The body language on TV looked different. When US President Barack Obama met Chinese Premier Wen Jiabao for the East Asia summit in Bali, Obama was relaxed, smiling and almost smug. Wen was conversely trying to force the conversation and striving to look jovial and unconcerned. It was a very different setting from the summit of two years earlier when both Obama and his Chinese counterpart Hu Jintao seemed to be on pins and needles. Back then, Obama was more worried while Hu was glacial.

These could just be false appearances. The reality behind the facades is that two years ago the United States was reaching out to China, setting aside old concerns about human rights. Now the US has a stated policy of encirclement of China and demands progress on human rights. [1] That is, Washington requires political reforms from Beijing. However, Obama was not insulting or confrontational with the Chinese government or people. He argued suavely that those reforms would be beneficial to the Chinese people, and thus he managed to drive a potential wedge between the government and the people, suggesting that he would side with the latter. Yet he had no intention to do so and he was still, for now, ready to engage the Chinese government.

In any event, the US is reaching out even to old foes such as Myanmar, which will be visited shortly by US Secretary of State Hillary Rodham Clinton. This could serve two purposes: It could suggest to Beijing that if it changes its attitude, Washington will also change, and it could get Myanmar on its side in case of more difficult confrontations. That could be why Obama announced that the US would cut military expenditures everywhere but in Asia.

It is a paradigm shift in bilateral ties between the US and China.

For decades, there was a general idea in Washington that economic reforms in China would take care of and move forward political reforms, and all of this would bring the two countries together. Or there was a geopolitical confrontational attitude with China, exemplified in 2001 at the beginning of the George W Bush presidency, when the US seemed poised to rein in China per se, as a geopolitical adversary irrespective of its political system. Both attitudes did not differentiate between the Chinese people and government and in fact pushed the government and people closer to each other. This, in turn, was making it more difficult for the US to take on China. Now it may be different: The US is ready to engage the Chinese government as long as it toes the line, otherwise Washington is ready to side with the Chinese people, and possibly help organize China's neighbors against Beijing.

It is a change of vision in Asian politics, almost an ideological shift. The basis for this is in the evolution of regional politics and economics.

The 1997 crisis and opportunity

The Asian financial crisis in 1997 was an important exemplification of a possible new paradigm for ties between China and the rest of Asia. The crisis started in Thailand in July 1997 and was stopped by China about a year later. China managed to do so through a mix of financial and administrative interventions. Speculation was threatening to force the devaluation of Hong Kong's currency after the former British colony was returned to Beijing's authority on July 1 of that year, but Beijing resisted because the Hong Kong dollar is held to a fixed exchange rate with the US dollar - a situation quite different from the peg holding other Asian currencies. The Hong Kong authorities hold deposits in the US dollar equivalent to the value of Hong Kong dollars in circulation, so if pressured, local authorities could just stop using the local currency and switch to US dollars almost without changing price tags. Moreover, China promised to intervene with its reserves, then already quite mighty, in support of the beleaguered currency.

In this way, China saved itself by averting a financial collapse that was hitting the rest of Asia and that in a few years changed the political landscape of the region. But at the same time, China also prevented a cycle of competitive devaluations in the region that could have sunk local economies for decades. China, in other words, was able to align its interests and those of the region, and this created a new political role for the country as some kind of savior of Asia. Moreover, it was almost the first experiment in regional leadership. The financial crisis also hit Japan, then the world's second-largest economy and the undisputed regional economic powerhouse, very hard. Yet Japan's markets crashed and the yen fell, while only China, whose currency was not freely tradable, stood up to the global speculative waves.

This proved that China was the new lighthouse of the region, and it also proved the wisdom of China's strategy vis-a-vis Japan. Japan had caved to US pressures and revalued its currency during the previous decade. The positive effect for this revaluation was short-lived for Japan, as the country in the late 1980s slowly moved into an economic slump that was still there in 1998 when the financial crisis hit Tokyo.

Conversely, Beijing refused to devalue its currency, the yuan, in 1997; it had refused earlier to make it freely tradable; and after the crisis, it shelved plans to make it tradable around the year 2000. In sum, China resisted all pressures from the West to follow their economic advice. China stuck to its guns and was successful, unlike Japan, which listened to the US and failed. This coincided with early criticism of the role of Washington and the International Monetary Fund (IMF) in the Asian crisis. Both were soon accused by some Western economists of having fueled the crisis with wrong prescriptions and wrong interventions.

The whole predicament created an objective moral authority for China in the region, and this authority was mainly due to China's economic czar Zhu Rongji. When in 1999 he proposed that Association of Southeast Asian Nations (ASEAN) member states shelve disputes in the South China Sea and launch concerted and cooperative development of the area, he could do so thanks to a moral authority his country and he himself had recently gained over other regional competitors and over the US. America's intervention in Asia in particular was under a shadow of doubt because it had vetoed the intervention of an Asian Monetary Fund the previous year and had supported an IMF intervention that had multiplied the effects of the financial crisis on the real economy.

This Chinese role helped China in the region and vis-a-vis Southeast Asian countries during the next decade. Southeast Asian countries started receiving a growing portion of Chinese foreign investments and attention just at the time when US and European investment was overall shrinking in the region, as the West was sucked into the new campaigns in Iraq and Afghanistan. Those drew enormous amounts of money out of the US economy, repaying Americans only with new scary bombs and threats in return.

For China, it looked like the best of times, yet those times came to an end with the 2008 financial crisis.

China's undervalued currency hits Asia
One effect of the financial crisis that was and possibly still is misunderstood and ignored in China is the indirect pressures of monetary contradictions between China and its Asian neighbors, which hit each other's exports differently.

Long before the most recent crisis - and in fact, shortly after the Asian financial crisis - the mainstream financial discourse switched horses on China's yuan. Although it had thought and argued that the yuan was overvalued, it later started arguing that the yuan was in fact undervalued. In a way, the very fact that China had successfully staved off the 1998 attacks and that economists had argued against the overvaluation of the yuan started lending credit to the belief that the yuan was possibly overvalued. This credence was reaffirmed by the empirical observations of the fast and steady increase of reserves, trade surplus, and productivity - all elements considered clear indicators of an overvaluation of the Chinese currency.

In recognition of this, on July 21, 2005, China de-pegged the yuan from the US dollar and introduced bands of fluctuations of 3%. Yet this was considered too little in many foreign countries, and China concentrated its political efforts on addressing accusations from the US in this respect while basically ignoring the fact that Asian countries were possibly even unhappier about the undervalued yuan.

This feeling was reinforced when in 2008 China reintroduced the fixed peg with the dollar for a couple of years after the outbreak of the US financial crisis.

This peg and its limited fluctuations were hitting US industries, which were unable to compete with the cheap Chinese imports, but they were also hitting Southeast Asian export industries, which were not yet fully recovered from the Asian financial crisis. Weaker Asian neighbors could not navigate a difficult and delicate polemic with China on currencies, and China ignored their plight and the fact that these countries had been quietly complaining about the undervalued yuan to the US.

Then the issue of the undervalued yuan had two negative political aspects for China: One, it created attrition with the US, and this was very apparent; and two, it created attrition with trade competitors and in particular with neighboring trade competitors, whose exports were so similar to Chinese exports. With the neighboring competitors again there were two aspects: First, China ignored their plight, and their export share was under growing pressure from Chinese industries. Second, China only looked at the powerful US as an interlocutor, and gave a sense that the neighbors would not be treated with equal dignity by China. Investment from China came pouring into Asian neighbors, partly compensating for the local difficulties, but that further complicated the picture, as it could crowd out local investments.

In sum, looking at China's intervention in the Asian financial crisis a decade earlier, was it a disaster in disguise? Or was it simply the swing of a pendulum, as ASEAN countries had to lean on China against the then-overbearing US and now have to lean on the US against now-overbearing China?

China simply did not recognize this context, which is of fundamental importance to grasp the complexities of the dispute in the South China Sea that flared up in 2010. Here the US intervened in the dispute, arguing that as part of the main international sea lanes, the South China Sea was of international interest. Therefore, Hillary Clinton offered that the US mediate in the dispute.

This pronouncement was enough to create immense trouble for China - internationally, and thus internally - turning the issue in some kind of second Taiwan, the island under the US protective umbrella, de facto independent, still formally part of one China.

The offer of mediation by itself was a declaration that the Chinese offer made a decade before by Zhu Rongji had been shattered. It affirmed that China was not able to deal with its immediate neighbors by itself, and it needed the United States to get involved its businesses. It further cast a powerful doubt on the possession of the islands, as the US mediation, while warmly welcomed by other neighbors, implicitly meant China had to give up some of its claims on the sea.

The possibility of renouncing the claim is particularly sensitive for China. The map with the dotted line was handed down to the People's Republic government by the fleeing Nationalist forces in 1947. For many years, Beijing had no capability to enforce the claim, which then simply reinforced that of the Taiwan-based Nationalist government. During the Vietnam War, the Chinese claim helped to keep at bay the US forces trying to pressure North Vietnam, which was allied with China. When China sided with the Americans and even went to war with Vietnam, Beijing's claim became convenient for the US as a further tool to press Vietnam, then a Soviet ally in Asia. A military clash between China and Vietnam on the disputed islands in 1988, when US and China ties were still good, was brushed away by the international press. Things started unfolding for Beijing in the South China Sea only in the 1990s, when the simultaneous economic growth of China and its neighbors pushed them all to the sea. But, as we saw, the growing tension was put off for one more decade.

This present tension is different and extremely irksome for Beijing. It's not just the obvious interest in the oil and gas below the South China Sea and the interest in stretching its hands into sea lanes vital for transportation to Japan or Korea. The possibility of giving up even part of the South China Sea opens the government to internal criticism: Beijing is getting weak, it is unable to stand up to foreign pressure, it is giving up precious territory, and in sum, it is a renegade government and it can be challenged by people in the streets or in the corridors of the central government. The Chinese political system currently is also cornered because it has little latitude to counter nationalist attacks, which could engulf the fiery public opinion. The defense of the national interests, embedded in the easy mechanical drawing of a map, is part of the legitimacy of the Communist Party's power, as it gained that power because it claimed to defend Chinese interests better from invading foreign forces (then the Japanese) than its competitors (then the Nationalists of the Kuomintang, or KMT).

The redefinition of this old nationalist claim on those sea lanes could be a very long and controversial process, if ever undertaken, and definitely it would look like surrender if done in the heat of the controversy about the South China Sea. State councilor Dai Bingguo indicated a change of mindset on November 22 when he said that a solution in that sea should make all neighbors comfortable. [2]

However, this dispute cannot be turned into a second Taiwan issue for Beijing. Taiwan is already a very thorny question in the hands of the US. To affirm that the South China Sea is as crucial would multiply the pawns in other people's hands and, by extension, it would heat up tension in the sea spaces around the Senkaku/Diaoyu Islands, which are similarly contested with Japan.

Moreover, the South China Sea is objectively different from Taiwan. That island is inhabited by the Han people (the majority ethnic group in China), who speak Mandarin, and it is ruled by a government claiming until recently to be more Chinese than Beijing's government. If Beijing were to give up its claim to the island, it would be harder to explain why it still rules such regions as Tibet or Xinjiang, with local non-Han populations.

Yet the South China Sea remains very delicate as ultra-nationalists in China still resent Mao Zedong's vast territorial concessions to the country's neighbors and in particular to the USSR. There are still voices arguing that these territories should be reclaimed. Beijing has no intention of reclaiming them, but giving up existing claims could give more fuel to the people eager to redraw all borders.

To China it seems clear, but perhaps outside of China it is not clear at all, that Beijing would be in a very difficult position if it were to intervene in the situation. To Beijing then, the real point of the US raising this issue seems to be to set a trap whose only real goal is to put China under pressure.

From the perspective of some Asian neighbors, China's attitude during the past decade was worrisome, as it stepped on their interests and only considered the US. In a decade or so, China could grow even stronger and more difficult to deal with. Therefore it must be pressed on this now, also as a reminder that the neighbors will defend their turf against China's growth and will not just be swallowed, like many times in history, by China's overwhelming presence.

This is an economic and geopolitical issue. Yet Obama decided to cast aside geopolitical concerns and concentrate on ideological issues of human rights, as we saw in Australia. The new approach outlines the contours of a new cold war around China. The enemy in this case would not be the Chinese people but the Chinese government. China's policy is not decided, but preparations and soldiers are being arrayed. If China does not give in to political reforms and cuts military expenditures, soon enough everything could be ready around China to turn the screw of political pressure further, while the international situation, both political and economic, is not good for anybody.

Politically, the wave of Jasmine Revolution sweeping through the Middle East looks like a dire warning for the Chinese elite. Economically, the gloomy prospects for 2012 could crush many Chinese export-oriented factories, creating unemployment in formerly booming towns. Both elements could combine to stir up turmoil among the less fortunate in crucial industrial areas far from the capital and its leaders.

The warning is similar to those that were blared to Libyan leader Muammar Gaddafi and Syrian leader Bashar al-Assad: Reform or be toppled. Assad has decided so far not to trust the US and to fight the revolution mounting in his country. Chinese leaders, diffident of US intentions, may act similarly, but certainly taking down the Chinese leaders could be a much longer and harder endeavor than taking down Gaddafi. But the US did it with the USSR, so why not with Beijing? After all, the Cold War was the one thing the US proved to be good at.

Moreover, the US concerns can be easily sold to the American public. The United States has an open political system; China does not. Beijing could take advantage of America's openness to infiltrate and influence the US political decision-making process, while Washington cannot do the same with the Chinese system. In fact, China, because of its tight controls over media and culture, proved unable to influence the American public, and thus its soft power has little grasp over that country. Conversely, despite Beijing's political restrictions, the US media and culture have far more clout in China. Therefore, Beijing may fear that if it were to give in to US demands, Washington could de facto take over China's political command and control system. Therefore, there are risks for the Chinese leadership both in resisting and giving in to the US.

However, risks - as in all wars, soft or hard as they may be - are not just one-sided. A conflict between the US and China raises the typical prospect of a Three Kingdoms strategy, the one exemplified in the famous strategic novel The Romance of the Three Kingdoms. This was the strategy devised by Mao that brought the Chinese Communist Party to power. As the Japanese started the invasion of China in 1937, Mao tried to gain leverage between the two main competitors, Japan and the KMT.

Similarly now, as the US and China prepare for confrontation, a third or fourth competitor could trump both in a decade or two. The list of growing and ambitious states is not short. [3] Without any specific order, one can see India, Brazil, South Africa, Nigeria, Mexico, Turkey and Indonesia, besides the old flames eager to get a second shot, such as Russia or Japan - and that's ruling out the possibility that Europe could manage its long-awaited political merger and surge back as a dominant economic and political power.

Yet again here the US has long experience while China has none. The US managed to kill decades of enmity between France and Germany, which had fought three massive wars from 1870 to 1945, after World War II, lining up both countries against the common ideological threat of the USSR. For that purpose, the US pushed first for greater unity in Western Europe from the 1950s to 1980s, and then for an eastward expansion of the European Union to solidify the territorial loss of Moscow in Europe after the collapse of the USSR. In the same fashion, the US could push for greater political unity in Europe, if it could align the EU against "communist China". The same could happen with Russia, India or Indonesia - even Iran or North Korea - if Washington were to perceive the threat coming from Beijing as growing and very real.

China at the moment cannot do the same. It does not have similar experience. China, in fact, has no recent or ancient experience in equal alliances - despite US-underscored leadership in the North Atlantic Treaty Organization, Washington has great experience in taking on a very measured, transparent, and respectful attitude toward its allies - and China's tradition is only in feudal, unequal ties, where minor countries bow to China's superior power.

To face these challenges, China has possibly one year, the time it will take to usher in the next group of leaders who will be promoted in the Party Congress next autumn. They will have to decide what to do with the US, and their own country. Massive reforms are needed on many fronts, and possibly even a great change in mindset. Without them a combination of interests in the US and in Asia could take on the Chinese leadership and a new form of "soft war" could ensue.

Notes
1. Remarks by President Barack Obama to the Australian Parliament on November 17, 2011: "Meanwhile, the United States will continue our effort to build a cooperative relationship with China. All of our nations - Australia, the United States - all of our nations have a profound interest in the rise of a peaceful and prosperous China. That's why the United States welcomes it. We've seen that China can be a partner from reducing tensions on the Korean Peninsula to preventing proliferation. And we'll seek more opportunities for cooperation with Beijing, including greater communication between our militaries to promote understanding and avoid miscalculation. We will do this, even as we continue to speak candidly to Beijing about the importance of upholding international norms and respecting the universal human rights of the Chinese people."

2. See Chinese text here (http://news.china.com/domestic/945/20111122/16880700.html).

3. The United States, China and the New Global Geometry."(http://mepc.org/articles-commentary/speeches/united-states-china-and-new-global-geometry) Remarks at the Hopkins-Nanjing Center by Charles W Freeman Jr, November 10, 2010, Nanjing, China.  (2011-11-30 Asia Times)