting its
image as a responsible international power and maintaining stable
relations with the United States and other MENA countries. Since January
2012, the U.S. Department of State has consistently exempted China on a
biannual basis from sanctions on foreign countries importing crude oil
from Iran because, although China had continued to import crude oil from
Iran, the State Department judged China had ``significantly reduced''
those imports.* \44\ Chinese national oil companies reportedly have
negotiated discounts on Iranian crude oil purchases, leveraging Tehran's
growing international isolation and consequently limited export
markets.\45\
  China in 2013 apparently began to exploit a loophole in U.S. sanctions
by continuing to reduce its crude oil imports from Iran while
dramatically increasing its fuel oil imports, which are not technically
covered by U.S. sanctions. According to the Wall Street Journal, China
in the first seven months of 2013 imported $495 million worth of Iranian
fuel oil, compared to $1 million in 2012. While fuel oil is less
valuable and more difficult to refine than crude oil, Chinese oil
companies appear to have imported large amounts at discounted rates from
Iran, enabling China to partially compensate for its reduction in crude
oil imports. \46\ China's energy relations with Iran thus adhere
to the letter, but not the spirit, of U.S. sanctions.
 
------------------------------------------------------------------------

      
---------------------------------------------------------------------------
    * The State Department is scheduled to announce the next round of 
exemptions in December 2013.
     In July 2013, the U.S. House of Representatives passed 
H.R. 850 (``Nuclear Iran Prevention Act of 2013''), a bill that would, 
among other things, require countries to reduce their fuel oil as well 
as crude oil imports in order to qualify for the State Department's 
exemption from sanctions. Wayne Ma and Tennille Tracy, ``Sanctions Gap 
Allows China to Import Iranian Oil,'' Wall Street Journal, August 21, 
2013. http://online.wsj.com/article/
SB1000-142412788732-4-6-1-9-5-0-4-5-7-9-0-2-6-3-3-3-6-11696094.html.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Saudi Arabia, Iran, Iraq, and Oman: China's Major Energy Partners in
 
  Chinese companies have pursued several large investment contracts to
develop Iranian oil and gas.* However, these projects have moved slowly,
and some have stalled or been suspended in recent years.\47\ According
to Dr. Downs, ``Reasons for the shrinking presence of China's oil
companies in Iran include sanctions that have made it difficult for
China's oil companies to secure equipment and technologies needed to
operate in Iran, unhappiness with contract terms, uncertainty about
whether Iran's nuclear program will spark a military conflict, and
reported guidance from China's leadership to move slowly in Iran.'' \48\
 
  Iraq: China is benefitting greatly from Iraq's postwar oil production.
Between 2008 and 2012, the value of Iraqi crude oil exports to China
increased by almost 870 percent.\49\ China also is the largest foreign
investor in Iraq's oilfields.\50\ China National Petroleum Corporation
(CNPC), a Chinese national oil company, and British Petroleum are
jointly developing Iraq's Rumaila field, which accounted for one-third
of Iraqi oil production in 2012.\51\ Dr. Downs testified to the
Commission that Rumaila in 2012 was CNPC's most productive overseas
project and accounted for nearly half of the company's net overseas oil
and gas production. CNPC also is invested in Iraq's al-Adhab and Halfaya
oilfields.\52\ At the time of this Report's publication, CNPC's listed
subsidiary PetroChina is in talks to become an investor in a $50 billion
Exxon Mobil-operated project to develop one of Iraq's largest oilfields,
West Qurna-1.\53\
 
  Oman: Oman increasingly is an important source of energy for China and
was the fourth-largest source of Chinese crude oil imports in the first
half of 2013.\54\ In addition to Saudi Arabia, Iraq, and other
producers, China has relied on Oman in 2012 and 2013 to compensate for
decreases in imports from Iran. China-Oman investment ties in the energy
sector are more limited than the previously discussed countries. CNPC
has a production-sharing contract for a 50 percent stake in Oman's Block
5, which has both oil and natural gas assets.\55\
 
------------------------------------------------------------------------


Fostering Friendly Relations in MENA

    China seeks to develop and maintain friendly ties with all 
MENA countries (and the Palestinian territories) without being 
drawn into the region's conflicts or power struggles.\56\ 
Beijing hopes to leverage these relationships to extend China's 
regional and global influence; portray China as a responsible 
global power; and promote regional stability with a view toward 
advancing its own economic, political, and security interests. 
China's efforts appear to be working. A 2013 Pew Global 
Research study found that MENA countries tend to view China 
more as a partner than an enemy.* Dr. Murphy testified that 
government officials throughout the region have favorable views 
toward China, although they ``do not want relations with China 
to endanger their existing close relationships with the United 
States.'' \57\
---------------------------------------------------------------------------
    * China's potentially lucrative investments in Iranian projects 
have been facilitated in part by the fact that these projects have been 
abandoned or passed over by major Western companies due to political 
risk and sanctions on Iran's energy and banking sectors. U.S.-China 
Economic and Security Review Commission, Hearing on China and the 
Middle East, written testimony of Erica Downs, June 6, 2013; Scott 
Harold and Alireza Nader, China and Iran: Economic, Political, and 
Military Relations (Santa Monica, CA: RAND Corporation, 2012), p. 5. 
http://www.-rand.org/content/dam/rand/pubs/occasional-_-papers/2012/
RAND-_-OP351.pdf.
    * The 2013 Pew Global Research study included Egypt, Israel, 
Jordon, Lebanon, the Palestinian territories, and Tunisia. Pew Research 
Center, America's Global Image Remains More Positive than China's: But 
Many See China Becoming the World's Leading Power (Washington, DC: Pew 
Global Research, June 18, 2013), pp. 25-26. http://www.pewglobal.org/
files/2013/07/Pew-Research-Global-Attitudes-Project-Balance-
of-Power-Report-FINAL-July-18-2013.pdf. Other studies from the late 
2000s indicating positive views of China by Middle East countries 
include: Shibley Telhami, 2006 Annual Arab Public Opinion Survey 
(College Park, MD: University of Maryland, February 2007), slide 9; Pew 
Research Center, Rising Environmental Concern in 47-Nation Survey: 
Global Unease with Major World Powers (Washington, DC: Pew Research 
Center, June 27, 2007), p. 29. http://www.pewglobal.org/files/pdf/
256.pdf; and Julie Ray, ``China's Leadership Better Regarded Outside 
the West,'' Gallup World, April 29, 2008. http: // www.-gallup-.-com / 
poll / 106858 / chinas-leadership-better-regarded-outside-west.aspx.
---------------------------------------------------------------------------
    At the same time, Beijing considers MENA a ``graveyard of 
great powers'' and generally seeks to avoid becoming involved 
in the region's rivalries and conflicts or being perceived as 
aligning with particular countries or stakeholders.\58\ With a 
large degree of success, China to date has simultaneously 
fostered advantageous relationships with regional rivals such 
as Israel and the Palestinians, Israel and Iran, Saudi Arabia 
and Iran, and even Iraq and Iran when they were at war in the 
1980s. Beijing's reluctance to overtly align with or 
against countries in MENA reflects pragmatic decision making 
aimed at maximizing China's economic and political advantage in 
the region.
---------------------------------------------------------------------------
     China sold weapons to both Iraq and Iran during the war, 
using the conflict to advantage its ailing arms manufacturing industry. 
China's sales to each side did not attract serious criticism from 
either Iran or Iraq. If anything, it strengthened Sino-Iranian ties and 
mutual trust. John W. Garver, China & Iran: Ancient Partners in a Post-
Imperial World (Seattle, WA: University of Washington Press, 2006), pp. 
59, 82; U.S. Defense Intelligence Agency, ``China's Defense Industrial 
Modernization and Arms Sales'' (Washington, DC). http://www.dia.mil/
public-affairs/foia/ pdf/CHINA/
CHINA % 27S % 20-DEFENSE % 20-INDUSTRIAL % 20-MODERNIZATION % 20-AND 
%-20-ARMS%20-SALES.pdf; and Scott Harold and Alireza Nader, China and 
Iran: Economic, Political, and Military Relations (Santa Monica, CA: 
RAND Corporation, 2012), p. 3. http://www.-rand.org/content/dam/rand/
pubs/occasional-_-papers/2012/RAND-_-OP351.pdf.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
China's Non-Interference Policy and MENA
 
  China claims respect for other countries' sovereignty and opposes
interference in the internal affairs of other countries.\59\ This
principle is rooted in Beijing's opposition to establishing an
international precedent that legitimizes regime change, which it likely
judges could have implications for Chinese Communist Party rule in the
event of upheaval in China. The non-interference principle guides
Beijing's approach and policies toward MENA and is reflected in
Beijing's aversion to challenging sitting regimes or the political
status quo in other countries and its reluctance to overtly align with
any one side in a conflict or rivalry.\60\
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
China's Non-Interference Policy and MENA--Continued
 
  Yitzhak Shichor, professor emeritus at the Hebrew University of
Jerusalem and the University of Haifa, asserts that China does in fact
involve itself in the affairs of other countries when Beijing judges it
is in China's national interest to do so. Dr. Shichor testified to the
Commission that China applies the principle of non-interference in a
``flexible, pragmatic, and creative'' way.\61\ This appears to be the
case in China's relations with MENA in recent years. For example, China
in the name of non-interference and respect for sovereignty does not
support United Nations (UN) Security Council action or sanctions to
punish regimes in Iran and Syria for destabilizing activity, violence,
and human rights abuses.\62\ Beijing quietly has supported regimes in
both countries while Chinese diplomats stress China's impartiality to
international audiences.*
 
------------------------------------------------------------------------


Ensuring Domestic Stability and Control

    One of China's objectives in its foreign relations with 
MENA countries (and to an even greater extent with Central Asia 
) is promoting domestic security, particularly in 
Xinjiang Uighur Autonomous Region, home to many of China's 
ethnic Turkic Muslims. Episodic ethnic and political unrest in 
Xinjiang has in the past attracted support from overseas Muslim 
groups, particularly in MENA and Central Asia.= Beijing fears 
these overseas groups could encourage what it refers to as 
``separatist insurgencies.'' \63\ In its diplomatic engagement 
with MENA countries, especially with CASCF, China solicits 
support for its policies to suppress ``separatist'' activities 
in Xinjiang. For example, the 2010 CASCF Communique states that 
the organization's Arab countries are ``against religious 
extremist forces or ethnic separatist forces engaged [in] 
terrorism or anti-China separatist activities.'' \64\
---------------------------------------------------------------------------
    * For example, Chinese Ministry of Foreign Affairs spokesperson 
Hong Lei in May 2013 asserted China's impartiality in the Syrian 
conflict, saying, ``China has no selfish interests on the Syrian issue 
and has no intention to protect any party. China is positive and open 
to any resolution plan that is widely acceptable to all relevant 
parties in Syria.'' Ministry of Foreign Affairs (China), ``Foreign 
Ministry Spokesperson Hong Lei's Remarks on the UN General Assembly's 
Adoption of the Resolution on the Syrian Issue,'' May 16, 2013. http://
www.fmprc.gov.cn/eng/xwfw/s2510/2535/t1040948.shtml.
     Beijing's imperative for stability and control in Xinjiang 
is a key driver of China's foreign policy in Central Asia. For 
additional discussion, see International Crisis Group, China's Central 
Asia Problem (Bishkek, Kyrgyzstan; Beijing, China; Brussels, Belgium: 
February 27, 2013), 
pp. 6-8. http: // www.crisisgroup.org /  / media / Files / asia / 
north - east- asia / 244- chinas- central- asia-problem.pdf.
    = Dr. Shichor testified to the Commission that ``the Chinese 
[government has] been very careful so far not to allow external 
financial or any other kind of support to Muslims in China.'' Dr. 
Murphy elaborated, saying Beijing is ``concerned about informal 
financing [for Xinjiang's Muslim groups] . . . especially from Turkey, 
[and] possibly from the Gulf states.'' U.S.-China Economic and Security 
Review Commission, Hearing on China and the Middle East, testimony of 
Yitzhak Shichor, June 6, 2013; U.S.-China Economic and Security Review 
Commission, Hearing on China and the Middle East, testimony of Dawn 
Murphy, June 6, 2013.
---------------------------------------------------------------------------
    According to Dr. Murphy, ``After the beginning of the Arab 
Spring, China's concern regarding domestic stability in 
relation to the Middle East has shifted from issues related to 
Xinjiang to a concern over preventing the spread of Arab 
Spring-style upheaval from the Middle East to China.'' \65\ 
Starting in 2011, Chinese officials sought to ensure that 
unrest did not manifest in China by suppressing Arab Spring-
inspired ``Jasmine Revolution'' protests, censoring related 
information on the Internet, and emphasizing through official 
and semi-official media outlets that popular calls for 
democracy across MENA were misguided.\66\

Promoting Regional Stability

    Beijing increasingly views stability in MENA as essential 
to protecting and advancing China's expanding interests and 
ensuring China's future security.\67\ Some of China's efforts, 
including offering support for the Israeli-Palestinian peace 
process, counterpiracy operations, and peacekeeping operations, 
promote stability in MENA.\68\ At the same time, Chinese ties 
with rogue regimes and terrorist organizations and arms sales 
to the region have in the past undermined peace and security.

    Support for the Israeli-Palestinian Peace Process: China 
maintains relatively positive ties with both Israel and the 
Palestinians. Though Beijing remains wary of becoming entangled 
in the conflict, it has since the late 1990s indicated a desire 
to play a greater role in the peace process.
    Historically, China has strongly supported the 
Palestinians. Beijing first expressed support for Palestinian 
statehood in 1955 and provided arms, military training, and 
other aid to the Palestinian Liberation Organization and the 
Popular Front for the Liberation of Palestine through the 
1980s.* \69\ China did not formally recognize Palestine until 
1988, however. Four years later, China formally recognized 
Israel, although Beijing had quietly cultivated economic and 
political ties with Israel since the late 1970s.\70\ Following 
the establishment of diplomatic ties, Sino-Israeli economic, 
technological, and military ties grew substantially.
---------------------------------------------------------------------------
    * The nature of China's provision of arms to Palestinian 
organizations is not well documented. AK-47 assault rifles and other 
small arms appear to constitute the bulk of Chinese weapons transfers. 
China also provided training opportunities for Palestinian soldiers in 
China and in the Middle East. John K. Cooley, ``China and the 
Palestinians,'' Journal of Palestinian Studies 1:2 (Winter 1972): 26. 
http://palestine-studies.org/files/Special-%-20-Focus/
Through-%-20-the-%-20-Eyes-%-20-of-%-20-Others/
China-%-20-and-%-20-the-%-20-Palestinians.pdf; Dawn Murphy, Rising 
Revisionist? China's Relations with the Middle East and Sub-Saharan 
Africa in the post-Cold War Era (Washington, DC: George Washington 
University, 2012), pp. 81-86.
---------------------------------------------------------------------------
    China made occasional statements supporting Israeli-
Palestinian reconciliation in the 1980s and 1990s but became 
more actively invested in the peace process in the early 2000s. 
This appears to be largely due to requests from several Arab 
countries for Beijing to become more involved. These countries 
likely judged China could balance U.S. influence over the peace 
process given Beijing's longstanding support for the 
Palestinians.\71\ In response, Beijing in 2002 established its 
first ever ``special envoy'' diplomat. The special envoy is 
responsible for the entire region but focuses on the Israeli-
Palestinian conflict in particular. Observers note that this 
position entails gathering and sharing information more so than 
playing an active role in the mediation process.\72\
    In the spring of 2013, Beijing signaled a new willingness 
to engage in the peace process. Chinese President Xi Jinping in 
May issued a ``Four Point Proposal'' emphasizing a two-state 
solution, peaceful negotiation, the ``land-for-peace'' 
principle, and ``a greater sense of responsibility and 
urgency'' among the international community to resolve the 
conflict.\73\ This proposal reiterates China's earlier 
statements on the conflict and is largely consistent with the 
official U.S. position.* President Xi publicized the proposal 
himself, indicating the importance China's top leaders ascribe 
to the issue. The announcement of the proposal coincided with 
visits to Beijing by President Mahmoud Abbas of the Palestinian 
territories and Israeli Prime Minister Benjamin Netanyahu. 
China's Ministry of Foreign Affairs at the time stated China 
``is willing to offer necessary assistance if the leaders of 
Palestine and Israel have the will to meet in China.''\74\ 
Nevertheless, Beijing appears to have designed the leaders' 
itineraries such that neither leader would be in the same 
Chinese city at the same time.\75\ It remains to be seen if 
Beijing's recent overtures will translate to concrete actions 
to facilitate the peace process.
---------------------------------------------------------------------------
     The ``land for peace'' principle originates in UN Security 
Council Resolution 242, which states, ``The establishment of a just and 
lasting peace in the Middle East . . . should include the application 
of both the following principles: Withdrawal of Israeli armed forces 
from territories occupied in the recent conflict; [and] [t]ermination 
of all claims or states of belligerency and respect for and 
acknowledgement of the sovereignty, territorial integrity and political 
independence of every State in the area and their right to live in 
peace within secure and recognized boundaries free from threats or acts 
of force.'' United Nations, ``United Nations Security Council 
Resolution 242,'' (New York, NY: November 22, 1967). http://
unispal.un.org/unispal.nsf/0/7D 35E1F-729DF-491C-85256EE-700686136.
    * Beijing's position on the conflict was formally established in 
1997. It was slightly revised in 2003 to reflect the ``road map to 
peace'' proposed by the United States, the European Union, Russia, and 
the UN in 2003. Dawn Murphy, Rising Revisionist? China's Relations with 
the Middle East and Sub-Saharan Africa in the post-Cold War Era 
(Washington, DC: George Washington University, 2012), p. 217.

    Counterpiracy Operations: Since January 2009, China has 
sustained a naval task group in the Gulf of Aden to conduct 
counterpiracy operations. This represents China's 
largest overseas military presence. As of October 2013, China's 
People's Liberation Army (PLA) Navy had deployed around 10,000 
personnel in 15 successive two- or three-ship task forces over 
four years. Chinese official media sources state the PLA Navy 
has protected more than 5,000 commercial ships from China and 
more than 50 other countries over the course of 500 
escorts.\76\ Chinese counterpiracy patrollers have made port 
calls for resupply or military-to-military engagements to 12 
MENA ports: Algiers, Algeria (1 visit); Al Manamah, Bahrain 
(1); Alexandria, Egypt (1); Haifa, Israel (1); Shuwaikh, Kuwait 
(1); Casablanca, Morocco (1); Muscat, Oman (1); Salalah, Oman 
(15); Doha, Qatar (1); Jiddah, Saudi Arabia (4); Abu Dhabi, 
United Arab Emirates (1); and Aden, Yemen (8).\77\
---------------------------------------------------------------------------
     For past Commission reporting on China's counterpiracy 
operations, see chapter 2, section 1, ``Military and Security Year in 
Review,'' of this Report; U.S.-China Economic and Security Review 
Commission, 2009 Annual Report to Congress (Washington, DC: U.S. 
Government Printing Office, November 2009), pp. 118, 123, 125, 127; 
U.S.-China Economic and Security Review Commission, 2011 Annual Report 
to Congress (Washington, DC: U.S. Government Printing Office, November 
2011), p. 162; and U.S.-China Economic and Security Review Commission, 
2012 Annual Report to Congress (Washington, DC: U.S. Government 
Printing Office, November 2012), pp. 135, 138.
---------------------------------------------------------------------------
    Beijing maintains it will not pursue a permanent military 
presence abroad. However, some Chinese commentators since the 
late 2000s have called for China to develop a permanent or 
semipermanent overseas naval presence in the Indian Ocean to 
address logistical challenges associated with sustaining the 
PLA Navy's counterpiracy presence in the Gulf of Aden and help 
secure China's maritime trade routes in the Indian Ocean. China 
could seek to establish repair, refuel, and replenishment 
stations in MENA or the Indian Ocean to address logistical 
challenges associated with sustaining the PLA Navy's 
counterpiracy presence in the Gulf of Aden and help secure 
China's maritime trade routes in the Indian Ocean. Such a 
logistics hub also could facilitate potential future missions 
in the region, such as noncombatant evacuations, disaster 
relief, defense of maritime trade routes, and limited force 
projection.\78\ Countries in the Gulf of Aden, particularly 
Oman and Yemen, have allowed frequent PLA Navy port visits over 
the past four years and likely would be top candidates for 
China's first logistics hub.\79\ China probably will not pursue 
traditional overseas bases in the near term due to longstanding 
political restraints, Beijing's concern about international 
backlash against a larger overseas military presence, and the 
current absence of a strategic requirement to persistently 
project power globally.\80\

    Peacekeeping Operations: China has participated in four UN 
peacekeeping operations in MENA since 2001: UN Truce 
Supervision Organization,* UN Iraq-Kuwait Observer Mission, UN 
Interim Force in Lebanon, and UN Supervision Mission in Syria. 
More than 3,200 troops have participated in these missions.\81\ 
As of September 2013, China had four peacekeepers in the UN 
Truce Supervision Organization and 343 peacekeepers in the UN 
Interim Force in Lebanon.\82\
---------------------------------------------------------------------------
    * The UN Truce Supervision Organization, established in 1948, 
``monitor[s] ceasefires, su- pervise[s] armistice agreements, 
prevent[s] isolated incidents from escalating and assist[s] other UN 
peacekeeping operations in the region to fulfill their respective 
mandates'' in MENA. United Nations, ``United Nations Truce Supervision 
Organization.'' http://www.un.org/en/peacekeeping/missions/untso/.
     An Iranian manufacturing company owner interviewed by the 
New York Times in September 2013 characterized Iran's oil trading 
relationship with China as an ``oil-for-junk program.'' Thomas 
Erdbrink, ``Iran Staggers as Sanctions Hit Economy,'' New York Times, 
September 30, 2013. http://www.nytimes.com/20--13/--10/0--1/world/
middleeast/iran-staggers-as-sanctions-hit-economy
.html?pagewanted=all&--r=0.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Chinese Activities that Undermine MENA Security
 
  While China generally seeks stability in MENA, some Chinese activities
in the region undermine security and stability.
 
 Commercial ties to rogue regimes: Chinese companies frequently
 invest in and trade with authoritarian regimes in MENA and elsewhere in
 the world. This is typified by Chinese national oil companies, which
 have profited from Iran's international isolation.\83\ For example,
 China's national oil companies seek to exploit Tehran's sanctions-
 crippled economy  to negotiate advantageous contracts and
 barter agreements and secure lucrative investments. Chinese state-owned
 Zhuhai Zhenrong Corp. in 2012 reportedly ordered an $80 million
 shipment of Syrian crude oil in defiance of Western sanctions.\84\ In a
 June 2013 interview for the Financial Times, Syrian Deputy Prime
 Minister for the Economy Kadri Jamil said China, Russia, and Iran are
 ``supporting us [the Syrian regime] politically, militarily--and also
 economically.'' \85\
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Chinese Activities that Undermine MENA Security--Continued
 
 Arms sales: In recent years, China has sold arms in limited
 quantities to MENA countries.* According to the Stockholm International
 Peace Research Institute, China delivered arms to Algeria, Egypt, Iran,
 Saudi Arabia, and Syria from 2008 to 2012 in fulfillment of orders made
 between 1992 and 2009. For the past decade, Iran has been the
 primary beneficiary of Chinese arms (mostly antiship cruise missiles)
 and dual-use technology transfers to the region.\86\ Moreover, U.S.
 officials have indicated Chinese entities may not be in full compliance
 with international nuclear nonproliferation efforts aimed at Iran,
 though the Chinese government claimed it ceased assisting Tehran's
 nuclear program in 1997.\87\
 
    In some cases, Chinese arms used in MENA appear to have been
 acquired via third countries or from Chinese weapons manufacturers
 without necessarily being sanctioned by the Chinese government.\88\
 Chinese weapons manufacturers have sold or attempted to sell arms or
 dual-use technologies to Iran and Libya in violation of international
 and U.S. sanctions.\89\ Chinese officials usually deny the sales or
 offers were made with the knowledge and consent of the Chinese
 government. Regardless of Beijing's level of involvement, its lax
 enforcement of export controls allows this proliferation to occur.\90\
 
 Ties with regional terrorist groups: Beijing maintains official
 ties with both Hamas and Hezbollah, although the United States, the
 European Union, and other powers designate both Hamas and the military
 wing of Hezbollah terrorist organizations. Both groups reportedly have
 used Chinese-made arms in attacks on Israel, though it is unclear if
 the Chinese government sanctioned or was aware of the transfer of these
 arms. According to news reports, Hamas in 2006 launched around 50
 Chinese rockets in attacks on Israel, and Hezbollah in 2008 attacked an
 Israeli naval vessel with a Chinese-made C-802 antiship missile
 transferred from Iran.\91\ In 2012, families of Israeli students killed
 in a 2008 terror attack by Hamas filed a lawsuit against a New York
 City branch of the state-owned Bank of China for providing support for
 Hamas terrorist activities.\92\ Bank of China rejected the allegations
 as groundless.\93\
 
------------------------------------------------------------------------

      
---------------------------------------------------------------------------
    * This was not always the case. From the 1950s to the late 1970s, 
China donated large quantities of small arms and provided military 
training to revolutionary groups in the region. In subsequent decades, 
China's arms transfers have been more limited. Dawn Murphy, Rising 
Revisionist? China's Relations with the Middle East and Sub-Saharan 
Africa in the post-Cold War Era (Washington, DC: George Washington 
University, 2012), p. 84; Stockholm International 
Peace Research Institute, ``SIPRI Arms Transfers Programme.'' http://
portal.sipri.org/publications /pages/transfer/splash.
     These transfers included towed guns (Algeria); trainer/
combat aircraft and unmanned aerial vehicles (Egypt); armored personnel 
carriers and possibly portable surface-to-air missiles and antiship 
missiles (Iran); self-propelled guns (Saudi Arabia); and air search 
radar (Syria). Stockholm International Peace Research Institute, 
``SIPRI Arms Transfers Programme.'' http://portal.-sipri.org/
publications/pages/transfer/splash.

---------------------------------------------------------------------------
China's Geopolitical Challenges in MENA

    China faces several geopolitical challenges in MENA. 
Instability, regime changes, and power shifts in recent years 
likely have demonstrated to Beijing that its preferred low-key 
method of managing its relationships in the region is 
unsustainable. In addition, Beijing's positions on Syria and 
Iran implicate China in violence, human rights abuses, and 
weapons proliferation and put China at odds with the United 
States in the region.

Regime Change and Unrest: Tunisia, Egypt, Libya, and Syria

    China was unprepared to respond to the abrupt political 
upheaval and regime changes of the Arab Spring.\94\ This likely 
is due to Beijing's inclination to cultivate relationships with 
ruling parties and its overall lack of experience in the 
region. Both Chinese and Western observers note the relative 
inexperience of China's diplomatic corps in MENA as a reason 
for its difficulty in responding to sweeping changes in the 
region. Director and professor of the Middle East Studies 
Institute at the Shanghai International Studies University Liu 
Zhongmin assessed ``China's response to the political unrest 
[in MENA] was somewhat lagging behind.'' He continued, 
``China's contacts and communication with the political 
opposition in the Middle Eastern countries were not active 
enough.'' \95\ According to Jon B. Alterman, director of the 
Middle East Program at the Center for Strategic and 
International Studies, ``China's [MENA] diplomacy has been more 
cautious than it has been deft.'' \96\ In his testimony to the 
Commission, he elaborated that China's policy toward unrest in 
the region is uninformed, ``in part because [China] does not 
know [about the region's opposition groups], but also because 
it has not paid close attention to the societies from which 
they have sprung.'' \97\

    Tunisia: Beijing moved quickly to censor domestic news 
about the Tunisian uprising and took steps to form ties with 
the transitional government in January 2011.\98\ A Chinese 
Foreign Ministry spokesperson stated China's hope for a 
peaceful resolution to the unrest and the resumption of 
friendly ties with the Tunisian government regardless of the 
uprising's outcome. However, after that initial statement, 
Beijing was silent on the unrest and transition, at least in 
public.\99\ Chinese diplomats were and to an extent remain 
unfamiliar with Tunisia's Islamist political groups, including 
the ruling Ennahdha party, which was voted into power in late 
2011.\100\

    Egypt: Prior to the overthrow of former Egyptian President 
Hosni Mubarak, Beijing had been cultivating relations with the 
Mubarak regime in order to expand its economic profile, secure 
ties to one of the most powerful countries in the region, and 
promote access to critical infrastructure in Egypt, including 
the Suez Canal.\101\ In the months following the uprising and 
overthrow, Chinese diplomats reportedly struggled to forge 
relations with the transitional Egyptian government, apparently 
due to suspicions on the part of Egypt's new leaders, who 
considered Beijing to have been a strong supporter of the 
Mubarak government.\102\ Nevertheless, Egypt's newly elected 
president Mohamed Morsi in August 2012 chose China for his 
first state visit outside the Middle East. Relations between 
Beijing and Cairo remained stable and positive throughout the 
Morsi Administration. Bilateral trade increased by 27 percent 
between 2010 and 2012, and the two sides signed several 
agreements on investment and science and technology 
cooperation.\103\
    After the Egyptian military removed President Morsi from 
power in July 2013 and during subsequent months of unrest and 
violence, Chinese officials were circumspect in their official 
statements on the situation. Public reticence notwithstanding, 
Beijing appears to be observing developments in Egypt closely: 
Chinese Minister of Foreign Affairs Wang Yi spoke over the 
phone with his Egyptian counterpart in the new government 16 
times between President Morsi's removal and August 16.\104\ 
Minister Wang expressed that ``China attaches high attention to 
the situation in Egypt, and has called on all parties concerned 
to give up violence to avoid bloodshed and to prevent more 
casualties. China supports [sic] to resolve differences through 
dialogues and consultations, to restore law and order, and to 
advance steadily the process of inclusive political 
transition.'' \105\ Minister Wang further asked the Egyptian 
government to ensure the safety of Chinese citizens, 
enterprises, and institutions in the country.\106\
    While Sino-Egyptian economic ties remained largely 
unaffected by the transition from the Mubarak to the Morsi 
governments, bilateral trade appears to have faltered somewhat 
in 2013 amid renewed unrest surrounding removal of the Morsi 
government and installment of the military government.\107\ It 
is unclear whether the decrease in bilateral trade in 2013 can 
be attributed to the ongoing political unrest. Chinese 
investment in Egypt continued in 2013, with Sinopec purchasing 
a stake in U.S. energy company Apache's Egyptian oilfield 
operations in August. According to Apache, the company's 
``exploration and production operations, which are located in 
remote, unpopulated areas, remain unaffected by political 
events in the region.'' \108\

    Libya: More so than during the relatively quick power 
transitions in Tunisia and Egypt in 2011, China faced 
challenges on several fronts during the months-long Libyan 
conflict. Instability and violence threatened the safety of 
Chinese citizens and the security of Chinese investments and 
trade ties.\109\ China in early 2011 evacuated 35,000 citizens 
from Libya in its first major noncombatant evacuation 
operation.\110\ As violence by then Libyan President Muammar 
el-Qaddafi's regime escalated, China in February 2011 voted to 
approve UN Security Council Resolution 1970, which imposed 
sanctions on President Qaddafi and his close associates, 
imposed an arms embargo on Libya, and provided humanitarian 
assistance, among other things.\111\ Less than three weeks 
later, China abstained from the vote on UN Security Council 
Resolution 1973, which authorized the Security Council to 
establish a no-fly zone and pursue an immediate ceasefire in 
Libya.\112\ China almost certainly understood that its 
abstention would enable military intervention in Libya, but it 
also allowed Beijing flexibility to publicly hew to its policy 
of non-interference and express surprise and regret when North 
Atlantic Treaty Organization (NATO) forces predictably 
intervened in Libya.\113\
    Nevertheless, through the spring and summer of 2011 China 
appeared reluctant to sever ties with the Qaddafi regime. 
Journalists from Toronto's Globe and Mail found evidence 
suggesting state-owned weapons manufacturer Chinese North 
Industries Corporation had offered at least $200 million in 
arms to the Qaddafi regime while the arms embargo (which China 
had voted for) was in place.\114\ China also was the only UN 
Security Council member not to call for Qaddafi to step down 
and the last UN Security Council member to recognize Libya's 
new transitional government in the fall of 2011.\115\ Despite a 
decline in 2011, bilateral trade (particularly Chinese exports 
to Libya) rebounded in 2012 and the first half of 2013.\116\

    Syria: Despite its emphasis on neutrality and peaceful 
resolution in public statements,* China takes a hardline stance 
on the Syrian conflict. Beijing's position seems to be based on 
an ideological opposition to foreign intervention (China has 
limited economic or strategic interests in Syria). Beijing 
likely fears actions designed to overthrow a sovereign regime 
could legitimize regime change and external intervention and 
thus threaten China's own core interests of sovereignty and 
territorial integrity. This position seems to be reinforced by 
China's apparent regret over its abstention from, and thus 
tacit support for, foreign intervention in Libya authorized by 
UN Security Council Resolution 1973.\117\
---------------------------------------------------------------------------
    * China's stated position on the Syrian conflict emphasizes an end 
to violence, political transition under the guidance of the UN and the 
Arab League, and humanitarian assistance. Beijing endorsed the UN's 
``six-point plan'' for peace in Syria developed by former UN-Arab 
League envoy to Syria Kofi Annan, although it has rejected efforts 
within the UN to pressure President Assad to acquiesce to UN 
resolutions or step down. Priyanka Boghani, ``Syria peace plans: China 
vs. United Nations,'' Global Post, November 1, 2012. http://
www.global-post.com/dispatch/news/regions/middle-east/syria/121101/
syria-peace-plans-china-vs-united-nations.
---------------------------------------------------------------------------
    China repeatedly has used its veto power to prevent the UN 
Security Council (and other UN bodies) from singling out, 
blaming, or imposing sanctions on the Syrian government.\118\ 
China has vetoed three UN Security Council resolutions to take 
action against President Assad and exercised three ``no'' votes 
to punish President Assad in the UN General Assembly and UN 
Human Rights Council.\119\ China also has opposed any military 
action, even in support of humanitarian efforts, in Syria.\120\ 
In response to the Obama Administration's August 2013 
statements suggesting possible unilateral air strikes against 
Syria, a Chinese Ministry of Foreign Affairs spokesperson 
stated, ``China is highly concerned about the relevant 
country's [United States] plan on taking unilateral military 
action.'' The spokesperson then said the international 
community should ``avoid complicating the Syrian issue and 
dragging the Middle East down into further disaster.''\121\
    China's position on the Syria conflict aligns with the 
Russian position, though the two countries may have different 
motivations for their respective stances.\122\ China and Russia 
have voted the same on issues related to Syria in the UN 
Security Council, and China supported a Russian proposal that 
the Syrian government hand over the country's chemical weapons 
under UN supervision. Foreign Minister Wang in mid-September 
2013 said, ``China welcomes the framework agreement reached 
between Russia and the U.S. in Geneva on the issue of chemical 
weapons in Syria. We believe it will ease the tense situation 
in Syria, and open a path for the chemical weapons issue to be 
resolved.'' \123\ Beijing and Moscow in September 2013 released 
a joint statement on the Syrian conflict, conveying shared 
concerns about the security and humanitarian situation and 
supporting an ``accurate and objective international 
investigation'' into the reported use of chemical weapons in 
Syria, among other things.\124\
    According to the Stockholm International Peace Research 
Institute's Arms Transfers Database, China has not delivered or 
approved the sale of weapons to Syria since 2010.* \125\ The 
most recent Chinese arms transfers to Syria were four Type-120 
air search radar systems, which were ordered in 2009 and 
delivered in 2010.\126\ Unconfirmed reporting also suggests 
that Chinese-made shoulder-launched FN-6 antiaircraft missiles 
were transferred by third parties to Syrian rebels.\127\
---------------------------------------------------------------------------
    * China provided arms to Syria before 2010, however. According to 
the Congressional Research Service, China since 2004 signed arms 
transfer agreements with Syria worth $800 million (representing about 9 
percent of global arms transfers to Syria from 2004 to 2011). Richard 
F. Grimmett and Paul K. Kerr, Conventional Arms Transfers to Developing 
Countries, 2004-2011 (Washington, DC: Congressional Research Service, 
August 24, 2012), pp. 44-45. http://www.-fas.-org/sgp/crs/weapons/
R42678-.-pdf.
---------------------------------------------------------------------------
    Beijing has expended considerable diplomatic energy and 
incurred widespread criticism for its position on the Syrian 
conflict. In her testimony before the Commission, Dr. Murphy 
asserted Beijing's position on Syria marks a departure from 
China's historical approach to the Middle East insofar as it 
alienates other countries in the region and represents a firm 
and sustained opposition to U.S. interests.\128\ Many in the 
international community, including the United States, assert 
China's position protects the Assad regime and prevents 
necessary international measures to promote the peaceful 
resolution of the conflict. Then U.S. Ambassador to the UN 
Susan Rice in February 2012 said the United States was 
``disgusted'' by China's (and Russia's) vetoes of otherwise 
unanimous UN Security Council resolutions on Syria and remarked 
that the UN's mission was being ``held hostage'' by China and 
Russia.\129\ Moreover, whereas MENA countries (and public 
opinion) generally favor China's presence and policies in the 
region, this has not been true regarding the Syrian conflict. 
Several Arab League countries, particularly Saudi Arabia and 
Qatar, criticized China for its position on Syria.\130\ At the 
time of this Report's publication, China appears to judge the 
benefits of continuing to shield and enable the Assad regime 
outweigh the potential costs of supporting international 
efforts to hold the regime accountable.

Iran

    The Commission has in recent years reported at length on 
Sino-Iranian economic, political, and military 
relations. This section discusses China-Iran ties in 
the context of China-MENA relations specifically.
---------------------------------------------------------------------------
     Commission publications on China and Iran from 2011 to 
2013 include Marybeth Davis et al., China-Iran: A Limited Partnership 
(Washington, DC: CENTRA Technology, Inc. for the U.S.-China Economic 
and Security Review Commission, April 2013). http://
origin.www-.-uscc.gov/sites/default/files/Research/China-
Iran-_-A-%20-Limited-%20-Partnership-.-pdf; U.S.-China Economic and 
Security Review Commission, 2012 Annual Report to Congress (Washington, 
DC: U.S. Government Printing Office, 2012), pp. 334-336; and U.S.-China 
Economic and Security Review Commission, 2011 Annual Report to Congress 
(Washington, DC: U.S. Government Printing Office, 2011), pp. 252-260.
---------------------------------------------------------------------------
    Beijing's relationship with Tehran is simultaneously 
China's closest and most problematic bilateral relationship in 
the region.\131\ The multiple facets of this relationship--
including energy ties, arms and dual-use technology sales, and 
diplomatic support--have enabled Tehran's destabilizing 
policies and damaged U.S.-China relations and China's 
international reputation. However, Beijing appears to judge 
these consequences are worth the energy security benefits 
gained from continued cooperation with Iran. China also likely 
prefers that the United States not enjoy unchecked power and 
influence in the Middle East.\132\ According to a report by 
CENTRA Technology, Inc. sponsored by the Commission, ``China 
has used its relations with Iran to balance against U.S. 
interests and what it sees as hegemonic policies in the Middle 
East.'' \133\ However, should China seek a more robust 
political and security presence in MENA, countries of the 
region could seek to pressure China to reconsider its support 
for Iran.
    China's reduction in Iranian crude oil imports in 2012 and 
2013 was made possible by Saudi Arabia, Iraq, Oman, and other 
countries' willingness and ability to compensate for the lost 
barrels of oil. Significant increases in Iraqi oil production 
expected in the coming years and decades could provide a 
reliable alternative source of oil for Beijing should it seek 
to further decrease Iranian imports.\134\ Moreover, Saudi 
Arabia, a powerful regional player and energy powerhouse with 
its own concerns about Iran, has demonstrated a commitment to 
Chinese energy security. As China increasingly relies on these 
countries for its energy, Beijing may determine it can moderate 
its support for and ties with Tehran without sacrificing the 
energy security benefits it currently gains from the 
relationship. However, Beijing at present does not seem to 
assess that sacrificing its relationship with any of its major 
oil suppliers is in its interests. As long as this remains the 
case, Beijing is unlikely to seriously revise its relationship 
with Tehran on this basis.\135\
    Beijing does not appear to judge Iran's nuclear program as 
a serious threat to Chinese economic or security interests or 
to security in MENA.\136\ Joel Wuthnow, researcher at CNA China 
Studies, testified to the Commission, ``Although some Chinese 
analysts accept the premise that an Iranian nuclear weapon 
might spark a regional arms race, few have publicly discussed 
whether and how such an outcome may damage Chinese interests.'' 
\137\ However, as China's presence and influence in the region 
grows, Dr. Wuthnow suggested Middle Eastern countries and the 
United States may find opportunities to persuade China that 
Iran's behavior poses a risk to ``regional security, and thus 
to China's own interests in Iran and the region.'' \138\

Implications for the United States

    The United States has deep and longstanding interests in 
MENA, which it seeks to protect and advance through economic 
engagement, strategic partnerships and security arrangements, 
and a large military presence. As China's interests and 
presence in the region grow, they inevitably will impact U.S. 
objectives and influence there.
    Beijing recognizes the United States is the most 
influential external power in MENA and formulates its regional 
policies with this in mind. A Saudi Arabian ambassador to China 
remarked, ``In order to understand China's relations with the 
Gulf states, one must understand Sino-American relations.'' 
\139\ Historically, China has sometimes opposed or resented 
U.S. influence and policies in MENA, but has sought to avoid 
directly challenging the United States in the region.\140\ 
According to Dr. Alterman, ``Chinese officials are keenly aware 
of the advantages of supplementing the United States in 
regional affairs, but they show little interest in supplanting 
the United States . . . [China] studiously avoids forcing 
countries to choose between the United States and China.'' 
\141\ Rather, in preferring a minimally involved role in the 
region, China benefits from the U.S. security presence there.

     L``Free riding'' on U.S. security efforts: China 
is in many ways a ``free rider'' on U.S. power and influence in 
MENA, while contributing relatively little to regional security 
itself.\142\ Associate Professor and Deputy Director of the 
Department of Arabic Language and Culture at Peking University 
Wu Bingbing asserts, ``The United States provides the ultimate 
strategic security guarantee to Saudi Arabia . . . China lacks 
the ability to provide such a security guarantee, and is not 
sure how far the Sino-Saudi friendship can go.'' \143\ China's 
successful investments and growing energy trade with Iraq, 
which has experienced a postwar oil boom, is another example of 
China reaping benefits from U.S. security efforts in the 
region.\144\

     LLearning from U.S. military activities: China's 
military since the 1990s has gained insight into modern warfare 
and, more specifically, U.S. military strategy and capabilities 
from studying U.S. military campaigns in the Middle East.\145\ 
Dr. Shichor testified to the Commission that MENA is ``the key 
region in the world that serves as a laboratory for testing 
[and] experimenting . . . with Western weapons [and] state-of-
the-art American military technology, which provides a very 
significant input into China's defense modernization.'' * \146\
---------------------------------------------------------------------------
    * Dean Cheng, research fellow at the Heritage Foundation's Asian 
Studies Center, similarly asserts that both U.S. wars in Iraq are 
``very influential'' to the PLA's tactical, operational, and strategic 
thinking. Dean Cheng, ``Chinese Lessons from the Gulf Wars,'' in Andrew 
Scobell et al., Chinese Lessons from Other Peoples' Wars (Carlisle, PA: 
U.S. Army War College Strategic Studies Institute, November 2011), pp. 
153-199.

    Recently, however, Beijing has been more willing to assert 
its priorities and worldview, even at the expense of its 
broader relationship with the United States. For example, 
Beijing's relationship with Tehran and its position on the 
Syrian conflict undermine U.S. objectives in the region. Dr. 
Murphy testified that China's position in the UN Security 
Council on Syria represents China's most strident challenge to 
the United States in the region to date and suggested China's 
position on Syria could represent a turning point in China's 
MENA policy toward a greater willingness to assert its own 
interests even if at the expense of its broader relationship 
with the United States.
    China is becoming a more influential power in the region 
overall by virtue of its growing economic interdependence with 
the region's oil producers, particularly Saudi Arabia. 
According to Dr. Alterman, ``Many [MENA] petroleum producers 
see China as the future, a rising power that will be consuming 
their oil for decades more. China's eagerness for economic 
growth makes [China] a necessarily less fickle power, and one 
with a reliance on the Middle East that the United States does 
not share in the same way. Some see the U.S. relationship as 
something that can only diminish, while the relationship with 
China is something that will only grow.'' \147\
    Dr. Murphy testified that alignment in values between the 
Chinese government and some MENA governments could be a cause 
for concern in Washington as China's influence in the region 
grows. Regarding sovereignty, respect for human rights and 
democracy, and the role of the state in the economy, Dr. Murphy 
testified, ``Many states in the Middle East share . . . China's 
view of the world on those issues more than they share the U.S. 
view.'' \148\ This kind of ideological alignment could have 
implications for relative U.S. and Chinese influence in the 
region in the future.

Conclusions

 LChina is expanding and deepening its trade and 
investment ties with countries in MENA. More than half of 
China's crude oil imports are from MENA producers, and China 
increasingly looks to the region as an export market for 
manufactured goods and services.

 LEnergy security is a key driver of China's engagement 
in MENA. As China's continued economic growth becomes more 
dependent on a steady supply of oil and natural gas from the 
region, Beijing likely will augment already robust economic 
ties with stronger political and security engagement.

 LChina, driven primarily by its growing demand for 
energy, seeks to promote a framework for stability in MENA that 
supports its own economic, political, and security interests. 
These efforts include supporting the resolution of the Israeli-
Palestinian conflict, conducting counterpiracy operations, and 
participating in UN peacekeeping missions. Conversely, China's 
position on the Syrian conflict and its support for Iran 
undermine peace and stability in the region.

 LChina struggled to diplomatically adapt to regime 
changes across MENA during and after the Arab Spring. Beijing's 
instinct has been to support sitting regimes in Egypt, Libya, 
and Syria and to oppose international intervention in these 
countries.

 LMost MENA governments appear to judge China plays a 
positive role in the region. Oil- and natural gas-producing 
states in particular look to China as their future primary 
market. Moreover, governments in China and some MENA countries 
appear to share similar stances on issues of sovereignty, human 
rights and democracy, and the role of the state in the economy. 
However, many MENA countries have criticized China for its 
support for the Assad regime in Syria.

 LHistorically, China largely has avoided challenging 
U.S. influence and power in the Middle East. In recent years, 
however, when key Chinese interests are at stake, China has 
made use of its permanent membership in the UN Security Council 
to oppose U.S. policies and objectives in the region.

                     ENDNOTES FOR SECTION 1

      1. Bo Zhiyue, ``China's Middle East Policy: Strategic Concerns 
and Economic Interests,'' Middle East Insights 61 (April 19, 2012); 
U.S.-China Economic and Security Review Commission, Hearing on China 
and the Middle East, testimony of Dawn Murphy, June 6, 2013; Jon B. 
Alterman and John Garver, The Vital Triangle: China, the United States, 
and the Middle East (Washington, DC: Center for Strategic and 
International Studies, 2008), p. 21; Abdulaziz Sager, ``GCC-China 
Relations: Looking Beyond Oil--Risks and Rewards,'' in China's Growing 
Role in the Middle East (Washington, DC: Nixon Center, 2010), p. 2; 
Zhao Hongtu, ``China's Energy Interest and Security in the Middle 
East,'' in China's Growing Role in the Middle East (Washington, DC: 
Nixon Center, 2010), p. 58; and Dawn Murphy, Rising Revisionist? 
China's Relations with the Middle East and Sub-Saharan Africa in the 
post-Cold War Era (Washington, DC: George Washington University, 2012), 
pp. 103-108.
      2. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, testimony of Dawn Murphy, June 6, 2013.
      3. China National Bureau of Statistics, via CEIC database. http:/
/www.ceic-data-.com/en.
      4. Al-Masah Capital Limited, China and India's Growing Influence 
in the MENA Region: Their Legacy and Future Footprint (Dubai, United 
Arab Emirates: April 2011), p. 4. http://ae.zawya.com/researchreports/
p-----2010----07----22----09----20----27/
2010-1219----p----2010----07----22----09----20----27----092416.pdf.
      5. China National Bureau of Statistics, via CEIC database. http:/
/www.ceic-data-.com/en.
      6. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
      7. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Bryant Edwards, June 6, 
2013.
      8. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
      9. Dawn Murphy, Rising Revisionist? China's Relations with the 
Middle East and Sub-Saharan Africa in the post-Cold War Era 
(Washington, DC: George Washington University, 2012), pp. 306-308; ME 
Newswire (Dubai), ``ZTE Wins Contract to Provide 3G Wi-Fi Router MF29 
to UAE Operator du,'' July 10, 2013. http://www.-me-newswire.net/news/
7938/en.
     10. Jason Subler, ``China's ZTE says it basically dropped Iran 
business,'' Reuters, April 18, 2013. http://www.reuters.com/article/
2013/04/18/us-zte-iran-id-US-BRE-93H0A820130418; Steve Stecklow, 
``Exclusive: Huawei CFO linked to firm that offered HP gear to Iran,'' 
Reuters, January 31, 2013. http://www.reuters.com/article/2013/01/31/
us-huawei-skycom-idUSBRE90U0CC20130131.
     11. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
     12. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
     13. Qian Xuewen, ``Sino-Arab Economic and Trade Cooperation: 
Situations, Tasks, Issues, and Strategies'' Journal of Middle Eastern 
and Islamic Studies (in Asia) 5:4 (2011): 71-72. http://
research.shisu.edu.cn/picture/article/13/1a/61/
2a-6-0-7-5-9-1-4-baf96-f497-dd535-e44a6/221d8186-90ef-4e68-92be-
ab52fd835095.pdf.
     14. Deborah Brautigam and Tang Xiaoyang, ``African Shenzhen: 
China's special economic zones in Africa,'' Journal of Modern African 
Studies 49:1 (2011): 40-41. http://www.afriquechine.net/en/20--1--1/
African-Shenzhen-China-s-special-economic-zones--in-Africa.pdf.
     15. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Bryant Edwards, June 6, 
2013.
     16. Dan Levin, ``China's Return to the Silk Road,'' Fast Company, 
July 2011. http://www.fastcompany.com/1760843/chinas-return-silk-road; 
Evan Osnos, ``Q&A: Ben Simpfendorfer on China and the Arab World,'' New 
Yorker, June 15, 2009. http://www.newyorker.com/online/blogs/evanosnos/
2009/06/ben-simpendorfer-on-china-and-the-arab-world.html; and Mohammed 
Turki Al-Sudairi, Sino-Saudi Relations: An Economic History (Geneva, 
Switzerland: Gulf Research Council, August 2012), p. 25. http://
grc.net/index.php?frm----module=contents&frm----action=detail----book&pub-_
-type=16&sec=Contents&frm-_-title=&book-_-id=79283&op-_-lang=en.
     17. Ministry of Commerce (China), ``China-GCC FTA.'' http://
fta.mofcom.gov.cn/topic/engcc.shtml; Guoyou Song and Wen Jin Yuan, 
``China's Free Trade Agreement Strategies,'' Washington Quarterly 35:4 
(Fall 2012): 112, 115. http: // csis.org / files /publication/
twq12FallSongYuan.pdf. See chapter 1, section 1, of this Report, 
``Trade and Economics Year in Review,'' for additional discussion of 
China's existing and planned free trade agreements.
     18. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
     19. Ministry of Commerce (China), 2011 Statistical Bulletin of 
China's Outward Foreign Direct Investment (Beijing, China: China 
Statistics Press, 2012), pp. 74-76.
     20. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Bryant Edwards, June 6, 
2013.
     21. Al-Masah Capital Limited, China and India's Growing Influence 
in the MENA Region: Their Legacy and Future Footprint (Dubai, United 
Arab Emirates: April 2011), p. 17. http://ae.zawya.com/researchreports/
p----2010----07----22----09----20----27/
2010-1219----p----2010----07----22----09----20----27----092416.pdf.
     22. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Bryant Edwards, June 6, 
2013.
     23. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Bryant Edwards, June 6, 
2013.
     24. MergerMarket, The New Silk Road: Investing in and venturing 
with Middle Eastern companies (Hong Kong: Latham & Watkins, 2012), p. 
8; Jon B. Alterman, China's Balancing Act in the Gulf (Washington, DC: 
Center for Strategic and International Studies, August 2013), pp. 1, 3, 
4. https://csis.org/files/publication/
130821----Alterman----ChinaGulf----Web.pdf; Abdulaziz Sager, ``GCC-China 
Relations: Looking Beyond Oil--Risks and Rewards,'' in China's Growing 
Role in the Middle East (Washington, DC: Nixon Center, 2010), p. 2; 
Zhao Hongtu, ``China's Energy Interest and Security in the Middle 
East,'' in China's Growing Role in the Middle East (Washington, DC: 
Nixon Center, 2010), p. 58; and Dawn Murphy, Rising Revisionist? 
China's Relations with the Middle East and Sub-Saharan Africa in the 
post-Cold War Era (Washington, DC: George Washington University, 2012), 
pp. 103-108.
     25. China National Bureau of Statistics, via CEIC database. http:/
/www.ceicdata-.com/en.
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April 22, 2013. http://www.eia.gov/countries/cab.cfm?fips=CH.
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Presentation to the Press'' (London, United Kingdom: November 12, 
2012), slide 6. http://www-.-slide-share.net / 
internationalenergyagency / world- energy- outlook-2012- presentation-
to- press; Christopher Johnson, ``China oil imports to take over U.S. 
by 2017: WoodMac,'' Reuters, August 20, 2013. http: // 
www.reuters.com/article/2013/08/20/us-china-oil-
id-US-BRE-97J0BB20130820.
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China and the Middle East, written testimony of Erica Downs, June 6, 
2013.
     30. Jon B. Alterman, China's Balancing Act in the Gulf 
(Washington, DC: Center for Strategic and International Studies, August 
2013), p. 1. https://csis.org/files/publication/
130821----Alterman----ChinaGulf----Web.pdf; U.S.-China Economic and 
Security Review Commission, Hearing on China and the Middle East, 
written testimony of Jon B. Alterman, June 6, 2013; and Scott Harold 
and Alireza Nader, China and Iran: Economic, Political, and Military 
Relations (Santa Monica, CA: RAND Corporation, 2012), pp. 16-18. http:/
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RAND----OP351.pdf.
     31. Marc Lanteigne, Chinese Foreign Policy: An Introduction (New 
York, NY: Routledge, 2009), p. 86.
     32. Statoil, Energy Perspectives: Long-term macro and market 
outlook, June 2013 (Stavanger, Norway: June 11, 2013), p. 22. http://
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Energy%20Perspectives%202013.pdf.
     33. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013; Scott Harold and Alireza Nader, China and Iran: Economic, 
Political, and Military Relations (Santa Monica, CA: RAND Corporation, 
2012), pp. 16-18. http://www.rand.org/content/dam/rand/pubs/
occasional----papers/2012/RAND----OP351.pdf.
     34. Scott Harold and Alireza Nader, China and Iran: Economic, 
Political, and Military Relations (Santa Monica, CA: RAND Corporation, 
2012), p. 18. http://www.-rand.org/content/dam/rand/pubs/
occasional-_-papers/2012/RAND-_-OP351.pdf.
     35. Mohammed Turki Al-Sudairi, Sino-Saudi Relations: An Economic 
History (Geneva, Switzerland: Gulf Research Center, August 2012), p. 9. 
http://grc.net/
index.php?frm-----module=contents&frm-------action=detail-------book&pub----
_-type-=--16-&-sec-=-Contents-&-frm-_-title-=-&-book-_-id-=-79283-&-op-_
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Implications for the United States (Washington, DC: Woodrow Wilson 
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Iran, Saudi Record,'' Reuters, March 21, 2012. http://www.reuters.com/
article/2012/03/21/china-crude-iran-idUSL3E8EL37820120321.
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ASIA%20Program----China%20and%-20the%20PG.pdf.
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Iranian relations, see Marybeth Davis et al., China-Iran: A Limited 
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origin-.www.uscc.gov/sites/default/files/Research/China-Iran-- A % 20 Limited % 20 Partnership-.-pdf; U.S.-China Economic and Security 
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Downs, ``China-Gulf Energy Relations,'' in Bryce Wakefield and Susan L. 
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United States (Washington, DC: Woodrow Wilson International Center for 
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China and the Middle East, written testimony of Erica Downs, June 6, 
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www.reuters.com/article/2013/08/22/petrochina-iraq-
idUSL4N0GN29G20130822.
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China and the Middle East, written testimony of Erica Downs, June 6, 
2013.
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China and the Middle East, written testimony of Erica Downs, June 6, 
2013.
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www.reuters.com/article/2013/08/22/petrochina-iraq-
idUSL4N0GN29G20130822.
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the United States, and the Middle East (Washington, DC: Center for 
Strategic and International Studies, 2008), p. 19; U.S.-China Economic 
and Security Review Commission, Hearing on China and the Middle East, 
written testimony of Dawn Murphy, June 6, 2013.
     57. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
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the United States, and the Middle East (Washington, DC: Center for 
Strategic and International Studies, 2008), p. 17.
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(European Society of International Law 4th Research Forum, Tallinn, 
Estonia, December 2, 2011); Economist, ``China's evolving foreign 
policy: the Libyan dilemma,'' September 10, 2011. http://
www.economist.com/node/21528664.
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Unavoidable: China's Options on External Interference in the Middle 
East'' China Report 49:1 (2013): 28-29.
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China and the Middle East, written testimony of Yitzhak Shichor, June 
6, 2013.
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Economic and Security Review Commission, Hearing on China and the 
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Kemp, The East Moves West: India, China, and Asia's Growing Presence in 
the Middle East (Washington, DC: Brookings Institution Press, 2010), p. 
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China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
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Middle East and Sub-Saharan Africa in the post-Cold War Era 
(Washington, DC: George Washington University, 2012), pp. 217-218.
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China and the Middle East, written testimony of Andrew Erickson, June 
6, 2013.
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China and the Middle East, written testimony of Andrew Erickson, June 
6, 2013.
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economy,'' Financial Times (London), June 27, 2013. http://www.ft.com/
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Report to Congress (Washington, DC: Government Printing Office, 2011), 
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Report to Congress (Washington, DC: Government Printing Office, 2011), 
pp. 258.
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Sudan to Syrian Rebels,'' New York Times, August 12, 2013. http://
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Libyan memos,'' Globe and Mail (Toronto), September 19, 2011. http://
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Pomfret, ``Chinese firms bypass sanctions on Iran, U.S. says,'' 
Washington Post, October 18, 2010. http://www.washington-post.com/wp-
dyn/content/article/2010/10/17/AR-2010-101703723.html; and Glenn R. 
Simpson and Jay Solomon, ``Fresh Clues of Iranian Nuclear Intrigue,'' 
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says,'' Washington Post, October 18, 2010. http://
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AR2010101703723.html; CNN, ``China denies report, says it did not sell 
weapons to Libya,'' September 6, 2011. http://www.cnn.com/2011/WORLD/
africa/09/05/libya.war/index.html; and William Maclean and Ben 
Blanchard, ``Exclusive: Chinese trader accused of busting Iran missile 
embargo,'' Reuters, March 1, 2013. http://www.reuters.com/article/2013/
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in China,'' Ynetnews.com, December 31, 2008. http://www.ynetnews.com/
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Range Chinese Rockets at Israel--Updated,'' Wired, December 31, 2008. 
http://www.wired.com/dangerroom/2008/12/hamas-chinese-a/; and Brett M. 
Decker and William C. Triplett II, ``Israel beware: China arms 
Hezbollah,'' Washington Times, November 17, 2011. http://
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of China, October 23, 2012. http://www.scribd.com/doc/110977008/Rot-v-
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China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013.
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China's Diplomacy,'' Journal of Middle Eastern and Islamic Studies (in 
Asia) 6:1 (2012): 10.
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DC: Center for Strategic and International Studies, 2013), p. 9.
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China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013.
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Brookings Institution, November 18, 2011). http://www.brookings.edu/
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China Elections and Governance, February 9, 2011. http://
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China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013; Liu Zhongmin, ``On Political Unrest in the Middle East and 
China's Diplomacy'' Journal of Middle Eastern and Islamic Studies (in 
Asia) 6:1 (2012): 10.
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Diplomat, August 16, 2013. http://thediplomat.com/china-power/why-is-
china-dithering-while-cairo-burns/; Brian Spegele, ``Egypt's Morsi 
Firms China Ties,'' Wall Street Journal, August 29, 2013. http://
online.wsj.com/article/
SB10000872-3-96390444-2305045776172-71550304082.html.
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China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013.
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/www.ceicdata-.com/en; Brian Spegele, ``Egypt's Morsi Firms China 
Ties,'' Wall Street Journal, August 29, 2013. http: // 
online . wsj . com / article / 
SB10000872-3-96390444-2305045776172-71550304082.html; Chris Zambelis, 
``Egypt Turns Quietly to Asia,'' Middle East Institute, February 25, 
2013. http://www.mei.edu/content/egypt-turns-quietly-asia; and Islam 
Serour, ``Morsy's visit to China yields fruitful outcome,'' Daily News 
Egypt, August 28, 2013. http: // www.dailynewsegypt.com/2012/08/
28/morsys-visit-to-china-yields-fruitful-outcome/.
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(Wang Yi talks to Egyptian Foreign Minister Fahmy by phone), August 16, 
2013. http://news.xinhua-net.com/2013-08/16/c----125187131.htm.
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Yi Holds Telephone Talks with Foreign Minister Nabil Fahmy of Egypt,'' 
July 28, 2013. http://www.fmprc.gov.cn/eng/zxxx/t1062694.shtml.
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Yi Holds Telephone Talks with Foreign Minister Nabil Fahmy of Egypt,'' 
(Beijing, China: August 16, 2013). http://www.fmprc.gov.cn/eng/zxxx/
t1067774.shtml.
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Egypt,'' CNN, August 30, 2013. http://money.cnn.com/2013/08/30/news/
economy/apache-sinopec-egypt/index.html.
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Financial Times (London), April 10, 2013. http: // www.ft.com/intl/
cms/s/0/3312c30e-a02d-11e2-88b6-00144feabdc0.html#axzz2hGId9wkr; 
Reuters, ``China urges Libya to protect investments,'' August 23, 2011. 
http: // www.reuters.com/article/2011/08/23/us-china-libya-
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China and the Middle East, written testimony of Andrew Erickson, June 
6, 2013.
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Security Council Resolution 1970, Libya Sanctions'' (New York, NY: 
February 26, 2011). http://usun.state.gov/briefing/statements/2011/
157194.htm.
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UN Security Council Resolution on Libya'' (New York, NY: March 18, 
2011). http://usun.state.gov/briefing/statements/2011/158614.htm.
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Center for Strategic and International Studies, 2013), p. 10.
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memos,'' Globe and Mail (Toronto), September 2, 2011. http://
www.theglobeandmail.com/news/world/china-offered-gadhafi-huge-
stockpiles-of-arms-libyan-memos/article1363316/.
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dilemma,'' September 10, 2011. http://www.economist.com/node/21528664.
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    117. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013; I-wei Jennifer Chang, ``China's Evolving Stance on Syria'' 
(Washington, DC: Middle East Institute, February 18, 2013). http://
www.mei.edu/content/chinas-evolving-stance-syria.
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China Leadership Monitor 39 (Fall 2012): 3. http://
carnegieendowment.org/files/Swaine----CLM----39----09-1312----2.pdf.
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Middle East Institute, February 18, 2013. http: // 
www.the-middle-east-institute-.-org / content / chinas -evolving-
stance-syria; United Nations General Assembly, ``General Assembly 
Adopts Text Condemning Violence in Syria, Demanding that all Sides End 
Hostilities'' (New York, NY: May 15, 2013). http://www.un.org/News/
Press/docs/2013/ga11372-.-doc-.-htm.
    120. Michael Swaine, ``Chinese Views of the Syrian Conflict,'' 
China Leadership Monitor 39 (Fall 2012): 2. http://
carnegieendowment.org/files/Swaine----CLM----39----09-1312----2.pdf.
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Syria,'' September 2, 2013. http://hosted.ap.org/dynamic/stories/A/
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T-&-CTIME-=-2013-09-02-04-55-43.
    122. David Cohen, ``China criticizes American action on Syria, but 
shows little interest in the result,'' China Brief 13:18 (Washington, 
DC: Jamestown Foundation: September 12, 2013). http: // 
www.jamestown.org/programs/china-brief/ single / ?tx _ tt 
news[tt----_-news]-=-4--13-47-&-tx----_-tt-news-[back-Pid]-=-25-&-cHash-
=-50026--1--1-faca6-f0--19-a3-db95-a3549 cebf6#-.-Ujsg-QXfdJ-_-c; Liu 
Li, ``The Syrian Crisis and the Restructuring of the Middle East'' 
(Beijing, China: China Institute of International Studies, September 4, 
2013). http://www.ciis.org.cn/english/2013-09/04/content-_-6273015.htm.
    123. CNTV, ``Chinese FM Wang Yi, French FM Fabius Discuss U.S.-
Russia Agreement on Syria's Chemical Weapons,'' September 15, 2013. OSC 
ID: CHO2013-091616109058. http://www.opensource.gov.
    124. Xinhua, ``China, Russia issue joint statement on Syria 
crisis,'' September 26, 2013. http://news.xinhuanet.com/english/china/
2013-09/26/c----132752238.htm.
    125. Stockholm International Peace Research Institute, ``SIPRI Arms 
Transfers Programme.'' http://portal.sipri.org/publications/pages/
transfer/splash.
    126. Stockholm International Peace Research Institute, ``SIPRI Arms 
Transfers Programme.'' http://portal.sipri.org/publications/pages/
transfer/splash.
    127. C.J. Chivers and Eric Schmitt, ``Arms Shipments Seen from 
Sudan to Syrian Rebels,'' New York Times, August 12, 2013. http: // 
www.nytimes.com/2013/08/13/world/africa/arms-shipments-
seen-from-sudan-to-syria-rebels.html ? hp & -_ -r- = -1 & ; Tim 
Fernholz, ``China's arms industry is hoping for some good PR from the 
Syrian rebels,'' Quartz, August 14, 2013. http://qz.com/114918/while-
china-backs-the-syrian-government-its-arms-industry-is-hoping-for-some-
good-pr-from-the-rebels/.
    128. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
    129. Luis Martinez, ``US `Disgusted' by China, Russia Veto of UN 
Resolution to End Violence in Syria,'' ABC News, February 4, 2012. 
http://abcnews.go.com/blogs/politics/2012/02/us-disgusted-by-
russia-china-veto-of-un-resolution-to-end-violence-in-syria/.
    130. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
    131. Jon B. Alterman, China's Balancing Act in the Gulf 
(Washington, DC: Center for Strategic and International Studies, August 
2013). https://csis.org/files/publication/
130821----Alterman----ChinaGulf----Web.pdf.
    132. Scott Harold and Alireza Nader, China and Iran: Economic, 
Political, and Military Relations (Santa Monica, CA: RAND Corporation, 
2012), p. 2. http://www.-rand.org/content/dam/rand/pubs/
occasional--_-papers/20--12/RAND--_-OP35--1.pdf; Marybeth Davis et al., 
China-Iran: A Limited Partnership (Washington, DC: CENTRA Technology, 
Inc., for the U.S.-China Economic and Security Review Commission, April 
2013), p. 33. http: // origin.www.uscc.gov/sites/default/files/
Research/China-Iran--A-%20-Limited%20Partnership.pdf.
    133. Marybeth Davis et al., China-Iran: A Limited Partnership 
(Washington, DC: CENTRA Technology, Inc., for the U.S.-China Economic 
and Security Review Commission, April 2013), p. 7. http: // 
origin.www.uscc.gov/sites/default/files/Research/China-Iran--
A%20Limited%20Partnership.pdf.
    134. Gabe Collins, ``Drilling Rig Containment: Iraq's Postwar Oil 
Boom Helps Fuel U.S. Leverage Against Iran,'' China Oil Trader, April 
2, 2013. http://www.china-oil-trader.com/?p=408.
    135. John W. Garver, professor of international affairs at the 
Georgia Institute of Technology, phone interview with Commission staff, 
April 12, 2013.
    136. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Joel Wuthnow, June 6, 
2013.
    137. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Joel Wuthnow, June 6, 
2013.
    138. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Joel Wuthnow, June 6, 
2013.
    139. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013.
    140. Jon B. Alterman and John Garver, The Vital Triangle: China, 
the United States, and the Middle East (Washington, DC: Center for 
Strategic and International Studies, 2008), p. 10.
    141. Jon B. Alterman, ``China's Soft Power in the Middle East,'' in 
Andrew C. Kuchins et al., Chinese Soft Power and its Implications for 
the United States (Washington, DC: Center for Strategic and 
International Studies, March 11, 2009), p. 63. http://csis.org/files/
media/csis/pubs/090310----chinesesoftpower----chap5.pdf.
    142. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, testimony of Yitzhak Shichor, June 6, 2013; 
Bryce Wakefield, ``Introduction,'' in Bryce Wakefield and Susan L. 
Levenstein, eds., China and the Persian Gulf: Implications for the 
United States (Washington, DC: Woodrow Wilson International Center for 
Scholars, 2011), p. 2. http: // www.wilsoncenter.org/sites/
default/files/ ASIA %20 Program-_- China %20 and %20 the %20 PG.pdf; 
Emile Hokayem, ``Looking East: A Gulf Vision or a Reality?'' in Bryce 
Wakefield and Susan L. Levenstein, eds., China and the Persian Gulf: 
Implications for the United States (Washington, DC: Woodrow Wilson 
International Center for Scholars, 2011), p. 41. http://
www.wilsoncenter.org/sites/default/files/
ASIA%2--0Program--------China-%2--0-and-%2--0the %20-PG.pdf; and David 
Schenker, ``What a Changing Middle East Means for China'' The 
Washington Institute, July 1, 2013. http://
www.washington-institute-.-org/policy-analysis/view/what-a-changing-
middle-east-means-for-china.
    143. Wu Bingbing, ``Strategy and Politics in the Gulf as Seen From 
China,'' in Bryce Wakefield and Susan L. Levenstein, eds., China and 
the Persian Gulf: Implications for the United States (Washington, DC: 
Woodrow Wilson International Center for Scholars, 2011), p. 23. http: /
/ www.wilsoncenter.org/sites/default/files/
ASIA%20Program----China%20and%20the%20PG.pdf.
    144. Tim Arango and Clifford Krauss, ``China Is Reaping Biggest 
Benefits of Iraq Oil Boom,'' New York Times, June 2, 2013. http://
www.nytimes.com/2013/06/03/world/middleeast/china-reaps-biggest-
benefits-of-iraq-oil-boom.html?pagewanted=all&----r=0.
    145. Dean Cheng, ``Chinese Lessons from the Gulf Wars,'' in Andrew 
Scobell et al., Chinese Lessons from Other Peoples' Wars (Carlisle, PA: 
U.S. Army War College Strategic Studies Institute, November 2011), pp. 
153-199.
    146. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, testimony of Yitzhak Shichor, June 6, 2013.
    147. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Jon B. Alterman, June 
6, 2013.
    148. U.S.-China Economic and Security Review Commission, Hearing on 
China and the Middle East, written testimony of Dawn Murphy, June 6, 
2013.
                           SECTION 2: TAIWAN

Introduction
    This section--based on the Commission's meetings with 
Taiwan officials in Washington and Taipei and independent 
research--examines cross-Strait relations; Taiwan's 
international space; Taiwan's role in the East and South China 
Sea disputes; U.S.-Taiwan relations; and cross-Strait military 
and security issues. The section concludes with a discussion of 
the implications of the current cross-Strait dynamic for the 
United States.

Cross-Strait Relations

Diplomatic Affairs

    During the Chinese Communist Party's (CCP) 18th Congress in 
November 2012, outgoing CCP General Secretary Hu Jintao 
expressed hope that China and Taiwan ``would jointly explore 
cross-Strait political relations and make fair and reasonable 
arrangements for them.'' \1\ Mr. Hu also called for both sides 
to ``discuss the development of a [cross-Strait] military 
confidence-building mechanism'' and ``reach a peace 
agreement,'' though he did not provide timelines to achieve 
these objectives.\2\ Mr. Hu's remarks generated concern in 
Taiwan that China's incoming leadership might seek to shift the 
focus of cross-Strait diplomatic relations from economic to 
political and security issues.\3\ However, Beijing has signaled 
in subsequent public statements its near-term preference to 
avoid more sensitive areas and concentrate on sustaining 
progress on cross-Strait economic agreements.
    In a July 2013 meeting, Taiwan President Ma Ying-jeou told 
the Commission that his agenda for cross-Strait diplomatic 
relations during his second term includes securing follow-on 
agreements to the Economic Cooperation Framework Agreement 
(ECFA) signed between the two sides in 2010, expanding cross-
Strait educational exchanges, and establishing reciprocal 
representation offices. President Ma has indicated ``the time 
is not yet ripe for both countries to speak of political 
dialogue'' on unification.\4\ He has not discounted meeting 
President Xi before the end of his second term but said in July 
2013 such a meeting would be conditional on ``whether [Taiwan] 
needs it, whether the [Taiwan] people support it, [and] that we 
can meet with dignity.'' \5\
    Since the Commission's 2012 Report, Taiwan's semiofficial 
Straits Exchange Foundation (SEF) and its Chinese counterpart, 
the Association for Relations across the Taiwan Strait 
(ARATS),* held talks from June 20 to June 22 in Shanghai. This 
meeting, the ninth round of SEF-ARATS talks since May 2008, 
resulted in a major agreement on trade in services. See below 
for full treatment of this agreement.
---------------------------------------------------------------------------
    * SEF and ARATS facilitate cross-Strait negotiations and manage 
cross-Strait relations in the absence of formal ties between the 
governments of Taiwan and China.
---------------------------------------------------------------------------
    Talks between Taiwan's ruling Kuomintang (KMT) party and 
the CCP picked up after a brief slowdown around the CCP's 18th 
Party Congress in November 2012. Former Taiwan Vice President 
(1996-2000) and KMT party elder Lien Chan in February 2013 
visited Beijing to meet with then President Hu and incoming 
president Xi Jinping.\6\ In June 2013, former KMT Chairman Wu 
Poh-hsiung (2007-2009) met with President Xi.\7\ In the absence 
of formal diplomatic ties, this party-to-party dialogue serves 
as a way for China and Taiwan to relay high-level information. 
Taiwan's main opposition party, the Democratic Progressive 
Party (DPP), has criticized KMT-CCP talks on grounds they are 
secretive and have not been authorized by the Taiwan people or 
Taiwan's legislature.\8\
    Some prominent DPP members have publicly tied the party's 
defeat in Taiwan's 2012 presidential election to voter concerns 
that cross-Strait relations would deteriorate under a DPP 
administration. In response, the DPP has taken several actions 
designed to boost the party's image as a viable alternative to 
the ruling KMT and improve the Taiwan public's perception of 
its ability to interact with China.

     LDeveloping a new policy for cross-Strait 
engagement: In November 2012, the DPP established the China 
Affairs Committee to formulate a new policy for cross-Strait 
engagement. Nine prominent DPP members, including Party 
Chairman Su Tseng-chang and former DPP presidential candidate 
Tsai Ing-wen, compose the committee. At its first meeting in 
May 2013, Chairman Su said the party's China agenda will be 
guided by a ``new type of framework and thinking involving: how 
to persist and make the Taiwan Dream a reality, how to open a 
new order for cross-Strait interaction and how to contribute to 
regional stability and peace.'' \9\

     LBuilding cross-Strait ties: In October 2012, 
Frank Hsieh, the DPP's 2008 presidential candidate, visited 
Xiamen and Beijing to meet with academics and high-ranking 
Chinese officials involved in cross-Strait affairs. According 
to Mr. Hsieh, the trip was intended as the ``first step for 
bilateral exchanges'' between the DPP and China. Mr. Hsieh 
added, ``Cross-Strait engagement cannot be monopolized by the 
[KMT]. The DPP cannot stand still and neither should it be 
marginalized from the platform of bilateral dialogue.'' \10\ 
Since then, more high-profile DPP officials have visited 
China.\11\ A spokesperson for China's Taiwan Affairs Office * 
said it is ``more than happy to help'' DPP members visit China 
and that ``any discussion, seminar, cooperation, or political 
talks that may help increase or elevate cross-Strait relations 
will be welcomed.'' \12\
---------------------------------------------------------------------------
    * The Taiwan Affairs Office is an agency within China's State 
Council that is responsible for overseeing China's cross-Strait 
policies.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
China's New Passport Design  Creates Controversy in Taiwan
 
  In May 2012, China introduced a new passport design that includes
images of two popular tourist sites in Taiwan and depicts Beijing's
South China Sea claims.* Taiwan's Mainland Affairs Council 
responded with a strong statement: ``[China's] inclusion of photographs
of Taiwan's territory and landscape entirely ignores existing facts and
provokes controversy, while at the same time not only harms the
foundation of mutual trust established through efforts by the two sides
over the recent years, but also hurts the feelings of Taiwan's 23
million people. [China's] action is absolutely unacceptable to the
[Taiwan] government.'' \13\
 
  Many South China Sea claimants harshly criticized China's new
passports. Vietnam and the Philippines are not stamping the new
passports and instead are issuing separate visa sheets. The Mainland
Affairs Council explained that since Taiwan does not recognize China's
passports, it could not take similar measures to protest the new design.
A council official also said, ``Since the entry papers of Chinese
citizens bear the full name of [Taiwan] and its national flag, it is
sufficient declaration of our nation's autonomy.'' After pressure from
opposition legislators, a Mainland Affairs Council spokesperson in
December 2012 said Taiwan would develop ``countermeasures in response to
the passport issue.'' \14\ However, as of the writing of this Report,
Taiwan has yet to announce these countermeasures.
 
------------------------------------------------------------------------


Trade

    From January through July 2013 (the most recent months for 
which official statistics are available), the total value of 
trade between China = and Taiwan was $71.8 billion. The total 
value of cross-Strait trade during this period grew by 2.79 
percent compared to the same period in 2012. Through the first 
seven months of 2013, China remained Taiwan's largest export 
market, accounting for approximately $47.3 billion worth of 
exports (26.9 percent of Taiwan's total exports). China 
followed behind Japan as Taiwan's second largest source of 
imports, accounting for approximately $24.5 billion worth of 
imports (15.5 percent of Taiwan's total imports).\15\ See 
figure 1 for Taiwan's trade with China from 2008 to 2012.
---------------------------------------------------------------------------
    * Taiwan does not recognize China's passports. Chinese citizens 
visiting Taiwan must apply for a ``compatriot pass'' issued by Taiwan's 
National Immigration Agency.
     The Mainland Affairs Council is a cabinet-level agency in 
Taiwan's executive branch that is responsible for overseeing Taiwan's 
cross-Strait policies.
    = Throughout the trade and investment subsections, ``China'' 
excludes Hong Kong and Macau.

   Figure 1:  Taiwan's Trade with China, 2008-2012 (U.S. $ billions)



    Source: Bureau of Foreign Trade (Taiwan), ``Trade Statistics.'' 
http: // cus93 . trade . gov . tw /ENGLISH/FSCE/.

    In 2012, China's gross domestic product (GDP) was 
approximately $8.2 trillion while Taiwan's GDP was 
approximately $474 billion, according to the International 
Monetary Fund. On a per capita basis (purchasing power parity), 
China and Taiwan's GDPs were $9,055 and $38,356, respectively.*
---------------------------------------------------------------------------
    * International Monetary Fund, ``World Economic Outlook Database.'' 
http: // www.imf.org/external/pubs/ft/weo/2013/02/weodata/
index.aspx. According to the International Monetary Fund (IMF), the 
purchasing power parity (PPP) between two countries is the ``rate at 
which the currency of one country needs to be converted into that of a 
second country to ensure that a given amount of the first country's 
currency will purchase the same volume of goods and services in the 
second country as it does in the first.'' In the IMF's World Economic 
Outlook online database, the implied PPP conversion rate is expressed 
as national currency per current international dollar.

---------------------------------------------------------------------------
Investment

    Although China remained the top destination for Taiwan 
foreign direct investment (FDI) in 2012, Taiwan's approval of 
$10.9 billion in investments in China in 2012 represented a 
16.6 percent decrease from the previous year and a three-year 
low.\16\ From January through July 2013, the value of Taiwan 
FDI to China continued to decrease, slipping 17.23 percent from 
the previous year.\17\ Officials at the American Institute in 
Taiwan (AIT), which serves as the de facto U.S. embassy in 
Taiwan, told the Commission that Taiwan businesses increasingly 
are looking for investment opportunities in Southeast Asia, 
Africa, and Latin America as manufacturing costs in China 
continue to rise.
    Mainland investment in Taiwan continued to grow in the 
first seven months of 2013, with the value of investments 
increasing 79.34 percent compared to the same period in 
2012.\18\ In 2012, Chinese FDI in Taiwan totaled $328.1 
million, a 650 percent increase from the previous year. The 
growth in 2012 was due largely to a $139 million investment by 
state-owned China Ocean Shipping (Group) Company and other 
Chinese shipping firms into Kaohsiung-based Kao Ming Container 
Terminal Corporation and the establishment of branches in 
Taiwan of two Chinese state-owned banks: Bank of Communications 
and Bank of China.\19\

Economic Agreements

    Since President Ma's first term began in 2008, Taiwan and 
China have signed several agreements that have deepened and 
broadened cross-Strait economic relations. Most importantly, 
the two sides in June 2010 signed the ECFA, which serves as a 
roadmap for future economic integration through a series of 
four major follow-on agreements concerning investment 
protection, trade in goods, trade in services, and trade 
dispute settlement.\20\ Since the Commission's 2012 Report, 
China and Taiwan have made further progress toward developing 
and implementing the ECFA follow-on agreements as well as 
advancing economic cooperation in other areas.

     LTrade promotion offices: Taiwan opened its first 
trade promotion office in Shanghai in December 2012 and since 
then has established offices in Beijing and Guangzhou.\21\ 
China opened its first trade promotion office in Taipei in 
January 2013.\22\ These offices are designed to facilitate 
cross-Strait trade, primarily in the service sector, by 
providing local market information, product advertising, and 
consulting services to their side's businesses.

     LTrade in goods agreement: As part of the ECFA, 
Taiwan and China agreed to reduce and gradually eliminate 
tariffs on select imports. The final group of these ``early 
harvest'' items became tariff free on January 1, 2013. Through 
this arrangement, China has removed tariffs on 539 items 
imported from Taiwan while Taiwan has removed tariffs on 267 
items imported from China.\23\ Taipei and Beijing intend to 
build on this progress by completing a more comprehensive trade 
in goods agreement, which President Ma told the Commission he 
hopes the two sides will sign by the end of 2013.

     LCurrency clearing agreement: In January 2013, 
Taiwan and China signed a direct currency clearing agreement. 
This followed an August 2012 memorandum of understanding on the 
subject between both sides' central banks.\24\ In the past, 
Taiwan banks were not allowed to conduct transactions in 
China's renminbi (RMB), and China's banks were not able to deal 
in Taiwan's New Taiwan Dollar (NTD). As a result, trade deals 
or money transfers were initially denominated in a third 
currency (usually the U.S. dollar) and then converted to the 
local currency. Designated Chinese banks in Taiwan began 
conducting RMB transactions in February 2013, and designated 
Taiwan banks in China began conducting NTD transactions in 
April 2013.\25\

     LTrade in services agreement: In June 2013, Taiwan 
and China signed a services trade agreement to eliminate 
investment restrictions and other barriers across 11 service 
sectors in both countries. Taiwan investors will gain access to 
80 service subsectors in China, including those in e-commerce, 
printing, construction, transportation, tourism, entertainment, 
and funeral services. In return, Chinese investors will gain 
access to 64 service subsectors in Taiwan, including those in 
car rental, cargo transportation, beauty parlors, online 
gaming, and funeral services.\26\ As of the writing of this 
Report, Taiwan's legislature has not yet ratified the agreement 
due to political and public opposition.

     LTrade dispute settlement mechanism: Taiwan and 
China in 2013 continued to discuss a mechanism to help resolve 
trade disputes between the two sides that might arise from the 
interpretation, implementation, and application of the ECFA 
follow-on agreements. This subject is on the agenda for the 
next SEF-ARATS meeting.\27\

Taiwan's International Space

    Beijing's insistence on the ``one China principle'' 
precludes any country or international organization from 
simultaneously recognizing China and Taiwan, thereby 
restricting Taiwan's full participation in the international 
community. Nevertheless, Taiwan pursues greater international 
space by maintaining its official diplomatic relations with 23 
countries,* expanding its participation in international 
organizations, and strengthening economic partnerships with 
countries other than China.
---------------------------------------------------------------------------
    * The following 23 countries have official diplomatic relations 
with Taiwan: Belize, Burkina Faso, the Dominican Republic, El Salvador, 
the Gambia, Guatemala, Haiti, the Holy See, Honduras, Kiribati, the 
Marshall Islands, Nauru, Nicaragua, Palau, Panama, Paraguay, Saint 
Christopher and Nevis, Saint Lucia, Saint Vincent and the Grenadines, 
Sao Tome and Principe, Solomon Islands, Swaziland, and Tuvalu.
---------------------------------------------------------------------------
    In 2008, China and Taiwan reached a tacit understanding--or 
what President Ma unilaterally declared to be a ``diplomatic 
truce''--to stop poaching each other's diplomatic partners in 
order to maintain positive momentum in the cross-Strait 
relationship.\28\ China appears to have adhered to this 
diplomatic truce during President Ma's first term, though 
Beijing's March 2013 call for the Vatican to sever ties with 
Taiwan shortly before President Ma's trip to the city-state for 
the Investiture Mass of Pope Francis runs counter to the tacit 
agreement. It is not clear if this action signaled a policy 
shift or was motivated by other factors, such as Beijing's 
longstanding rift with the Vatican.\29\
    China continues to attempt to restrict Taiwan's 
participation in international organizations and activities. 
For example, Beijing pressured Indonesia to discourage Taiwan 
from attending the Jakarta International Defense Dialogue in 
March 2013. Taiwan ultimately did not participate in the 
event.\30\ In another instance, China boycotted Japan's March 
2013 commemorative ceremony for the 2011 Tohoku earthquake 
after Tokyo invited Taiwan to attend the event. Tokyo had faced 
domestic criticism for excluding Taiwan, the largest aid donor 
following the earthquake, from 2012's commemorative ceremony. 
China's Ministry of Foreign Affairs said Tokyo's decision to 
invite Taiwan ``violated the principles and spirit of the 
China-Japan Joint Statement and the commitments of the Japanese 
side.'' \31\
    Nevertheless, Taiwan has made important progress on issues 
affecting its international space. In July 2013, President 
Obama signed legislation directing the U.S. Secretary of State 
to ``develop a strategy to obtain observer status for Taiwan in 
the ICAO.'' \32\ The president of the UN's International Civil 
Aviation Organization (ICAO) in September 2013 invited a Taiwan 
delegation to attend the upcoming ICAO assembly as his 
``guests.'' \33\
    Furthermore, Taiwan has advanced its international trade 
ties. Taiwan and New Zealand signed a free trade agreement in 
July 2013, which marks Taiwan's first such deal with a country 
with which it does not have official diplomatic relations; 
Taiwan and Singapore agreed in principle to a free trade 
agreement in May 2013; \34\ and Taiwan is participating in 
negotiations with 22 other World Trade Organization members, 
including the United States, on a multilateral Trade in 
Services Agreement.
    Taiwan's Ministry of Economic Affairs told the Commission 
that Taiwan's efforts to expand its trade ties with the Asia 
Pacific region are part of President Ma's larger push to 
diversify Taiwan's economic partners to avoid overreliance on 
China. Other Taiwan officials explained to the Commission that 
the agreements will help promote Taiwan's inclusion in Asia's 
broader economic integration, including participation in 
multilateral trade pacts such as the Trans-Pacific Partnership 
and the Regional Comprehensive Economic Partnership.

Taiwan's Role in the East and South China Seas Disputes

    Taiwan claims ``historic'' sovereignty over the Senkaku 
Islands (known as Diaoyutai in Taiwan) in the East China Sea 
and over all of the South China Sea. Japan objects to Taiwan's 
East China Sea claims; Brunei, Malaysia, Philippines, and 
Vietnam object to Taiwan's South China Sea claims. Taiwan thus 
far has called for peaceful solutions and joint development of 
resources to avoid escalation of tensions while defending its 
own territorial claims. Although Taiwan and China have not 
openly denied each other's claims since doing so would raise 
the sensitive issue of the definition of ``one China,'' there 
is no evidence the two countries are cooperating in their 
positions or approaches to the maritime disputes.

East China Sea

    On April 10, 2013, Taiwan and Japan signed a fisheries 
agreement after 17 years of intermittent negotiations. The 
agreement, concluded before the start of the annual fishing 
season, delineates a broad fishing zone of 1,750 square miles 
near the Senkakus--with the exception of the islands' 12 
nautical mile territorial waters--where Taiwan and Japanese 
fishing boats can operate freely.\35\ It includes no reference 
to sovereignty over the disputed territory. President Ma said 
the agreement demonstrates Taiwan's constructive role in 
reducing tension in the East China Sea without compromising 
Taiwan's maritime claims and could be used as a blueprint and 
impetus for a similar agreement between Taiwan and other 
countries with claims in the South China Sea.\36\
    Beijing said it was ``extremely concerned'' about the 
agreement and urged Tokyo to ``earnestly abide by its promises 
on the Taiwan issue.'' \37\ After the signing of the fisheries 
agreement, Beijing also reiterated its call for China and 
Taiwan to ``safeguard the overall interests of the Chinese 
nation.'' \38\

South China Sea

    In the South China Sea, Taiwan adheres to the principles of 
the 2002 Declaration on the Conduct of Parties in the South 
China Sea.* However, Taiwan's political status precludes it 
from signing it or participating in any formal cooperation with 
other claimants in the region. Taiwan administers Itu Aba 
Island (also known as Taiping) and Pratas Reef (also known as 
Dongsha) and stations 100 to 150 Coast Guard personnel on each 
island to enforce local fisheries, conduct search and rescue, 
and demonstrate Taiwan's sovereignty. In 2013, Taiwan announced 
plans to upgrade Itu Aba by building a new wharf able to 
accommodate larger, more capable naval and maritime law 
enforcement ships. Currently, only small patrol craft can dock 
at the island. Furthermore, a greater capacity to dock larger 
ships will facilitate the planned extension of Itu Aba's 
existing runway by about 20 percent. The longer runway will 
allow larger and heavier military aircraft to take off and land 
there.\39\ See figure 2 for a map of Taiwan-controlled islands 
in the South China Sea.
---------------------------------------------------------------------------
    * A 2002 Declaration on the Conduct of Parties in the South China 
Sea adopted by China and the Association of Southeast Asian Nations 
encourages claimants to, among other measures, exercise self-restraint 
in occupying any previously unoccupied land features in disputed waters 
in order to avoid escalating ongoing disputes.
---------------------------------------------------------------------------
    In March 2013, the Philippine Coast Guard opened fire on a 
Taiwan fishing boat operating in disputed waters in the South 
China Sea, resulting in the death of a Taiwan fisherman and 
sparking a diplomatic row with Taiwan. Manila and Taipei both 
claim the incident took place within their respective exclusive 
economic zones  in the South China Sea.\40\ According 
to an AIT brief to the Commission, there is a long history of 
Philippine fishermen harassing Taiwan fishermen in the South 
China Sea, and this incident pushed Taiwan to a breaking point.
---------------------------------------------------------------------------
     According to the United Nations Convention on the Law of 
the Sea, a coastal state is entitled to an exclusive economic zone, a 
200 nautical mile zone extending from its coastline within which that 
state can exercise jurisdiction to explore and exploit natural 
resources, but not full sovereignty.
---------------------------------------------------------------------------
    In the initial aftermath of the shooting, Taiwan called for 
the Philippines to issue a formal government apology, pay 
compensation to the victim's family, punish the perpetrators, 
and initiate cooperative fishery talks. After it claimed the 
Philippines failed to adequately address its demands, Taiwan 
stopped accepting new Filipino labor applications; = suspended 
trade, fishery, and technology exchanges with the Philippines; 
and removed the Philippines from Taiwan's visa waiver 
program.\41\ Taiwan also deployed two naval ships and four 
maritime law enforcement ships to the disputed waters. Taiwan 
removed the sanctions in August after the Philippines offered 
an official apology on behalf of the Philippine president, 
agreed to pay compensation to the victim's family, and 
recommended homicide charges for the Philippine Coast Guard 
personnel who opened fire on the Taiwan fishing boat.\42\ 
Taiwan and the Philippines also are discussing measures to 
reduce the risk of future incidents and working to establish a 
bilateral fisheries mechanism.\43\
---------------------------------------------------------------------------
    = According to an AIT brief to the Commission, there were 
approximately 80,000 Filipinos living/working in Taiwan before Taipei 
stopped accepting new Filipino labor applications.
---------------------------------------------------------------------------

                       Figure 2:  South China Sea



    Source: New York Times, ``Territorial Claims in the South China 
Sea,'' http://www.nytimes/com/interactive/20--12/05/3--1/world/asia/
Territorial-Claims-in-South-China-Sea.html?ref=southchina sea, adapted 
by the U.S.-China Economic and Security Review Commission. Locations of 
various features are not exact.
Next Media Controversy
    In November 2012, Next Media Ltd.--a Hong Kong-based media 
company that is critical of Beijing--agreed to sell its Taiwan 
print and television media outlets to a group of Taiwan 
businessman with extensive commercial interests in China.\44\ 
Before being finalized, however, the $600 million deal required 
the approval of Taiwan regulators.
    Next Media's sale generated significant public opposition 
in Taiwan, primarily due to the involvement of Tsai Eng-meng as 
a principal investor. Mr. Tsai is a pro-Beijing billionaire 
whose corporation owns Want China Times, one of Taiwan's four 
largest newspapers. Freedom of the press advocates and the DPP 
charged that the deal, if approved, would give Mr. Tsai's group 
a near monopoly over Taiwan's print media as well as provide 
China greater opportunities to influence the Taiwan media.\45\
    In March 2013, Taiwan's independent media regulator and 
antitrust agency proposed new antimonopoly rules, which 
apparently scuttled the deal.\46\ Although Next Media maintains 
the buyers pulled out from the purchase,\47\ Taiwan media 
speculated Mr. Tsai cancelled the deal because of growing 
public pressure and concern about a potential government 
inquiry into his media assets.\48\

U.S.-Taiwan Relations
Taiwan's Role in the U.S. Rebalance to Asia
    In October 2011, then Assistant Secretary of State for East 
Asian and Pacific Affairs Kurt Campbell testified to the U.S. 
House of Representatives, Foreign Affairs Committee that ``an 
important part of this turn to Asia is maintaining a robust and 
multidimensional unofficial relationship with Taiwan.'' \49\ 
Since then, however, U.S. officials appear to have avoided 
making explicit references to Taiwan's actual or potential role 
in the U.S. rebalance to Asia in public statements. For 
example, U.S. Secretary of Defense Chuck Hagel in a June 2013 
speech on the rebalance limited his remarks on Taiwan to the 
following: ``The United States strongly supports the efforts 
made by [China] and Taiwan in recent years to improve cross-
Strait relations. We have an enduring interest in peace and 
stability in the Taiwan Strait. The United States remains firm 
in its adherence to a one-China policy based on the three joint 
U.S.-China communiques and the Taiwan Relations Act.'' \50\
    Some U.S. security experts propose a more prominent role 
for Taiwan in the U.S. rebalance to Asia. According to Michael 
Mazza, research fellow at the American Enterprise Institute:

        Taiwan's potential role in the U.S. pivot to Asia has 
        been largely ignored . . . Because of its proximity to 
        and knowledge of China, Taiwan is uniquely equipped to 
        help U.S. efforts to (1) expand presence and access in 
        the region by ensuring U.S. forces can utilize 
        facilities on the island in the event of a conflict; 
        (2) build partnership capacity by improving its self-
        defense capabilities; and (3) improve military 
        innovation by sharing experience, technology, and 
        intelligence with the United States. Rather than 
        fearing damaging bilateral ties with China, the United 
        States should take advantage of the benefits this 
        important partnership can offer.\51\

    Similarly, Mark Stokes, executive director of the Project 
2049 Institute, and L.C. Russell Hsiao, research fellow at the 
Project 2049 Institute, argue:

        Taiwan should be the central guiding focus of defense 
        planning in the Asia Pacific region . . . Taiwan is the 
        principal security partner in the region that is 
        willing and able to develop the kind of force needed 
        for networked, integrated deep interdiction operations 
        in an [antiaccess/area denial] environment. Taiwan's 
        knowledge of single points of failure in the PLA's air 
        and missile defense system could someday save many 
        lives. Maintaining Taiwan's capacity to interdict 
        single points of failure in the PLA's [antiaccess/area 
        denial] system could relieve the United States of part 
        of its heavy operational burden and reduce risks of 
        escalation . . . [Furthermore], Taiwan is uniquely 
        positioned to contribute to regional situational 
        awareness of the air, space, sea and cyber domains.\52\

Diplomatic Affairs
    In February 2013, AIT and the Taipei Economic and Cultural 
Representative Office in the United States (TECRO) signed an 
updated agreement on reciprocal privileges and immunities. The 
agreement, which replaces the 1980 agreement on this subject, 
enhances legal protection for AIT personnel in Taiwan and TECRO 
personnel in the United States. Specifically, according to the 
U.S. Department of State, certain AIT and TECRO employees now 
have ``expanded protection from criminal jurisdiction and 
arrest as well as specified immunities from providing 
testimony.'' \53\ Previously, these personnel only had such 
protections within the scope of authorized work functions.

Democratic Progressive Party Outreach to Washington
    The opposition DPP has increased engagement with the United 
States to repair perceived damage to bilateral ties and to 
``rebrand'' the party's image as a ``responsible'' alternative 
to the ruling KMT.\54\ DPP Chairman Su Tseng-chang visited 
Washington, DC in June 2013 to inaugurate the DPP's new 
representative office * and to build closer ties with the 
United States. During a speech at the Brookings Institution, 
DPP Chairman Su said, ``Friends here are anxious to learn how 
the DPP plans to manage Taiwan's relations with China. Past 
history has left its imprint and the DPP has to work hard to 
regain the confidence of our international friends.'' \55\
---------------------------------------------------------------------------
    * The DPP had an office in Washington in the 1990s but closed it 
during DPP President Chen Shui-bian's administration from 2000-2008. 
Shu-yuan Lin and Jay Chen, ``DPP office in Washington to open by 
June,'' Central News Agency (Taipei), February 28, 2013. http://focus 
taiwan.tw/news/aipl/201302280015.aspx.

Trade
    In March 2013, the United States and Taiwan held the first 
round of talks under the Trade and Investment Framework 
Agreement (TIFA)  since 2007. Talks had stalled over 
Taiwan's ban on importing U.S. beef containing ractopamine, a 
common feed additive,= but resumed after Taiwan's legislature 
lifted some restrictions on the use of ractopamine in beef in 
July 2012. However, Taiwan's ban on ractopamine in pork remains 
in place and could hinder future U.S.-Taiwan trade talks.
---------------------------------------------------------------------------
     The Trade and Investment Framework Agreement, established 
in 1994, serves as the primary mechanism for the United States and 
Taiwan to discuss trade- and investment-related issues in the absence 
of official diplomatic ties.
    = The chemical ractopamine is used as a feed additive for 
livestock, intended to increase muscle size and leanness in livestock 
such as cattle and pigs. The U.S. government has approved the use of 
ractopamine since 2003 and has declared that meat from animals fed the 
additive is safe for human consumption.
---------------------------------------------------------------------------
    According to the Office of the U.S. Trade Representative, 
the March TIFA meeting, held in Taipei, ``produced numerous 
results, including new joint statements on investment 
principles and information and communication technology 
services, and the launch of new TIFA working groups on 
investment and technical barriers to trade.'' Taiwan also 
agreed to ``conduct bilateral technical exchanges to facilitate 
the establishment of science-based maximum residue levels for 
pesticides.'' \56\ In a meeting with the Commission, President 
Ma said Taiwan hopes TIFA talks will lead to negotiations on a 
U.S.-Taiwan investment agreement and Taiwan's participation in 
the Trans-Pacific Partnership. Officials from Taiwan's Ministry 
of Economic Affairs acknowledged to the Commission that 
developing a bilateral investment agreement with the United 
States would be difficult due to Taiwan's political status but 
said 
they believed U.S. congressional members supported the agreement
 
    The new TIFA working group on investment held its first 
meeting in September. According to U.S. Deputy Assistant 
Secretary of State for East Asian and Pacific Affairs Kin Moy, 
``There was a discussion on promoting a transparent and 
predictable investment regime, and an exchange of preliminary 
views on a potential U.S.-Taiwan Bilateral Investment 
Agreement.'' \57\ The new TIFA working group on technical 
barriers to trade is scheduled to meet in October. The next 
full TIFA meeting will occur in 2014 in Washington, DC.\58\
U.S. Arms Sales to Taiwan
    Taiwan continues to be one of the largest buyers of U.S. 
arms in the world and is the largest in Asia. Since President 
Ma assumed office in 2008, Taiwan has agreed to purchase 
approximately $18.3 billion of U.S. arms. In August 2013, 
President Ma said, ``Although cross-Strait relations have 
gradually eased and cross-Strait relations are now the most 
peaceful in more than six decades, we still cannot afford to be 
lax in terms of combat readiness . . . [Taiwan] will continue 
to purchase U.S.-built weapons that [Taiwan] cannot produce on 
[its] own.'' \59\ Responding to concerns about the impact of 
Taiwan's declining defense budget on U.S.-Taiwan arms sales, 
Taiwan's Ministry of Defense said it will ``increase the budget 
or apply for special funds from the [Taiwan legislature] if the 
United States agrees on more arms sales to Taiwan.'' \60\ See 
figures 3-4 for more details on U.S. arms sales to Taiwan.

       Figure 3: Value of U.S. Arms Sales Notifications to Taiwan
------------------------------------------------------------------------
                                                   Value of Arms Sales
                     Year                        Notification  (billion
                                                          USD)
------------------------------------------------------------------------
        2001                                                      1.082
------------------------------------------------------------------------
        2002                                                      1.521
------------------------------------------------------------------------
        2003                                                      0.775
------------------------------------------------------------------------
        2004                                                      1.776
------------------------------------------------------------------------
        2005                                                      0.280
------------------------------------------------------------------------
        2006                                                         --
------------------------------------------------------------------------
        2007                                                      3.717
------------------------------------------------------------------------
        2008                                                      6.463
------------------------------------------------------------------------
        2009                                                         --
------------------------------------------------------------------------
        2010                                                      6.392
------------------------------------------------------------------------
        2011                                                      5.852
------------------------------------------------------------------------
Source: U.S.-Taiwan Business Council and Project 2049 Institute, Chinese
  Reactions to Taiwan Arms Sales (Arlington, VA: March, 2012), p. 38.
  http://project2049.net/documents/
2012--chinese--reactions--to--taiwan--arms--sales.pdf.



                                                           Figure 4: U.S. Arms Sales to Taiwan
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                           Projected  Value
                       Year of Notification                              Weapon, Item, or Service           (million USD)*      Status       Delivery
                                                                                                               
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                                                          330 PAC-3 missiles a3,100ring unitsNot    Beginning in
                                                                                                                              delivered       2014 \61\
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                                     32 UGM-84L Harpoon missiles                200          Not     Expected in
                                                                                                                              delivered            2013
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                                        Spare parts for F-5E/F, C-130H,  F-     334      Ongoing   Not applicable
                                                                   16A/B, and Indigenous Defense Fighter                     deliveries
                                                                                         (IDF) aircraft
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                                182 Javelin missiles and command                 47    Delivered            2011
                                                                                           launch units
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                            Four E-2T aircraft refurbishment and                250             Com2011-2013 \62\
                                                                                               upgrades
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2008                                                                 30 AH-64 Apache helicopters and              2,532          Six       2013-2014
                                                                                       related ordnance                       delivered
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2010                                                                                          114 PAC-3 missiles a2,810ring unitsNot    Beginning in
                                                                                                                              delivered       2014 \63\
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2010                                                                60 UH-60M Black Hawk helicopters              3,100          Not   2014-2018 \64\
                                                                                                                              delivered
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2010                                                                  12 ATM-84L and RTM-84L Harpoon                 37      Unknown         Unknown
                                                                                               missiles
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2010                                                            60 MIDS/LVT-1 terminals to improve F-               340          Not         Unknown
                                                                                                 16A/B C4ISR Sec.  systems    delivered
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2010                                                             Two OSPREY-class mine hunting ships                105    Delivered       2012 \65\
                                                                           (refurbishment and upgrades)
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2011                                                              145 F-16/AB aircraft refurbishment              5,300          Not       2016-2017
                                                                                           and upgrades                        complete
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2011                                                                             F-16 pilot training                500      Ongoing   Not applicable
--------------------------------------------------------------------------------------------------------------------------------------------------------
   2011                                                              Spare parts for F-16A/B, F-5E/F,  C-               52      Ongoing   Not applicable
                                                                                 130H, and IDF aircraft
--------------------------------------------------------------------------------------------------------------------------------------------------------
Source: Except where indicated, this information is compiled from the following three sources: U.S.-Taiwan Business Council and Project 2049 Institute,
  Chinese Reactions to Taiwan Arms Sales (Arlington, VA: March, 2012). http://project2049.net/documents/2012--chinese--reactions--to--taiwan--arms--sales.pdf;
  Shirley Kan, Taiwan's Major U.S. Arms Sales since 1990 (Washington, DC: Congressional Research Service, July 23, 2013); and Piin-Fen Kok and David J.
  Firestein, Threading the Needle: Proposals For U.S. And Chinese Actions On Arms Sales To Taiwan (New York, NY and Washington, DC: East West Institute,
  September 2013).

         
---------------------------------------------------------------------------
    * These values represent amounts as presented to Congress at the 
time of notification, which may differ from the actual amount Taiwan 
pays for the weapon, item, or service.
     These are the weapons, items, and services as presented to 
Congress at the time of notification, which may differ from the actual 
weapons, items and services that the United States ultimately sells to 
Taiwan.
    = Consistent with Figure 3, these values represent amounts as 
presented to Congress at the time of notification, which may differ 
from the actual amount Taiwan pays for the weapon, item, or service.
    Sec. C4ISR refers to command, control, communications, computers, 
intelligence, surveillance, and reconnaissance.
---------------------------------------------------------------------------
Cross-Strait Military and Security Issues
Military Balance
    Since the late 1990s, China's military modernization has 
focused on improving its capabilities for Taiwan conflict 
scenarios that include U.S. intervention. This modernization 
program likely is designed to hedge against a failure of 
China's cross-Strait diplomatic strategy; deter Taiwan from 
taking steps toward de jure independence; signal to the United 
States that China is willing to use force against Taiwan if 
necessary; and enhance China's ability to deter, delay, or deny 
any U.S. intervention in a cross-Strait conflict.
    China's People's Liberation Army (PLA) is more prepared 
than in the past to conduct several different military 
campaigns against Taiwan, including a partial naval blockade 
and a limited air and missile campaign.

     LChina has a large and sophisticated short-range 
ballistic missile (SRBM) force, including over 1,100 mobile 
SRBMs that are positioned in southeast China and able to strike 
Taiwan. China continues to improve the range, accuracy, and 
payloads of its SRBMs with the introduction of new missiles or 
variants and component upgrades.\66\

     LThe PLA has approximately 2,300 combat aircraft 
capable of participating in large-scale air operations, 490 of 
which are based within range of Taiwan. By contrast, the Taiwan 
Air Force has approximately 410 combat aircraft.\67\

     LThe PLA Navy has approximately 75 major surface 
combatants, 85 missile patrol boats, and 60 conventional and 
nuclear submarines. These units are available for a range of 
missions, such as enforcing a blockade of Taiwan. As China's 
naval modernization continues, an increasing percentage of 
these ships and submarines will feature advanced weaponry. In 
contrast, the Taiwan Navy has 26 major surface combatants, 45 
missile patrol boats, and two operational submarines.\68\

     LAlthough China at this time does not appear to be 
pursuing the amphibious capabilities necessary to conduct a 
large-scale invasion of Taiwan, the PLA Navy since 2008 has 
commissioned three new amphibious transport docks. These large 
amphibious ships--which can carry a mix of air-cushion landing 
craft, amphibious armored vehicles, helicopters, and marines--
improve China's ability to seize and hold Taiwan's offshore 
islands.\69\

    Furthermore, major elements of China's military 
modernization focus on developing long-range strike 
capabilities to place U.S. ships, aircraft, and bases in the 
Western Pacific at risk. (See chapter 2, section 1, ``Military 
and Security Year in Review,'' for full treatment of China's 
antiaccess/area denial capabilities.)
    Taiwan's ability to defend against China's growing military 
capabilities is declining. The key shortcomings in Taiwan's 
defensive capabilities are its insufficient infrastructure 
hardening and lack of mobile systems.\70\ For example, Taiwan 
relies on fixed land-based coastal surveillance radars for 
maritime surveillance. The PLA likely would destroy these 
vulnerable sites during initial air and missile strikes in a 
campaign against Taiwan, severely degrading Taiwan's ability to 
defend itself. China's overwhelming quantitative and 
qualitative advantage over Taiwan also would challenge the 
Taiwan military's ability to sustain high-intensity operations 
during a conflict.

Defense Spending Trends

    Cross-Strait defense spending trends since 2001 have 
dramatically shifted in China's favor. The officially reported 
budget gap in 2013 totaled more than $100 billion.
    China's official defense budget rose to approximately $117 
billion in 2013 from $106 billion in 2012, marking the 22nd 
consecutive year-on-year increase. Furthermore, China's total 
defense-related expenditure likely is significantly higher than 
the official budget figure. The Institute of International 
Strategic Studies assesses China's actual defense spending is 
40 to 50 percent higher than the official figure.\71\ Most 
analysts expect China's defense spending will continue to grow 
steadily in the near term, even if economic growth slows. (See 
chapter 2, section 1, ``Military and Security Year in Review,'' 
for full treatment of China's 2013 defense budget.)
    Taiwan's defense budget, on the other hand, continues to 
decline. Taiwan's official defense budget contracted to $10.5 
billion in 2013 from $10.6 billion in 2012. Taiwan's 2013 
defense spending represents 2.1 percent of its GDP, a record 
low matched only in 2006 and 2011. This is less than 3 percent 
of GDP--the level at which President Ma pledged to maintain 
defense spending--and marks a substantial decrease from 3.8 
percent of GDP in 1994. Furthermore, 2013 defense spending 
accounts for only 16.2 percent of the total government budget, 
down from 24.3 percent in 1994.\72\ In response to concerns 
about Taiwan's declining defense budget relative to GDP, 
President Ma has explained defense spending cannot be expected 
to keep pace with Taiwan's GDP growth.\73\ Taiwan's GDP growth 
rate was 10.7 percent in 2010, 4 percent in 2011, and 1.3 
percent in 2012.\74\
    Taiwan's defense spending likely will remain stagnant 
through at least the end of President Ma's term in 2016 as he 
continues to implement a strategy he described to the 
Commission as the ``institutionalization of rapprochement as 
the first line of defense.'' Moreover, President Ma has little 
incentive to increase the defense budget, since improved cross-
Strait relations have reduced public perceptions of the China 
threat in Taiwan \75\ while domestic and social welfare issues 
have become more salient as Taiwan's economy attempts to 
recover from the global financial crisis and its workforce 
ages. U.S. officials and outside observers suggest that if this 
trend continues, then the Taiwan military may struggle to 
maintain a credible deterrent capability.\76\

Chinese Espionage against Taiwan

    Despite warming cross-Strait ties, China continues to 
engage in aggressive espionage activities against Taiwan. Since 
September 2012, Taiwan has arrested at least six former or 
active Taiwan military officers, including one flag officer, 
for espionage.\77\ In one case, a former Taiwan Navy commander, 
who had served as the head of the political warfare division at 
Taiwan's Naval Meteorological and Oceanographic Office, may 
have provided to China classified submarine nautical charts as 
well as hydrographic information about the waters surrounding 
Taiwan.\78\ These cases underscore the breadth and depth of 
China's espionage activities against Taiwan and demonstrate 
Taiwan's vulnerability to espionage.
    Former AIT director William Stanton said in March 2013 that 
espionage cases in recent years ``have been harmful not only 
because of the potential loss of unknown quantities of 
classified information, but also because their success and 
frequency serves to undermine U.S. confidence in security 
cooperation with Taiwan.'' \79\ AIT told the Commission the 
Chinese espionage threat to Taiwan is ``a real concern'' that 
the United States has raised with Taiwan ``at the highest 
levels'' but emphasized recent espionage cases do not mean the 
U.S.-Taiwan arms sale process has been infiltrated.

Taiwan Defense Policy and Reform

Quadrennial Defense Review

    In March 2013, Taiwan published its second Quadrennial 
Defense Review.* \80\ The 2013 Quadrennial Defense Review 
offers no major changes to Taiwan's defense strategy from the 
2009 version. It reiterates President Ma's emphasis on force 
preservation and infrastructure hardening while maintaining the 
ability to combat China's air and naval forces in the Taiwan 
Strait. The defense review also endorses and refines key 
defense reforms that are in various stages of implementation, 
such as fielding a smaller, better educated, and more effective 
all-volunteer force and developing and fielding innovative and 
asymmetric capabilities.
---------------------------------------------------------------------------
    * Taiwan began the Quadrennial Defense Review process as a result 
of 2008 legislation stipulating that the Ministry of National Defense 
must submit a Quadrennial Defense Review to the legislature no later 
than 10 months after each presidential inauguration. The Quadrennial 
Defense Review serves as Taiwan's most authoritative public statement 
on its defense strategy and provides the foundation for defense 
policymaking. Taiwan also uses the Quadrennial Defense Review as a 
public relations tool to inform and attempt to influence domestic and 
foreign opinion. The Quadrennial Defense Review is drafted by the 
Ministry of National Defense's Integrated Assessment Office and 
includes input from ministry staff units and agencies, Taiwan's 
military services, and civilian experts. Alexander Chieh-cheng Huang, A 
Midterm Assessment of Taiwan's First Quadrennial Defense Review 
(Washington, DC: Brookings Institution, February 2011).

---------------------------------------------------------------------------
All-volunteer Force Transition

    Since 2008, Taiwan has been implementing a program to 
gradually convert its conscript-heavy active duty military into 
an all-volunteer force. The all-volunteer force transition has 
been more expensive than anticipated, and the military has had 
difficulty recruiting high-quality volunteers due to a number 
of factors, including a declining birth rate, a quickly aging 
workforce, and a culture that does not hold military service in 
high esteem. While the all-volunteer force was originally 
scheduled for completion by the end of 2014, the Taiwan 
Ministry of National Defense announced in September 2013 that 
Taiwan will continue to conscript some active duty personnel 
until 2017 in order to maintain readiness and overcome current 
manpower shortfalls.\61\
    Taiwan is diverting funds from other portions of the 
defense budget to ease the rising personnel costs resulting 
from the all volunteer transition. Between 2009 and 2013, 
Taiwan increased the share allocated for personnel by 
approximately 10 percent while reducing shares allocated for 
operations and investments.\82\
    The Taiwan military's ability to attract volunteers may be 
further hampered by the death of a 24-year old conscript in 
July 2013. Army Corporal Hung Chung-chiu, found with a banned 
camera-equipped mobile phone while on a military base, was 
placed in solitary confinement for a week and forced to perform 
strenuous exercises in summertime heat that ultimately caused 
him to die from heat stroke. An investigation uncovered further 
hazing and abuses of power by Taiwan military officials. 
Corporal Hung's death triggered large public demonstrations 
against the military, including an August 3 protest near the 
presidential office in Taipei that drew a crowd of over 
100,000. Minister of Defense Kao Hua-chu resigned over the 
incident, and 18 military officers and noncommissioned 
officers, including a general officer, were indicted with 
various crimes for their roles in the soldier's death.\83\ Then 
Deputy Minister of National Defense Andrew Yang told the 
Commission that Taiwan must ``face the problem [of abuse of 
power and unprofessionalism in the military], fix it, and take 
responsibility.''

Downsizing and Streamlining

    In order to cover the recruitment and retention costs 
inherent in an all-volunteer force, the Taiwan military is 
downsizing its active duty force from approximately 270,000 to 
215,000. Furthermore, the Taiwan legislature in November 2012 
passed six laws that provide the legal foundation to begin 
streamlining the military's structure under the ``Jingtsui 
Program.'' The most significant change is the planned 
consolidation of the service branches from six to three. The 
functions of the Combined Logistics Command, Military Police 
Command, and Reserve Command will be merged into the remaining 
service branches--the army, navy, and air force. Other changes 
include the reduction of general and flag officer billets by 
approximately 25 percent and the consolidation of the Ministry 
of National Defense's six departments into four.\84\

Integrating Innovative and Asymmetric Capabilities

    Taiwan has focused on integrating innovative and asymmetric 
platforms and weapon systems into its military since 
approximately 2009. Taiwan fielded 30 stealthy patrol craft 
from 2009 to 2011 and 32 unmanned aerial vehicles in 2012 and 
continues to develop other asymmetric platforms and systems, 
including unmanned combat aerial vehicles and land attack 
cruise missiles (LACMs).\85\ This approach is designed to 
improve Taiwan's ability to defend against the PLA's rapidly 
growing capabilities and allow the Taiwan military to target 
assessed vulnerabilities in the PLA's strategy and weapon 
systems. Furthermore, Taiwan judges asymmetric systems will be 
more cost-effective and will reduce its reliance on major, 
conventional weapon systems that are expensive, difficult to 
maintain, and vulnerable to the PLA's precision strike 
capabilities.\86\

Accepting New Missions

    Taiwan's perception of its security environment has evolved 
since 2008 due to a number of developments, including the 
devastation caused by Typhoon Morakot in 2009, heightened 
tension over maritime territorial disputes in the region, and 
increased levels of piracy in important maritime trade routes. 
In response, Taipei is pushing its military to gradually 
improve its ability to conduct nontraditional missions, such as 
humanitarian assistance/disaster relief inside and outside of 
Taiwan, defense of Taiwan's sovereignty and commercial 
interests in the East and South China Seas, and protection of 
distant maritime trade routes.\87\ As part of its effort to 
meet these requirements, the Taiwan Coast Guard in March 2013 
commissioned the first two ships under a new development 
program that calls for the construction of 37 new units over 
the next 10 years.\88\

Strengthening Cyber and Electronic Warfare Capabilities

    China conducts extensive cyber operations against Taiwan's 
government and corporate networks. For example, China targeted 
the publicly accessible websites of Taiwan's National Security 
Bureau approximately 3.34 million times in 2012, according to 
the agency. Taiwan is increasing its budget for cyber warfare, 
integrating cyber warfare into Taiwan's routine training and 
large-scale exercises, adding a fourth unit to the 
Communication Electronics and Information Bureau, and 
constructing an ``experimental'' facility that will simulate 
cyber attacks on the nation's critical infrastructure to help 
train Taiwan's cyber defenders.\89\

Taiwan's Military Modernization

    Taiwan continues to domestically produce military platforms 
and weapon systems. Key programs under development or recently 
completed include the following:

     LMissile corvette: Taiwan began work on a 
prototype of a new class of catamaran-style missile corvette in 
November 2012. Taiwan plans to build up to 11 corvettes by 
2014. The new ship will carry long-range antiship cruise 
missiles and feature better sea-keeping ability, range, and 
endurance compared to Taiwan's current patrol fleet. In a 
potential conflict with China, the corvette will enhance the 
lethality and survivability of Taiwan's antisurface force.\90\

     LReplenishment oiler: Taiwan began to construct 
its long-planned second replenishment oiler in December 2012. 
The additional oiler, scheduled for completion in 2014, will 
help the Taiwan Navy sustain operations at sea and improve 
Taiwan's ability to conduct humanitarian assistance, presence 
patrols, and port visits to countries that retain diplomatic 
relations with Taiwan.\91\

     LLand attack cruise missiles: Taiwan began to 
field its Hsiung Feng (HF)-2E LACM in May 2012, with 
deployments to three mobile missile squadrons complete by early 
2013. The missile's 375-500 mile range suggests it is designed 
to strike targets on mainland China, such as airfields and air 
defense sites. Taiwan also is developing a longer-range LACM, 
known as the ``Yun Feng.'' Public information on the Yun Feng 
is limited, but press reporting indicates it will be able to 
achieve supersonic speeds and strike targets at twice the range 
of the HF-2E.\92\

     LMultiple-launch rocket system: Taiwan certified 
its long-delayed Ray Ting (RT)-2000 multiple-launch rocket 
system during an April 2013 military exercise and since has 
deployed it operationally. In a potential Chinese invasion, the 
RT-2000 will provide Taiwan with quick-fire capability against 
Chinese amphibious ships as they cross the Taiwan Strait. With 
a range of up to 25 miles and a wheeled chassis allowing for 
easy maneuverability, the RT-2000 is a significant improvement 
over its predecessor, the Kung Feng VI.\93\

    Taiwan also continues to acquire and pursue military 
equipment and training from the United States. Select programs 
include the following:

     LP-3C Orion maritime patrol aircraft: Taiwan in 
September 2013 received the first of the 12 refurbished P-3C 
Orion maritime patrol aircraft that it purchased from the 
United States in 2007. The aircraft will supplement and 
ultimately replace Taiwan's aging S-2T maritime patrol 
aircraft. The P-3C will increase the capability and endurance 
of the military's fixed-wing maritime patrol aircraft force, 
improving Taiwan's ability to perform antisubmarine warfare and 
intelligence, surveillance, and reconnaissance.

     LApache attack helicopters: In 2010, the United 
States agreed to sell 30 AH-64 Block III Apache attack 
helicopters to Taiwan for $2.04 billion. Taiwan began pilot and 
crew training in November 2012 and is scheduled to receive the 
helicopters in groups from October 2013 to July 2014. Taiwan 
has yet to order the Apache's principal weapon, the AGM-114L 
Hellfire missile,\94\ suggesting Taiwan may be concerned about 
cost or developing its own missile.

     LPAC-3 missiles: In January 2013, the United 
States awarded Lockheed Martin a $755 million production 
contract to supply Taiwan with 168 Patriot Advanced Capability 
(PAC-3) missiles and 27 launcher modification kits. Taiwan is 
scheduled to begin receiving the missiles in early 2014.\95\ 
The PAC-3 is an air defense missile designed to intercept 
aircraft and ballistic and cruise missiles.

     LSubmarines: In 2001, the United States approved 
Taiwan's request to purchase diesel-electric submarines via the 
foreign military sales process. However, the sale has stalled 
for a number of reasons on both sides. These include partisan 
political gridlock in Taiwan's legislature, delays in Taiwan's 
commitment of funds, and disagreements between Washington and 
Taipei over costs. Furthermore, the United States has not built 
a diesel-electric submarine since the 1950s or operated one 
since 1990. Multiple reports in recent years claim Taipei is no 
longer committed to acquiring the submarines from the United 
States and is considering designing and manufacturing the 
submarines domestically, with U.S. and possibly other foreign 
technical assistance. Taiwan officials over the last several 
years reportedly have met with government officials or 
commercial entities from a number of countries--including 
Russia, Greece, Germany, Japan, and Spain--seeking assistance 
on submarine construction, submarine technology, or the 
purchase of used submarines.\96\ Furthermore, Taiwan's Ministry 
of National Defense in March 2013 announced plans to conduct a 
feasibility study over the next four years to determine 
Taiwan's ability to produce submarines domestically.\97\ Taiwan 
officials continue to stress to the Commission the importance 
of acquiring submarines. During the Commission's recent trip to 
Taiwan in July, Taiwan officials emphasized that the navy's 
ability to counter China's expanding and modernizing submarine 
fleet will continue to erode as Taiwan's aging submarine force 
increasingly is unable to support Taiwan Navy antisubmarine 
training. Taiwan's current fleet of four submarines includes 
two former U.S. boats that were built in the 1940s and 
transferred to Taiwan in the 1970s.

     LFighters: In October 2012, the United States 
awarded Lockheed Martin a $1.85 billion contract to begin 
performing a mid-life upgrade on Taiwan's existing fleet of 145 
F-16 A/B fighter aircraft. The upgrades will occur from 2017 to 
2022 in groups of 24 aircraft.\98\ However, many analysts 
believe the retrofit program does not adequately address all of 
Taiwan's air defense requirements. Without additional 
acquisitions, Taiwan's fighter force will face substantial 
numerical shortfalls as Taiwan's F-5 fighters are retired over 
the next five to 10 years. In response to Congressional 
concerns over U.S. arms sales to Taiwan, Robert Nabors, 
Assistant to the President and Director of the Office of 
Legislative Affairs, wrote in an April 2012 letter that the 
Obama Administration is ``committed to assisting Taiwan in 
addressing the disparity in numbers of aircraft through our 
work with Taiwan's defense ministry on its development of a 
comprehensive defense strategy vis-a-vis China.'' Mr. Nabors 
also said the Obama Administration would decide on a ``near 
term course of action on how to address Taiwan's fighter gap, 
including through the sale to Taiwan of an undetermined number 
of U.S.-made fighter aircraft.'' \99\ This language differs 
from an earlier White House letter on the subject, which 
definitively stated the Obama Administration's position that 
``the F-16 A/B upgrade effectively meets Taiwan's current 
needs.'' \100\

     LOLIVER HAZARD PERRY-class guided-missile frigates 
(FFG): The U.S. Fiscal Year 2013 National Defense Authorization 
originally contained provisions authorizing the transfer of up 
to four surplus PERRY FFG to Taiwan. However, the legislation 
did not pass due to disagreements over other parts of the bill. 
Both the 2012 and 2013 versions of the Naval Vessels Transfer 
Acts called for the transfer of four PERRY FFG to Taiwan, but 
neither act has been passed. Taiwan currently has eight PERRY 
FFG, which were partially built in Taiwan in the 1990s and 
early 2000s with U.S. authorization and assistance. These ships 
are equipped with U.S. medium-range air defense missiles and 
indigenous long-range antiship cruise missiles. Additional 
major surface combatants like the PERRY would replace Taiwan's 
KNOX-class frigates, which are scheduled for retirement in the 
next few years.\101\

Taiwan Military Training

    The Taiwan military routinely conducts exercises to train 
in core combat competencies, integrate new weapon systems and 
tactics, evaluate and refine operational concepts and plans, 
and demonstrate to China and the United States that it has a 
credible deterrent capability. In 2013, high-profile exercises 
included the following:

     LHan Kuang: Han Kuang, Taiwan's only national-
level joint exercise, is conducted annually and consists of a 
field training exercise and a command post exercise. The 2013 
field training exercise, which occurred in April, focused on 
air defense, maritime interdiction, antiamphibious landing, and 
ground defense. Taiwan media portrayed the event--in which 81 
rockets were fired from nine RT-2000 multiple rocket launchers 
and over 7,500 soldiers participated--as the largest display of 
force by Taiwan since 2008.\102\ The command post exercise, 
which occurred in July, simulated a full-scale Chinese invasion 
of Taiwan in 2017 to test the military's ability to conduct 
command and control for joint operations.\103\

     LSouth China Sea Live-Fire Exercises: In April 
2013, the Taiwan Coast Guard conducted its biannual live-fire 
exercise near Itu Aba. This was the second live-fire drill on 
the island since Taiwan transferred long-range artillery and 
mortars there in August 2012 and the first drill in which those 
weapons were fired.\104\

     LFriendship and Training Cruise: In spring 2013, 
the Taiwan Navy conducted its annual Friendship and Training 
Cruise to the Caribbean and Central America. The deployment, 
which consisted of two naval combatants and a replenishment 
ship, called at Belize, Panama, Nicaragua, Honduras, El 
Salvador, Guatemala, and the Dominican Republic. Taiwan uses 
these cruises to train for long-distance navigation and 
strengthen ties with countries that maintain diplomatic 
relations with Taiwan.\105\

     LSurface-to-Air Missile Test: In September 2013, 
the Taiwan Navy successfully fired a Standard Missile 2 (SM-
2)--Taiwan's most capable air defense missile--against a drone 
target during a simulated Chinese air attack. This is the first 
time Taiwan has fired a SM-2 since 2007 and only the sixth time 
since Taiwan acquired the missiles from the United States in 
the mid-2000s.\106\ Taipei-based military analyst J. Michael 
Cole, citing Taiwan military sources, explains, ``Taiwan must 
first obtain permission from the [United States] before it can 
proceed with firing the Raytheon Corporation-made fleet area 
air defense weapon, primarily over fears that the Chinese 
military will use the occasion to collect sensitive information 
about the system (Chinese `fishing' vessels, some bristling 
with antennas, are often spotted in sea areas near where 
Taiwanese naval exercises are held). Additionally, because of 
its maximum range of about [105 miles], the [United States] has 
expressed concerns over the risks involved in firing the 
weapon, along with the political implications of doing so.'' 
\107\

Implications for the United States

    Since 2008, Taipei and Beijing have taken steps to reduce 
cross-Strait tension and increase economic, cultural, and 
educational ties. The recent cross-Strait rapprochement 
benefits the United States by reducing the likelihood of a 
U.S.-China conflict over Taiwan; contributing to peace, 
prosperity, and stability in East Asia; and allowing U.S. 
policymakers to focus their time and attention on other 
priorities in the U.S.-China and U.S.-Taiwan relationships.
    At the same time, warming ties between China and Taiwan 
raise concerns for Washington and Taipei. Increasing cross-
Strait economic integration will continue to tie Taiwan closer 
to China. This could strengthen China's bargaining power over 
Taiwan and allow Beijing to make progress toward its long term 
goal of unification. Responding to these concerns, officials 
from Taiwan's National Security Council insisted to the 
Commission that Taipei's economic engagement with Beijing is 
carefully calibrated to promote both Taiwan's economic growth 
and continued autonomy.
    Furthermore, the counterintelligence risks to Taiwan and 
U.S. military information shared with Taiwan are increasing as 
cross-Strait ties expand and Chinese citizens visit Taiwan in 
greater numbers. China now has greater access to Taiwan and 
better opportunities to conduct intelligence operations against 
Taiwan citizens both in Taiwan and China.
    Despite the recent cross-Strait rapprochement, the core 
sovereignty and security issues between Taiwan and China remain 
unresolved. China's military modernization has significantly 
increased Beijing's ability to achieve air, sea, and 
information superiority against Taiwan and to project power 
across the Taiwan Strait. Furthermore, important elements of 
the PLA's modernization are designed to restrict U.S. freedom 
of action throughout the Western Pacific. These ``antiaccess/
area denial'' capabilities raise the costs and risks to the 
United States for intervention in a potential Taiwan conflict 
involving China.
    As the cross-Strait military balance of power continues to 
shift in China's favor, Taiwan may seek to develop closer 
political ties with Washington and to acquire additional U.S. 
arms and related military assistance. Taiwan's diminishing 
ability to maintain a credible deterrent capability may provide 
incentives and create opportunities for Beijing to take on 
greater risk in its approach to cross-Strait relations, 
including pressuring Taiwan to move toward political talks or 
using military force to achieve political objectives.

Conclusions

 LCross-Strait economic, cultural, and educational ties 
continue to expand and deepen. However, domestic political 
dynamics and priorities in China and Taiwan still constrain 
movement on political and security issues.

 LSince the Commission's 2012 report, Taiwan has used 
creative diplomacy to sign two free trade agreements and secure 
participation in a key international organization. Taiwan's 
expanding international space helps the country counterbalance 
its economic reliance on China by increasing its 
competitiveness in the world economy, raises the cost to 
Beijing of military coercion against Taiwan, and promotes 
regional stability.

 LPresident Ma since his reelection in January 2012 has 
accelerated efforts to increase Taiwan's economic engagement 
with the United States and gain U.S. support for expanding 
Taiwan's international space while continuing to advocate for 
future U.S. arms sales.

 LTaiwan's military over the last decade has improved 
its ability to conduct joint operations and has developed some 
asymmetric capabilities. However, China's rapid military 
modernization during this time has outpaced these improvements 
and negated many of the military advantages Taiwan previously 
held over China.

                     ENDNOTES FOR SECTION 2

      1. Hu Jintao, ``Firmly March on the Path of Socialism with 
Chinese Characteristics and Strive to Complete the Building of a 
Moderately Prosperous Society in All Respects'' (Beijing, China, 
November 8, 2012). http://news.xinhuanet.com/english/special/18cpcnc/
2012-11/17/c----131981259.htm.
      2. Hu Jintao, ``Firmly March on the Path of Socialism with 
Chinese Characteristics and Strive to Complete the Building of a 
Moderately Prosperous Society in All Respects'' (Beijing, China, 
November 8, 2012). http://news.xinhuanet.com/english/special/18cpcnc/
2012-11/17/c----131981259.htm.
      3. Central News Agency (Taipei), ``Beijing to step up pressure 
for political talks: Taiwan official,'' December 6, 2012. http://
www.wantchinatimes.com/news-subclass-
cnt.aspx?id=20121206000108&cid=1101.
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talks with Beijing,'' Want China Times (Taipei), April 21, 2013. http:/
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Submarine-Fleet.
     98. Shirley Kan, Taiwan's Major U.S. Arms Sales since 1990 
(Washington, DC: Congressional Research Service, March 14, 2013), p. 
25.
     99. Robert Nabors, Letter to The Honorable Senator John Cornyn 
(Washington, DC: April 27, 2012). http://www.scribd.com/doc/91542419/
WH-Letter-to-Sen-Cornyn-4-27-12.
    100. U.S.-Taiwan Business Council, Defense and Security Report: 
Annual Review 2012 (Arlington, VA: January 1, 2013), p. 25.
    101. Rogge Chen and Jay Chen, ``Taiwan to buy two U.S. frigates,'' 
Focus Taiwan, May 20, 2013. http://focustaiwan.tw/news/aipl/
201305200036.aspx.
    102. J. Michael Cole, ``Taiwan's Military Flexes its Muscles,'' 
Diplomat, May 12, 20--13. http:/--/thediplomat.--com/20--13/05/--12/
taiwan---holds---han-----kuang---29-live-fire---exercise/; Taiwan 
Today, ``President Ma oversees Han Kuang drill in Penghu,'' April 18, 
2013. http://www.taiwantoday.tw/ct.asp?xItem=204210&ctNode=445.
    103. Guo Jia-Liang, ``Hanguang Diannao Fuzhu Zhihuisuo Yanxi Yi 
Zhonggong Junli Fazhan Jinxing Yanlian'' (Han Kuang Computer-Aided 
Command Post Exercise Conducted According to the Communist Party of 
China's Military Strength Development), Military News Agency (Taipei), 
July 10, 2013. http://www.mnd.gov.tw/Publish.aspx?cnid=67&p=58002; 
Rogge Chen and Sofia Wu, ``War game to simulate Chinese surprise attack 
on Taiwan: MND,'' Focus Taiwan, July 9, 2013. http://focus--taiwan.tw/
news/aipl/201307090034.aspx.
    104. Central News Agency (Taipei), ``Live-Fire Drill Held on Itu 
Aba Island by Coast Guard,'' April 23, 2013. http: // 
www.taipeitimes.com/News/taiwan/archives /2013/04/23/
2003560506; Agence France-Presse, ``AFP: Taiwan Stages Live-Fire Drill 
in Contested Spratlys,'' April 22, 2013. OSC ID: AFP20130422965005. 
http://www.-open-source.gov.
     105. Ministry of Foreign Affairs (Taiwan), ``ROC Navy's Midshipmen 
Cruising And Training Squadron 2013 Visits Belize,'' May 2, 2013. 
http://www.mofa.gov.tw/EnPDA/News/Detail/f252bfaa-7e2e-46ac-9f22-
c01a00a72f62?arfid=-0b-060a-2d-e921-4f32-893b-821c252eb4f9.
     106. Joseph Yeh, ``Navy launches SM-2 missile during drill off 
East Coast,'' China Post (Taipei), September 27, 2013. http: // 
www.chinapost. com . tw / taiwan /national/national-news/2013/09/27/
389912/Navy-launches.htm.
     107. J. Michael Cole, ``Taiwan Navy Shoots Down a Simulated 
Chinese Drone,'' Diplomat, September 27, 2013. http://thediplomat.com/
flashpoints-blog/2013/09/27/taiwans-navy-shoots-down-a-simulated-
chinese-drone/.
                     SECTION 3: MACAU AND HONG KONG

Introduction
    China exercises sovereignty over two former European 
colonies, Macau and Hong Kong. Both former colonies operate as 
special administrative regions (SAR) of the People's Republic 
of China (PRC) under the ``one country, two systems'' 
framework.* Control of Macau was officially transferred from 
the Portuguese Republic to the PRC in 1999, and control of Hong 
Kong reverted from British control to the PRC in 1997. While 
geographically close, the two former colonies are quite 
distinct, and the governance issues that Hong Kong presents 
differ markedly from those of Macau. Whereas Macau has 
experienced an economic rebirth, with booming prosperity and 
dramatic reduction in street crime under Chinese rule, Hong 
Kong was already a well-run, thriving economic powerhouse prior 
to its handover, and many of its citizens have felt more 
acutely the drawbacks of living under the new regime. The 
result, as one former Hong Kong official noted in a July 
meeting with Commissioners, is that ``Macau is the patriotic 
SAR, while Hong Kong is the defiant one.'' \1\
---------------------------------------------------------------------------
    * The ``one country, two systems'' framework is a policy measure 
adopted by the PRC following the establishment of Hong Kong and Macau 
as SARs. The system grants Hong Kong and Macau the right to self govern 
their economy and political system to a certain extent, excluding 
foreign affairs.
---------------------------------------------------------------------------
    During the 2013 report cycle, the Commission held a hearing 
in Washington, DC, on June 27 on Macau and Hong Kong. The 
Commission heard from expert witnesses on the evolution of the 
gaming industry in Macau and the investments there by three 
U.S.-based casino companies. The Commission also examined the 
implications to U.S. regulators and to the U.S.-based casinos 
of the gaming industry in Macau. The Commission hearing in June 
included testimony on the efforts in Hong Kong by prodemocracy 
forces to achieve universal suffrage in the elections of the 
legislature and executive as promised under Hong Kong's Basic 
Law. The Commission examined the increasing police surveillance 
of the prodemocracy movement and the decline of press freedom 
in Hong Kong. The Commission also visited Hong Kong in July and 
met with current and former government officials and 
representatives of nongovernmental organizations.


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
A Note on this Section
 
  The Commission is not an investigative or regulatory body but
functions as a policy advisor to Congress. The purpose of the
Commission's work in holding its June 27 hearing and in travelling to
Hong Kong and the People's Republic of China in July 2013 was to collect
information that would enable it to assess the risk to U.S. national and
economic security from a variety of perspectives. As in all of its work,
the Commission's ultimate goal is to report to Congress on the topics
within its mandate and to make recommendations to Congress for
appropriate policy and legislative changes. The Commission did not seek
nor did it find evidence of wrongdoing by any U.S.-based casino company,
either in Macau or Las Vegas.
 
------------------------------------------------------------------------


Macau's Economy Depends on Gambling

    The gaming sector is the most important element of the 
Macau SAR economy, and Macau's government is heavily dependent 
on a 35 percent tax on gross gaming revenue.\2\ Macau's tax 
collections from the gaming sector in 2012 totaled $13.9 
billion, which accounted for 87.5 percent of total government 
revenue.\3\ As Macau's gambling sector has grown rapidly, Macau 
has accumulated the world's third-largest budget surplus as a 
percentage of gross domestic product (GDP).\4\ Macau's per 
capita GDP, at $78,275, is 12 times the size of mainland 
China's and considerably higher than that of the United States 
at $49,964.\5\
    Although gambling is illegal on the Mainland (with the 
exception of state-run lotteries), Beijing allowed Macau's 
gaming industry to continue operations following its reversion 
to PRC sovereignty.\6\ Macau's gaming sector thrived and, in 
2006, officially surpassed Las Vegas as the world's largest 
gambling market. Macau's official annual gross gaming revenue 
is now more than six times that of Las Vegas, surpassing $38 
billion in 2012.\7\ Taking off-book profits into consideration, 
the actual gaming market is estimated to be much higher. During 
the Commission's trip to Hong Kong in July 2013, Steve Vickers, 
former head of the Royal Hong Kong Police's Criminal 
Intelligence Bureau and an acknowledged authority on Macau's 
gaming sector and Asian organized crime issues, estimated that 
the real value of Macau's gaming industry is likely six times 
larger than the official reported size, making the actual 
market worth more than $200 billion, over four times Macau's 
2012 official GDP.\8\ (Mr. Vickers is now a private consultant 
and investigator in Hong Kong.)
    The exponential growth of Macau's gaming revenue has been 
driven primarily by visitors from mainland China. According to 
the Macau government, 16.9 million people visited Macau from 
mainland China in 2012, accounting for 60 percent of total 
visitors. Other visitors are primarily from Hong Kong or 
Taiwan, accounting for 30 percent.\9\

Money Laundering in Macau

    Macau in 2001 liberalized a home-grown, monopolistic 
concession system and opened bidding for casino operation 
licenses to a limited number of foreign casino operators.\10\ 
The introduction of new and larger casinos led to substantial 
increases in cash flow, which consequently presented an 
increased risk for money laundering within Macau's financial 
and gaming institutions.* Among all financial institutions, 
casinos generally present the greatest risk for money 
laundering.\11\ ``It is the variety, frequency and volume of 
transactions that makes the casino sector particularly 
vulnerable to money laundering. Casinos are by nature a cash 
intensive business and the majority of transactions are cash 
based . . . It is this routine exchange of cash for casino 
chips or plaques, TITO [ticket-in, ticket-out] tickets, 
and certified cheques, as well as the provision of electronic 
transactions to and from casino deposit accounts, casinos in 
other jurisdictions, and the movement of funds in and out of 
the financial sector which makes casinos an attractive target 
for those attempting to launder money,'' \12\ according to the 
Asia-Pacific Group on Money Laundering and the Financial Action 
Task Force, a Paris-based intergovernmental body.
---------------------------------------------------------------------------
    * According to the most recent Macau government statistics, U.S. 
direct investment in Macau totaled $677.3 million at the end of 2011, 
although unofficial numbers put the figure between $8 billion and $10 
billion. There are more than 30 U.S. firms doing business in Macau. 
U.S. Department of State, ``U.S. Relations with Macau'' (Washington, 
DC: August 16, 2013).
     A ticket representing large slot machine payouts in lieu 
of coins.
---------------------------------------------------------------------------
    In Macau there is an even larger risk of money laundering 
within the VIP gaming room operations, which are physically 
conducted within the casinos but remain outside of the casino's 
official oversight.\13\ The risk is further enhanced because so 
much of the money that is wagered in Macau goes through the 
loosely regulated VIP rooms. In 2012, VIP baccarat rooms in 
Macau casinos accounted for 69.3 percent of total revenue from 
games of chance.\14\
    The structure of VIP gaming operations--as an independent 
contractor of the casino--dates back to the 1930s and is legal 
under Macau law. But regulatory oversight of VIP rooms, junket 
operators, and affiliates who supply the clients and manage the 
money remains opaque and prone to substantial abuse.\15,16\ 
``The movement of funds associated with gaming-related tourism 
is poorly understood and may pose particular money laundering 
risks, e.g., international movement of funds for casino junket 
operations.'' \17\ The PRC's strict capital controls that limit 
the amount of money individuals can carry to or otherwise 
transfer from mainland China to Macau have created a unique 
opportunity for the VIP gaming rooms to participate in a grey 
financial market. Large sums of renminbi (RMB) are moved 
through the independent VIP gaming room operations with the 
help of junket operators and their affiliates on the Mainland. 
That renminbi can be converted to Hong Kong dollars by gamblers 
in the casino and then transferred abroad through a variety of 
legitimate means, such as bank or casino wire transfers.
    According to I. Nelson Rose, professor of law at Whittier 
Law School, who testified at the Commission's June 27 hearing, 
Macau's weak enforcement of anti-money-laundering prohibitions 
comes, in part, ``from lack of experience, since big-scale 
casino gambling is less than ten years old. And part comes from 
the enormous amounts of money coming in and the junket system, 
which make it difficult to track all the transactions and gives 
incentives to ignore what may be going on. And China likes the 
economic booms of Macau and Hong Kong, and has plans to spend 
hundreds of billions of dollars to create large regional 
centers around the two SARs.'' \18\ Nevada regulators generally 
agree that the problem lies more with Macau and its loose 
regulations of VIP gaming room operators and junket operators 
in Macau and on the Mainland. While Nevada's affiliated casinos 
in Macau offer ``robust compliance'' with anti-money-laundering 
protocols, ``that robust compliance, however, is only up to a 
point; that point is where the VIP room operators assume 
responsibility,'' said Nevada State Gaming Control Commission 
Chairman A.G. Burnett in testimony before the Commission.\19\
    According to a 2013 report from the U.S. Department of 
State, the gaming industry in Macau ``relies heavily on 
loosely-regulated gaming promoters and collaborators, known as 
junket operators,\20\ for the supply of wealthy gamblers, 
mostly from nearby mainland China.'' \21\ The report notes that 
in addition to supplying customers, the junket operators bear 
much of the risk that high rollers will renege on the unsecured 
loans that casinos and junket operators typically extend to 
heavy gamblers. (In the Macau system, the junket operators are 
allowed to extend credit to gamblers from the Mainland and buy 
chips directly from the Macau casinos to supply to their 
customers. If the customers fail to repay the loans, it is the 
junket operator who is not repaid. The casinos have already 
collected from the junket operators.) ``Increasingly popular 
among gamblers seeking inscrutability and alternatives to 
China's currency movement restrictions, junket operators are 
also popular among casinos aiming to reduce credit default risk 
and unable to legally collect gambling debts in China, where 
gambling is illegal,'' the State Department report notes.\22\
    One problem is the abuses of the junket operators in 
collecting debts from customers through threats of violence and 
other nonjudicial means. ``Other extra-legal means of debt 
collection may indeed come into play,'' according to a 2007 
University of Nevada study. ``The extent to which extra-legal 
means of debt collection (i.e., threats, intimidation, 
violence, induced crime such as embezzlements, etc.) occurs is 
an obvious concern for regulators, especially those from 
outside Macau that oversee companies which are concession or 
subconcession holders in Macau.'' \23\
    All of these concerns have led American companies operating 
casinos in Macau to take additional steps to prevent illegal 
activity in their operations. Some of those steps were detailed 
in a submission by the companies to the Commission and are set 
forth at the end of this section. The Commission is not in a 
position to evaluate the adequacy of these measures to insulate 
these companies from the danger of association with illegal 
activity. However, Mr. Rose, who was one of the witnesses at 
the Commission hearing, has in a subsequent article warned that 
in evaluating the danger of illegality ``it is important . . . 
to distinguish between casinos (in Macau) that are licensed by 
U.S. states and those that are not.'' Mr. Rose noted further 
that, ``in practice, there are two separate regulatory systems 
working in Macau. There are the casinos that are subject only 
to Macanese regulations. And there are those that are also 
subject to controls by states and nations outside of the PRC--
in particular, the three casino operators who are also licensed 
by Nevada and other states.''
    Macau's junket operations have a history of affiliation 
with Asian organized crime,\24\ which presents added risks for 
U.S.-licensed companies operating casinos in Macau, according 
to Nevada's state gaming regulators. Numerous junkets may have 
ties to organized crime, and public media and intelligence 
sources ``have affiliated all but one of the seven VIP Room 
operator groups of interest with reputed Asian organized crime 
figures,'' according to Mr. Burnett.\25\ ``It is common 
knowledge [that] the operation of VIP rooms in Macau casinos 
had long been dominated by Asian organized crime commonly 
referred to as triads [and] the same [organized crime] figures 
are allegedly still working the VIP operations.'' \26\
    U.S.-based casino companies are also subject to 
``suitability requirements'' under state gaming laws that 
prohibit consorting with criminal elements, even outside the 
United States. Furthermore, the grey market nature of Macau's 
loosely regulated junket operators and underground banking 
system raises the possibility for exploitation of casinos by 
international criminals seeking to launder illicit funds. 
Although U.S.-licensed casinos have implemented strict 
safeguards to prevent criminal activity from occurring within 
their Macau casinos,\27\ loose regulation by China and Macau of 
third-party junket operators and their affiliates that support 
the success of Macau casinos presents considerable risks.
    Macau has taken steps to improve the efficacy of its laws 
preventing the abuse of gaming and financial institutions by 
criminals; however, according to Assistant Secretary for 
Terrorist Financing at the U.S. Department of the Treasury 
Daniel L. Glaser, Macau's regulators have fallen far short in 
complying with internationally recognized standards, and 
numerous deficiencies remain in its regulatory framework.\28\ 
The PRC has also recently expressed interest in closer 
monitoring of Macau's gaming industry as part of its nationwide 
initiative to crack down on corruption. However, to date, the 
PRC has not implemented any significant policy measures to 
regulate Macau's grey market VIP gaming system.

The Role of Money Laundering and Capital Flight from the Mainland

    The PRC maintains strict capital controls to limit the 
amount of cash taken out by individuals from mainland China to 
$3,260 per day and $50,000 per year.\29\ Despite these 
restrictions, individuals from mainland China are able to 
bypass the PRC's capital controls and move large sums of money 
into Macau by making money transfers through various grey 
market channels. One of the most common methods is for 
individuals to physically smuggle cash.\30\ Mainland Chinese 
may also bypass the PRC's capital controls via ``pawn shops'' 
and ``jewelry dealers'' in Macau.* Underground banks also play 
a key role in moving illicit funds outside of mainland China, 
directly transferring RMB to VIP accounts at Macau casinos.\31\ 
Individuals will then collect the RMB in the form of special 
gambling chips at Macau casinos and cash them out in Hong Kong 
dollars after using the chips for gambling.\32,33\ Although the 
exact amount of money moved through underground banks in 
unknown, Yan Lixin, secretary general of the China Center for 
Anti-Money-Laundering Studies at Fudan University in Shanghai, 
estimates that 30-40 percent of all capital moving through 
underground banking channels is dirty money being 
laundered.\34\
---------------------------------------------------------------------------
    * It is common to witness individuals making purchases at ``pawn 
shops'' or ``jewelry shops'' using China's domestic bank card Unionpay 
to purchase items and immediately return them for Hong Kong dollars, 
which then can be moved out of the country. The ``front'' shops, which 
are located throughout Macau and within casinos, also operate as 
underground banks by extending high-interest-rate loans to gamblers. 
Financial Times, ``Macao Casino Boom Fuelled by Illicit Cash,'' January 
3, 2012. http://www.ft.com/intl/cms/s/0/833b06bc-1a63-11e1-ae4e-
00144feabdc0.-html; U.S.-China Economic and Security Review Commission, 
Hearing on Macau and Hong Kong, testimony of I. Nelson Rose, June 27, 
2013.
---------------------------------------------------------------------------
    There is a high risk to Macau for money laundering, 
especially considering its gaming-driven economy. Macau is 
noted as a ``jurisdiction of primary concern'' in a 2012 report 
by the U.S. Department of State in its International Narcotics 
Control Strategy Report.\35\ A 2013 State Department report 
specifically identifies Macau's junket operators as 
contributing to the vulnerability for money laundering and 
notes that ``Macau Government officials indicate the primary 
sources of laundered funds--derived from local and overseas 
criminal activity--are gaming-related crimes, property 
offenses, and fraud.'' \36\ The U.S. Central Intelligence 
Agency also notes that ``Macau continues to face the challenges 
of managing its growing casino industry, money-laundering, and 
the need to diversify the economy away from heavy dependence on 
gaming revenues.'' \37\ Moreover, The Economist reported that a 
memo sent in December 2009 from the U.S. consulate in Hong Kong 
to the U.S. Secretary of State said that ``[Macau's] phenomenal 
success is based on a formula that facilitates, if not 
encourages, money laundering.'' \38\ The memo noted that 
``[s]ome of these mainlanders are betting with embezzled state 
money or proceeds from official corruption, and substantial 
portions of these funds are flowing on to organized crime 
groups in mainland China, if not Macau itself.'' \39\
    A 2009 report by the Financial Action Task Force, a 
multinational organization that sets standards for the 
prevention of money laundering and the financing of terrorism, 
provided multiple case studies outlining cash smuggling and 
money laundering in Macau. According to one case study, ``Cash 
Smuggling and Underground Remittance,'' a Mainland customer who 
wanted to gamble in a Macau casino entrusted a junket affiliate 
with a large sum of money. The junket affiliate then brought 
the cash to a ``front'' shop that he operates as an underground 
bank in Zhuhai, a city in the Guangdong Province near the 
border of Macau. The cash was then divided into small lots, 
which were then smuggled into Macau by many ``professional 
commuters.'' A junket operator in Macau then collected the cash 
and deposited the money into a casino account in the form of 
cash, checks, bank transfers, and remittances. When the full 
sum was deposited, the casino agent converted the sum into a 
cashier's order to the VIP room of the casino. The VIP room 
then issued chips to the Mainland customer, who could start 
gambling.\40\
    An indicator of the money-laundering problem in Macau is 
evident in the rising number of suspicious transaction reports 
* filed with Macau's financial intelligence unit. In 2012, the 
total number of ``suspicious transaction reports'' filed 
increased to 1,840 from 1,563, up 18 percent from 2011.\41\ The 
top three reasons triggering suspicious transaction reports in 
2012 were (1) the inability of clients to provide 
identification or important personal information, (2) the 
possible match of a client with an internal watch list or other 
black list, or (3) a client's attempt to convert gambling chips 
without partaking in gambling activities.\42\ Reports 
originating specifically from Macau's gambling institutions 
have increased as a share of total suspicious transaction 
reports from 52 percent in 2007 to 72 percent in 2012,\43\ 
indicating a potential, growing, money-laundering problem in 
Macau's gaming institutions or a growing willingness to 
report.
---------------------------------------------------------------------------
    * The Macau SAR Financial Intelligence Office requires casino 
concessionaires, subconcessionaires, and junket promoters to report any 
``transaction relating to the practice of gaming or betting that, given 
its nature, unusual nature or complexity, indicates an activity of 
money laundering or terrorist financing.'' Jorge Godinho, ``The 
Prevention of Money Laundering in Macau Casinos,'' Gaming Law Review 
and Economics 17:4 (2013): 272.
     Suspicious transaction reports from the casinos rose from 
347 in 2007 to 1328 in 2012. Reports from all other financial sources 
in Macau rose from 343 to 510 during the same period. Government of 
Macau, Financial Intelligence Office Newsletter for Gaming Sector 
(Macau, SAR: Financial Intelligence Office, 2007-2013), http://
www.gif.gov.mo/web1/doc/Newsletter/
Casino-_-Newsletter-_-Issue-_-8-_-201305-.-pdf.

---------------------------------------------------------------------------
Money Laundering in Macau's Gaming System

    In Macau, one of the main channels for money laundering is 
in the gaming sector through underregulated junket operators or 
VIP room operators and their affiliates on the Mainland, which 
include the underground banking system that supports their 
operations. The junket operators ``smooth a money-laundering 
route that processes billions of dollars every year,'' 
according to The Times of London.\44\ U.S. regulators have also 
described junket operators and their affiliates as especially 
able to offer money-laundering services.
    Junket operators attract high-stakes gamblers to VIP rooms 
within Macau casinos by offering clients special services, 
including travel arrangements, hotel rooms, loans and money 
transfers, and a stack of chips waiting at a reserved chair at 
a baccarat table. In return, the junket operators receive a 
commission on the amount of chips they deal and a percent of 
the gambling losses incurred by their VIP clients.= Unlike 
gambling industries in the United States and Singapore, casinos 
operating in Macau--including subsidiaries of U.S.-licensed 
casinos--are heavily dependent on the junket system as the 
primary source of income. Mr. Vickers noted the heavy reliance 
of U.S.-licensed casinos on the Macau junket system during a 
briefing with the Commission in July: ``Without the junkets, 
none of the U.S. operators would make a red cent.'' \45\ In 
2012, baccarat, the preferred game of high rollers in VIP 
rooms, accounted for 69 percent of total casino-generated 
revenue in Macau.\46\
---------------------------------------------------------------------------
    = Junkets frequently receive a commission from the casino based on 
total gaming play, or ``rolling chip turnover.'' This commission is 
based on the number of chips dealt, guaranteeing the junket will 
receive a commission whether the client wins or loses. The commission 
is determined in the contract between the junket and the casino and 
usually ranges from 0.8 percent to 1.25 percent. Carlos Siu Lam, 
``Controlling Internal Operations Risk: VIP Rooms in Macau,'' Casino 
Enterprise Management, http://www.casino-enterprise-management.com/
articles/october-2012/controlling-internal-operational-risk-vip-rooms-
macau; Wuyi Wang and William R. Eadington, ``VIP-Room Contractual 
System of Macau's Traditional Casino Industry'' (Reno, NV: University 
of Nevada, Working Paper 07-001, 2007), p. 6. http://
www.business.unr.edu/econ/wp/papers/unrecon-wp-07001.pdf.
---------------------------------------------------------------------------
    Although junket operators are common throughout the world--
including Las Vegas, where they are referred to as 
``independent agents''--junket operators in Macau are 
significantly more involved in gambling operations and operate 
very differently, with far fewer restrictions. According to the 
written testimony submitted for the June 27 Commission hearing 
by Mr. Rose:

        The Macau VIP Gaming promoters, on the other hand, are 
        nothing like the traditional junket operators 
        associated with American casinos, who were often paid a 
        flat fee per head to bring in players. The Macau VIP 
        gaming promoters can do virtually every part of the 
        gambling transaction: recruit players, arrange 
        transportation, provide credit, operate the gaming room 
        in the casino, and collect the gambling debt.\47\

    Not only is the heavy reliance on the junket system and the 
direct involvement of junket operators in gaming transactions 
uncommon outside Macau, the business relationship between Macau 
casinos and junket promoters is also unique. Macau's junket 
system is not subject to the same regulatory requirements as 
casinos, and it is up to casinos, not the gaming regulator, to 
craft due diligence procedures with junket operators.\48\ Also, 
unlike states such as Nevada, where junket operators are 
subject to in-depth background checks, strict internal control 
standards, and independent audits that are conducted in VIP 
rooms, in Macau, obtaining a junket license is a cursory 
process, and VIP rooms rely on in-house accountants to report 
on the financial status of their business.* \49\
---------------------------------------------------------------------------
    * Representatives of Wynn Resorts and MGM Resorts met with the 
Commission on October 21 and 23 and indicated that they maintain 
supervision of all the VIP gaming rooms through surveillance videos, 
cash room auditing, and personnel controls.
---------------------------------------------------------------------------
    According to experts who provided testimony to the 
Commission, Macau's junkets may have links to organized crime. 
During the Commission's June 2013 hearing, Mr. Burnett noted 
that ``it is common knowledge that the operation of VIP rooms 
in Macau casinos had long been dominated by Asian Organized 
Crime (AOC), commonly referred to as `triads.'' \50\ Former 
Director of the Financial Crimes Enforcement Network of the 
U.S. Treasury Department James H. Freis, Jr., also recognized 
the possible link between Macau junkets and the triads in his 
written testimony. He wrote that ``in some capacity, the 
involvement of organized crime groups such as China's triads is 
likely.'' Finally, during the Commission's trip to Hong Kong in 
July, Mr. Vickers noted the junkets' connection to organized 
crime: ``The junket model in Macau should be the enemy, not the 
industry in Macau, because it is demonstrably connected to 
organized crime.'' However, despite likely affiliation with the 
triads, junkets continue to proliferate in Macau casinos. From 
2006 to 2013, the total number of licensed junket promoters 
grew from 76 to 202.\51\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Role and Risks of Macau's Junket System
 
  Due to the PRC's limit on the amount of money an individual can move
outside of mainland China, Macau VIP room operators hire or partner with
junket affiliates, or ``subjunkets,'' to make arrangements in mainland
China to extend credit to wealthy Mainland Chinese clients to gamble in
Macau's casinos--essentially bypassing the PRC's capital controls. In
turn, junket affiliates are then required to collect debts incurred by
clients in Macau casinos back on the Mainland in the form of RMB (see
figure 1, below).
  Although junket promoters are licensed in Macau, VIP room operators
and their affiliates are composed of an extensive network of junket
financiers, credit guarantors, and other profit participants, which are
all unlicensed by Macau's gaming regulator. Such junket affiliates are
often comprised of local groups that have knowledge of Mainland clients'
credit histories to ensure that they will be able to collect gaming
debts when the client returns to the Mainland.\52\ However, the
collection of gambling debts is illegal in mainland China, presenting
the risk of junket operators and their affiliates resorting to
extrajudicial measures to collect incurred debts, which can lead to
threats and violence, according to Mr. Rose.\53\ A 2008 report published
by the Macau Polytechnic Institute shed light on the risks of
unenforceable debt collection when it examined 99 publically reported
cases of VIP gamers from mainland China.\54\ The report found that seven
of the ``high rollers'' included in the study ended up either committing
suicide or were murdered.\55\
 
------------------------------------------------------------------------


 Figure 1:  Simplified Money-laundering Technique Using Junket/Casino 
                                 System



    Source: U.S.-China Economic and Security Review Commission 
(Washington, DC).

Money Laundering in Financial Institutions

    Outside of the gaming industry, Macau's banks have also 
been involved in money-laundering activities. One well-known 
example occurred in 2005 when the U.S. Treasury Department's 
Financial Crimes Enforcement Network found a Macau-based bank, 
Banco Delta Asia, to be participating in the laundering of 
counterfeit U.S. dollars on behalf of the North Korean 
government.\56\ The Financial Crimes Enforcement Network 
recognized Banco Delta Asia as a primary money-laundering 
concern, stating, ``Banco Delta Asia's special relationship 
with the DPRK [Democratic People's Republic of Korea] has 
specifically facilitated the criminal activities of North 
Korean government agencies and front companies. One well-known 
DPRK front company that has been a client of [Banco Delta Asia] 
for over a decade has conducted numerous illegal activities, 
including distributing counterfeit currency.'' \57\
    The bank was also linked to drug smuggling. ``In addition 
to facilitating illicit activities of the DPRK, investigations 
reveal that [Banco Delta Asia] has serviced a multi-million 
dollar account on behalf of a known international drug 
trafficker,'' the Financial Crimes Enforcement Network 
noted.\58\ Following the investigation, in 2007 the U.S. 
Treasury Department finalized a rule to ban the Macanese bank 
from access to the U.S. financial system under the USA Patriot 
Act.\59\

Vulnerabilities in Macau's Regulatory System

    Macau first passed legislation requiring financial and 
gaming institutions to report suspicious transactions * in 
1998, which was replaced by a revised set of laws in 2006 that 
criminalized money laundering and required stricter reporting 
in the gaming sector.\60\ The legal reforms in 2006 brought 
Macau more in line with global anti-money-laundering standards. 
Improvements included reporting requirements for suspicious 
transactions over a certain cash value; customer due diligence 
procedures intended to prevent gambling by corrupt officials 
using public funds; and additional record-keeping 
requirements.\61\ However, according to Mr. Glaser, multiple 
deficiencies still exist in Macau's anti-money-laundering and 
counter-terrorist-financing framework, including Macau's 
refusal to seize stolen money.\62\
---------------------------------------------------------------------------
    * The Macau SAR Gaming Inspection Coordination Bureau defines a 
suspicious transaction as ``The operation relating to the practice of 
gaming or wagering which, by its nature, non-habitual manner or 
complexity, indicates any activity of money laundering or terrorist 
financing.'' Macau SAR Gaming Inspection Coordination Bureau, 
``Instruction No. 2/2006 Preventive Measures against Crimes of Money 
Laundering and Terrorist Financing,'' p. 2. http://www.gif.gov.mo/web1/
en_law.html.

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Compliance with International Standards

    The premier international standards for effective anti-
money-laundering and combating the financing of terrorism are 
set by the Financial Action Task Force, a multinational body 
established in 1989.\63\ The organization, of which the United 
States and Macau are both members, has created a list of 40 
recommendations to prevent money laundering and the financing 
of terrorism. Macau is subject to a periodic review of its 
compliance with the recommendations as a member of the Asia-
Pacific Group on Money Laundering, Asia's regional Financial 
Action Task Force body. The most recent evaluation of Macau's 
compliance with Financial Action Task Force recommendations was 
conducted in 2006 and published by the Asia-Pacific Group in 
2007. Macau's next evaluation will occur in 2015 or 2016, and 
its compliance will be gauged against a new set of Financial 
Action Task Force recommendations that were revised in 
2012.\64\
    The 2007 evaluation recognized the risk of money laundering 
in Macau's gaming sector and noted multiple deficiencies in its 
anti-money-laundering and counter-terrorist-financing 
framework. According to the report, ``[Macau's] close proximity 
[to the] border with [the] PRC and its open economy do pose a 
threat to ML/FT [money laundering and financing of terrorism] 
activities.'' \65\ The evaluation also discovered several 
specific deficiencies in Macau's compliance with the Financial 
Action Task Force recommendations, including the refusal to 
respond to foreign requests to freeze assets, the inability to 
effectively implement UN Security Council resolutions on the 
financing of terrorism, and the inability of Macau's Customs 
Service to investigate money-laundering cases. Other 
shortcomings specific to the gaming sector included a lack of a 
risk-based assessment of gaming customers and operators, 
inadequate inspection and oversight of casinos and junket 
operators and promoters, a lack of communication among gaming 
regulators, and a high threshold ($62,500) for reporting large 
transactions at casinos.\66\ In the report, Macau received a 
``compliant'' rating in only seven of a total of 49 
recommendations,* with the majority receiving a rating of only 
``partially compliant.'' Against the same recommendations, the 
United States was ``compliant'' in 15 of 49 recommendations in 
its 2007 evaluation, with the majority receiving a rating of 
``largely compliant.'' \67\
---------------------------------------------------------------------------
    * The mutual evaluation measured compliance with the Financial 
Action Task Force's 40 recommendations (2003) and included an 
additional nine special recommendations on counter-terrorist-financing 
measures. Compliance with the Financial Action Task Force 
recommendations is rated on a scale that includes ``compliant, largely 
compliant, partially compliant, and non-compliant.'' Asia-Pacific Group 
on Money Laundering, APG/OGBS Mutual Evaluation Report on Macau, China 
(July 24, 2007), p. 210. http://www.apgml.org/documents/
default.aspx?s=date&c=7.
---------------------------------------------------------------------------
    Since the report was published in 2007, ``Macau has yet to 
address a number of deficiencies in its AML/CFT [anti-money-
laundering and counter-terrorist-financing] framework that were 
identified by the APG [Asia-Pacific Group on Money 
Laundering],'' according to Mr. Glaser.\68\ He noted four major 
deficiencies identified in the evaluation report that have yet 
to be addressed: (1) Macau still has not implemented a method 
to freeze bank accounts in anti-money-laundering and counter-
terrorist-financing cases; (2) Macau has not yet enacted a 
number of legal enhancements to its customer due diligence 
requirements; (3) Although Macau has been asked to lower its 
high transaction reporting threshold for casinos to $3,000 as 
recommended by the Financial Action Task Force, Macau 
continues to allow a very high threshold of $62,500 for 
reporting large transactions at casinos; (4) Macau has yet to 
implement an effective, cross-border, cash declaration 
system.\69\
---------------------------------------------------------------------------
     Financial Action Task Force Recommendation 12 sets the 
reporting threshold at $3,000 for gaming institutions. Financial Action 
Task Force, ``FATF Recommendation 16: Reporting of Suspicious 
Transactions and Compliance, Text of the Recommendation and 
Interpretative Note'' (Paris, France). http://www.un.org/en/sc/ctc/
docs/bestpractices/fatf/40recs-moneylaundering/fatf-rec-16.pdf.

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Shortcomings in Macau's Gaming Sector Regulation

    Although casinos and junket promoters are licensed by 
Macau's gaming regulator, there remain significant 
vulnerabilities with unlicensed junket operators, junket 
affiliates, and satellite casinos * that play an integral role 
in Macau's gaming system. These entities are not subject to the 
same regulations and reporting requirements as licensed 
entities and thus are more susceptible to money laundering and 
influence from organized crime (see figure 2, below). During 
the Commission's June 27 hearing, Mr. Burnett noted this 
vulnerability in his written testimony, that ``criminal 
transactions are widely alleged to take place just out of the 
direct purview of the casino,'' pointing to the susceptibility 
for criminal organizations to infiltrate junket groups.\70\ 
``Such activities include back-betting, side-betting, loan 
sharking, violent loan collections, underground banking, and 
money laundering.'' \71\
---------------------------------------------------------------------------
    * Satellite casinos are owned and operated by third parties and are 
not considered concession or subconcession holders. I. Nelson Rose, 
``Does Macau Create Legal Risks for American Operators?'' Gaming Law 
Review and Economics 14:6 (2010): 454.

         Figure 2:  Vulnerabilities in Macau's Licensing System



    Source: U.S.-China Economic and Security Review Commission 
(Washington, DC).

    Macau's junket operators are not subject to the same 
transparency requirements as casinos, and strict privacy 
controls prevent U.S. regulators from obtaining information on 
individuals operating in Macau subsidiaries of U.S. parent 
casinos.\72\ The Macau SAR Gaming Inspection and Coordination 
Bureau (Portuguese acronym, DICJ), Macau's gaming regulator, is 
also only required to publically disclose the names of licensed 
junket promoters in Macau and does not disclose financial 
information. More importantly, information about the unlicensed 
junket operators, their affiliates, and third-party satellite 
casinos is inaccessible to the public and regulatory 
counterparts overseas. The lack of information presents 
difficulties in determining the origin of money flowing through 
such operations, and U.S. state regulators do not have the 
authority or resources to independently conduct investigations 
in Macau or other foreign jurisdictions.\73\ Mr. Burnett 
explained the legal barrier in obtaining relevant information 
from Macau regulators in his testimony to the Commission:

        The Macanese Privacy Act 8/2005, which took effect 
        February 2006, has varying degrees of interpretation. 
        It essentially forbids businesses there from 
        transferring data on individuals to any other country. 
        In general, therefore, it has precluded us from 
        obtaining information from our operators to the degree 
        we are accustomed to.

    Although Macau regulators require reporting for 
transactions that are deemed ``suspicious'' in nature, there 
are shortcomings in the reporting requirements of gaming 
institutions. Macau's eyes and ears for the gaming sector, the 
Gaming Inspection and Coordination Bureau, require gaming 
institutions to automatically report all transactions above 
$62,500.* In the 2007 evaluation published by the Asia-Pacific 
Group, this threshold is considered too high to comply with 
Financial Action Task Force recommendations.\74\ Moreover, the 
Gaming Inspection and Coordination Bureau does not report 
detailed information on the number or nature of such reports 
filed to the public; however, Gaming Inspection and 
Coordination Bureau officials have indicated that the number of 
reports filed annually is increasing, reaching hundreds of 
thousands per year.\75\
---------------------------------------------------------------------------
    * All transactions under the $62,500 threshold that are deemed 
suspicious in nature are required to be reported to the Macau SAR 
Financial Intelligence Office. Jorge Godinho, ``The Prevention of Money 
Laundering in Macau Casinos,'' Gaming Law Review and Economics 17:4 
(2013): 271-272.

---------------------------------------------------------------------------
Influence of PRC Regulations on Macau

    Capital controls implemented by the PRC that are intended 
to prevent illicit cross-border transfers should, in theory, 
hinder Macau's economic growth. In reality, capital controls 
have caused more money to cycle through Macau due to Macau's 
thriving VIP gaming industry, which relies on junkets and their 
affiliates to facilitate cross-border money transfers for 
clients via underground banks. The circumvention of capital 
controls by junkets to get money from mainland China to Macau 
has been tolerated by Beijing and, according to Mr. Rose, 
``Beijing doesn't view this as much of a problem, unless it 
becomes a scandal, as when government officials embezzle 
[money] and lose it in Macau.'' \76\ Recent reports, however, 
have signaled that Beijing is beginning to take measures to 
prevent illicit cross-border transfers and money laundering in 
Macau as part of the nationwide crackdown on corruption 
promoted by PRC President Xi Jinping. A December 2012 Wall 
Street Journal article reported that police in mainland China 
and Macau detained multiple individuals who work for Macau's 
biggest junket operators, a move described by a Macau casino 
executive as ``an attempt by the Chinese government to tell 
people in the market that they need to behave, especially 
regarding underground money transfers.'' \77\ The recent 
appointment of the PRC's former Hong Kong liaison Li Gang to 
deputy director of the Central Liaison Office in Macau was also 
seen as an effort to gain closer oversight over Macau's gaming 
industry.\78\ Despite these actions, analysts such as Grant 
Govertsen of Macau-based Union Gaming Research, remain 
skeptical about China engaging in a large-scale crackdown.\79\ 
In response to comments from Beijing's liaison office, Mr. 
Govertsen predicted in February that ``there would not be any 
changes in policy on Macau,'' based on Beijing's official 
pronouncements.\80\
    Experts have argued that Macau's heavy reliance on junkets 
operating in the grey market can only be reduced if mainland 
China repeals its strict capital controls or permits the 
collection of gambling debts in mainland China.\81\ The PRC's 
capital controls have encouraged clients to utilize junkets to 
facilitate money transfers, thus making it difficult to 
determine the origin of funds coming from mainland China. On 
top of the capital controls, PRC regulations forbidding the 
collection of gambling debts have given rise to a troubling 
grey market. Unlike the United States, where collection 
lawsuits by casinos can be filed and gamblers can be charged 
criminally for writing bad checks,* casinos are not allowed to 
collect gaming-related debts through the courts in mainland 
China. This prevents Macau casinos from directly seeking VIP 
customers, and they instead rely on unsupervised junket 
operators to attract clients. Casinos in Macau would prefer to 
attract VIP clients themselves and, according to Mr. Rose, 
``the casinos want to get rid of [VIP operators because the 
casinos themselves] want to be the VIP operators.'' \82\
---------------------------------------------------------------------------
    * Gambling debts in the United States can be collected through some 
state courts, but the process can be difficult and expensive. Some 
courts outside Nevada may choose not to honor debts for gambling if 
that activity is considered illegal in that state. Holders of unpaid 
gambling debts have sometimes resorted to criminal prosecutions for 
fraud in order to coerce payments from debtors. Casinos also make a 
practice of partially forgiving debts in order to collect a fraction of 
money owed by gamblers. I. Nelson Rose, telephone interview with 
Commission staff, September 14, 2013.

---------------------------------------------------------------------------
Implications for the United States

    In Macau, undeclared cross-border cash flows, criminal 
influence in the opaque junket system, an ambiguous privacy law 
preventing disclosure of criminal activities, and substandard 
anti-money-laundering and counter-terrorist-financing 
regulations have several implications for the United States. 
First, Macau's junket system and its apparent link with 
organized crime present legal risks for the foreign affiliates 
of U.S.-licensed casinos operating in Macau. Those affiliates 
are dependent for their revenues on the same loosely regulated 
junket and shadow banking system. Second, Macau's gambling 
system has attracted the attention of Chinese nationals seeking 
to circumvent the PRC's strict capital controls. Some are 
corrupt officials hoping to invest abroad funds received 
through bribery and extortion--money that may be used for other 
illegitimate purposes in order to escape notice and taxation. 
Third, individuals or criminal groups involved in activities 
that have the potential to threaten U.S. national security may 
be able to exploit Macau's underregulated financial and gaming 
institutions to disguise illegally obtained funds, which could 
be used in a variety of nefarious ways against the United 
States. North Korea has used Macau's financial system to 
launder counterfeit U.S. dollars, for example. Money laundering 
has proven useful in other criminal activities, such as the 
international smuggling trade in small arms, drugs, and 
cigarettes.
    Macau's junket system and its susceptibility to organized 
crime and money laundering present direct legal risks for U.S.-
licensed casinos operating in Macau. The business models of 
U.S. parents' Macau casinos are based on the losses of VIP 
clients introduced to the casinos by junket operators. As Mr. 
Burnett noted, ``It is what the business model allows to occur 
outside of the casino's purview (in the VIP rooms and with the 
junket operators) that may pose problems.'' \83\ U.S.-based 
casinos risk loss of their state-issued license if they become 
associated with crime figures abroad. Such rules are known as 
``suitability'' requirements. According to the trade 
publication Casino Enterprise Management:

        At its core, suitability involves a judgment about an 
        individual's character based on his or her history and 
        a prediction about his or her likely future behavior. 
        It necessarily immerses the regulator in the murky 
        areas of social science, psychology and even 
        philosophy. In making a licensing decision, a gaming 
        board or commission must determine the eligibility and 
        suitability of each applicant and, in the case of 
        business entity applicants, associated qualifiers. The 
        burden is always on the applicant to establish 
        eligibility and suitability through clear and 
        convincing evidence as to his or her character, 
        reputation, integrity, business probity, experience and 
        ability, financial means and responsibility, and any 
        other criteria that the board or commission may deem 
        appropriate.\84\

    All U.S. casinos are licensed by at least one U.S. 
state.\85\ Respective state regulators have the power to 
monitor the activity of U.S. companies in Macau and can 
exercise the right to revoke a casino's state license if a 
casino licensed in its state is determined to be associating 
with criminals, even if those associations are outside U.S. 
borders. Nevada, for example, requires that it review the 
overseas operations of casinos licensed in the state to 
determine if a licensee is complying with its Foreign Gaming 
Statute, which prohibits licensees from engaging in activity 
that ``reflects or tends to reflect discredit or disrepute upon 
this state or gaming in this state.'' \86\ New Jersey's Casino 
Control Act has similar stipulations, requiring licensees to be 
of ``good character, honesty and integrity'' on a continuing 
basis, obliging them to provide clear and convincing evidence 
in support.\87\


------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Issues Facing U.S.-licensed Casinos in Macau
 
  U.S.-licensed casinos began operating in Macau in 2004, when Sands
opened its first gambling establishment. Currently, three U.S.-licensed
casinos have operations in Macau: MGM Resorts International, Las Vegas
Sands Inc., and Wynn Resorts Ltd. All three casinos have come under
various forms of regulatory scrutiny regarding their Macau operations.
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Issues Facing U.S.-licensed Casinos in Macau--Continued
 
  MGM--In 2009, MGM ran into trouble when a New Jersey gaming regulator
investigated the casino's joint-venture partnership with the daughter of
the Macau casino mogul Stanley Ho. In a special report by the New Jersey
Division of Gaming Enforcement, Stanley Ho's daughter was deemed
unsuitable under New Jersey's Casino Control Act, based on family links
to organized crime in Macau and the PRC.\88\ As a result of the report,
in March 2010 MGM decided to enter into a settlement with the New Jersey
Division of Gaming Enforcement that required MGM to divest 50 percent of
its stake in a New Jersey casino. The agency also barred MGM from
applying for a casino license.\89\ In 2013, a petition was approved to
allow MGM to apply for permission to retain its interest in its New
Jersey assets, but a decision on the application will not be made by New
Jersey regulators until a more thorough investigation is conducted to
determine MGM's compliance with the state regulations.'' \90\ MGM noted
in a meeting with Commissioners and staff on October 23 that Nevada,
Maryland, Illinois, Michigan, and Mississippi regulators had found no
suitability issues relating to MGM's partnership with Ms. Ho.
 
  Las Vegas Sands--Intracompany transfers * have presented a risk of
junkets associated with triads transferring money from Macau into the
United States. Evidence from a 2010 lawsuit filed by a former Sands
executive included a ledger detailing that Sands had transferred over
$28 million for more than two dozen junket operators between Macau and
Las Vegas.\91\ Two junket operators who were listed on the ledger,
Cheung Chi Tai and Charles Heung, were identified by the U.S. Senate
Permanent Subcommittee on Investigations as officers of triad groups in
a 1992 report on organized crime in Asia.\92\ In the report, Charles
Heung was identified as an officer of the Sun Yee On triad,\93\ and
Cheung Chi Tai was identified as an officer of the Wo Hop To triad.\94\
 
  As a result of increasing concerns from regulators, Sands has
reportedly restructured its compliance functions, which entailed
discontinuing intracompany transfers on behalf of its ``high-rolling
customers.'' \95\ In addition, the casino also hired three former
Federal Bureau of Investigation (FBI) agents to strengthen anti-money-
laundering efforts and improve background checks of VIP customers and
junket operators.\96\
 
  Wynn--In 2012, Macau police detained a partner of one of Macau's major
junket operators that had ties with the former Communist Party chief in
Chongqing, Bo Xilai. The junket operator the individual was affiliated
with was reported to operate in both Wynn and Las Vegas Sands
casinos.\97\
 
------------------------------------------------------------------------

         
---------------------------------------------------------------------------
    * Intracompany transfers, or ``cross-property deposits,'' are 
common between foreign subsidiaries of U.S. casinos and their U.S. 
parent casinos. They are subject to compliance with the Currency and 
Foreign Transactions Reporting Act of 1970 (commonly referred to as the 
``Bank Secrecy Act'' or ``BSA''). Nevada Gaming Control Board, 
telephone correspondence with Adriana Fralick and Commission staff, 
September 23, 2013.

    The success of Macau's gaming sector is closely tied to the 
underground and shadow banking system to facilitate money 
transfers from mainland China.\98\ Junket operators and their 
affiliates utilize underground and shadow banks to extend loans 
and facilitate cross-border transfers for Mainland customers 
who want to gamble in Macau, allowing them to bypass China's 
capital controls. Although the exact amount of credit extended 
to Macau gamblers and the amount of money flowing from mainland 
China to Macau via underground banks is unknown, the Chinese 
shadow banking system overall ``poses serious risk to China's 
financial and social stability.'' \99\
    Furthermore, the loosely regulated junket and shadow 
banking system that support Macau's gaming industry may allow 
individuals involved in criminal activities that threaten U.S. 
national security to exploit financial and gaming institutions 
in Macau to disguise illegally obtained funds. After money has 
effectively been ``laundered,'' criminals may freely move those 
funds in the international financial system, and there is a 
risk of ``dirty money'' making its way into the United States 
or other countries to be used for illegitimate purposes. 
Criminals may exploit intracompany accounts to move money from 
casino subsidiaries in Macau into the United States.\100\
    Macau's banking institutions have also presented a risk to 
the United States. As in the case of Banco Delta Asia, 
individuals or organizations involved in activities against the 
interests of the United States may exploit financial 
institutions in Macau to launder counterfeit U.S. dollars, 
disguise financial transfers, or deposit funds from illegal 
activities such as drug trafficking. Because Macau's law 
enforcement agencies lack certain capabilities to effectively 
freeze or seize assets as identified in the 2007 mutual 
evaluation, it may be difficult to prevent the financing of 
criminal or terrorist activities in a timely manner.\101\

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Submissions from U.S.-based Casino Operators
 
  The Commission met with two U.S. casino companies, Wynn Resorts and
MGM Resorts International, on October 21 and 23 at their request. The
two companies disagreed with some portions of this section and offered
additional information of their own with respect to actions they have
taken to mitigate the risks the Commission and others have identified.
Their information follows.
 
  Wynn: ``Macau's junkets operators are under continual supervision and
audit by the gaming regulator, financial intelligence unit and monetary
authority. Further, Macau casino companies such as Wynn are active
participants in VIP rooms providing dealers, supervisors, pit managers
and security. The rooms are also under surveillance by Wynn staff and
the gaming regulator who has full access to Wynn's surveillance system.
In addition to regulatory audits, Wynn's internal audit group audits
junket compliance with AML [anti-money-laundering] rules/procedures.
 
------------------------------------------------------------------------



------------------------------------------------------------------------
 
------------------------------------------------------------------------
 
Submissions from U.S.-based Casino Operators--Continued
 
  ``Wynn files Suspicious Transaction Reports every month. Recently,
Wynn Macau employees became suspicious of an attorney gambling with
funds wired to the casino from a questionable account. The report Wynn
Macau made to the Hong Kong Police resulted in uncovering and
prosecuting a system of embezzling from client trust funds. Wynn Macau
is actively vigilant, using years of experience in law enforcement and
gaming, with respect to suspicious financial activities. The company has
a strong incentive to report such activities because the company is
legally required to do so and the gaming licenses of the company are at
risk. The company trains its employees to be zealous in reporting
anything that may be even considered slightly suspicious. For example,
if a customer comes to the casino, plays for cash, and wins $25,000 or
more and refuses to provide proper identification when he attempts to
cash out, we not only file a Suspicious Transaction Report, we also
refuse to cash out the customer.
 
  ``The Macau authorities and Wynn are active participants in VIP rooms
providing dealers, supervisors, pit managers and security. The rooms are
also under surveillance by Wynn staff and the gaming regulator who has
full access to Wynn's surveillance system. In addition to regulatory
audits, Wynn's internal audit group audits junket compliance with AML
rules/procedures.
 
  ``Junkets and subjunkets are licensed by the gaming regulator if they
pass a background check and police clearance. Wynn Macau then engages in
its own due diligence of its junkets prior to allowing them to commence
operations. Wynn Macau only does business with licensed junket operators
(after all background screening is completed and the junket found
suitable to do business with Wynn Macau).
 
  ``With respect to know-your-customer-protocols, Macau casinos are
required to screen their patron databases and Wynn Macau employs the
Worldcheck Database to screen for patrons who may pose AML, crime/
fidelity, terrorism, OFAC [Office of Foreign Assets Control] or PEP
[politically exposed persons] risk. Macau is in the process of exploring
currency importation declarations.''
 
  MGM: ``Macau's internal controls are sufficient to safeguard assets
and promote fair and equitable gaming within the Macau jurisdiction. In
addition the Maryland Lobbying Gaming Control Commission found that MGM
Macau has policies and procedures that not only minimally satisfy the
rules, regulations and laws of the Macau government, but have instituted
procedures that go substantially above and beyond these minimum
requirements.\102\
 
  ``MGM background checks are conducted on the following entities
related to gaming promoters: Individual applicants and company's
shareholders and directors (and) any individual, entity or group
providing a guarantee of credit in connection with the VIP room
operations in MGM Macau.''
 
------------------------------------------------------------------------


Universal Suffrage, Press Freedom, and Police Surveillance in Hong Kong

    Tensions over erosions of Hong Kong's traditional civic 
freedoms appear in Hong Kong street demonstrations and in 
social media sites. Issues of particular concern include the 
Hong Kong government's slow progress in granting the universal 
suffrage stipulated in the region's Basic Law, tightening 
restrictions on the press, and stepped-up police surveillance 
of civil rights activists. Several legislators who met with 
Commissioners in Hong Kong in July expressed concerns that 
growing political polarization and heavy-handed efforts by the 
pro-Beijing-controlled government to stifle dissent threaten to 
render the city ungovernable.\103\ These concerns are borne out 
by the numbers. In one July poll, the pro-Beijing chief 
executive scored a record low approval rating of just 15.8 
percent, while 37 percent of respondents reported that they do 
not trust the Hong Kong government.\104,105\
    Hong Kong never enjoyed a fully democratic government under 
British rule. But before Hong Kong's return to the PRC, Hong 
Kong's citizens enjoyed popular participation in political 
affairs as well as ``a vibrant media,'' ``an effective and 
meritocratic bureaucracy,'' rule of law, and the protection of 
key civil rights and liberties under the Letters Patent and 
Royal Instructions that served as Hong Kong's principal 
constitutional documents.\106\ Hong Kong's Basic Law, a sort of 
``mini-constitution promulgated to implement the basic policies 
of the central government toward Hong Kong,'' provides for 
``the separation and preservation of the two economic, social, 
political and legal systems through the legal entrenchment of 
Hong Kong's [preexisting] systems'' until 2047.* \107,108\
---------------------------------------------------------------------------
    * The Basic Law of the Hong Kong Special Administrative Region 
(SAR) is a constitutional document that sets out the basic principles 
agreed to in the 1984 Sino-British Joint Declaration on the Question of 
Hong Kong. The Joint Declaration spelled out agreed-upon terms for the 
government of Hong Kong after Great Britain's return of the region to 
the sovereignty of the PRC. According to this declaration, the Hong 
Kong SAR would retain its capitalist system and lifestyle for 50 years. 
The declaration went into effect after the handover of Hong Kong on 
July 1, 1997. The Basic Law was drafted by a committee of Mainland and 
Hong Kong Chinese and was formally adopted by the National People's 
Congress on April 4, 1990.
---------------------------------------------------------------------------
    Sophie Richardson, China director at the Human Rights 
Watch's Washington office, testified at a Commission hearing on 
June 27 that since its return to PRC sovereignty in 1997, Hong 
Kong has ``remained the only part of China with a robust and 
independent legal system, relatively strong protections on the 
freedom of expression, and limited but regular elections.'' 
\109\ But she noted that since the handover, there have been 
very worrying developments, as maintaining the economic 
strength of the region's traditionally capitalist system has 
clearly been prioritized by Beijing, whereas preservation of 
the civil rights associated with political autonomy has not. 
Dr. Richardson noted that ``large numbers of Hong Kong 
residents continue to object to what are considered intrusions 
on Hong Kong's autonomy and rally in remarkable numbers to 
remember events like the Tiananmen massacre,'' but government 
efforts to restrain their freedom have grown.\110\ Freedom 
House's Madeline Earp told the Commission that in the initial 
years following the handover of Hong Kong to mainland China, 
the region's role as a ``golden goose'' for the Mainland helped 
to insulate it from antidemocratic pressures in Beijing.\111\ 
Nowadays, however, the relative affluence of many Mainland 
coastal cities and ports, such as Shanghai, has reduced Hong 
Kong's economic importance to the Mainland. While Hong Kong 
does still play a unique economic role within the PRC that 
Beijing is ``loathe to tinker too much with,'' Hong Kong's 
prosperity is not the impenetrable shield of civic freedoms it 
once was.\112\ Beijing also wields greater political leverage 
in the region, because many Hong Kong business leaders now hold 
Mainland investments that they did not have 20 years ago.
    Recent examples of Beijing's constraints on Hong Kongers' 
freedom include more frequent requests to the National People's 
Congress Standing Committee to interpret the Basic Law, 
appointments of pro-Beijing partisans in key Hong Kong 
institutions, denials of Hong Kong visas to Chinese dissidents, 
and an inflammatory proposal designed by the Hong Kong 
Curriculum Development Council * to require Hong Kong schools 
to teach students the nationalistic version of history taught 
on the Mainland.\113,114\ Backlash against this national 
education initiative reached a crescendo in the summer and fall 
of 2012. At least 30,000 people reportedly attended a July 2012 
protest against the education plan, while roughly 30,000 
attended a September 2012 protest.\115\ Many thousands of 
protestors waved colonial flags. To the organizers, the flag 
symbolized an era of greater protection of civil rights and 
liberties under British colonial rule.\116,117\ In the end, the 
colonial flag demonstrations grew so big and intense that the 
Hong Kong government retracted plans for the new patriotic 
history lessons.\118\ But while popular resistance to the 
nationalistic education requirements demonstrated the 
persistence of self-determination for Hong Kong's citizens, it 
contrasts with many more examples of how important rights and 
liberties in the region are eroding.
---------------------------------------------------------------------------
    * The Mainland government did not design the contested educational 
curriculum. Rather, it was designed by the Hong Kong Curriculum 
Development Council, a body whose members are appointed by the Hong 
Kong chief executive, whose leanings are decidedly pro-Beijing.

---------------------------------------------------------------------------
Universal Suffrage

    The most significant problem for democratic rights 
activists is the Hong Kong government's lack of progress toward 
ensuring universal suffrage in the election of the Legislative 
Council and the chief executive. Although the Basic Law 
articulates a goal of achieving some form of universal suffrage 
in the elections of both the chief executive and the 
legislature, the dominance of the Hong Kong government by 
politicians allied to Beijing has stymied progress in achieving 
universal suffrage. Beijing-friendly current Chief Executive 
Leung Chun-ying (CY Leung) is described as ``a populist on 
economic issues'' with ``a limited tolerance of democracy and 
public demonstrations.'' \119\
    Despite assurances by Chief Executive Leung that he 
supports universal suffrage, neither the Mainland government 
nor the Hong Kong chief executive has ``outlined clear plans on 
how universal suffrage might be instituted.'' \120,121\ In 
March 2013, Chief Executive Leung said in meetings with Chinese 
President Xi Jinping that he was committed to the process of 
achieving universal suffrage in Hong Kong by 2017. He 
reiterated this commitment in July, promising that free and 
open elections for the Legislative Council would follow in 
2020. But as Dr. Richardson noted in her testimony, these dates 
have been Beijing's tentative targets since statement decision 
made by the National People's Congress Standing Committee in 
2007.\122\ Many Pan-Democrats * are afraid that the Mainland is 
seeking to postpone universal suffrage or stop it altogether by 
rigging elections to limit them to candidates who are pro-
Beijing. The idea would be to ensure that the Hong Kong 
government continues to be dominated by pro-Beijing 
representatives. Article 22 of the Basic Law stipulates that no 
offices or Mainland authorities may interfere in the affairs of 
the Hong Kong SAR, but pro-Beijing sympathies are not deemed 
interference. In elections of the chief executive and the 
Legislative Council, Mainland sympathizers continue to enjoy a 
distinct advantage due to the configuration of the electoral 
system.\123,124\
---------------------------------------------------------------------------
    * Politicians and members of civil society affiliated with a 
variety of prodemocracy groups often band together to promote their 
common cause and are collectively referred to as pan-democrats.
---------------------------------------------------------------------------
    Article 45 of the Basic Law specifies that ``the ultimate 
aim'' for selection of the chief executive, the highest office 
in the Hong Kong government, is ``universal suffrage upon 
nomination by a broadly representative nominating committee in 
accordance with democratic procedures.'' \125\ At present, the 
chief executive is chosen from a slate of nominees by a 1,200-
person election committee. Shi Zhangshan, a Washington, DC-
based Hong Kong expert, notes that ``it took 10 years to 
increase the members of the Hong Kong Election Committee from 
400 to 800 and then 1,200'' and that by sticking to the pace of 
this so-called progressive approach, it would take Hong Kong 
10,000 years to gain universal suffrage for its seven million 
citizens.\126\ The current election committee is heavily 
populated with business figures, who have investments in 
mainland China, as well as politicians and labor leaders with 
strong connections to Beijing, giving it a distinctly pro-
Beijing slant. A former Legislative Council member told 
Commissioners that Beijing effectively controls roughly 950 of 
the 1,200 election committee votes for chief executive.\127\ In 
the 2012 chief executive election, pro-Beijing candidate CY 
Leung won with 689 votes, while Henry Tang, the runner-up and 
also a pro-Beijing candidate, received 285.\128\ By contrast, 
the most popular prodemocracy candidate, Albert Ho of the 
Democratic Party, received a mere 79 votes.
    Article 68 of the Basic Law specifies that ``the ultimate 
aim is the election of all the members of the Legislative 
Council by universal suffrage.'' \129\ For the time being, 35 
members of the 70-person legislature are directly chosen 
through geographical constituencies in which members of the 
general population are each afforded one vote. Another 30 
members are elected by traditional functional constituencies, 
in which professionals in specific fields such as insurance, 
transportation, health care, education, accounting, commerce, 
industry, finance, and tourism are allowed to cast a vote in 
addition to their vote in their geographic constituency,'' 
giving them greater voting power than the general 
populace.\130\ Certain business entities and professional 
organizations are also given votes in the functional 
constituencies. Five Legislative Council members are elected by 
district council constituencies, which are made up of regular 
voters not in professional sectors already represented by the 
traditional functional constituencies. The greater 
representation of some segments of society as a result of the 
functional constituencies, combined with the dominant support 
for pro-Beijing candidates among functional constituency 
voters, has ensured that the Legislative Council remains in the 
control of pro-Beijing representatives. Since 2004, the split 
has stood at roughly 60/40. Figure 3 illustrates the politics 
of legislators elected by the functional constituencies vs. 
those elected by the geographic constituencies. Figure 4 shows 
the pan-Democrat vs. pro-Beijing split in the Legislative 
Council over time.

Figure 3:  Pan-Democrat vs. Pro-Beijing Representatives in Legislative 
                           Council, 2012-2016




    Source: Chung-Kai Sin, ``Political Elections, Parties and Reforms 
since 1984,'' June 8, 2013.

Figure 4:  Pan-Democrats vs. Pro-Beijing Representatives in Legislative 
                           Council, 1998-2012



    * DPHK--Democratic Party of Hong Kong; DAB--Democratic Alliance for 
the Betterment and Progress of Hong Kong; HKFTU--Hong Kong Federation 
of Trade Unions.

    Source: Chung-Kai Sin, ``Political Elections, Parties and Reforms 
Since 1984,'' June 8, 2013.

    Since two-thirds of all Legislative Council members are 
required to endorse any amendment to the process of electing 
the chief executive, pro-Beijing dominance in the Legislative 
Council dims the prospects for amendments that would advance 
universal suffrage. The pall that this has cast on hopes of 
achieving universal suffrage is amplified by a December 29, 
2007, statement by the National People's Congress Standing 
Committee that universal suffrage in the election of the 
Legislative Council will be implemented only after 
implementation of universal suffrage in the election of the 
chief executive.\131,132\
    In discussions with Commissioners during a July fact-
finding trip to Hong Kong, Legislative Councilor Chung-Kai Sin 
explained that Pan-Democrats' worries over prospects for 
universal suffrage have been stoked by recent statements from 
the Mainland.\133\ In March, for example, Qiao Xiaoyang, 
chairman of the legal committee of the National People's 
Congress, warned that Beijing ``would not accept a chief 
executive candidate who adopted a confrontational attitude 
towards the central government.'' \134\ In July, Zhang 
Xiaoming, director of the central government's liaison office 
in Hong Kong, used a sieve to illustrate the advantages of a 
screening and filtration process to ensure that all candidates 
for chief executive are acceptable to Beijing.\135\ Chief 
Executive Leung says he favors allowing all adults to vote but 
is vague about whether he would support allowing the chief 
executive ballot to feature candidates opposed by Beijing.\136\
    In March 2013, 27 lawmakers from 12 pan-democratic groups 
formed the Alliance for True Democracy to demand that the 
government deliver universal suffrage in the 2017 election, but 
it is unclear if this coalition will remain united. Past 
efforts by the various democratic parties to promote universal 
suffrage have dissolved into disagreement. Mr. Shi notes that 
Beijing has lots of practice dividing the opposition, and these 
divisions are surfacing once again. Some Pan-Democrat lawmakers 
have backed Martin Lee Chu-ming, former chairman of the 
Democratic Party, in his recent suggestion for a screening 
committee to ensure that at least five candidates stand for 
election and that one of them is prodemocracy, but others have 
chastised him for recommending a screening mechanism at 
all.\137\
    April 2013 saw the formation of a civil disobedience 
movement to support 2017 suffrage. Dubbed ``Occupy Central'' 
(Hong Kong's core downtown financial district), the movement 
was started by Benny Tai, a law professor at Hong Kong 
University. Professor Tai says the Occupy Central movement will 
be peaceful and will feature several days of deliberation 
culminating in early 2014, when occupiers will gather in small 
groups to discuss political reform. The movement's plan is to 
follow this deliberation with a Hong Kong-wide ballot allowing 
people to choose their vision of reform. It would then demand 
that the government carry out the popular will. Sit-in protests 
would follow in the central city should the government resist.
    ``The key point of the movement is about developing a 
democratic culture of rational discussion and consensus 
building by the people themselves,'' says Professor Tai.\138\ 
But business groups, led by the Chinese General Chamber of 
Commerce, fear that the movement will hurt the city's economy, 
while pro-Beijing groups argue that it will hurt the city's 
interests more broadly. One pro-Beijing group, Voice of Loving 
Hong Kong, staged counterprotests at the first Occupy 
deliberation on June 9.\139\ One former official describes the 
movement as having ``touched a nerve'' with Beijing and notes 
that many companies with ties to Beijing have been persuaded to 
take out full page advertisements against Occupy Central in 
various Hong Kong newspapers.\140\ The Hong Kong government has 
also publicly warned that it sees no possibility of the Occupy 
Central gatherings being lawful, and former Central Policy Unit 
head Lau Siu-kai expressed concerns that the movement would 
become radical and ``end in bloodshed.'' \141,142\

Press Freedom

    Pro-Beijing newspapers such as Wen Wei Po have accused 
``external powers'' of being behind the Occupy Movement, while 
a leading mainstream English-language newspaper, the South 
China Morning Post, ran an editorial earlier this year saying 
that ``Hong Kongers need genuine democracy--of that there can 
be no doubt,'' but then followed the editorial by declaring its 
opposition to Occupy Central's peaceful civil disobedience 
plans.\143\ Within the Hong Kong press community and among 
international free press advocacy groups, such editorial 
kowtows to the pro-Beijing government are widely perceived as 
demonstrative of the Mainland's increasing sway over the Hong 
Kong press. Article 27 of the Basic Law grants Hong Kong 
residents ``freedom of speech, of the press, and of 
publication'' and, on the surface, it would seem that a vibrant 
Hong Kong press remains alive and well today, given that the 
city of seven million people supports 46 daily newspapers and 
642 periodicals as of 2010.\144\ But the large number of media 
outlets belies what Ms. Earp and other critics say is a 
diminishing diversity of voices in the Hong Kong press.\145\ 
According to Ms. Earp, in the early years after the handover, 
PRC media interventions in Hong Kong were generally limited to 
Mainland political issues, but political pressures and the 
influence of Mainland economic interests on Hong Kong media 
owners are increasingly evident.\146\ Beijing's Hong Kong 
Liaison Office, for example, ``played a uniquely aggressive 
role in the run-up to the chief executive election last year, 
effectively ordering news outlets to support the eventual 
winner.'' \147\
    In 2005, Freedom House ranked Hong Kong 28th in the world 
among 197 countries and territories in terms of press freedom 
and assigned it a status of ``free,'' but by 2012, Hong Kong's 
ranking had fallen to 33rd and ``partly free.'' \148\ In 
January, Reporters without Borders released its World Press 
Freedom Index 2013, showing Hong Kong press freedom at a five-
year low of 58th out of 179 locations worldwide.\149,150\ Its 
2002 ranking had been 18th.\151\ Reporters without Borders 
ranked mainland China 173 for 2013, while Taiwan garnered the 
top spot among Asian localities, coming in at 47.\152\ But 
Taiwan may not be a regional gold standard for long, as 
Mainland pressures on the media are increasingly apparent 
there, too. In both places, potential media buyouts threaten to 
give pro-Beijing business magnates control over independent 
news outlets currently known for being critical of the Mainland 
government. For example, in late 2012, Jimmy Lai, the outspoken 
owner of Hong Kong-based Next Media and the pro-Democracy Apple 
Daily paper, sold his Taiwan media holdings to a group of 
businessmen supportive of the Beijing government.\153\ In early 
2013, China Daily reported that a Shanghai real estate tycoon 
was seeking a controlling stake in Hong Kong's cash-strapped 
and increasingly pro-Beijing broadcaster Asia Television 
Limited.\154\
    The Hong Kong press itself reports a sense of diminishing 
freedom. In 2007, a major Hong Kong Journalists Association 
survey showed that 58.4 percent of the industry respondents 
felt press freedom had been eroded since the 1997 
handover.\155\ In early 2012, a survey asked if press freedom 
had deteriorated since Donald Tsang took over as chief 
executive seven years before. The survey showed that 87 percent 
of the 663 journalists polled indicated that they felt it 
had.\156\ Growing political interference from Beijing, tighter 
government controls on information, and rising self-censorship 
by the media outlets themselves were the key reasons cited in 
this trend.* More than 92 percent of respondents in the Hong 
Kong Journalists Association's spring survey felt that 
government restraints on information had surpassed self-
censorship as the main factor undermining press freedom.\157\ 
This sense of diminishing press freedom correlates with survey 
data indicating that the Hong Kong public perceives newspapers 
as less credible, though it is worth acknowledging that U.S. 
media credibility has been on a downward trajectory over the 
past decade, too.\158\
---------------------------------------------------------------------------
    * According to a spring 2013 Hong Kong Journalists Association 
poll, of the 663 reporters, photographers, editors, and media 
management respondents, 92.7 percent attributed the erosion of press 
freedom to the Hong Kong government's tighter grip on information; 71 
percent attributed it to increased self-censorship; and 67.5 percent 
attributed it to the growing influence of the Chinese central 
government.
---------------------------------------------------------------------------
    Following the election of Mr. Leung to chief executive in 
2012, press freedom advocates reported an escalation in 
government efforts to censor and control media access to 
official information. This is viewed as problematic, because it 
is not simply the Hong Kong government that controls the 
release of information to the press but specifically the 
governing party dominating access to official information.* 
\159\ Decisions to grant or refuse media licensing under Hong 
Kong's Broadcasting Ordinance are made by the executive branch. 
Some prodemocracy stations, such as Citizens' Radio, have had 
difficulty obtaining licenses.\160,161\ Free press 
advocates also contend that the government has reduced the 
number of full press conferences it holds for Hong Kong media 
and more often opts to communicate information via press 
releases, thereby denying journalists the opportunity to ask 
questions.\162\ The government has also reportedly begun 
offering information on background without specific attribution 
or via anonymous statements.\163,164\ Hong Kong officials 
contend that the Hong Kong government's issuance of press 
releases and video clips has actually declined over the past 
five years (from 177 in 2008 to 127 in 2012), while the number 
of press conferences and briefings has steadily increased (from 
1,181 in 2008 to 1,372 in 2012). The Hong Kong Journalists' 
Association cites its own research to contend that those 
numbers do not tell the full story, since full press 
conferences are typically held only for noncontroversial 
issues, whereas off-the-record background briefings are more 
frequently used for politically sensitive matters.\165\ In 
2012, press complaints rose about police blocking media access 
to emergency hotlines and restricting access to political 
protests and other politically sensitive events.\166\ In August 
2011, for example, the media were largely denied access during 
a three-day visit by Chinese Vice Premier Li Keqiang, and press 
that were admitted to the official ceremonies were confined to 
a designated press area remote from event activities.\167\ 
Though it is not clear that police treatment of the press has 
improved since that time, a government report on the complaints 
arising from the Li Keqiang visit does note, ``Public concerns 
over the magnitude of the security operation have unfortunately 
created an overcast on the reputation of the Police.'' The 
report also stresses that the episode provides a valuable 
opportunity to make ``improvements in the planning and 
execution of security operations, to avoid similar complaints 
in the future and to reaffirm commitment [by the Hong Kong 
police] to discharging duties professionally and lawfully 
without any political consideration, and safeguarding 
fundamental rights and freedoms of the public.'' \168\
---------------------------------------------------------------------------
    * Mak Yinting, chairperson of the Hong Kong Journalists 
Association, notes in a July 2012 CNN op-ed, ``Hong Kong press freedom 
under Chinese attack'': ``In one recent example, a population policy 
report was presented at a Rotary Club lunch by Chief Secretary Stephen 
Lam. A closed-door briefing was held, during which no audio or video 
recording was allowed. The full report was also not provided to the 
media, who were told to find it on the government's website.''
     The Hong Kong government contends that over a several year 
period, Citizens' Radio repeatedly failed to submit requested 
additional information and clarification regarding its proposed use of 
frequency spectrum and that the Broadcasting Authority decided not to 
grant a license because of these information insufficiencies in the 
Citizens' Radio application. Unlicensed broadcasting is criminal in 
Hong Kong, and HKSAR v Wong Yuk Man and others (2012) notes that the 
unlicensed and uncoordinated use of radio frequencies may interfere 
with licensed users and emergency, air, and navigational services 
users.
---------------------------------------------------------------------------
    Newly proposed legislation would further limit journalists. 
An antistalking bill that may be considered this year could 
hinder journalists' ability to seek out information from 
sources. The Hong Kong Journalists Association has said that 
while it agrees that ``innocent people should be protected from 
harassment in the form of stalking,'' the new law, ``if 
implemented, will have an adverse impact on legitimate 
journalistic activities and could be abused to block genuine 
investigative activities by journalists.'' \169\ Another law 
would limit personal data that corporate directors must make 
public. While supporters argue that this law is important for 
enhancing protections of individual personal data, detractors 
are concerned that it will unduly shield directors from media 
scrutiny.\170\ The debate over the corporate director data law 
comes in the wake of major U.S. media outlets embarrassing the 
Chinese leadership with allegations of corruption, nepotism, 
and profiteering that were partially substantiated by research 
involving Hong Kong's corporate databases. The databases helped 
the media to confirm that multi-billion-dollar business 
interests were vested in the families of then Chinese Premier 
Wen Jiabao and President-designate Xi Jinping. Press freedom 
advocates contend that reporting the business details of the 
families of government is a legitimate press function, but 
supporters of the proposed data restrictions argue that 
business directors should be afforded greater personal 
privacy.\171\
    Media self-censorship is also a pervasive concern. A poll 
conducted in May 2013 by the Public Opinion Program of the 
University of Hong Kong found that 48 percent of respondents 
believed that the local news media practiced self-censorship. 
The veracity of this perception was borne out by the 2012 Hong 
Kong Journalists Association poll results, which showed 36 
percent of media employees conceding that ``they or their 
supervisors had practiced self-censorship in the past 12 
months.'' \172\ In that same Hong Kong Journalists Association 
survey, 79.2 percent of journalists said self-censorship has 
grown since 2005.\173,174\
    Self-censorship has increased as the Chinese central 
government has co-opted media company owners. According to the 
2013 annual report of the Hong Kong Journalists Association, 
roughly 50 percent of Hong Kong media owners have been 
appointed to the National People's Congress or the Chinese 
People's Political Consultative Conference. Publishers of the 
four leading pro-Beijing newspapers--Ta Kung Pao, Wen Wei Po, 
Hong Kong Commercial Daily, and the Hong Kong edition of China 
Daily--are ``routinely appointed to one of the two national 
bodies.'' \175\ These four papers, which make up 13.3 percent 
of news outlets in Hong Kong, have also recently implemented 
special vetting groups for articles pending publication.\176\ 
Owners of an additional 36.7 percent of Hong Kong's news 
outlets have been appointed to the Chinese bodies. Only four 
news outlets (13.3 percent) are clearly free of Beijing or Hong 
Kong government ties. These are the two newspapers published by 
Jimmy Lai's Next Media Group (Apple Daily and Sharp Daily); 
am730, a free newspaper published by the fiercely independent 
Hong Kong businessman and philanthropist Shih Wing-ching; and 
Metropolis Daily, the Hong Kong edition of the international 
Metro newspaper series published by Swedish-owned Metro 
International.\177\
    According to the Belgium-based International Federation of 
Journalists, during the legislative and chief executive 
elections in 2012, the Hong Kong media received ``a white-list 
of pro-establishment candidates whom they were expected to 
promote unconditionally.'' \178\ At least some in the media 
establishment followed the government's suggestions. In one 
incident, Sing Pao Daily News newspaper editors admitted to 
having altered veteran columnist Johnny Lau's opinion column to 
support Mr. Leung ahead of the election. After the election, 
Mr. Lau's column was dropped from the paper following a piece 
he wrote on the death of a Mainland dissident.* \179\ Such 
reports of internal censorship within the top ranks of the Hong 
Kong media have risen as media owners have established closer 
ties with the Mainland. Many Hong Kong media owners have 
business interests in mainland China to protect, and others 
have accepted honorary political titles in the PRC, despite the 
fact that accepting such titles poses a conflict of 
interest.\180\
---------------------------------------------------------------------------
    * Although Sing Pao Daily News is not one of the four leading pro-
Beijing newspapers, it maintains clear ties to Beijing. As of December 
2012, Sing Pao Daily News has been run by Tian Bingxin, a veteran 
journalist for Chinese government-run Xinhua News Agency. Prior to Mr. 
Tian's appointment, Sing Pao was run by mainland Chinese businessman 
Xie Haiyu.
---------------------------------------------------------------------------
    While violent retaliation against the press in Hong Kong 
for its political reporting remains uncommon, some press 
advocates say it is on the rise. There were 11 attacks against 
journalists and media outlets in Hong Kong in 2012 and the 
first half of 2013, and the attackers in only two of those 
incidents were brought to justice. In February 2013, a South 
China Morning Post photographer was slapped, shoved, and 
verbally assaulted while covering a sensitive story on parallel 
importers. \181\ In July 2012, a New Tang Dynasty 
television reporter covering a Falun Gong protest was 
threatened by a pro-Beijing counterprotestor wielding a butcher 
knife.\182\ In August and September 2012, Sing Tao News 
Corporation's offices were attacked by masked men who smashed 
equipment and windows with an axe.\183\ Apple Daily parent 
company NextMedia and owner Jimmy Lai were the targets of a 
series of attacks in June 2013, including a raid in the early 
hours of June 30 in which masked men armed with knives 
intimidated workers and burned 26,000 copies of the forthcoming 
Apple Daily issue.\184\ On June 26, the driver of a truck 
unloading copies of Apple Daily was chased by knife-wielding 
assailants who then set the truck and cargo on fire. On June 
19, attackers rammed Mr. Lai's house gate with a car and left 
behind two axes. Mr. Lai offered a reward for information 
leading to the attackers, whom he believed were motivated by 
antidemocratic sentiments. Police believe the attacks are 
related, and two arrests have been made, but no charges have 
yet been filed.\185\
---------------------------------------------------------------------------
     Parallel trading, buying in demand goods like foreign baby 
formula tax-free in Hong Kong and reselling them on the Mainland for a 
profit, is a growing industry in Hong Kong. It is also a growing cause 
of local unrest because it has increased prices and decreased the 
supply of certain goods in Hong Kong.
---------------------------------------------------------------------------
    A few attacks have also occurred in the presence or at the 
hands of police, suggesting a degree of official coercion or 
complacency. On August 7, 2013, the International Federation of 
Journalists condemned a series of attacks on members of the 
press at an August 4 incident in which photographers covering a 
pro- and antipolice protest were blocked and pushed to the 
ground by unidentified assailants. One of the photographers, 
Yel Tang of Ming Pao newspaper, noted that policemen on the 
scene declined to intervene on the journalists' behalf.\186\ 
(Hong Kong authorities dispute this contention, noting that 
five people were arrested and charged with ``common assault'' 
and ``disorderly conduct in a public place.'') A handful of 
journalists have also been detained by police while covering 
protests and official events. In June 2012, a journalist for 
Apple Daily was detained and questioned after shouting a 
question at Hu Jintao about Hong Kongers' support for the 
victims of the 1989 Tiananmen Square massacre.\187\

Police Surveillance

    Under British rule of Hong Kong, police had longstanding, 
unofficial authority to conduct surveillance, but the 2006 
posthandover Interception of the Communications and 
Surveillance Ordinance granted police broader and more explicit 
authority to conduct physical and communications surveillance 
for the sake of public security.\188\ The law does impose 
restrictions on law enforcement's ability to intercept 
communications without authorization, but it does not 
explicitly ban surveillance for political purposes, and breach 
of the ordinance is not criminal. The bill passed 32 to zero 
after Pan-Democratic lawmakers in the 60-member Legislative 
Council walked out of the chamber in protest when all of the 
200 amendments they sought to introduce were defeated or ruled 
out of order.\189\ In 2011, authorized wiretaps and covert 
surveillance led to the arrest of 137 people, and there is 
growing concern among democracy advocates that the surveillance 
is targeted at them.
    In 2013, police began testing video cameras clipped to 
their uniforms, which they are not permitted to use to film the 
public unless they have a ``justifiable reason,'' such as 
gathering evidence in confrontational scenarios or incidents 
where a breach of the peace has occurred or is deemed likely to 
occur. Like highway patrol cameras, they will record the 
actions of citizens and officers alike. Hong Kong democracy 
rights activists have expressed concerns that the cameras will 
be used to monitor political activists. Human Rights Watch has 
reported that police are using these cameras to take close-up 
shots of demonstrators even when there is not criminal behavior 
during the demonstrations ``and even when protestors have 
explicitly told the police that they do not wish to be 
filmed.'' \190\ If a person blocks the camera, he or she can be 
charged with obstructing a police officer in the execution of 
his duty.\191\
    The introduction of police cameras comes at a time when 
protests against the Hong Kong leadership are up sharply. In 
addition to the Occupy Central efforts and the rallies against 
the national education proposal, thousands of Hong Kong 
residents have participated in protests calling for the 
resignation of Chief Executive Leung, and anywhere from 100,000 
to 400,000 Hong Kongers turned out to participate in July 1 
prodemocracy rallies despite heavy rain. In addition, tens of 
thousands of Hong Kongers also turned out for the June 4 vigil 
commemorating the victims of the 1989 violence in Tiananmen 
Square. Some prodemocracy advocates worry that police might use 
the cameras at such events to build up a database on social 
activists for ``political prosecutions.'' \192,193\ Indeed, 
Pan-Democratic legislators meeting with Commissioners in Hong 
Kong reported that police are now monitoring and arresting 
prodemocracy demonstrators as much as 12 to 24 months after 
their participation in political events.\194\ In July 2013, for 
example, Yau Ka-yu was reportedly arrested and charged with 
illegal assembly in relation to her 15-month-old participation 
in an April 2012 protest outside the China Liaison Office in 
Hong Kong.\195\
    Article 27 of the Basic Law grants Hong Kong residents 
``freedom of association, of assembly, of procession and of 
demonstration,'' but demonstrations and protests are also 
governed by the Public Order Ordinance. This ordinance was 
amended in 1997, shortly before the handover, to stipulate that 
organizers of groups of more than 50 protestors or processions 
of more than 30 protesters ``have to both notify the police 
seven days in advance and receive a `notice of no objection' 
from the government before they can be held.'' \196\ According 
to Hong Kong-based Civil Human Rights Front, there were 444 
arrests of protestors in 2011, ``which surpassed the total 
number of protestors arrested since 1997.'' \197\ The increase 
in arrests may also be partially attributed to a threefold 
increase in protests and processions, from 2,300 in 2002 to 
6,800 in 2011. According to Ms. Richardson, police insisted 
that the increased arrests are due to increased violence, but 
``protestors allege that the government is using parts of the 
Public Order Ordinance, which includes vague standards such as 
whether at a given protest `a breach of the peace is likely to 
be caused,' to punish and deter protestors.'' \198\
    A watchdog system exists for police abuses of power, but 
while it can report on complaints and make recommendations to 
the commissioner of police and the chief executive, it cannot 
take direct action to rectify problems. From mid-2010 to mid-
2011, complaints to the Independent Police Complaints Council 
surged over 50 percent from the prior year. There were 2,672 
allegations against police in 2008; 4,257 allegations in 2009; 
and 7,964 allegations in 2010.\199\ The biggest spikes involved 
allegations of the fabrication of evidence, and assault, but 
Hong Kong authorities note that more than 80 percent of total 
complaints received have been for minor issues such as 
``misconduct,'' ``improper manner,'' ``use of offensive 
language,'' and ``neglect of duty.'' \200\ Some of these 
incidents involved Hong Kong authorities apprehending and 
handing over Chinese political dissidents to Beijing without 
due process and despite there being no extradition treaty 
between Hong Kong and the Mainland.\201\
    Police requests for electronic data also appear to be on 
the rise. In late 2012, for example, Google reported that in 
the first half of the year it had received 192 requests for 
data to use in investigations compared to 325 in all of 2011 
and 140 in all of 2010. The increase prompted calls for an 
investigation into privacy violations. However, Hong Kong laws 
no longer protect data privacy where the data are obtained for 
``prevention, preclusion, or remedying of unlawful or serious 
improper conduct.'' \202\ Without explicit protections for the 
exercise of free speech and freedom of assembly, existing 
protections may be inadequate to protect the exercise of such 
civil liberties.\203\

Implications for the United States

    While the U.S. approach to bilateral relations with China 
and the SARs has allowed integrated discussion and 
consideration of a range of security and economic issues, Hong 
Kong's civil rights and liberties concerns have increasingly 
fallen through the cracks as other China-related issues have 
taken precedence.
    Hong Kong's traditional civic values continue to be 
integral to its international economic power and importance. It 
is these civil rights and political freedoms that have ensured 
that transparency and the rule of law remain hallmarks of Hong 
Kong's trade and investment culture. This makes Hong Kong an 
important gateway for business relations with the Mainland. As 
these traditions are permitted to erode, it will be to the 
detriment of U.S.-China bilateral economic relations more 
broadly.
    Furthermore, the United States has long taken the position 
that it expects Beijing to uphold the democratic commitments it 
made in the Sino-British Declaration and in the Basic Law. To 
the extent that these issues are marginalized in our bilateral 
engagement with China, the United States is not only 
overlooking important economic interests but also compromising 
fundamental American values for the sake of diplomatic 
expedience.

Conclusions

 LThe rapid inflow of money to Macau, its casino-
oriented economy, and its proximity to the PRC present a 
significant risk of money laundering and financing of 
terrorism, particularly in the underregulated shadow banking 
and junket system supporting the VIP gaming business in Macau.

 LA combination of the PRC's strict capital controls 
and restrictions on the collection of gambling debts has given 
rise to grey market alternatives to facilitate the movement of 
gambling funds into Macau. Gambling debt collection conducted 
by unregulated third- party affiliates in the Mainland is 
susceptible to organized crime and violence.

 LMacau's junkets with alleged criminal affiliations 
present legal risks for U.S.-licensed casinos operating VIP 
rooms in Macau. Casinos found to be working with junkets 
directly or indirectly associated with Asian organized crime 
may be subject to revocation of their state-issued license to 
operate in the United States.

 LMacau's loose regulation of the junket system and its 
strict privacy law prevent U.S. regulators from accessing 
information they are accustomed to, and U.S. state regulators 
lack the authority and resources to independently conduct 
investigations in foreign jurisdictions. This prevents U.S. 
regulators from accurately accessing the situation in Macau and 
effectively stops them from evaluating individuals conducting 
business with U.S.-licensed casinos.

 LMacau's anti-money-laundering and counter-terrorist-
financing framework has fallen short in complying with 
internationally recognized standards. Numerous vulnerabilities 
remain in its regulations, including deficiencies relating to 
Macau's inability to effectively freeze financial assets and 
its inadequate inspection and oversight of casinos and junket 
operators and promoters.

 LDespite reports that the PRC aims to more closely 
monitor Macau's gaming industry as part of its nationwide 
initiative to crack down on corruption, there is no substantial 
evidence to suggest that Beijing intends a crackdown on illicit 
money transfers and money laundering in Macau.

 LTo protect their licenses to do business in the 
United States, American casinos have adopted a number of 
measures designed to prevent illegal activities in their VIP 
rooms. The Commission is not in a position to evaluate whether 
those measures are fully adequate to insulate the operations of 
those rooms from illegal activity.

 LDespite official statements of support from Beijing 
and the Hong Kong chief executive, the continued lack of 
meaningful progress calls into question Beijing's real 
intentions. Prospects for universal suffrage by 2017 are 
dimming. Political interference, government restraints on 
access to information, and self-censorship continue to take a 
toll on press freedom in Hong Kong. Public perceptions of media 
credibility have declined since the handover. Violent attacks 
on prodemocracy news outlets and their owners are on the rise, 
and the totality of the evidence suggests that Beijing does not 
intend to allow real democracy to develop in Hong Kong.

 LProdemocracy activists express alarm over stepped-up 
police surveillance at protests, which they fear may be aimed 
at chilling public discourse or quelling public dissent.

 LAll of these trends run counter to the Basic Law's 
assurances that Hong Kong's traditional democratic and civil 
rights would be preserved for the first 50 years following the 
handover.

 LThe systematic disenfranchisement of those who 
support greater democratic freedoms and civil liberties has 
created a climate of political polarization that may undermine 
Hong Kong's fundamental governability.

                     ENDNOTES FOR SECTION 3

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Commissioners and staff, July 26, 2013.
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Special Administrative Region Statistics and Census Service, 2013), p. 
16. http://www.dsec.gov.mo/Statistic-.-aspx-?-Node-Guid-=-ba1a4eab-
213a-48a3-8fbb-962d-15dc-6f-87.
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Comparison.'' https://www.cia.gov/library/publications/the-world-
factbook/rankorder/
2222-rank-.-html-?-country-name-=-Macau-&-country-code-=-mc-&-region-Cod
e-=-eas-&-rank-=-3-#-mc.
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(Washington, DC: 2013).
      6. I. Nelson Rose, ``The Explosive But Sporadic Growth of 
Gambling in Asia,'' Gambling and the Law (2010). http: // 
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explosive-but-sporadic-growth-of-gambling-in-asia.
      7. Macau SAR Gaming Inspection and Coordination Bureau, ``Gaming 
Statistics.'' http: // www.dicj.gov.mo / web / en / information / 
contacts _ casino / content.html#sjm. Wynn Resorts estimates the total 
at $45 billion. Barry B. Langberg, Meeting with Commission, October 23, 
2013, Washington, DC.
      8. Government of Macau, Gross Domestic Product 2012 (Macau, SAR: 
Statistics and Census Service), p. 28. http://www.dsec.gov.mo/
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      9. Macau SAR, Statistics and Census Service, ``Visitor Arrivals 
and Same-day Visitor Arrivals by Place of Residence'' (Macau, SAR). 
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Liberalization after the Handover.'' http://www.dicj.gov.mo/web/en/
history/.
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Money Laundering, Vulnerabilities of Casinos and Gaming Sector (Paris, 
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documents/reports/
Vulnerabilities-%20-of-%20-Casinos-%20-and-%20-Gaming-%20-Sector-.-pdf.
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Money Laundering, Vulnerabilities of Casinos and Gaming Sector (Paris, 
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Macau and Hong Kong, written testimony of A.G. Burnett, June 27, 2013.
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2012/content.html#n1.
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Commission staff, September 17, 2013.
     19. U.S.-China Economic and Security Review Commission, Hearing on 
Macau and Hong Kong, written testimony of A.G. Burnett, June 27, 2013.
     20. Junket operators in Macau casinos arrange for travel to and 
from the Mainland, and hotel rooms and in-casino credit to gamblers 
visiting Macau.
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Strategy Report Volume II: Money Laundering and Financial Crimes 
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rls/nrcrpt/2013/database/211182.htm.
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Strategy Report Volume II: Money Laundering and Financial Crimes 
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rls/nrcrpt/2013/database/211182.htm.
     23. Wuyi Wang and William R. Eadington, ``VIP-Room Contractual 
System of Macau's Traditional Casino Industry'' (Reno, NV: University 
of Nevada, Working Paper 07-001, 2007), p. 6. http://
www.business.unr.edu/econ/wp/papers/un-recon-wp-07-001.pdf.
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Macau and Hong Kong, written testimony of A.G. Burnett, June 27, 2013.
     25. U.S.-China Economic and Security Review Commission, Hearing on 
Macau and Hong Kong, written testimony of A.G. Burnett, June 27, 2013.
     26. U.S.-China Economic and Security Review Commission, Hearing on 
Macau and Hong Kong, written testimony of A.G. Burnett, June 27, 2013.
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Laundering,'' Wall Street Journal, January 24, 2013. http://
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Macau and Hong Kong, written testimony of Daniel L. Glaser, June 27, 
2013.
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Global Monetary System'' (Washington, DC: The Brookings Institution, 
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underground-banking-triangle-thrives.
     33. Casinos in Macau may sell nonnegotiable chips, also known as 
``dead chips,'' or ``clay chips'' to junket operators at a slight 
discount below their face value. Junket operators then provide the dead 
chips to their client gamblers, often as a loan. The so-called dead 
chips cannot be cashed out directly at the cashier's cages within the 
VIP rooms. They must first be used to gamble, often at the baccarat 
table. The junket operators receive a commission on the number of chips 
they transfer to the client. If the intent is to launder the money or 
convert the money from renminbi into another currency, whatever money 
is lost to gambling by the client is an incidental cost of the money 
laundering. Wuyi Wang and William R. Eadington, ``VIP-Room Contractual 
System of Macau's Traditional Casino Industry'' (Reno, NV: University 
of Nevada, Working Paper 07-001, 2007), pp. 11-13. http://
www.business.unr.edu/econ/wp/papers/unrecon-wp-07-001-.-pdf.
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Underground Banking Triangle Works, Reuters, May 20, 2013. http: // 
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underground-banking-triangle-thrives.
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of Primary Concern. (Washington, DC: 2012). http://www.state.gov/j/inl/
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for Gaming Sector 8 (Macau, SAR: Financial Intelligence Office, May, 
2013), p. 4. http://www.-gif-.-gov-.-mo/web1/doc/Newsletter/
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Intelligence Office, 2013), p. 98. http://www.gif.gov.mo/web1/doc/
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(Hong Kong), June 10, 2013.
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global index,'' South China Morning Post (Hong Kong), January 31, 2013.
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4, 2013).
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assaulting-south-china-morning-post-photographer.
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Falun Gong in Hong Kong,'' Epoch Times (New York), July 6, 2012.
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Information Leading to Arson Attackers,'' Hollywood Reporter, July 1, 
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2, 2012).
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York Times, August 6, 2006.
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York Times, August 6, 2006.
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Macau and Hong Kong, written testimony of Sophie Richardson, June 27, 
2013.
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next month,'' South China Morning Post (Hong Kong), February 23, 2013.
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next month,'' South China Morning Post, (Hong Kong), February 23, 2013.
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interviews with Commissioners and staff, July 26, 2013.
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Today for Illegal Assembly,'' July 25, 2013.
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Macau and Hong Kong, written testimony of Sophie Richardson, June 27, 
2013.
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Macau and Hong Kong, written testimony of Sophie Richardson, June 27, 
2013.
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Macau and Hong Kong, written testimony of Sophie Richardson, June 27, 
2013.
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up 60pc,'' South China Morning Post (Hong Kong), March 5, 2010; South 
China Morning Post (Hong Kong), ``Police Complaints a Cause for 
Concern,'' July 9, 2011.
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Violated Chinese Dissident's Rights,'' New York Times, January 26, 
2010.
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Hong Kong Police,'' South China Morning Post (Hong Kong), November 16, 
2012.
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Hong Kong Police,'' South China Morning Post (Hong Kong), November 16, 
2012.
                            RECOMMENDATIONS

China and the Middle East and North Africa

The Commission recommends:

 LCongress support efforts by the Department of Defense 
to strengthen cooperation with China on counterpiracy in the 
Gulf of Aden and elsewhere.

 LCongress consider the merits of including fuel oil 
purchases in the current sanctions regime prohibiting countries 
from purchasing crude oil from Iran.

 LCongress work with the Departments of State, 
Commerce, and the Treasury to utilize the full range of 
incentives and disincentives to encourage China to reduce its 
ties with Iran, including exploring conditioning Chinese energy 
companies' future investments in the United States on limiting 
commercial ties with Iran.

 LCongress urge the Department of State to elevate the 
U.S.-China Middle East Dialogue to include an annual meeting at 
the Cabinet level and to increase meetings at the 
undersecretary level from once to twice per year.

 LCongress direct the Administration to provide a 
report to Congress on China's enforcement of its export 
controls, to include an assessment of the level of scrutiny the 
Chinese government applies to end users in transfers that are 
of proliferation concern.

Taiwan

The Commission recommends:

 LCongress direct the Administration to transmit an 
unclassified report to Congress on U.S. arms sales to Taiwan 
from 2001 to 2013. It should detail each of Taiwan's requests 
for purchase of U.S. weapons, defense items, or defense 
services during this period; describe Taiwan's justification 
for each request; report on any Administration decision to 
reject, delay, or alter each request; and provide an update on 
the status of sales that have been previously approved.

 LCongress encourage the Administration to continue 
discussions between the United States and Taiwan concerning a 
bilateral investment agreement.

 LCongress urge Cabinet-level officials to visit Taiwan 
to promote commercial, technological, and people-to-people 
exchanges and direct the Administration to permit official 
travel to Taiwan for Department of State and Department of 
Defense personnel above the rank of office director or, for 
uniformed military personnel, above the level of O6.

Macau and Hong Kong

The Commission recommends:

 LCongress urge the State Department to negotiate with 
the Macanese government to fix the shortcomings in its 
regulatory framework. Potential reforms would include 
implementing an effective asset freezing mechanism, an increase 
in due diligence procedures in casinos, reduction in the high 
threshold for reporting suspicious transactions within casinos, 
establishing more transparent cross-border reporting 
requirements, and a requirement that junket operators and their 
affiliates disclose detailed financial information and 
implement stricter licensing requirements

 LCongress reconvene a congressional caucus on Hong 
Kong to ensure continuous attention to the region's democracy 
and civil rights issues.

 LCongress adopt a resolution urging China to keep its 
commitments to universal suffrage as articulated in the 1984 
Sino-British Joint Declaration on the Question of Hong Kong and 
the Basic Law of the Hong Kong Special Administrative Region.

 LCongress reaffirm its support for human rights and 
the rule of law in Hong Kong.

 LCongress renew the biennial reporting requirements of 
the U.S.-Hong Kong Policy Act of 1992.

 
                         COMPREHENSIVE LIST OF


 
                    THE COMMISSION'S RECOMMENDATIONS

       Chapter 1: The U.S.-China Trade and Economic Relationship

Section 2: Trends in Chinese Investment in the United States

The Commission recommends:

 1. LCongress assess the extent to which existing laws provide 
for inadequate or ineffective remedies against the 
anticompetitive actions of Chinese state-owned or state-
invested enterprises operating in the U.S. market. Additional 
remedies may be required to account for the fact that these 
enterprises may not be operating based on commercial 
considerations.

 2. LCongress assess whether to amend the Committee on Foreign 
Investment in the United States (CFIUS) statute to allow review 
of greenfield investments for threats to U.S. national 
security.

 3. LCongress direct the Department of Commerce to develop a 
comprehensive, ongoing inventory of Chinese foreign direct 
investment (FDI) in the United States and, on an annual basis, 
update the inventory. The inventory should identify the 
ownership structure of the entity engaging in the investment. 
In preparing the inventory, the department should call on 
private sector entities engaged in monitoring Chinese 
investments in the United States and such other entities to 
ensure that its report is complete and accurate. The department 
should prepare a comprehensive report to Congress on an annual 
basis identifying the FDI by Chinese entities that were made in 
the previous calendar year. In its report, the department 
should indicate those investments that received any assistance 
from the ``Select USA'' program. The department should also 
identify, on an ongoing basis, the lines of commerce that each 
of the investments are engaged in.

Section 3: Governance and Accountability in China's Financial System

The Commission recommends:

 4. LCongress direct the Administration to press China for more 
cooperation with the international community in order to 
address the global economic risks of unregulated and 
underregulated shadow banking and ask the Department of the 
Treasury to provide an annual report to Congress on the risks 
of shadow banking.

 5. LCongress direct the Administration, in any bilateral 
investment treaty negotiations, to make fair and equitable 
market access and treatment for financial services firms a 
priority.

 6. LCongress direct the Administration to assist the 
Securities and Exchange Commission (SEC) and the Public Company 
Accounting Oversight Board by encouraging China to develop 
better regulatory oversight enforcement capabilities and more 
transparent markets, during annual and biannual bilateral 
dialogues, as well as multilateral dialogues.

 7. LCongress empower the SEC to set minimum standards for 
companies listing and maintaining listings on U.S. exchanges 
and enable the SEC to directly delist foreign companies not in 
compliance with these standards.

Section 4: China's Agriculture Policy, Food Regulation, and the U.S.-
        China Agriculture Trade

The Commission recommends:

 8. LCongress monitor the implementation of the U.S.-China Plan 
of Strategic Cooperation in Agriculture (2012-2017) to ensure 
that U.S. funding is being allocated in such a way as to 
improve the safety, sustainability, efficiency, and security of 
food production in China and the United States.

 9. LCongress require the U.S. Department of Agriculture (USDA) 
and the U.S. Trade Representative to conduct a comprehensive 
review of China's agricultural subsidies, discriminatory taxes, 
state trading, and procurement practices; take account of the 
damages incurred by U.S. farmers and downstream industries; and 
suggest appropriate remedies.

10. LCongress urge the Secretary of Agriculture to engage, as 
part of the Joint Committee on Commerce and Trade and the 
Strategic and Economic Dialogue, with his/her Chinese 
counterparts to address those Chinese policies and practices 
that limit U.S. exports of value-added products.

11. LCongress direct the Interagency Trade Enforcement Center 
(ITEC) to conduct a review of the selective use of value added 
tax (VAT) rebates by China and determine whether they have a 
trade-distorting effect and whether the selective use of VAT 
rebates is consistent with the original intent of the General 
Agreement on Tariffs and Trade (GATT) provision allowing for 
VAT rebates. The ITEC should prepare a report for the U.S. 
Trade Representative and the relevant Committees of 
jurisdiction and identify what steps should be taken to address 
any GATT inconsistencies, should they be found.

12. LCongress direct the USDA to negotiate with China to 
synchronize approvals of biotechnology to ensure stable and 
predictable market access for U.S. seed companies and crop 
growers in the Chinese market.

13. LCongress require that the USDA prepare an annual report on 
competitive factors in the pork industry. In preparing such 
reports, the department shall evaluate the impact, if any, of 
the recent purchase of Smithfield Foods on the ability of other 
U.S. producers to export pork products to China. In addition, 
the report shall identify any changing pricing structures 
throughout the pork production chain to determine whether there 
is price or profit suppression as a result of the Smithfield 
transaction.

14. LCongress direct the USDA to exercise extreme caution in 
negotiating equivalency status for Chinese exports of processed 
poultry using Chinese-origin birds. Congress should also 
increase its support of USDA's Food Safety and Inspection 
Service in its role as protector of meat and poultry food 
safety so that the United States serves as a world model for 
high-quality, science-based regulations.

15. LCongress ensure that the Food and Drug Administration 
makes it a priority to increase the number of physical 
inspections of Chinese food imports at the border; to increase 
the rigor of those inspections to include testing for pathogens 
and chemical, pesticide, and drug residues, and processed food 
ingredients; and to conduct more frequent and thorough 
inspections in food facilities in China. Congress should also 
urge the USDA to permanently assign inspection personnel to 
China so that the exporting plants receive regular visits by 
USDA inspectors.

16. LCongress require the Secretary of Agriculture to prepare a 
report to Congress identifying those organic food products 
being imported into the United States from China. The report 
should include a comprehensive evaluation of the different 
methodologies employed by the United States and China to 
certify that a product is organic and what steps, if any, are 
being taken to harmonize any discrepancies that might exist.

17. LCongress evaluate whether a requirement that U.S. food 
importers purchase insurance against food-borne illnesses and 
pathogens from Chinese imports would improve food safety. Such 
a program would involve private sector risk insurance with 
insurance companies evaluating the safety of various sources 
and charging risk-based premiums based on the methods employed 
by Chinese exporters to address food-borne illnesses and 
pathogens.

          Chapter 2: China's Impact on U.S. Security Interests

Section 2: China's Cyber Activities

The Commission recommends:

18. LCongress adopt legislation clarifying the actions 
companies are permitted to take regarding tracking intellectual 
property stolen through cyber intrusions.

19. LCongress amend the Economic Espionage Act (18 U.S.C. 
Sec. 1831-1839) to permit a private right of action when trade 
secrets are stolen.

20. LCongress support the Administration's efforts to achieve a 
high standard of protection of intellectual property rights in 
the Trans-Pacific Partnership and the Transatlantic Trade and 
Investment Partnership.

21. LCongress encourage the Administration to partner with 
other countries to establish an international list of 
individuals, groups, and organizations engaged in commercial 
cyber espionage. The Administration and partner governments 
should develop a process for the list's validation, 
adjudication, and shared access.

22. LCongress urge the Administration to continue to enhance 
its sharing of information about cyber threats with the private 
sector, particularly small- and medium-sized companies.

23. LCongress direct the Administration to prepare an inventory 
of existing federal use of cloud computing platforms and 
services and determine where the data storage and computing 
services are geographically located. Such inventory should be 
prepared annually and reported to the appropriate committees of 
jurisdiction.

24. LCongress urge the Administration to expedite progress in 
its implementation of Section 806 of the National Defense 
Authorization Act for Fiscal Year 2011 (Public Law 111-383), 
which was intended to enhance the Department of Defense's 
ability to address supply chain risks.

Section 3: China's Maritime Disputes

The Commission recommends:

25. LCongress fund the U.S. Navy's shipbuilding and operational 
efforts to increase its presence in the Asia Pacific to at 
least 60 ships and rebalance homeports to 60 percent in the 
region by 2020 so that the United States will have the capacity 
to maintain readiness and presence in the Western Pacific, 
offset China's growing military capabilities, and surge naval 
assets in the event of a contingency.

26. LCongress fund Departments of Defense and State efforts to 
improve the air and maritime capabilities of U.S. partners and 
allies in Asia, particularly with regard to intelligence, 
surveillance, and reconnaissance, to improve maritime domain 
awareness in the East and South China Seas.

27. LCongress urge the Department of Defense to continue to 
develop the U.S.-China maritime security relationship in order 
to strengthen strategic trust. The relationship should be 
within the bounds of the National Defense Authorization Act for 
Fiscal Year 2000 (Public Law 106-65) and based on the 
principles of reciprocity and transparency.

28. LCongress fund U.S. Coast Guard engagement efforts with 
coast guard and maritime law enforcement agencies in the 
Western Pacific to increase understanding among civilian 
maritime bodies in the Asia Pacific.

                     Chapter 3: China and the World

Section 1: China and the Middle East and North Africa

The Commission recommends:

29. LCongress support efforts by the Department of Defense to 
strengthen cooperation with China on counterpiracy in the Gulf 
of Aden and elsewhere.

30. LCongress consider the merits of including fuel oil 
purchases in the current sanctions regime prohibiting countries 
from purchasing crude oil from Iran.

31. LCongress work with the Departments of State, Commerce, and 
the Treasury to utilize the full range of incentives and 
disincentives to encourage China to reduce its ties with Iran, 
including exploring conditioning Chinese energy companies' 
future investments in the United States on limiting commercial 
ties with Iran.

32. LCongress urge the Department of State to elevate the U.S.-
China Middle East Dialogue to include an annual meeting at the 
Cabinet level and to increase meetings at the undersecretary 
level from once to twice per year.

33. LCongress direct the Administration to provide a report to 
Congress on China's enforcement of its export controls, to 
include an assessment of the level of scrutiny the Chinese 
government applies to end users in transfers that are of 
proliferation concern.

Section 2: Taiwan
The Commission recommends:

34. LCongress direct the Administration to transmit an 
unclassified report to Congress on U.S. arms sales to Taiwan 
from 2001 to 2013. It should detail each of Taiwan's requests 
for purchase of U.S. weapons, defense items, or defense 
services during the immediately preceding one-year period; 
describe Taiwan's justification for each request; report on any 
Administration decision to reject, delay, or alter each 
request; and provide an update on the status of sales that have 
been previously approved.

35. LCongress encourage the Administration to continue 
discussions between the United States and Taiwan concerning a 
bilateral investment agreement.

36. LCongress urge Cabinet-level officials to visit Taiwan to 
promote commercial, technological, and people-to-people 
exchanges and direct the Administration to permit official 
travel to Taiwan for Department of State and Department of 
Defense personnel above the rank of office director or, for 
uniformed military personnel, above the level of O6.

Section 3: Macau and Hong Kong
The Commission recommends:

37. LCongress urge the State Department to negotiate with the 
Macanese government to fix the shortcomings in its regulatory 
framework. Potential reforms would include implementing an 
effective asset-freezing mechanism, an increase in due 
diligence procedures in casinos, reduction in the high 
threshold for reporting suspicious transactions within casinos, 
establishing more transparent cross-border reporting 
requirements, and a requirement that junket operators and their 
affiliates disclose detailed financial information and 
implement stricter licensing requirements.

38. LCongress reconvene a congressional caucus on Hong Kong to 
ensure continuous attention to the region's democracy and civil 
rights issues.

39. LCongress adopt a resolution urging China to keep its 
commitments to universal suffrage as articulated in the 1984 
Sino-British Joint Declaration on the Question of Hong Kong and 
the Basic Law of the Hong Kong Special Administrative Region.

40. LCongress reaffirm its support for human rights and the 
rule of law in Hong Kong.

41. LCongress renew the biennial reporting requirements of the 
U.S.-Hong Kong Policy Act of 1992.

 
                          ADDITIONAL VIEWS OF


 
                       COMMISSIONER PETER BROOKES

    I continue to have concerns with the Macau section of the 
report and question its inclusion in the final edition.

 
                          DISSENTING VIEWS OF


 
                      COMMISSIONER ROBIN CLEVELAND

    Over the past several years, the Commission has taken an 
increasingly anti-business tone and approach in its reporting. 
Frustrated by the Chinese government's unwillingness to 
implement the reforms and policies some commissioners deem 
necessary, the Commission reports have become increasingly 
critical of US companies doing business in China. This approach 
is abundantly clear in the chapter on Macau. The final result 
was a slanted, speculative diatribe based on a flawed and 
unbalanced process. In short, we failed our public duty to 
provide a useful, reliable report.
    Commission efforts to secure a complete range of views on a 
given hearing have on occasion fallen short, but no other 
hearing has so deliberately excluded panelists in order to 
shape the outcome. In this instance, staff consulted with 
Commissioners hostile to the industry then chose not to invite 
the US companies whose operations were the subject of the 
hearing. Worse, staff failed to inform Commissioners they had 
chosen not to invite the companies, then, when asked, misled 
the Commission about efforts to contact them. To date, no 
explanation has been provided as to why gaming companies were 
deliberately excluded from a hearing on gambling in Macau. 
While two companies were granted private meetings after the 
report was made publicly available, they were unfairly denied 
the timely opportunity during the public hearing to describe 
their operations and safeguards and address Commissioners 
concerns. Following the private meetings and faced with new, 
relevant information, the chapter was hastily edited to remove 
glaring inaccuracies. Commissioners also felt it necessary to 
formally acknowledge that no evidence of wrongdoing was 
uncovered. Since the companies presented their perspective so 
late in the process, it was impossible to determine in a 
careful or comprehensive manner whether additional information 
in the chapter may have been contrived, irresponsible or just 
plain wrong. Similarly, it was not possible to deliberately 
evaluate or vet the views presented by the companies.
    The Commission's bias is also evident when discussing law 
enforcement and compliance. While multiple opinions are 
included criticizing deficiencies in Macau's supervision of 
gambling, the Commission chose to exclude the bulk of a key 
State Department report which addresses efforts to strengthen 
law enforcement and financial regulation. An example of this 
selection bias is the Commission claim that ``an indicator of 
the money laundering problem is evident in the rising number of 
suspicious transaction reports.'' (p. 360) Why is this an 
indicator of an increased problem rather than evidence of more 
vigilant pursuit of law enforcement efforts? Indeed, the 
Commission seems to contradict itself by including a 
recommendation to increase the number of these reports.
    In addition to bias, the report is replete with 
contradictory and questionable assertions that are represented 
as Commission judgments when, in fact, they are the views of 
individuals. For example, in one place the report states, 
``junket operations have a history of affiliation with Asian 
organized crime'' (p. 358) and a few pages later says instead, 
they ``may have links to organized crime.'' (p. 361) Although 
appearing to be a Commission assertion of fact, the 
inconsistent statements rely on the views held by a Nevada 
industry regulator with a good reputation, but no professional 
history or experience supervising the Macau markets.
    Macau is a complicated and hugely challenging operating 
environment with a reliance on an industry that is growing 
rapidly and has had a dubious legal past. Regulators have 
understandably had difficulties keeping pace with the growth. 
However, no effort was made by the Commission to learn from 
anyone actually engaged on the ground in the business, 
regulation or supervision of gambling. It may well be an 
industry and region demanding additional legal, financial and 
policy scrutiny. Certainly that is a subject worthy of 
consideration. But when the Commission prejudicially promotes 
one view over another and explicitly disregards all facts, we 
have compromised the integrity of the process, the report and 
any conclusions which could be drawn.

 
                          ADDITIONAL VIEWS OF


 
                      COMMISSIONER WILLIAM REINSCH

    Once again this year I support issuing the report, 
notwithstanding my disagreement with some of its conclusions 
and recommendations, which I discuss below.
    Overall, the report does a fair job of detailing the 
Commission's work in 2013, and its recommendations accurately 
reflect the views of a majority of commissioners. Once again, 
however, I want to express my disappointment at the report's 
consistent tendency to avoid acknowledging any good news and to 
focus unrelentingly on the bad news. There is no shortage of 
the latter, and it is largely true that we seem to be at a 
point where business, labor and numerous nongovernmental 
organizations are all dissatisfied with aspects of the 
bilateral relationship. Certainly, our government has not been 
reluctant to make clear its displeasure with Chinese actions--
or inactions--that have adversely affected our relationship.
    At the same time, the leadership transition in China brings 
with it the prospect of economic change more rapid than we have 
witnessed for the past ten years. At this point that prospect 
is unrealized, but there are more than a few signs that is 
going to change, possibly fairly soon. In that regard, the 
report could do a better job of recognizing not only the 
imbalances in the Chinese economy--which it does with 
enthusiasm--but also the forces within China pressing for 
meaningful reform and the occasional steps, however modest, 
that are taken in that direction.
    Similarly, with respect to the military relationship, the 
report correctly focuses on China's military buildup and 
growing aggressiveness in the region but is quicker than I 
would be to see the situation in black and white rather than 
gray and to ascribe hostile intentions to China. It is a fair 
point that when it comes to our military security, it is better 
to be safe than sorry, but I nonetheless would have preferred 
that the report take a more nuanced view of recent 
developments.
    With respect to recommendations that are disappointing, at 
the top of the list is the Commission's willingness to inject 
itself into the debate over Iran sanctions, particularly the 
suggestion we consider conditioning Chinese energy investments 
in the U.S. on their limiting commercial ties with Iran. Making 
this and other suggestions far exceeds the Commission's 
mandate, gets it into issues where it has little expertise, and 
ignores the impact it could have on domestic oil production at 
the very moment it is growing rapidly. More important, the 
recommendation is singularly ill-timed as it comes at precisely 
when the U.S. for the first time in years has the prospect of 
making progress at the negotiating table with Iran. There is a 
significant national debate on this issue right now, and I hope 
that those engaged in it will recognize that the Commission has 
no business wading into it and will ignore our advice.
    Second, the recommendations on cyber security, while 
highlighting an important and growing problem and making some 
useful recommendations for dealing with it, veer off 
prematurely into cloud computing, an issue which deserves more 
study before the Commission produces a recommendation on it.
    Third, the Commission has once again fallen victim to 
paranoia about Chinese investment in the U.S. In my judgment, 
the U.S. has adequate means in place via CFIUS to review a 
foreign investment's national security implications, which is 
the appropriate criterion. There is no good justification 
presented for treating Chinese investment more harshly than 
others, yet the Commission has once again proposed doing so. We 
went through this with Japan in the 1980s and did not 
distinguish ourselves as a people for having done so, and I 
hope we will not make the same mistake again. We should be 
better than that.
    Finally, readers of the various additional and dissenting 
views this year will note some controversy over the 
Commission's discussion of Macau and gambling. This is the 
first time in the Commission's existence that it has studied 
Macau--overdue in my view--and it is impossible to look at 
Macau without addressing gambling. My conclusion from our work 
is that the nexus with U.S. interests is clear. Money 
laundering and the alleged involvement of organized crime raise 
important issues for law enforcement. The possibility that 
large sums of money could end up in the hands of our 
adversaries is something we should not simply dismiss. More 
work needs to be done on this by U.S. authorities, and I hope 
it will be.
    As far as the process of considering Macau is concerned, my 
task as chairman this year was to make sure it was a fair one, 
and I believe that was accomplished. The parties that wished to 
talk to commissioners had the opportunity to do so; divergent 
views were heard and in many respects were recognized in the 
report. I believe the report accurately reflects what we 
learned through testimony, interviews and study. The fact that 
a large bipartisan majority of the Commission supported this 
section as well as the final report, attests to that.

 
                   ADDITIONAL VIEWS OF COMMISSIONERS


 
                    JAMES TALENT AND MICHAEL WESSEL,


 
                   CAROLYN BARTHOLOMEW, DENNIS SHEA,


 
                   KATHERINE TOBIN, AND LARRY WORTZEL

    We are pleased to join the Report which the Commission is 
issuing today and want to add these additional views to 
highlight for Congress our particular concern over the 
significant military buildup in which China has been engaged 
since the mid-1990s.
    No one born since the end of World War II has known a time 
when the United States has not had overwhelming naval 
superiority in the Western Pacific. The United States has used 
that power to support its treaty obligations, protect the 
freedom of trade and travel, deter aggression that could lead 
to war, and promote the resolution of disputes peacefully 
through the application of international norms and processes. 
All of these are vital American interests; in using its power 
to uphold them, the United States has created an environment 
conducive to peace, economic opportunity, and the progress of 
democracy in countries like Taiwan, Japan, South Korea, and the 
Philippines.
    As the Report notes, the Chinese military buildup is 
changing the balance of power in the Asia Pacific, challenging 
65 years of uncontested U.S. military preeminence in the 
region. China is building a modern Navy that will, according to 
our Report, consist of 313-342 mostly modern vessels by the 
year 2020. If current trends in American naval shipbuilding 
continue, the Chinese Navy will be larger than America's; and 
China can and will concentrate its presence almost entirely in 
the Western Pacific, whereas the United States Navy has and 
will continue to have global responsibilities.
    The Report also documents one of the purposes for which 
China is engaged in this military buildup. China has made 
expansive claims of sovereignty in the East and South China 
Seas. It has eschewed multilateral talks to resolve these 
disputes and is instead pursuing a policy of coercive action by 
flooding disputed areas with both civilian maritime enforcement 
and PLA Navy ships in order to assume de facto administrative 
control over those areas. Other claimants are left with the 
alternatives of assenting to China's claims or starting an 
armed conflict with Beijing's highly capable maritime force.
    The Chinese Communist Party leaders are serious about 
continuing this policy. As the Report notes, they are asserting 
a hegemonic presence in large parts of Asia and the Pacific, 
both in support of their specific claims of sovereignty and as 
part of realizing the ``China Dream'' by which they hope to 
legitimize their rule in the minds of the Chinese people 
despite the fact that they have specifically disavowed any 
intention of establishing democracy at home. These are vital 
interests in the minds of Chinese leaders, and there is no 
reason to believe they will abandon them as long as the balance 
of power in the region is moving in their favor.
    We support the Administration's policy of ``rebalancing'' 
towards the Pacific. The Report notes that the purpose of this 
policy is to strengthen America's ties with its allies and 
ensure a peaceful resolution of disputes in the region. If the 
policy is supported with vigorous diplomacy, a military 
presence adequate to deter China, reliance on international 
norms and institutions, and a firm but respectful approach to 
Chinese ambitions, it has a good chance of preserving the peace 
while protecting the vital interests of the United States and 
the rights of all countries in the Western Pacific. But if the 
military balance continues to shift in China's direction, there 
is a danger that the rebalance policy will provoke the Chinese 
leadership without adequately deterring them from aggressive 
action.
    America is not alone in its desire for peace and the 
recognition of the rights of all nations in the Western 
Pacific. As is our custom, the Commission travelled to several 
countries in the Far East this year, including Taiwan and Japan 
as well as Hong Kong and mainland China. America's allies and 
partners are concerned about the growing danger of armed 
conflict in the East and South China Sea--a danger recognized 
in our Report--and are eager for the United States to continue 
its leadership role in the area. There is a good chance that 
other countries will assist the United States in maintaining 
the burden of peace and security. Japan, in particular, has the 
means and increasingly the desire to increase its capabilities. 
But given the historical context, a Japanese military buildup, 
however benign its intent, has the potential to be 
destabilizing unless it occurs under the umbrella of American 
leadership and continued commitment to the region.
    For all of these reasons, the Report recommends that 
Congress fund America's shipbuilding program at a level 
adequate to support increasing America's naval presence to at 
least the modest degree called for by the rebalance policy. We 
are writing these additional views to emphasize the importance 
of that recommendation. China's military buildup, along with 
its aggressive legal, administrative, and diplomatic efforts in 
support of its sovereignty claims, is disturbing the 
equilibrium in the Western Pacific. The consequences are 
potentially staggering, and we feel it our duty to emphasize to 
the Congress the importance of a purposeful, bipartisan, and 
timely response.

 
                   ADDITIONAL VIEWS OF COMMISSIONERS


 
                    MICHAEL WESSEL AND JAMES TALENT,


 
                          AND KATHERINE TOBIN

    This year, for the first time, the Commission examined 
issues relating to Macau. Macau receives a massive amount of 
revenue from gambling. The revenue dwarfs that of Nevada's 
approximately $11 billion with an estimated $45 billion in 
gaming revenues last year for Macau.
    Macau, like Hong Kong, is a Special Administrative Region 
of the People's Republic of China. It falls under the policy of 
``one country, two systems'' and the ultimate control of the 
PRC's central government. While gambling is illegal on the 
Mainland, the gambling culture has deep roots in Macau. Since 
its transfer back to China in 1999, Macau has blossomed as the 
gambling destination for Mainland Chinese citizens.
    In part, Macau's success is due to the arrival of U.S.-
headquartered and licensed casino operators who have created 
world-class destinations for gamblers around the globe. Their 
investments in Macau enhanced consumer confidence in the 
operations, quality of accommodations, and property 
attractions.
    The Commission heard testimony of a Nevada state regulator, 
of federal government officials, and academic and legal experts 
on gaming law and operations. Their testimony also addressed 
the potential for money laundering and other illegal activities 
that have typically accompanied gambling operations in the 
past.
    The Commission is not a law enforcement or regulatory body: 
It was created by Congress as an accompaniment to the grant of 
Permanent Normal Trade Relations to China and that country's 
accession to the World Trade Organization. The Commission's 
charge is to report to Congress on issues in the bilateral 
relationship that may affect U.S. interests. The Commission, 
over the years, has identified important matters that deserved 
the attention of Congress and other policymakers, including 
China's manipulation of the value of its currency, China's 
cyber-espionage activities, the rise of China's military, and 
numerous other issues.
    It is our view that the underlying questions about the 
integrity of operations in Macau bear further scrutiny by 
Congress. As part of this review, Congress should examine 
whether federal oversight and, potentially, regulation of the 
overseas activities of domestically-licensed gambling 
enterprises is merited.
    Macau operates differently than many, if not most, other 
jurisdictions. In Las Vegas, for example, there are entities 
which essentially operate as tour operators, seeking to attract 
gamblers to the 
casinos. For their efforts, they receive compensation from the c
asinos.
    In Macau, the structure is different. Junket operators, 
also known as VIP room operators, receive licenses from Macau 
authorities and may act independently from the casinos. These 
operators may further subcontract operations. But, their 
operations occur within the casino property. A significant 
portion of the U.S.-based casinos revenue--over two-thirds, 
according to one casino--occurs in these VIP or junket rooms.
    Two U.S.-based gaming companies contacted the Commission to 
share their views on the matters and issues raised during the 
June 27 Commission hearing and the subsequent debate that took 
place during the Commission's report drafting sessions. These 
enterprises noted that they recognize the challenges of 
operating in Macau. They insisted that they have taken 
extraordinary measures to limit or eliminate the potential for 
illegal activities to occur, including money laundering, on 
their licensed property or within the junket and VIP room 
operations.
    According to the written testimony of the Chairman of 
Nevada's State Gaming Control Board, A.G. Burnett, U.S.-
licensed casino operators may operate differently than their 
competitors also operating in Macau. That, in our opinion, does 
not eliminate the prospect for activities counter to U.S. 
interests to take place on their properties or to be 
facilitated by the VIP room/junket operators.
    As the section noted, the ``Commission did not seek nor did 
it find evidence of wrongdoing by any U.S.-based casino 
company, either in Macau or Las Vegas.'' We support that 
statement. Nevertheless, we believe that further scrutiny is 
appropriate.
    As Chairman Burnett stated in his written testimony,

        ``it is common knowledge, the operation of VIP Rooms in 
        Macau casinos had long been dominated by Asian 
        Organized Crime (AOC), commonly referred to as 
        ``triads.'' With the evolution of gaming in Macau, the 
        same AOC figures are allegedly still working the VIP 
        Operations; only now they do it behind a facade of 
        ``legitimate'' public corporations, complex corporate 
        structures, financial guarantees, and third-party 
        assignments. Public media and intelligence sources have 
        affiliated all but one of the seven VIP Room Operator 
        groups of interest with reputed AOC figures. Many of 
        these associations are linked through documented public 
        records. As such, since March 2010, the industry has 
        been facing an increasing deluge of media scrutiny 
        concerning the Nevada gaming companies' ties to 
        organized crime in Macau.''

    Chinese triads--the term applied to its organized crime 
gangs--are known to be involved in global activities. Indeed, a 
2003 publication of the Congressional Research Service, 
Transnational Activities of Chinese Crime Organizations, noted 
the participation of these groups ``in all major types of 
crime, including trafficking of human beings and various 
commodities, financial crimes, extortion, gambling, 
prostitution, and violent crimes.''
    The question for Congress, and federal authorities, is 
whether U.S. gaming enterprises are being used as venues--
knowingly or not--that advance the illegal activities of the 
Chinese triads. The steps these U.S.-based casinos have taken, 
which they indicate are constantly being upgraded and enhanced, 
may very well be sufficient. But the stakes are high enough to 
warrant further investigation.
    With bets worth billions of dollars from unknown origins 
flowing through the gambling rooms in these U.S.-licensed 
casinos operating in Macau, America cannot afford to turn a 
blind eye to the real possibility that this massive flow of 
funds is being used to mask money laundering. Further scrutiny 
is appropriate. That inquiry exceeds the expertise of the 
Commission and requires further investigation.

 
                          ADDITIONAL VIEWS OF


 
                       COMMISSIONER LARRY WORTZEL

    Captain Louis Renault, Claude Rains' character in the film 
Casablanca, is known for a number of great lines, including 
``I'm shocked . . . shocked to find that gambling is going on 
in there.'' And some of us on the U.S.-China Economic and 
Security Review Commission seem to be shocked that organized 
crime syndicates or money laundering may be associated with 
gambling in Macau. However, I do not see the issue of gambling 
in Macau and the potential legal risks to a few Nevada-based 
casino companies as a threat to the national security or 
economy of the United States. The section on Macau never should 
have found its way into the Commission's annual report.
    In attempting to craft a section for the annual report, we 
had to deal with an initial draft that, in my view, was filled 
with bias and innuendo. To address these problems, at the final 
stages of preparing the report, two groups of attorneys 
associated with casino companies descended on the Commission's 
offices seeking to ensure that the report included some 
statement of how these companies address supervision of the 
gaming industry in Macau.
    The flawed process aside, the transactions and activities 
in Nevada casino companies' operations and investments in Macau 
may present legal problems for the casinos, Nevada and the 
Office of the United States Attorney; but this particular 
excursion into how events in greater China may affect U.S. 
security and the economy went far outside the Commission's 
legislative mandate.
    That said the examination of Macau and gambling amounts to 
only about five percent to six percent of the total information 
in this year's annual report to Congress. It is a good report 
and contains a lot of valuable recommendations to Congress. For 
this reason, rather than dissent on the entire report, I have 
signed it but presented my additional views.

 
                               APPENDIX I


 
                    UNITED STATES-CHINA ECONOMIC AND


 
                   SECURITY REVIEW COMMISSION CHARTER

22 U.S.C. 7002 (2001)
    The Commission was created on October 30, 2000, by the 
Floyd D. Spence National Defense Authorization Act for 2001 
Sec. 1238, Pub. L. No. 106-398, 114 STAT. 1654A-334 (2000) 
(codified at 22 U.S.C. Sec. 7002 (2001), as amended by the 
Treasury and General Government Appropriations Act for 2002 
Sec. 645 (regarding employment status of staff) & Sec. 648 
(regarding changing annual report due date from March to June), 
Pub. L. No. 107-67, 115 STAT. 514 (November 12, 2001); as 
amended by Division P of the ``Consolidated Appropriations 
Resolution, 2003,'' Pub. L. No. 108-7 (February 20, 2003) 
(regarding Commission name change, terms of Commissioners, and 
responsibilities of Commission); as amended by Pub. L. No. 109-
108 (enacted November 22, 2005) (regarding responsibilities of 
Commission and applicability of FACA); as amended by Pub. L. 
No. 110-161 (enacted December 26, 2007) (regarding changing 
annual report due date from June to December; reporting 
unobligated balances and submission of quarterly financial 
reports; deemed Commission a committee of 
Congress for printing and bind- ing costs; 
amended employee compensation levels, and performance- based 
reviews and awards subject to Title 5 USC; and directed that 
travel by members of the Commission and its staff shall be 
arranged and conducted under the rules and procedures applying 
to travel by members of the House of Representatives and its 
staff). 
Sec. 7002.  United States-China Economic and Security Review Commission
    (a) Purposes. The purposes of this section are as follows:
    (1) To establish the United States-China Economic and 
Security Review Commission to review the national security 
implications of trade and economic ties between the United 
States and the People's Republic of China.
    (2) To facilitate the assumption by the United States-China 
Economic and Security Review Commission of its duties regarding 
the review referred to in paragraph (1) by providing for the 
transfer to that Commission of staff, materials, and 
infrastructure (including leased premises) of the Trade Deficit 
Review Commission that are appropriate for the review upon the 
submittal of the final report of the Trade Deficit Review 
Commission.

    (b) Establishment of United States-China Economic and 
Security Review Commission.
    (1) In general. There is hereby established a commission to 
be known as the United States-China Economic and Security 
Review Commission (in this section referred to as the 
``Commission'').
    (2) Purpose. The purpose of the Commission is to monitor, 
investigate, and report to Congress on the national security 
implications of the bilateral trade and economic relationship 
between the United States and the People's Republic of China.
    (3) Membership. The United States-China Economic and 
Security Review Commission shall be composed of 12 members, who 
shall be appointed in the same manner provided for the 
appointment of members of the Trade Deficit Review Commission 
under section 127(c)(3) of the Trade Deficit Review Commission 
Act (19 U.S.C. 2213 note), except that--
    (A) Appointment of members by the Speaker of the House of 
Representatives shall be made after consultation with the 
chairman of the Committee on Armed Services of the House of 
Representatives, in addition to consultation with the chairman 
of the Committee on Ways and Means of the House of 
Representatives provided for under clause (iii) of subparagraph 
(A) of that section;
    (B) Appointment of members by the President pro tempore of 
the Senate upon the recommendation of the majority leader of 
the Senate shall be made after consultation with the chairman 
of the Committee on Armed Services of the Senate, in addition 
to consultation with the chairman of the Committee on Finance 
of the Senate provided for under clause (i) of that 
subparagraph;
    (C) Appointment of members by the President pro tempore of 
the Senate upon the recommendation of the minority leader of 
the Senate shall be made after consultation with the ranking 
minority member of the Committee on Armed Services of the 
Senate, in addition to consultation with the ranking minority 
member of the Committee on Finance of the Senate provided for 
under clause (ii) of that subparagraph;
    (D) Appointment of members by the minority leader of the 
House of Representatives shall be made after consultation with 
the ranking minority member of the Committee on Armed Services 
of the House of Representatives, in addition to consultation 
with the ranking minority member of the Committee on Ways and 
Means of the House of Representatives provided for under clause 
(iv) of that subparagraph;
    (E) Persons appointed to the Commission shall have 
expertise in national security matters and United States-China 
relations, in addition to the expertise provided for under 
subparagraph (B)(i)(I) of that section;
    (F) Each appointing authority referred to under 
subparagraphs (A) through (D) of this paragraph shall--
    (i) appoint 3 members to the Commission;
    (ii) make the appointments on a staggered term basis, such 
that--
    (I) 1 appointment shall be for a term expiring on December 
31, 2003;
    (II) 1 appointment shall be for a term expiring on December 
31, 2004; and
    (III) 1 appointment shall be for a term expiring on 
December 31, 2005;
    (iii) make all subsequent appointments on an approximate 2-
year term basis to expire on December 31 of the applicable 
year; and
    (iv) make appointments not later than 30 days after the 
date on which each new Congress convenes.
    (G) Members of the Commission may be reappointed for 
additional terms of service as members of the Commission; and
    (H) Members of the Trade Deficit Review Commission as of 
the date of the enactment of this Act [enacted Oct. 30, 2000] 
shall serve as members of the United States-China Economic and 
Security Review Commission until such time as members are first 
appointed to the United States-China Economic and Security 
Review Commission under this paragraph.
    (4) Retention of support. The United States-China Economic 
and Security Review Commission shall retain and make use of 
such staff, materials, and infrastructure (including leased 
premises) of the Trade Deficit Review Commission as the United 
States-China Economic and Security Review Commission 
determines, in the judgment of the members of the United 
States-China Economic and Security Review Commission, are 
required to facilitate the ready commencement of activities of 
the United States-China Economic and Security Review Commission 
under subsection (c) or to carry out such activities after the 
commencement of such activities.
    (5) Chairman and vice chairman. The members of the 
Commission shall select a Chairman and Vice Chairman of the 
Commission from among the members of the Commission.
    (6) Meetings.
    (A) Meetings. The Commission shall meet at the call of the 
Chairman of the Commission.
    (B) Quorum. A majority of the members of the Commission 
shall constitute a quorum for the transaction of business of 
the Commission.
    (7) Voting. Each member of the Commission shall be entitled 
to one vote, which shall be equal to the vote of every other 
member of the Commission.

    (c) Duties.
    (1) Annual report. Not later than June 1 each year 
[beginning in 2002], the Commission shall submit to Congress a 
report, in both unclassified and classified form, regarding the 
national security implications and impact of the bilateral 
trade and economic relationship between the United States and 
the People's Republic of China. The report shall include a full 
analysis, along with conclusions and recommendations for 
legislative and administrative actions, if any, of the national 
security implications for the United States of the trade and 
current balances with the People's Republic of China in goods 
and services, financial transactions, and technology transfers. 
The Commission shall also take into account patterns of trade 
and transfers through third countries to the extent 
practicable.
    (2) Contents of report. Each report under paragraph (1) 
shall include, at a minimum, a full discussion of the 
following:
    (A) The portion of trade in goods and services with the 
United States that the People's Republic of China dedicates to 
military systems or systems of a dual nature that could be used 
for military purposes.
    (B) The acquisition by the People's Republic of China of 
advanced military or dual-use technologies from the United 
States by trade (including procurement) and other technology 
transfers, especially those transfers, if any, that contribute 
to the proliferation of weapons of mass destruction or their 
delivery systems, or that undermine international agreements or 
United States laws with respect to nonproliferation.
    (C) Any transfers, other than those identified under 
subparagraph (B), to the military systems of the People's 
Republic of China made by United States firms and United 
States-based multinational corporations.
    (D) An analysis of the statements and writing of the 
People's Republic of China officials and officially-sanctioned 
writings that bear on the intentions, if any, of the Government 
of the People's Republic of China regarding the pursuit of 
military competition with, and leverage over, or cooperation 
with, the United States and the Asian allies of the United 
States.
    (E) The military actions taken by the Government of the 
People's Republic of China during the preceding year that bear 
on the national security of the United States and the regional 
stability of the Asian allies of the United States.
    (F) The effects, if any, on the national security interests 
of the United States of the use by the People's Republic of 
China of financial transactions and capital flow and currency 
manipulations.
    (G) Any action taken by the Government of the People's 
Republic of China in the context of the World Trade 
Organization that is adverse or favorable to the United States 
national security interests.
    (H) Patterns of trade and investment between the People's 
Republic of China and its major trading partners, other than 
the United States, that appear to be substantively different 
from trade and investment patterns with the United States and 
whether the differences have any national security implications 
for the United States.
    (I) The extent to which the trade surplus of the People's 
Republic of China with the United States enhances the military 
budget of the People's Republic of China.
    (J) An overall assessment of the state of the security 
challenges presented by the People's Republic of China to the 
United States and whether the security challenges are 
increasing or decreasing from previous years.
    (3) Recommendations of report. Each report under paragraph 
(1) shall also include recommendations for action by Congress 
or the President, or both, including specific recommendations 
for the United States to invoke Article XXI (relating to 
security exceptions) of the General Agreement on Tariffs and 
Trade 1994 with respect to the People's Republic of China, as a 
result of any adverse impact on the national security interests 
of the United States.

    (d) Hearings.
    (1) In general. The Commission or, at its direction, any 
panel or member of the Commission, may for the purpose of 
carrying out the provisions of this section, hold hearings, sit 
and act at times and places, take testimony, receive evidence, 
and administer oaths to the extent that the Commission or any 
panel or member considers advisable.
    (2) Information. The Commission may secure directly from 
the Department of Defense, the Central Intelligence Agency, and 
any other Federal department or agency information that the 
Commission considers necessary to enable the Commission to 
carry out its duties under this section, except the provision 
of intelligence information to the Commission shall be made 
with due regard for the protection from unauthorized disclosure 
of classified information relating to sensitive intelligence 
sources and methods or other exceptionally sensitive matters, 
under procedures approved by the Director of Central 
Intelligence.
    (3) Security. The Office of Senate Security shall--
    (A) provide classified storage and meeting and hearing 
spaces, when necessary, for the Commission; and
    (B) assist members and staff of the Commission in obtaining 
security clearances.
    (4) Security clearances. All members of the Commission and 
appropriate staff shall be sworn and hold appropriate security 
clearances.

    (e) Commission personnel matters.
    (1) Compensation of members. Members of the United States-
China Economic and Security Review Commission shall be 
compensated in the same manner provided for the compensation of 
members of the Trade Deficit Review Commission under section 
127(g)(1) and section 127(g)(6) of the Trade Deficit Review 
Commission Act [19 U.S.C. 2213 note].
    (2) Travel expenses. Travel expenses of the United States-
China Economic and Security Review Commission shall be allowed 
in the same manner provided for the allowance of the travel 
expenses of the Trade Deficit Review Commission under section 
127(g)(2) of the Trade Deficit Review Commission Act [19 U.S.C 
Sec. 2213 note].
    (3) Staff. An executive director and other additional 
personnel for the United States-China Economic and Security 
Review Commission shall be appointed, compensated, and 
terminated in the same manner provided for the appointment, 
compensation, and termination of the executive director and 
other personnel of the Trade Deficit Review Commission under 
section 127(g)(3) and section 127(g)(6) of the Trade Deficit 
Review Commission Act [19 U.S.C. Sec. 2213 note]. The executive 
director and any personnel who are employees of the United 
States-China Economic and Security Review Commission shall be 
employees under section 2105 of title 5, United States Code, 
for purposes of chapters 63, 81, 83, 84, 85, 87, 89, and 90 of 
that title [language of 2001 amendment, Sec. 645].
    (4) Detail of government employees. Federal Government 
employees may be detailed to the United States-China Economic 
and Security Review Commission in the same manner provided for 
the detail of Federal Government employees to the Trade Deficit 
Review Commission under section 127(g)(4) of the Trade Deficit 
Review Commission Act [19 U.S.C. Sec. 2213 note].
    (5) Foreign travel for official purposes. Foreign travel 
for official purposes by members and staff of the Commission 
may be authorized by either the Chairman or the Vice Chairman 
of the Commission.
    (6) Procurement of temporary and intermittent services. The 
Chairman of the United States-China Economic and Security 
Review Commission may procure temporary and intermittent 
services for the United States-China Economic and Security 
Review Commission in the same manner provided for the 
procurement of temporary and intermittent services for the 
Trade Deficit Review Commission under section 127(g)(5) of the 
Trade Deficit Review Commission Act [19 U.S.C. Sec. 2213 note].

    (f) Authorization of appropriations.
    (1) In general. There is authorized to be appropriated to 
the Commission for fiscal year 2001, and for each fiscal year 
thereafter, such sums as may be necessary to enable the 
Commission to carry out its functions under this section.
    (2) Availability. Amounts appropriated to the Commission 
shall remain available until expended.

    (g) Federal Advisory Committee Act. The provisions of the 
Federal Advisory Committee Act (5 U.S.C. App.) shall not apply 
to the Commission.

    (h) Effective date. This section shall take effect on the 
first day of the 107th Congress.
Amendments:
    SEC. 645. (a) Section 1238(e)(3) of the Floyd D. Spence 
National Defense Authorization Act for Fiscal Year 2001 (as 
enacted by Public Law 106-398) is amended by adding at the end 
the following: ``The executive director and any personnel who 
are employees of the United States-China Economic and Security 
Review Commission shall be employees under section 2105 of 
title 5, United States Code, for purposes of chapters 63, 81, 
83, 84, 85, 87, 89, and 90 of that title.'' (b) The amendment 
made by this section shall take effect on January 3, 2001.''
    SEC. 648. DEADLINE FOR SUBMISSION OF ANNUAL REPORTS BY 
UNITED STATES-CHINA ECONOMIC AND SECURITY REVIEW COMMISSION. 
Section 1238(c)(1) of the Floyd D. Spence National Defense 
Authorization Act for Fiscal Year 2001 (as enacted into law by 
section I of Public Law 106-398) is amended by striking 
``March'' and inserting ``June''.
    Changes: Enacted into law by Division P of the 
``Consolidated Appropriations Resolution, 2003'' Pub. L. No. 
108-7 dated Febru- 
ary 20, 2003:
    H. J. Res. 2--
    DIVISION P--UNITED STATES-CHINA ECONOMIC AND SECURITY 
REVIEW COMMISSION
    SECTION 1. SHORT TITLE.--This division may be cited as the 
``United States-China Economic and Security Review 
Commission''.
    SEC. 2. (a) APPROPRIATIONS.--There are appropriated, out of 
any funds in the Treasury not otherwise appropriated, 
$1,800,000, to remain available until expended, to the United 
States-China Economic and Security Review Commission.
    (b) NAME CHANGE.--
    (1) IN GENERAL.--Section 1238 of the Floyd D. Spence 
National Defense Authorization Act of 2001 (22 U.S.C. 7002) is 
amended--as follows:

In each Section and Subsection where it appears, the name is 
changed to the ``U.S.-CHINA ECONOMIC AND SECURITY REVIEW 
COMMISSION''--
    (2) REFERENCES.--Any reference in any Federal law, 
Executive Order, rule, regulation, or delegation of authority, 
or any document of or relating to the United States-China 
Security Review Commission shall be deemed to refer to the 
United States-China Economic and Security Review Commission.
    (c) MEMBERSHIP, RESPONSIBILITIES, AND TERMS.--
    (1) IN GENERAL.--Section 1238(b)(3) of the Floyd D. Spence 
National Defense Authorization Act of 2001 (22 U.S.C. 7002) is 
amended by striking subparagraph (F) and inserting the 
following:
    ``(F) each appointing authority referred to under 
subparagraphs (A) through (D) of this paragraph shall--
    ``(i) appoint 3 members to the Commission;
    ``(ii) make the appointments on a staggered term basis, 
such that--
    ``(I) 1 appointment shall be for a term expiring on 
December 31, 2003;
    ``(II) 1 appointment shall be for a term expiring on 
December 31, 2004; and
    ``(III) 1 appointment shall be for a term expiring on 
December 31, 2005;
    ``(iii) make all subsequent appointments on an approximate 
2-year term basis to expire on December 31 of the applicable 
year; and
    ``(iv) make appointments not later than 30 days after the 
date on which each new Congress convenes;''.
    SEC. 635. (a) Modification of Responsibilities.--
Notwithstanding any provision of section 1238 of the Floyd D. 
Spence National Defense Authorization Act for Fiscal Year 2001 
(22 U.S.C. 7002), or any other provision of law, the United 
States-China Economic and Security Review Commission 
established by subsection (b) of that section shall investigate 
and report exclusively on each of the following areas:
    (1) PROLIFERATION PRACTICES.--The role of the People's 
Republic of China in the proliferation of weapons of mass 
destruction and other weapons (including dual use 
technologies), including actions, the United States might take 
to encourage the People's Republic of China to cease such 
practices.
    (2) ECONOMIC TRANSFERS.--The qualitative and quantitative 
nature of the transfer of United States production activities 
to the People's Republic of China, including the relocation of 
high technology, manufacturing, and research and development 
facilities, the impact of such transfers on United States 
national security, the adequacy of United States export control 
laws, and the effect of such transfers on United States 
economic security and employment.
    (3) ENERGY.--The effect of the large and growing economy of 
the People's Republic of China on world energy supplies and the 
role the United States can play (including joint research and 
development efforts and technological assistance), in 
influencing the energy policy of the People's Republic of 
China.
    (4) UNITED STATES CAPITAL MARKETS.--The extent of access to 
and use of United States capital markets by the People's 
Republic of China, including whether or not existing disclosure 
and transparency rules are adequate to identify People's 
Republic of China companies engaged in harmful activities.
    (5) REGIONAL ECONOMIC AND SECURITY IMPACTS.--The triangular 
economic and security relationship among the United States, 
Taipei and the People's Republic of China (including the 
military modernization and force deployments of the People's 
Republic of China aimed at Taipei), the national budget of the 
People's Republic of China, and the fiscal strength of the 
People's Republic of China in relation to internal instability 
in the People's Republic of China and the likelihood of the 
externalization of problems arising from such internal 
instability.
    (6) UNITED STATES-CHINA BILATERAL PROGRAMS.--Science and 
technology programs, the degree of non-compliance by the 
People's Republic of China with agreements between the United 
States and the People's Republic of China on prison labor 
imports and intellectual property rights, and United States 
enforcement policies with respect to such agreements.
    (7) WORLD TRADE ORGANIZATION COMPLIANCE.--The compliance of 
the People's Republic of China with its accession agreement to 
the World Trade Organization (WTO).
    (8) FREEDOM OF EXPRESSION.--The implications of 
restrictions on speech and access to information in the 
People's Republic of China for its relations with the United 
States in the areas of economic and security policy.
    (b) Applicability of Federal Advisory Committee Act.--
Subsection (g) of section 1238 of the Floyd D. Spence National 
Defense Authorization Act for Fiscal Year 2001 is amended to 
read as follows:
    (g) Applicability of FACA.--The provisions of the Federal 
Advisory Committee Act (5 U.S.C. App.) shall apply to the 
activities of the Commission.
    The effective date of these amendments shall take effect on 
the date of enactment of this Act [November 22, 2005].

Changes: Enacted into law by the Consolidated Appropriations 
Act, 2008, Pub. L. No. 110-161 dated December 26, 2007:
    H.R. 2764--
    For necessary expenses of the United States-China Economic 
and Security Review Commission, $4,000,000, including not more 
than $4,000 for the purpose of official representation, to 
remain available until September 30, 2009: Provided, That the 
Commission shall submit a spending plan to the Committees on 
Appropriations no later than March 1, 2008, which effectively 
addresses the recommendations of the Government Accountability 
Office's audit of the Commission (GAO-07-1128): Provided 
further, That the Commission shall provide to the Committees on 
Appropriations a quarterly accounting of the cumulative 
balances of any unobligated funds that were received by the 
Commission during any previous fiscal year: Provided further, 
That for purposes of costs relating to printing and binding, 
the Commission shall be deemed, effective on the date of its 
establishment, to be a committee of Congress: Provided further, 
That compensation for the executive director of the Commission 
may not exceed the rate payable for level II of the Executive 
Schedule under section 5314 of title 5, United States Code: 
Provided further, That section 1238(c)(1) of the Floyd D. 
Spence National Defense Authorization Act for Fiscal Year 2001, 
is amended by striking ``June'' and inserting ``December'': 
Provided further, That travel by members of the Commission and 
its staff shall be arranged and conducted under the rules and 
procedures applying to travel by members of the House of 
Representatives and its staff.

COMMISSION FINANCIAL MANAGEMENT
    SEC. 118. (a) REQUIREMENT FOR PERFORMANCE REVIEWS.--The 
United States-China Economic and Security Review Commission 
shall comply with chapter 43 of title 5, United States Code, 
regarding the establishment and regular review of employee 
performance appraisals.
    (b) LIMITATION ON CASH AWARDS.--The United States-China 
Economic and Security Review Commission shall comply with 
section 4505a of title 5, United States Code, with respect to 
limitations on payment of performance-based cash awards.

 
                              APPENDIX II


 
                      BACKGROUND OF COMMISSIONERS

The Honorable William A. Reinsch, Chairman

    Chairman William Reinsch was reappointed to the Commission 
by Senate Majority Leader Harry Reid for a seventh two-year 
term expiring December 31, 2013. He was elected as Chairman of 
the Commission for the 2013 Report cycle effective January 1, 
2013, and previously served as Chairman of the Commission for 
the 2011 Report cycle. Chairman Reinsch served as Under 
Secretary for Export Administration in the U.S. Department of 
Commerce. As head of the Bureau of Export Administration, later 
named the Bureau of Industry and Security, Chairman Reinsch was 
charged with administering and enforcing the export control 
policies of the U.S. government, including its antiboycott 
laws. Major accomplishments during his tenure included 
refocusing controls regarding economic globalization, most 
notably on high-performance computers, microprocessors, and 
encryption, completing the first revisions of the Export 
Administration regulations in over 40 years. In addition, he 
revised the interagency process for reviewing applications and 
permitted electronic filing of applications over the Internet.
    During this time, Chairman Reinsch delivered more than 200 
speeches and testified 53 times before various committees of 
the Congress. Before joining the Department of Commerce, 
Chairman Reinsch was a senior legislative assistant to Senator 
John Rockefeller and was responsible for the senator's work on 
trade, international economic policy, foreign affairs, and 
defense. He also provided staff support for Senator 
Rockefeller's related efforts on the Finance Committee and the 
Commerce, Science, and Transportation Committee.
    For over a decade, Chairman Reinsch served on the staff of 
Senator John Heinz as chief legislative assistant, focusing on 
foreign trade and competitiveness policy issues. During that 
period, Senator Heinz was either the chairman or the ranking 
member of the Senate Banking Committee's Subcommittee on 
International Finance. Senator Heinz was also a member of the 
International Trade Subcommittee of the Finance Committee. 
Chairman Reinsch provided support for the senator on both 
subcommittees. This work included five revisions of the Export 
Administration Act and work on four major trade bills. Prior to 
joining Senator Heinz's staff, Chairman Reinsch was a 
legislative assistant to Representatives Richard Ottinger and 
Gilbert Gude, acting staff director of the House Environmental 
Study Conference, and a teacher in Maryland.
    Today Chairman Reinsch is president of the National Foreign 
Trade Council. Founded in 1914, the council is the only 
business organization dedicated solely to trade policy, export 
finance, international tax, and human resources issues. The 
organization represents over 200 companies through its offices 
in New York City and Washington.
    In addition to his legislative and private sector work, 
Chairman Reinsch served as an adjunct associate professor at 
the University of Maryland's University College Graduate School 
of Management and Technology, teaching a course in 
international trade and trade policy. He is also a member of 
the boards of the Executive Council on Diplomacy and the Center 
for International Private Enterprise (CIPE). Chairman Reinsch's 
publications include ``Why China Matters to the Health of the 
U.S. Economy,'' published in Economics and National Security; 
``The Role and Effectiveness of U.S. Export Control Policy in 
the Age of Globalization'' and ``Export Controls in the Age of 
Globalization,'' both published in The Monitor. In addition, 
Chairman Reinsch has published ``Should Uncle Sam Control U.S. 
Technology Exports,'' published in Insight magazine; 
``Encryption Policy Strikes a Balance,'' published in the 
Journal of Commerce, and ``Building a New Economic Relationship 
with Japan,'' published with others in Beyond the Beltway: 
Engaging the Public in U.S. Foreign Policy.

The Honorable Dennis C. Shea, Vice Chairman

    Vice Chairman Dennis Shea was reappointed by Senate 
Republican Leader Mitch McConnell for a third two-year term 
expiring December 31, 2014. An attorney with 25 years of 
experience in government and public policy, he is the founder 
of Shea Public Strategies LLC, a public affairs firm based in 
Alexandria, Virginia. Before starting the firm, he served as 
Vice President for Government Affairs--Americas for Pitney 
Bowes Inc., a Fortune 500 company.
    Vice Chairman Shea's government service began in 1988, when 
he joined the Office of Senate Republican Leader Bob Dole as 
counsel, subsequently becoming the Senator's deputy chief of 
staff in the Office of the Senate Majority Leader. In these 
capacities, he advised Senator Dole and other Republican 
senators on a broad range of domestic policy issues, was 
involved in the drafting of numerous pieces of legislation, and 
was recognized as one of the most influential staffers on 
Capitol Hill. In 1992, Vice Chairman Shea's service with 
Senator Dole was interrupted when he ran for Congress in the 
Seventh District of New York. During the 1996 elections, Vice 
Chairman Shea continued to help shape the national public 
policy debate as the director of policy for the Dole for 
President Campaign. Following the elections, he entered the 
private sector, providing legislative and public affairs 
counsel to a wide range of clients while employed at BKSH & 
Associates and Verner, Liipfert, Bernhard, McPherson, and Hand.
    In 2003, Vice Chairman Shea was named the Executive 
Director of the President's Commission on the United States 
Postal Service. Many of the Commission's recommendations were 
subsequently adopted in the landmark 2006 postal reform 
legislation.
    In 2004, Vice Chairman Shea was confirmed as Assistant 
Secretary for Policy Development and Research at the U.S. 
Department of Housing and Urban Development. As Assistant 
Secretary, Vice Chairman Shea led a team responsible for 
conducting much of the critical analysis necessary to support 
the Department's mission. In 2005, Vice Chairman Shea left to 
serve as Senior Advisor to Senator Elizabeth Dole in her 
capacity as chairman of the National Republican Senatorial 
Committee.
    Vice Chairman Shea received a J.D., an M.A. in History, and 
a B.A. in Government, from Harvard University. He is admitted 
to the bar in New York and the District of Columbia. The Vice 
Chairman currently resides in Alexandria, Virginia, with his 
wife Elizabeth and daughter Juliette.

Carolyn Bartholomew

    Carolyn Bartholomew was reappointed to the Commission by 
House Democratic Leader Nancy Pelosi for a sixth two-year term 
expiring on December 31, 2013. She previously served as the 
Commission's Chairman for the 2007 and 2009 Report cycles and 
served as Vice Chairman for the 2010, 2008, and 2006 Report 
cycles.
    Commissioner Bartholomew has worked at senior levels in the 
U.S. Congress, serving as counsel, legislative director, and 
chief of staff to now House Democratic Leader Nancy Pelosi. She 
was a professional staff member on the House Permanent Select 
Committee on Intelligence and also served as a legislative 
assistant to then U.S. Representative Bill Richardson.
    In these positions, Commissioner Bartholomew was integrally 
involved in developing U.S. policies on international affairs 
and security matters. She has particular expertise in U.S.-
China relations, including issues related to trade, human 
rights, and the proliferation of weapons of mass destruction. 
Ms. Bartholomew led efforts in the establishment and funding of 
global AIDS programs and the promotion of human rights and 
democratization in countries around the world. She was a member 
of the first Presidential Delegation to Africa to Investigate 
the Impact of HIV/AIDS on Children and a member of the Council 
on Foreign Relations' Congressional Staff Roundtable on Asian 
Political and Security Issues.
    In addition to U.S.-China relations, her areas of expertise 
include terrorism, trade, proliferation of weapons of mass 
destruction, human rights, U.S. foreign assistance programs, 
and international environmental issues. She is the Vice 
President for Development and Corporate Initiatives for the 
BlueGreen Alliance and also serves on the board of directors of 
the Kaiser Aluminum Corporation and the nonprofit organization 
Asia Catalyst. Commissioner Bartholomew received a Bachelor of 
Arts degree from the University of Minnesota, a Master of Arts 
in Anthropology from Duke University, and a Juris Doctorate 
from Georgetown University Law Center. She is a member of the 
State Bar of California.

Peter T.R. Brookes

    Commissioner Brookes was reappointed to the Commission by 
House Republican Leader John Boehner for a two-year term 
expiring December 31, 2013. Commissioner Brookes served in the 
George W. Bush Administration as the Deputy Assistant Secretary 
of Defense for Asian and Pacific Affairs. Prior to joining the 
Bush Administration, Commissioner Brookes was a Professional 
Staff Member with the Committee on International Relations in 
the U.S. House of Representatives. Before his service in the 
Congress, Commissioner Brookes worked in the Central 
Intelligence Agency, for the State Department at the United 
Nations, and in the private sector.
    Now, Commissioner Brookes is a Senior Fellow at The 
Heritage Foundation and works to develop and communicate the 
Foundation's stance on foreign policy and national security 
affairs through media appearances, research, published 
articles, congressional testimony, and speaking engagements.
    Commissioner Brookes is a decorated military veteran, 
having served on active duty with the U.S. Navy in Latin 
America, Asia, and the Middle East. He is a doctoral candidate 
at Georgetown University and graduate of the U.S. Naval 
Academy, the Defense Language Institute, the Naval War College, 
and The Johns Hopkins University.

Robin Cleveland

    Commissioner Cleveland was reappointed by Senate Republican 
Leader Mitch McConnell for a third two-year term expiring 
December 31, 2014. After three decades of government service, 
Commissioner Cleveland is now serving as the Executive Director 
of the Office of Student Life at the Graduate School of 
Education and Human Development at The George Washington 
University. Having received her Masters degree in school 
counseling, Ms. Cleveland also is pursuing her doctorate as a 
counselor educator. Previously, Commissioner Cleveland worked 
for U.S. Senator Mitch McConnell in a number of positions in 
his personal office, on the Senate Select Committee on 
Intelligence, the Foreign Relations Committee, and the Senate 
Appropriations Committee. In addition, Commissioner Cleveland 
served as the Counselor to the President of the World Bank, and 
as the Associate Director of the Office of Management and 
Budget in the Executive Office of the President. During her 
tenure serving President Bush, Commissioner Cleveland co-led 
the interagency effort to develop and operationalize two 
Presidential initiatives: the Millennium Challenge Corporation 
and the President's Emergency Plan for AIDS Relief. These 
efforts reflect her commitment to link policy, performance, and 
resource management.
    Commissioner Cleveland graduated from Wesleyan University 
with honors and received her M.A. in Education and Human 
Development from The George Washington University.

Jeffrey L. Fiedler

    Commissioner Fiedler was reappointed to the Commission by 
House Democratic Leader Nancy Pelosi on December 23, 2011, for 
a fourth two-year term expiring December 31, 2013. He is 
assistant to the general president, and director, Special 
Projects and Initiatives, for the International Union of 
Operating Engineers. Previously, he was President of Research 
Associates of America (RAA) and the elected president of the 
Food and Allied Service Trades Department, AFL-CIO (``FAST''). 
This constitutional department of the AFL-CIO represented ten 
unions with a membership of 3.5 million in the United States 
and Canada. The focus of RAA, like FAST before it, was 
organizing and bargaining research for workers and their 
unions.
    He served as a member of the AFL-CIO Executive Council 
committees on International Affairs, Immigration, Organizing, 
and Strategic Approaches. He also served on the board of 
directors of the Consumer Federation of America and is a member 
of the Council on Foreign Relations. In 1992, Mr. Fiedler co-
founded the Laogai Research Foundation (LRF), an organization 
devoted to studying the forced labor camp system in China. When 
the foundation's executive director, Harry Wu, was detained in 
China in 1995, Mr. Fiedler coordinated the campaign to win his 
release. He no longer serves as director of the LRF.
    Mr. Fiedler has testified on behalf of the AFL-CIO before 
the Senate Foreign Relations Committee and the House 
International Affairs Committee and its various subcommittees, 
as well as the Trade Subcommittee of the House Ways and Means 
Committee concerning China policy. He attended three of the 
American Assembly conferences on China sponsored by Columbia 
University and has participated in a Council on Foreign 
Relations task force and study group on China. He has been 
interviewed on CBS, NBC, ABC, CNN, and CNBC on China policy, 
international trade issues, human rights, and child labor.
    A Vietnam veteran, he served with the U.S. Army in Hue in 
1967-68. He received his B.A. in Political Science from 
Southern Illinois University. He is married with two adult 
children and resides in Virginia.

Carte P. Goodwin

    Senator Carte P. Goodwin was appointed to the Commission by 
Senate Majority Leader Harry Reid for a two-year term expiring 
on December 31, 2013. He is an attorney with the Charleston, 
West Virginia, law firm of Goodwin & Goodwin, LLP. His practice 
includes commercial litigation, appellate advocacy, and 
intellectual property.
    In July 2010, West Virginia Governor Joe Manchin III 
appointed Senator Goodwin to the United States Senate to fill 
the vacancy caused by the passing of Senator Robert C. Byrd, 
where he served until a special election was held to fill the 
remainder of Senator Byrd's unexpired term.
    From 2005 to 2009, Senator Goodwin served four years as 
General Counsel to Governor Manchin, during which time he also 
chaired the Governor's Advisory Committee on Judicial 
Nominations. In addition, Senator Goodwin chaired the West 
Virginia School Building Authority and served as a member of 
the State Consolidated Public Retirement Board. Following his 
return to private practice in 2009, Senator Goodwin was 
appointed to chair the Independent Commission on Judicial 
Reform, along with former Supreme Court Justice Sandra Day 
O'Connor, which was tasked with evaluating the need for broad 
systemic reform to West Virginia's judicial system.
    Senator Goodwin also previously worked as a law clerk for 
the Honorable Robert B. King of the United States Court of 
Appeals for the Fourth Circuit. A native of Mt. Alto, West 
Virginia, Senator Goodwin received his Bachelor of Arts degree 
in Philosophy from Marietta College in Marietta, Ohio, in 1996 
and received his Doctor of Law degree from the Emory University 
School of Law, graduating Order of the Coif in 1999.
    Senator Goodwin currently resides in Charleston, West 
Virginia, with his wife, Rochelle; son, Wesley Patrick; and 
daughter, Anna Vail.

Daniel M. Slane

    Daniel Slane was reappointed to the Commission by Speaker 
of the House John Boehner for a third two-year term expiring on 
December 31, 2013. Commissioner Slane served as the 
Commission's Chairman for the 2010 Report cycle and as Vice 
Chairman for the 2011 Report cycle.
    Commissioner Slane served for two years on active duty as a 
U.S. Army Captain in Military Intelligence; in addition, he 
served for a number of years as a Case Officer with the U.S. 
Central Intelligence Agency. Commissioner Slane worked in the 
White House during the Ford Administration.
    In 1996, Commissioner Slane became a member of the board of 
trustees of The Ohio State University and was chairman from 
2005 to 2006. The Ohio State University is the nation's largest 
university, with an annual budget of over $4 billion. He is 
also the former chairman of University Hospital, a 1,000-bed 
regional hospital in Columbus, and the former chairman of the 
James Cancer Hospital, a National Cancer Institute 
Comprehensive Cancer Center. Commissioner Slane serves on the 
board of two financial institutions and a number of nonprofit 
organizations.
    Commissioner Slane is the founder and co-owner of the Slane 
Company, whose principal business includes real estate 
development, lumber, and furniture. He has extensive 
international business experience, including operating a 
business in China. Prior to becoming a member of the 
Commission, Commissioner Slane manufactured plywood and related 
wood products at factories in Harbin, Dalian, and Balu 
(Pizhou), China. In 2007, he sold his interest in that company.
    Commissioner Slane received a Bachelor of Science in 
Business Administration and a Juris Doctorate from The Ohio 
State University. He holds a master's degree in International 
Law from the Europa Institute at the University of Amsterdam in 
The Netherlands. Commissioner Slane is a member of the Ohio Bar 
and was formerly a partner in the law firm of Grieser, Schafer, 
Blumenstiel, and Slane.

The Honorable James M. Talent

    Senator Jim Talent was appointed by Senate Republican 
Leader Mitch McConnell for a one-year term expiring December 
31, 2013. Commissioner Talent is a national security leader who 
specializes in issues related to the Department of Defense. He 
has been active in Missouri and national public policy for over 
25 years.
    Senator Talent's public service began in 1984, when at the 
age of 28 he was elected to the Missouri House of 
Representatives where he served eight years, the last four as 
the Republican leader in the Missouri House.
    In 1992, he was elected to the first of four terms in the 
U.S. House of Representatives, where he represented Missouri's 
Second Congressional District. During his eight years in the 
U.S. House of Representatives, Senator Talent co-authored the 
historic welfare reform bill, championed national security 
issues on the House Armed Services Committee, and enacted 
legislation to help revitalize distressed neighborhoods, both 
urban and rural. He was the chairman of the House Small 
Business Committee from 1997-2001, where he worked on 
regulatory reform issues and on legislation to lower health 
care costs for small business people and their employees. Under 
Senator Talent's leadership, the Small Business Committee 
became one of the most prolific and bipartisan in the House of 
Representatives, passing numerous bills without a single 
dissenting vote.
    In 2002, Missourians elected Senator Talent to serve in the 
United States Senate, where he worked with Republicans and 
Democrats to enact critical legislation for Missouri. He served 
on the Senate Armed Services, Energy and Natural Resources, and 
Agriculture committees. Working with Oregon Democrat Ron Wyden, 
Senator Talent was successful in securing critical funding 
through construction bonding in the highway bill. He and 
Senator Dianne Feinstein (D-CA) succeeded in passing the most 
comprehensive anti-methamphetamine bill ever enacted into law. 
Senator Talent was a leader on energy issues and was 
instrumental in the passage of the renewable fuel standard.
    After leaving the Senate in 2007, Senator Talent joined The 
Heritage Foundation as a Distinguished Fellow specializing in 
military affairs and conservative solutions to poverty. In 
2008, he served as Vice Chairman of the Commission on 
Prevention of Weapons of Mass Destruction Proliferation and 
Terrorism. In 2010, he served on the independent panel that 
reviewed the Quadrennial Defense Review of the Department of 
Defense. He also has been a member of the executive panel 
advising the Chief of Naval Operations. Senator Talent was the 
first national figure outside Massachusetts to endorse Governor 
Mitt Romney for president in 2007 and was Governor Romney's 
senior policy advisor in both the 2008 and 2012 campaigns for 
president.
    Senator Talent is an attorney. He earned his B.A. from 
Washington University in St. Louis and his J.D. from the 
University of Chicago Law School.

The Honorable Katherine C. Tobin, Ph.D.

    Dr. Katherine Tobin was appointed to the U.S.-China 
Economic and Security Review Commission by Senate Majority 
Leader Harry Reid in December 2012 for a two-year term expiring 
December 31, 2014. Dr. Tobin has 15 years of experience as a 
business manager, market researcher, and consultant in 
corporate America at institutions including the Hewlett-Packard 
Corporation, IBM, and Catalyst. She also has worked for 15 
years as a university faculty member and administrator.
    In 2009, Dr. Tobin was appointed by President Obama as 
Deputy Assistant Secretary for Performance Improvement at the 
U.S. Department of Education. She focused on strengthening the 
Department's capacity to work more effectively with its 
political and educational partners at the national, state, and 
local levels.
    In 2006, Dr. Tobin was appointed by President George W. 
Bush and served three years as a member of the Board of 
Governors of the U.S. Postal Service. Dr. Tobin provided 
strategic vision to the executive team, helped direct and 
control expenditures, reviewed business practices, conducted 
long-range planning, and set policies on all postal matters. 
She also chaired the Board's Audit and Finance Committee at a 
critical time, when, due to Congress's 2006 legislation, the 
U.S. Postal Service needed to strengthen its organizational and 
financial controls to become compliant by 2010 with the 
Sarbanes-Oxley Act.
    During her years at Hewlett-Packard, Dr. Tobin worked in 
the Corporation's Computer Systems Division and the Systems 
Technology Division, which were responsible for developing 
minicomputer systems purchased around the world for business, 
medical, and scientific usage. Dr. Tobin worked closely with 
R&D and marketing teams early in the product development life 
cycle to ensure that customer needs were clearly understood and 
translated into engineering and market specifications.
    Working as a consultant with IBM's senior leaders, Dr. 
Tobin conducted research on the corporation's values across all 
its global operations, institutional brand awareness and 
preference, distribution channels management, and the creation 
of a new business plan for IBM's Global Financing business.
    Dr. Tobin earned a Ph.D. and Master of Arts degree from 
Stanford University. She earned a Master of Arts degree in 
Teaching from the University of Massachusetts and a Bachelor of 
Arts in English from Skidmore College.

Michael R. Wessel

    Commissioner Michael R. Wessel, an original member of the 
U.S.-China Economic and Security Review Commission, was 
reappointed by House Democratic Leader Nancy Pelosi for a 
seventh two-year term expiring on December 31, 2014.
    Commissioner Wessel served on the staff of former House 
Democratic Leader Richard Gephardt for more than two decades, 
leaving his position as general counsel in March 1998. In 
addition, Commissioner Wessel was Congressman Gephardt's chief 
policy advisor, strategist, and negotiator. He was responsible 
for the development, coordination, management, and 
implementation of the Democratic leader's overall policy and 
political objectives, with specific responsibility for 
international trade, finance, economics, labor, and taxation.
    During his more than 20 years on Capitol Hill, Commissioner 
Wessel served in a number of positions. As Congressman 
Gephardt's principal Ways and Means aide, he developed and 
implemented numerous tax and trade policy initiatives. He 
participated in the enactment of every major trade policy 
initiative from 1978 until his departure in 1998. In the late 
1980s, he was the executive director of the House Trade and 
Competitiveness Task Force, where he was responsible for the 
Democrats' trade and competitiveness agenda as well as overall 
coordination of the Omnibus Trade and Competitiveness Act of 
1988.
    Commissioner Wessel was intimately involved in the 
development of comprehensive tax reform legislation in the 
early 1980s and every major tax bill during his tenure. 
Beginning in 1989, he became the principal advisor to the 
Democratic leadership on economic policy matters and served as 
tax policy coordinator to the 1990 budget summit. In 1995, he 
developed the Ten Percent Tax Plan, a comprehensive tax reform 
initiative that would enable roughly four out of five taxpayers 
to pay no more than a 10 percent rate in federal income taxes, 
the principal Democratic tax reform alternative.
    In 1988, he served as national issues director for 
Congressman Gephardt's presidential campaign. During the 1992 
presidential campaign, he assisted the Clinton presidential 
campaign on a broad range of issues and served as a senior 
policy advisor to the Clinton Transition Office. In 2004, he 
was a senior policy advisor to the Gephardt for President 
Campaign and later co-chaired the Trade Policy Group for the 
Kerry presidential campaign. In 2008, he was publicly 
identified as a trade and economic policy advisor to the Obama 
presidential campaign.
    He has coauthored a number of articles with Congressman 
Gephardt and a book, An Even Better Place: America in the 21st 
Century. Commissioner Wessel served as a member of the U.S. 
Trade Deficit Review Commission in 1999-2000, a congressionally 
created commission charged with studying the nature, causes, 
and consequences of the U.S. merchandise trade and current 
account deficits.
    Today, Commissioner Wessel is President of The Wessel Group 
Incorporated, a public affairs consulting firm offering 
expertise in government, politics, and international affairs. 
He was formerly the Executive Vice President at the Downey 
McGrath Group, Incorporated. Commissioner Wessel is a member of 
the board of directors of Goodyear Tire and Rubber. 
Commissioner Wessel holds a Bachelor of Arts and a Juris 
Doctorate from The George Washington University. He is a member 
of the Bars of the District of Columbia and of Pennsylvania and 
is a member of the Council on Foreign Relations. He and his 
wife Andrea have four children.

Larry M. Wortzel, Ph.D.

    Larry Wortzel was reappointed by Speaker of the House John 
Boehner for a seventh two-year term expiring on December 31, 
2014. Dr. Wortzel has served on the Commission since November 
2001, was the Commission's Chairman for the 2006 and 2008 
Report cycles, and served as Vice Chairman for the 2009 Report 
cycle.
    A leading authority on China, Asia, national security, and 
military strategy, Commissioner Wortzel had a distinguished 
career in the U.S. Armed Forces. Following three years in the 
Marine Corps, Commissioner Wortzel enlisted in the U.S. Army in 
1970. His first assignment with the Army Security Agency took 
him to Thailand, where he focused on Chinese military 
communications in Vietnam and Laos. Within three years, he had 
graduated from the Infantry Officer Candidate School and the 
Airborne and Ranger schools. After four years as an infantry 
officer, Commissioner Wortzel shifted to military intelligence. 
Commissioner Wortzel traveled regularly throughout Asia while 
serving in the U.S. Pacific Command from 1978 to 1982. The 
following year, he attended the National University of 
Singapore, where he studied advanced Chinese and traveled in 
China and Southeast Asia. He next worked for the Under 
Secretary of Defense for Policy, developing counterintelligence 
programs to protect emerging defense technologies from foreign 
espionage. Also, the Commissioner managed programs to gather 
foreign intelligence for the Army Intelligence and Security 
Command.
    From 1988 to 1990, Commissioner Wortzel was the Assistant 
Army Attache at the U.S. Embassy in Beijing, where he witnessed 
and reported on the Tiananmen Massacre. After assignments as an 
army strategist and managing army intelligence officers, he 
returned to China in 1995 as the army attache. In December 
1997, Commissioner Wortzel became a faculty member of the U.S. 
Army War College, serving as the Director of the Strategic 
Studies Institute. He retired from the army as a colonel.
    After his military retirement, Commissioner Wortzel served 
as the director of the Asian Studies Center and vice president 
for foreign policy at The Heritage Foundation from 1999 to 
2006. Commissioner Wortzel's books include Class in China: 
Stratification in a Classless Society; China's Military 
Modernization: International Implications; The Chinese Armed 
Forces in the 21st Century; and Dictionary of Contemporary 
Chinese Military History. His newest book, The Dragon Extends 
its Reach: Chinese Military Power Goes Global, was published by 
Potomac Books, Inc., in 2013.
    A graduate of the Armed Forces Staff College and the U.S. 
Army War College, Commissioner Wortzel earned his Bachelor of 
Arts from Columbus College and his Master of Arts and Ph.D. 
from the University of Hawaii. He and his wife live in 
Williamsburg, Virginia.

Michael R. Danis, Executive Director

    Formerly served as a senior intelligence officer with the 
Defense Intelligence Agency. Mr. Danis managed the agency's 
technology transfer division, the U.S. government's sole 
analytical entity tasked with producing intelligence 
assessments regarding all aspects of foreign acquisition of 
U.S.-controlled technology and high-tech corporations. He also 
established and led a unique team of China technology 
specialists producing assessments on China's military-
industrial complex and the impact of U.S. export-controlled and 
other foreign technology on Chinese weapons development 
programs. While serving in the U.S. Air Force, Mr. Danis was 
twice temporarily assigned to the office of the defense attache 
in Beijing.

 
                              APPENDIX III


 
                   PUBLIC HEARINGS OF THE COMMISSION


----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
    Full transcripts and written testimonies are available online at the Commission's website: www.uscc.gov.
----------------------------------------------------------------------------------------------------------------


           February 7, 2013: Public Hearing on ``China's New

          Leadership and Implications for the United States''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman 
(Hearing Co-Chair); Hon. Dennis C. Shea, Vice Chairman (Hearing 
Co-Chair); Carolyn Bartholomew; Robin Cleveland; Jeffrey L. 
Fiedler; Hon. Carte P. Goodwin; Daniel M. Slane; Hon. James M. 
Tal- 
ent; Hon. Katherine C. Tobin; Michael R. Wessel; Larry M. Wortze
l.

    Witnesses: Christopher K. Johnson, Center for Strategic and 
International Studies; Cheng Li, The Brookings Institution; 
Eswar Prasad, Cornell University; Nicholas Borst, Peterson 
Institute for International Economics; James Mulvenon, Defense 
Group, Inc.; Roy D. Kamphausen, National Bureau of Asian 
Research; Lt. General Wallace `Chip' Gregson, Jr. (USMC, ret.), 
Center for the National Interest; David M. Lampton, The Johns 
Hopkins University, School of Advanced International Studies; 
Michael Auslin, American Enterprise Institute.

      March 7, 2013: Public Hearing on ``Corporate Accountability,

           Access to Credit, and Access to Markets in China's

                 Financial System--The Rules and Their

                   Ramifications for U.S. Investors''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Robin Cleveland (Hearing 
Co-Chair); Jeffrey L. Fiedler; Hon. Carte P. Goodwin (Hearing 
Co-Chair); Daniel M. Slane; Hon. James M. Talent; Hon. 
Katherine C. Tobin; Michael R. Wessel; Larry M. Wortzel.

    Witnesses: Cynthia M. Fornelli, The Center for Audit 
Quality; Thomas Quaadman, U.S. Chamber of Commerce; Paul 
Gillis,* Peking University, Guanghua School of Management; 
Regina Abrami, Lauder Institute for Management and 
International Studies; Carl Walter, formerly of JP Morgan 
China; Lynette H. Ong,* University of Toronto; Sheridan 
Prasso,* Bloomberg News; John Dearie, Financial Services Forum; 
Paul T. Saulski, Georgetown University Law Center; Stephen M.H. 
Simchak, American Insurance Association.

          April 4, 2013: Public Hearing on ``China's Maritime

              Disputes in the East and South China Seas''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Carolyn Bartholomew; Peter 
T.R. Brookes (Hearing Co-Chair); Jeffrey L. Fiedler; Hon. Carte 
P. Goodwin; Daniel M. Slane; Hon. James M. Talent; Hon. 
Katherine C. Tobin (Hearing Co-Chair); Michael R. Wessel; Larry 
M. Wortzel.

    Witnesses: Rear Admiral Michael McDevitt (USN, Ret.), CNA; 
Michael D. Swaine, Carnegie Endowment for International Peace; 
Jessica Chen Weiss, Yale University; Peter Dutton, U.S. Naval 
War College; Steven W. Lewis, Rice University; Lloyd Thrall, 
RAND Corporation.

        April 25, 2013: Public Hearing on ``China's Agricultural

               Policy and U.S. Access to China's Market''

                                Ames, IA

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Carolyn Bartholomew; Hon. 
Carte P. Goodwin; Daniel M. Slane (Hearing Co-Chair); Hon. 
James M. Talent; Hon. Katherine C. Tobin; Michael R. Wessel 
(Hearing Co-Chair).

    Witnesses: William Northey, Iowa Department of Agriculture 
and Land Stewardship; Fred Gale, U.S. Department of 
Agriculture; Dermot J. Hayes, Iowa State University; Kevin 
Brosch, DTB Associates LLP; William Westman, American Meat 
Institute; Patty Lovera, Food & Water Watch; Veronica Nigh, 
American Farm Bureau Federation; Colin A. Carter, University of 
California-Davis; David Miller, Iowa Farm Bureau; Barbara P. 
Glenn, CropLife America; Mark D. Lange, National Cotton Council 
of America; Julius Schaaf, U.S. Grains Council.

      May 9, 2013: Public Hearing on ``Trends and Implications of

               Chinese Investment in the United States''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Carolyn Bartholomew 
(Hearing Co-Chair); Robin Cleveland; Jeffrey L. Fiedler; Daniel 
M. Slane; Hon. James M. Talent; Hon. Katherine C. Tobin; 
Michael R. Wessel; Larry M. Wortzel (Hearing Co-Chair).

    Witnesses: Thilo Hanemann, Rhodium Group; Derek Scissors, 
The Heritage Foundation; Andrew Szamosszegi, Capital Trade, 
Inc.; Elizabeth J. Drake, Stewart & Stewart; Mark E. Plotkin, 
Covington & Burling LLP; Dean G. Popps, formerly of the U.S. 
Department of Defense.

     June 6, 2013: Public Hearing on ``China and the Middle East''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Carolyn Bartholomew; Peter 
T.R. Brookes; Robin Cleveland; Jeffrey L. Fiedler (Hearing Co-
Chair); Hon. Carte P. Goodwin; Daniel M. Slane; Hon. James M. 
Talent (Hearing Co-Chair); Hon. Katherine C. Tobin; Michael R. 
Wessel; Larry M. Wortzel.

    Witnesses: Dawn Murphy, Princeton-Harvard China and the 
World Program; Yitzhak Shichor, The Hebrew University of 
Jerusalem, and The University of Haifa; Erica S. Downs, The 
Brookings Institution; Bryant Edwards, Latham and Watkins LLP; 
Jon B. Alterman, Center for Strategic and International 
Studies; Joel Wuthnow, CNA; Andrew Erickson, U.S. Naval War 
College.

        June 27, 2013: Public Hearing on ``Macau and Hong Kong''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman 
(Hearing Co-Chair); Hon. Dennis C. Shea, Vice Chairman (Hearing 
Co-Chair); Carolyn Bartholomew; Peter T.R. Brookes; Daniel M. 
Slane; Hon. James M. Talent; Hon. Katherine C. Tobin; Michael 
R. Wessel.

    Witnesses: Daniel L. Glaser, U.S. Department of the 
Treasury; A.G. Burnett, Nevada State Gaming Control Board; 
James H. Freis Jr., Cleary Gottlieb Steen & Hamilton LLP, and 
formerly of U.S. Treasury Financial Crimes Enforcement Network 
(FinCEN); I. Nelson Rose, Whittier Law School; Sophie 
Richardson, Human Rights Watch; Madeline Earp, Freedom House.

                      July 11, 2013: Roundtable on

                  ``U.S.-China Cybersecurity Issues''

                             Washington, DC

    Commissioners present: Hon. William A. Reinsch, Chairman; 
Hon. Dennis C. Shea, Vice Chairman; Michael R. Wessel.

    Roundtable participants: Bruce Quinn, Rockwell Automation; 
Roy D. Kamphausen, National Bureau of Asian Research; James 
Mulvenon, Defense Group Inc.
---------------------------------------------------------------------------
    * Submitted material for the record.
---------------------------------------------------------------------------
                             APPENDIX IIIA


 
                  LIST OF WITNESSES TESTIFYING BEFORE


 
                             THE COMMISSION


 
                             2013 Hearings


----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
    Full transcripts and written testimonies are available online at the Commission's website: www.uscc.gov.
----------------------------------------------------------------------------------------------------------------



      Alphabetical Listing of Panelists Testifying before the USCC
------------------------------------------------------------------------
    Panelist Name        Panelist Affiliation          USCC Hearing
------------------------------------------------------------------------
Abrami, Regina        Lauder Institute for       March 7, 2013
                       Management
                        and International
                       Studies
------------------------------------------------------------------------
Alterman, Jon B.      Center for Strategic and   June 6, 2013
                        International Studies
------------------------------------------------------------------------
Auslin, Michael       American Enterprise        February 7, 2013
                       Institute
------------------------------------------------------------------------
Borst, Nicholas       Peterson Institute for     February 7, 2013
                        International Economics
------------------------------------------------------------------------
Brosch, Kevin         DTB Associates LLP         April 25, 2013
------------------------------------------------------------------------
Burnett, A.G.         Nevada State Gaming        June 27, 2013
                       Control
                        Board
------------------------------------------------------------------------
Carter, Colin A.      University of California-  April 25, 2013
                       Davis
------------------------------------------------------------------------
Dearie, John          Financial Services Forum   March 7, 2013
------------------------------------------------------------------------
Downs, Erica S.       The Brookings Institution  June 6, 2013
------------------------------------------------------------------------
Drake, Elizabeth J.   Stewart & Stewart          May 9, 2013
------------------------------------------------------------------------
Dutton, Peter         U.S. Naval War College     April 4, 2013
------------------------------------------------------------------------
Earp, Madeline        Freedom House              June 27, 2013
------------------------------------------------------------------------
Edwards, Bryant       Latham and Watkins LLP     June 6, 2013
------------------------------------------------------------------------
Erickson, Andrew      U.S. Naval War College     June 6, 2013
------------------------------------------------------------------------
Fornelli, Cynthia M.  The Center for Audit       March 7, 2013
                       Quality
------------------------------------------------------------------------
Freis Jr., James H.   Cleary Gottlieb Steen &    June 27, 2013
                        Hamilton LLP
------------------------------------------------------------------------
Gale, Fred            U.S. Department of         April 25, 2013
                       Agriculture
------------------------------------------------------------------------


 Alphabetical Listing of Panelists Testifying before the USCC  Continued
------------------------------------------------------------------------
    Panelist Name        Panelist Affiliation          USCC Hearing
------------------------------------------------------------------------
Gillis, Paul *        Peking University          March 7, 2013
------------------------------------------------------------------------
Glaser, Daniel L.     U.S. Department of the     June 27, 2013
                       Treasury
------------------------------------------------------------------------
Glenn, Barbara P.     CropLife America           April 25, 2013
------------------------------------------------------------------------
Gregson Jr., Wallace  Center for the National    February 7, 2013
  `Chip'               Interest
------------------------------------------------------------------------
Hanemann, Thilo       Rhodium Group              May 9, 2013
------------------------------------------------------------------------
Hayes, Dermot J.      Iowa State University      April 25, 2013
------------------------------------------------------------------------
Johnson, Christopher  Center for Strategic and   February 7, 2013
 K.                     International Studies
------------------------------------------------------------------------
Kamphausen, Roy D.    National Bureau of Asian   February 7, 2013
                       Research                  July 11, 2013
------------------------------------------------------------------------
Lampton, David M.     The Johns Hopkins          February 7, 2013
                       University,
                        School of Advanced
                        International Studies
------------------------------------------------------------------------
Lange, Mark D.        National Cotton Council    April 25, 2013
                       of
                        America
------------------------------------------------------------------------
Lewis, Steven W.      Rice University            April 4, 2013
------------------------------------------------------------------------
Li, Cheng             The Brookings Institution  February 7, 2013
------------------------------------------------------------------------
Lovera, Patty         Food & Water Watch         April 25, 2013
------------------------------------------------------------------------
McDevitt, Michael     CNA                        April 4, 2013
------------------------------------------------------------------------
Miller, David         Iowa Farm Bureau           April 25, 2013
------------------------------------------------------------------------
Mulvenon, James       Defense Group, Inc.        February 7, 2013
                                                 July 11, 2013
------------------------------------------------------------------------
Murphy, Dawn          Princeton-Harvard China    June 6, 2013
                       and the
                        World Program
------------------------------------------------------------------------
Nigh, Veronica        American Farm Bureau       April 25, 2013
                       Federation
------------------------------------------------------------------------
Northey, William      State of Iowa              April 25, 2013
------------------------------------------------------------------------
Ong, Lynette H.*      University of Toronto      March 7, 2013
------------------------------------------------------------------------
Plotkin, Mark E.      Covington & Burling LLP    May 9, 2013
------------------------------------------------------------------------
Popps, Dean G.        Formerly of the U.S.       May 9, 2013
                       Department
                        of Defense
------------------------------------------------------------------------
Prasad, Eswar         Cornell University         February 7, 2013
------------------------------------------------------------------------
Prasso, Sheridan *    Bloomberg News             March 7, 2013
------------------------------------------------------------------------
Quaadman, Thomas      U.S. Chamber of Commerce   March 7, 2013
------------------------------------------------------------------------
Quinn, Bruce          Rockwell Automation        July 11, 2013
------------------------------------------------------------------------
Richardson, Sophie    Human Rights Watch         June 27, 2013
------------------------------------------------------------------------


 Alphabetical Listing of Panelists Testifying before the USCC  Continued
------------------------------------------------------------------------
    Panelist Name        Panelist Affiliation          USCC Hearing
------------------------------------------------------------------------
Rose, I. Nelson       Whittier Law School        June 27, 2013
------------------------------------------------------------------------
Saulski, Paul T.      Georgetown University Law  March 7, 2013
                        Center
------------------------------------------------------------------------
Schaaf, Julius        U.S. Grains Council        April 25, 2013
------------------------------------------------------------------------
Scissors, Derek       The Heritage Foundation    May 9, 2013
------------------------------------------------------------------------
Shichor, Yitzhak      The Hebrew University of   June 6, 2013
                        Jerusalem and The
                       University
                        of Haifa
------------------------------------------------------------------------
Simchak, Stephen      American Insurance         March 7, 2013
 M.H.                  Association
------------------------------------------------------------------------
Swaine, Michael D.    Carnegie Endowment for     April 4, 2013
                        International Peace
------------------------------------------------------------------------
Szamosszegi, Andrew   Capital Trade, Inc.        May 9, 2013
------------------------------------------------------------------------
Thrall, Lloyd         RAND Corporation           April 4, 2013
------------------------------------------------------------------------
Walter, Carl          Formerly of JP Morgan      March 7, 2013
                       China
------------------------------------------------------------------------
Weiss, Jessica Chen   Yale University            April 4, 2013
------------------------------------------------------------------------
Westman, William      American Meat Institute    April 25, 2013
------------------------------------------------------------------------
Wuthnow, Joel         CNA                        June 6, 2013
 
------------------------------------------------------------------------
* Submitted material for the record.


 
                              APPENDIX IV


 
                      INTERLOCUTORS' ORGANIZATIONS


 
                         Asia Fact-Finding Trip


 
                               July 2013

TAIWAN, JAPAN, CHINA, AND HONG KONG, JULY 2013

    During the visit of a U.S.-China Commission delegation to 
Taiwan, Japan, China, and Hong Kong in July 2013, the 
delegation met with representatives of the following 
organizations:

In Taiwan

  Government of Taiwan
     LPresident Ma Ying-jeou
     LChing Chuan Kang Air Base
     LMinistry of Defense
     LMinistry of Economic Affairs
     LNational Security Council
     LMinistry of Foreign Affairs

  Political Enterprise
     LDemocratic Progressive Party

  Private Enterprise
     LAmerican Institute in Taiwan

In Japan

  U.S. Government
     LU.S. Embassy in Tokyo
     LU.S. Fleet Activities Yokosuka

  Government of Japan
     LMinistry of Economy, Trade and Industry
     LJapan Coast Guard
     LMaritime Self-Defense Force
     LMinistry of Defense
     LMinistry of Foreign Affairs

  Private Citizens
     LRetired Maritime Self-Defense Force officer
     LRetired Air Self-Defense Force officer
     LRetired Japan Coast Guard officer

  Research Organizations
     LJapan Institute of International Affairs
     LNational Institute for Defense Studies

In China

  U.S. Government
     LU.S. Embassy in Beijing
     LU.S. Consulate in Shanghai

  Government of the People's Republic of China
     LChina Food and Drug Administration
     LChinese People's Institute of Foreign Affairs
     LShaanxi Province Foreign Affairs Office

  Private Enterprise
     LArcher Daniels Midland
     LU.S. Meat Export Federation
     LYang Ling Qinling Mountains Modern Agriculture 
Co., Ltd.
     LXi'an Jinpeng Seed Co., Ltd.
     LBesun Pork Producer
     LZhongxing Edible Fungi Company
     LAmerican Chamber of Commerce Shanghai
     LYum! Brands, Inc.
     LU.S. Poultry and Egg Export Council
     LCargill, Inc.
     LOSI Group
     LPreferred Freezer Services

  Research Organizations
     LChinese Academy of Agricultural Sciences
     LNorthwest Agricultural and Forestry University

In Hong Kong

  U.S. Government
     LU.S. Consulate in Hong Kong

  Nongovernmental Organizations
     LHuman Rights Watch
     LChina Human Rights Lawyers' Concern Group
     LChina Labor Bulletin
     LPatriotic Democratic Movements of China
     LHuman Rights Monitor

  Political Enterprise
     LHong Kong Pan-Democrats

  Private Citizens
     LRetired administration official
     LRetired Democratic Party official

  Private Enterprise
     LSteve Vickers & Associates, Ltd.

 
                               APPENDIX V


 
                       LIST OF RESEARCH MATERIAL


 
                 Contracted and Staff Research Reports


 
                            Released in 2013


------------------------------------------------------------------------
 
------------------------------------------------------------------------
Disclaimer
 
The reports in this section were prepared at the request of the
 Commission to support its deliberations. They have been posted to the
 Commission's website in order to promote greater public understanding
 of the issues addressed by the Commission in its ongoing assessment of
 U.S.-China economic relations and their implications for U.S. security,
 as mandated by P.L. 106-398 and P.L. 108-7. The posting of these
 reports to the Commission's website does not imply an endorsement by
 the Commission or any individual Commissioner of the views or
 conclusions expressed therein.
------------------------------------------------------------------------


                      Contracted Research Reports

                   ----------------------------------

Red Cloud Rising: Cloud Computing in China

Prepared for the USCC by James Mulvenon, Leigh Ann Ragland,
  Joe McReynolds, and Matthew Southerland/
  Defense Group, Incorporated
September 2013
http://origin.www.uscc.gov/sites/default/files/Research/
Red-%20-Cloud
  %20-Rising-_-Cloud%20Computing%20in%20China.pdf

The Rise of China in Technology Standards: New Norms in
  Old Institutions

Prepared for the USCC by Dan Breznitz and Michael Murphee/
  Joint Management Services, LLC
January 2013
http://www.uscc.gov/sites/default/files/Research/
Rise-of-China-in
  Technology-Standards-.pdf

                Staff Research Reports and Backgrounders

            ------------------------------------------------

China's Third Plenum May Be More Than Just Talk

Written by USCC Economics Team
November 2013
http://origin.www.uscc.gov/sites/default/files/Research/
Staff-%20
  Backgrounder-_-China-%E2-%80-%99s-%20-Third-%20-Plenum-%20
  May-%20-Be-%20-More-%20-Than%20Just%20Talk.pdf

November Monthly Trade Bulletin

Written by USCC Economics Team
November 2013
http://origin.www.uscc.gov/sites/default/files/
trade----bulletins/
November%202013-%20-Trade-%20-Bulletin.pdf

September Monthly Trade Bulletin

Written by USCC Economics Team
September 2013
http://origin.www.uscc.gov/sites/default/files/
trade----bulletins/USCC
  %20-September-%20-trade-%20-bulletin-%20-9-%20-5-%20-13.pdf

China's Naval Modernization and Implications for the
  United States

Written by Senior Policy Analyst Craig Murray, Research Fellow
  Andrew Berglund, and Policy Analyst Kimberly Hsu
August 2013
http://origin.www.uscc.gov/sites/default/files/Research/
Backgrounder----

China-%27s-%20-Naval-%20-Modernization-%20-and-%20-Implications
  %20-for-%20-the-%20-United-%20-States.pdf

August Monthly Trade Bulletin

Written by USCC Economics Team
August 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
August-%20
  Trade-%20-Bulletin-%20-8-%20-7-%20-13-_-0-.pdf

China to Deploy ``Security Force'' to UN Peacekeeping
  Operation in Mali

Written by USCC Senior Policy Analyst Craig Murray
July 2013
http://www.uscc.gov/sites/default/files/Research/
Backgrounder----China
  %20-to-%20-Deploy-%20-Security-%20-Force-%20-to-%20-UN-%20
  Peacekeeping-%20-Operation-%20-in-%20-Mali-_-0-.pdf

July Monthly Trade Bulletin

Written by USCC Economics Team
July 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
July-%20-trade
  %20-bulletin-%20-7-%20-10-%20-13.pdf

China Investment Corporation: Recent Developments in
  Performance, Strategy, and Governance

Written by USCC Policy Analyst Iacob Koch-Weser and
  Research Fellow Owen Haacke
June 2013
http://www.uscc.gov/sites/default/files/Research/
China-%20-Investment
  %20-Corporation-_-Staff-%20-Report-_-0.pdf

China Seeks a ``New Type of Major-Country Relationship''
  with the United States

Written by USCC Research Director and Policy Analyst
  Caitlin Campbell and Senior Policy Analyst Craig Murray
June 2013
http://www.uscc.gov/sites/default/files/Research/
China-%20-Seeks-%20
  New-%20-Type-%20-of-%20-Major-
Country-%20-Relationship-%20-with
  
%20-United-%20-States-_-Staff-%20-Research-%20-Backgrounder.pdf

China's Expanding Military Operations in Foreign Exclusive
  Economic Zones

Written by USCC Policy Analyst Kimberly Hsu and
  Senior Policy Analyst Craig Murray
June 2013
http://www.uscc.gov/sites/default/files/Research/Staff-%20
  Backgrounder-_-China-%20-in-%20-Foreign-%20-EEZs.pdf

China's Military Unmanned Aerial Vehicle Industry

Written by USCC Policy Analyst Kimberly Hsu, Senior Policy
  Analyst Craig Murray, Research Intern Jeremy Cook, and
  Research Fellow Amalia Feld
June 2013
http://www.uscc.gov/sites/default/files/Research/China%27s-%20
  Military-%20-UAV-%20-Industry-_-14-%20-June-%20-2013.pdf

Taiwan's Declining Defense Spending Could Jeopardize
  Military Preparedness

Written by USCC Senior Policy Analyst Craig Murray and
  Research Intern Kyle Churchman
June 2013
h--ttp--:/----/--www--.--uscc--.gov/--sites/--default/files/
Research/T--aiwan--'s-%2--0-Declining
  
%20-Defense-%20-Spending-%20-Could-%20-Jeopardize-%20-Military
  %20-Preparedness-_-Staff-%20-Research-%20-Backgrounder.pdf

June Monthly Trade Bulletin

Written by USCC Economics Team
June 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
June-%20-2013
  %20-Trade-%20-Bulletin-_-6-%20-7-%20-13.pdf

China Missile Launch May Have Tested Part of a New
  Anti-Satellite Capability

Written by USCC Senior Policy Analyst Craig Murray
May 2013
http://www.uscc.gov/sites/default/files/Research/
China-%20-Missile
  
%20-Launch-%20-May-%20-Have-%20-Tested-%20-Part-%20-of-%20-a-%20

  New-%20-Anti-Satellite-%20-Capability-_-05.22.13.pdf

China's ``Core Interests'' and the East China Sea

Written by USCC Research Director and Policy Analyst
  Caitlin Campbell, Research Fellow Ethan Meick, Policy Analyst
  Kimberly Hsu, and Senior Policy Analyst Craig Murray
May 2013
http://www.uscc.gov/sites/default/files/Research/
China%27s-%20-Core
  %20-Interests-%20-and-%20-the-%20-East-%20-China-%20-Sea.pdf

China's 2012 Defense White Paper: The Diversified
  Employment of China's Armed Forces

Written by USCC Policy Analyst Kimberly Hsu, Senior Policy
  Analyst Craig Murray, and Research Intern Matt Wild
May 2013
http://www.uscc.gov/sites/default/files/Research/
China's-%20-2012-%20
  Defense-%20-White-%20-Paper-
The-%20-Diversified-%20-Employment
  %20-of-%20-China's-%20-Armed-%20-Forces.pdf

May Monthly Trade Bulletin

Written by USCC Economics Team
May 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
May-%20-Trade
  %20-Bulletin.pdf

April Monthly Trade Bulletin

Written by USCC Economics Team
April 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
April-%20-2013
  %20-Trade-%20-Bulletin.pdf

China's New Income Inequality Reform Plan and
  Implications for Rebalancing

Written by USCC Policy Analyst Nargiza Salidjanova
March 2013
http://www.uscc.gov/sites/default/files/Research/China-%20
  Inequality%20---%20-3-%20-12-%20-13.pdf

March Monthly Trade Bulletin

Written by USCC Economics Team
March 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
March-%20-2013
  %20-Trade-%20-Bulletin.pdf

February Monthly Trade Bulletin

Written by USCC Economics Team
February 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
February-%20-2013-%20-Trade-%20-Bulletin.pdf

The Reliability of China's Economic Data: An Analysis of
  National Output

Written by USCC Policy Analyst Iacob Koch-Weser
January 2013
http://www.uscc.gov/sites/default/files/Research/
TheReliabilityof
  China%27s-EconomicData.pdf

January Monthly Trade Bulletin

Written by USCC Economics Team
January 2013
http://www.uscc.gov/sites/default/files/trade----bulletins/
January-%20-2013-%20-Trade-%20-Bulletin.pdf



             APPENDIX VI


      ACRONYMS AND ABBREVIATIONS

AD                antidumping duty
ADR               American Depository Receipt
AIP               air-independent propulsion
AIT               American Institute in Taiwan
AMSC              American Superconductor
AOR               auxiliary replenishment oiler
ARATS             Association for Relations Across the Taiwan Strait
ASAT              antisatellite
ASBM              antiship ballistic missile
ASEAN             Association of Southeast Asian Nations
BEA               (U.S.) Bureau of Economic Analysis
BIT               bilateral investment treaty
C4ISR             command, control, communications, computers,
                   intelligence, surveillance, and reconnaissance
CAFC              Court of Appeals for the Federal Circuit
CASCF             China-Arab States Cooperation Forum
CCP               Chinese Communist Party
CERT              Computer Emergency Response Team
CFIUS             Committee on Foreign Investment in the
                   United States
CIC               China Investment Corporation
CMC               Central Military Commission
CNPC              China National Petroleum Corporation
CNOOC             China National Offshore Oil Corporation
CSRC              China Securities Regulatory Commission
CVD               countervailing duty
DDG               guided-missile destroyer
DICJ              Macau SAR Gaming Inspection and Coordination
                   Bureau
DOD               Department of Defense
DOJ               Department of Justice
DPP               Democratic Progressive Party (Taiwan)
ECFA              Economic Cooperation Framework Agreement
EEZ               exclusive economic zone
EU                European Union
FDA               (U.S.) Food and Drug Administration
FDI               foreign direct investment
FOCAC             Forum on China-Africa Cooperation
FSIS              Food Safety Inspection Service
FTA               free trade agreement
GATS              General Agreement on Trade in Services
GATT              General Agreement on Tariffs and Trade
GDP               gross domestic product
GPS               Global Positioning System
H-6K              Hongzha-6k
HPSCI             House Permanent Select Committee on Intelligence
ICAO              International Civil Aviation Organization
IMF               International Monetary Fund
IP                (1) intellectual property
                    (2) Internet Protocol
IPO               initial public offering
IT                information technology
ITEC              Interagency Trade Enforcement Center
J-15              Jian-15
JCG               Japan Coast Guard
JL-2              Julang-2
KMT               Kuomintang Party (Taiwan)
LACM              land attack cruise missile
LNG               liquefied natural gas
LPD               amphibious transport dock
MENA              Middle East and North Africa
MFN               Most Favored Nation treatment
MIIT               (China's) Ministry of Industry and Information
                   Technology
MINUSMA           United Nations Multidimensional Integrated
                   Stabilization Mission in Mali
MOFCOM            (China's) Ministry of Commerce
NASA              National Aeronautics and Space Administration
NATO              North Atlantic Treaty Organization
NDRC              (China's) National Development and Reform
                    Commission
nm                nautical mile
NDAA              National Defense Authorization Act
NSA               National Security Agency
NTD               New Taiwan Dollar
PBOC              People's Bank of China
PLA               People's Liberation Army
PTA               preferential trade agreement
PRC               People's Republic of China
PSC               Politburo Standing Committee
R&D               research and development
RIMPAC            Rim of the Pacific
RMB               renminbi
ROC               Republic of China (Taiwan)
S&ED              (U.S.-China) Strategic and Economic Dialogue
SAFE              (China's) State Administration of Foreign Exchange
SAIC              (China's) State Administration for Industry and
                    Commerce
SAR               special administrative region
SASAC             (China's) State-owned Assets Supervision and
                  Administration Commission
SEC               (U.S.) Securities and Exchange Commission
SEF               Straits Exchange Foundation
SLBM              submarine-launched ballistic missile
SME               small- and medium-sized enterprise
SOE               state-owned enterprise
SS                conventional submarine
SSBN              nuclear ballistic missile submarine
SSGN              guided-missile attack submarine
SSN               nuclear attack submarine
T-TIP             Transatlantic Trade and Investment Partnership
TECRO             Taipei Economic and Cultural Representative Office
TIFA              Trade and Investment Framework Agreement
TPP               Trans-Pacific Partnership
UAV               unmanned aerial vehicle
UK                United Kingdom
UN                United Nations
UNCLOS            United Nations Convention on the Law of the Sea
USDA              U.S. Department of Agriculture
USTR              U.S. Trade Representative
VAT               value-added tax
WTO               World Trade Organization
 

2013 COMMISSION STAFF

                  Michael R. Danis, Executive Director

                               __________

               Rickisha C. Berrien-Lopez, Staff Assistant

       Caitlin E. Campbell, Research Director and Policy Analyst 
                     for Energy and Foreign Affairs

  John D. Dotson, Senior Policy Analyst for Chinese Political Affairs

   C. Reed Eckhold, Congressional Liaison and Communications Director

             Christopher P. Fioravante, Management Analyst

   Kimberly C. Hsu, Policy Analyst for Military and Security Affairs

      Iacob N. Koch-Weser, Policy Analyst for Economics and Trade

    Paul C. Magnusson, Senior Policy Analyst for Economics and Trade

   R. Craig Murray, Senior Policy Analyst for Military and Security 
                                Affairs

              Lindsey R. Neas, Project Director and Editor

     Nargiza S. Salidjanova, Policy Analyst for Economics and Trade

   Matthew O. Southerland, Policy Analyst for Military and Security 
                                Affairs

         Anna R. Tucker, Policy Analyst for Economics and Trade

            Kathleen Wilson, Finance and Operations Director

ACKNOWLEDGEMENTS

    The Commission would like to express its deep appreciation to those 
who testified before the Commission as expert witnesses, the 
researchers and analysts who prepared research papers under contract to 
the Commission, and others who assisted with the Commission's work by 
briefing the Commissioners on a wide array of economic and security 
issues. The Commissioners are also grateful to the agencies of the 
intelligence community that briefed Commissioners on key issues of 
importance to the U.S.-China relationship. All these efforts helped 
inform the Commission's and the public's debate on issues vital to 
ongoing U.S.-China relations.

    The Commission offers its special thanks to The Honorable Daniel R. 
Russel, Assistant Secretary of State for East Asian and Pacific Affairs 
and Joseph Y. Yun, former Acting Assistant Secretary of State for East 
Asian and Pacific Affairs, and staff for their outstanding support of 
the Commission's fact-finding trip to Taiwan, Japan, China, and Hong 
Kong in July 2013. The Commission owes a deep debt of gratitude and 
thanks to the following officials of the U.S. Department of State for 
their outstanding assistance and support provided during the 
Commission's travel to Asia and their assistance in arranging the 
Commission's meetings with government officials, business 
representatives, and academics, which was instrumental in the success 
of the Commission's trips: Ambassador John V. Roos, U.S. Embassy in 
Tokyo, and staff; Ambassador Gary F. Locke, U.S. Embassy in Beijing, 
and staff, including Jullion Cooper, Thomas Hilleary, and Ryan Scott; 
Consul General Robert Griffiths, U.S. Consulate in Shanghai, and staff, 
including Seth Path; and Acting Consul General Matt J. Matthews, U.S. 
Consulate in Hong Kong, and staff, including Ory Abramowicz. The 
Commission would also like to thank Director Christopher J. Marut, 
American Institute in Taiwan, and staff, including Kris Kvols, for 
their outstanding assistance provided during the Commission's 
delegation visit to Taiwan.

    The Commissioners are especially grateful to Rona Mendelsohn, who 
served as technical editor of the Report, and Victoria McLaughlin, who 
served as transcriber for the Commission's 2013 public hearings. The 
Commissioners also express their special thanks to former staff members 
Douglas G. Fehrer, Robert G. Sheldon, Jonathan G. Weston, and Gavin J. 
Williams. A special thanks also to current and former interns and 
fellows, who assisted the Commissioners and staff during this Report 
cycle by preparing research material and background information and by 
providing administrative and program support for the 2013 briefings and 
public hearings. They include Andrew Berglund, Kyle Churchman, Owen 
Haacke, Lauren Kaye, Ethan Meick, Zoe Vallete, and Matthew Wild. 
Finally, the Commission expresses its thanks to the policy analyst 
staff for their exemplary assistance in framing the debate and 
assisting in the writing and editing of the final Report and to the 
administrative staff for ensuring the smooth operation of the 
Commission.
