But the thin traffic along a highway lined with fallow fields in China’s Jilin province, two years after it was finished, shows how far there is to go and why plans for high-speed rail links to Chinese cities along the border look misplaced.

The problem for Beijing is twofold: getting Pyongyang to buy into the idea of economic reform and the reluctance of Chinese businessmen to venture into one of the world’s riskiest investment destinations.

While China is frustrated with Pyongyang over its threats to wage war on South Korea and the United States, its efforts to build economic links with North Korea from places like Jilin help explain why Beijing is unlikely to crack down hard on the reclusive state.

Since then-Premier Wen Jiabao went to North Korea in 2009 – just months after Pyongyang’s second nuclear test – China has sought to stabilise the Korean peninsula by stepping up its effort to steer the North toward economic reform. China is not about to give up that goal even though it’s under U.S. pressure to get tough after North Korea’s third nuclear test, on February 12.

“It’s not even shepherding anymore. It’s more of just inundating North Korea with all of these influences from the Chinese side where the idea is to essentially corrupt them, show them what it tastes like to make money,” said John Park, a North Korea expert at the Massachusetts Institute of Technology and the Harvard Kennedy School.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

China oil imports to N.Korea link.reuters.com/fud86t

GRAPHIC: Korean economic divide r.reuters.com/gyn84t

GRAPHIC: N.Korea’s military link.reuters.com/zur27t

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

WEN’S VISIT A CATALYST

Chinese investment in North Korea was paltry before Wen’s visit, according to researchers.

Recent statistics are hard to find, but his trip breathed life into two economic zones: one at Rason, 50 km (30 miles) inside the North Korean border, opposite Jilin, and the other near the Chinese city of Dandong, further south in Liaoning province. Some factories and farms are operational in Rason. The zone near Dandong is still being built.

Wen’s trip opened the door to mining deals and allowed China to help expand the small port at the North Korean city of Rajin, the northernmost ice-free port in the region. His visit also paved the way for more North Korean state trading firms to do business in China, Park said.

Annual two-way trade is estimated at around $6 billion, making China the North’s biggest trade partner.

After Wen’s trip, then North Korean leader Kim Jong-il visited China three times before his death in December 2011. Among the places he saw was a flat-screen TV maker, an industrialised farm and a high-tech research and development centre. Current ruler Kim Jong-un, the elder Kim’s son, has not visited China since taking power.

But doing business with North Korea is frustrating, even for those in Jilin’s ethnic Korean prefecture of Yanbian, where many residents speak Korean and have links to the North.

The owner of a car company in Yanji, the region’s main city, would love to see truckloads of his vehicles head along the G12 and into North Korea. In an advertisement, the firm is billed almost exclusively as an exporter, but the reality is different.

“Most of our business is in China now,” said the company owner, who declined to be identified because he was concerned it would make it even harder to work with North Korea.

The manager of a Yanji Korean trade association who sells food packaging bags to North Korea also said it was difficult.

“We are doing less and less business with them now,” he said.

While China has halted some overland tourism into North Korea in the wake of the recent tensions, businessmen in Yanbian said most curbs came from North Korea.

“Their demands are higher and higher. Visas are difficult to get, crossing the border is difficult and they limit the things that can go across,” said the trade association manager, who also declined to be identified.

Some Chinese firms were also starting to lose confidence in investing in the Rason zone, said an official at the Jilin government who had knowledge of the matter. South Korea’s Yonhap news agency said last year the zone would get $3 billion in investment from Beijing.

JILIN’S KOREAN SPEAKERS WORK IN SOUTH KOREA, NOT NORTH

While decades of market reforms sparked an economic boom in China’s coastal regions, the dismantling of many state firms as part of those measures took a toll on northeastern provinces such as Jilin and Liaoning.

China has embarked on a programme to revitalise its rustbelt northeast, but some economists say a turnaround will partly rely on when Jilin and Liaoning can tap the potential mineral wealth and cheap labour of North Korea.

That, in turn, depends on Pyongyang.

“For the relatively impoverished North Korean government, China’s northeasterly drive ought to represent a golden opportunity,” Adam Cathcart and Christopher Green, editors of SinoNK.com, a website that specialises in ties between North Korea and China, wrote in an article this month.

“However, the response to date has been a complex mix of enthusiasm, investment and retrenchment, fear, and paranoia, abject confusion and even a certain strategic ambivalence.”

China shares a 1,400 km (870 mile) border with North Korea, roughly two-thirds of which belongs to Jilin. More than a million ethnic Koreans live in the province. The government hopes they can one day act as a bridge with North Korea but has instead exported Korean-speaking labour to work in South Korean factories since the early 1990s.

Jilin accounts for 28 percent of Chinese investment in the North, with 34 percent from Liaoning.

Experts say one of Beijing’s top objectives in hosting Kim Jong-il multiple times from 2000 to the time he died was clear: to showcase the fruits of China’s economic reforms.

Indeed, a source with ties to both Pyongyang and Beijing told Reuters last July that the North was gearing up to experiment with agricultural and economic reforms. However, nothing was announced and then North Korea conducted a long-range missile test in December and its third nuclear test in February, prompting fresh U.N. sanctions.

A pro-Pyongyang newspaper last week said North Korea, which has suffered chronic food shortages, had a surge in agricultural production due to a new pay-based incentive system for farmers last year.

The World Food Programme, which has an office in Pyongyang, said it was not aware of any changes in agricultural policy.

LUXURY CARS AND FANCY WATCHES

Across the border, it’s hard to gauge the impact of deepened economic ties with China.

A child nutrition survey in 2012 carried out by North Korea with U.N. assistance showed results in North Hamgyong province, which abuts Jilin, that appeared better in some cases than in South Hamgyong, next to Pyongyang. The usual assumption is that North Koreans live better the closer they are to Pyongyang.

Marcus Noland, senior fellow at the Washington-based Peterson Institute for International Economics, said that might suggest an impact from increased interaction with China. There was also talk of a building boom in Chongjin, North Hamgyong’s capital and the country’s third biggest city, he said.

“The economic integration with China is proceeding,” said Noland, an expert on North Korea’s economy.

“If it really appears that the Chinese are having an impact up in North Hamgyong I think that will probably spur some sort of internal debate, though probably not a very public one, about what should North Korea’s relationship to China be.”

One recent Chinese visitor who has done business in Chongjin said well-connected North Koreans preferred to ride in Mercedes Benz cars, wore fancy watches and spent hundreds of dollars on mobile phone bills each month.

Park said the North Korean elite were finding ways to tap into China’s economic might.

“If you look at the most senior members of the North Korean regime they are really engaged in business and commerce. You have a situation where, in a way, the elites in North Korea are now trying to leverage their positions of power to monetize them,” he said.

END OF THE ROAD

After the Chinese border city of Hunchun, the four-lane G12 expressway narrows into a smaller road leading to the Quanhe border crossing.

On the other side of the Tumen River that divides the two countries, the dirt road from the Rason economic zone to China was finally paved last summer. Chinese state media called it a big step in Rason’s development.

Jin Qiangyi, director of the Center for North and South Korean Studies at Yanbian University, said he believed the two-lane rural road was originally slated to be a highway. Its downgrade reflected uncertainty about the ability of companies to transport enough cargo to make it economical.

“From the economic angle I don’t think there are many people very enthusiastically investing in North Korea. There’s too much risk,” said Jin.

Still, China’s leaders have little choice but to stick with the economic integration strategy, Jin said, even as North Korea pushes up tensions on the Korean peninsula to their highest in decades.

Work is even under way on multi-billion dollar projects to extend bullet train lines to Dandong and Hunchun. The Dandong link is slated for completion in 2015.

“You can’t say they’ve failed yet,” Jin said. “But they haven’t succeeded.” (Additional reporting by Charlie Zhu in HONG KONG. Editing by Dean Yates)

But the thin traffic along a highway lined with fallow fields in China’s Jilin province, two years after it was finished, shows how far there is to go and why plans for high-speed rail links to Chinese cities along the border look misplaced.

The problem for Beijing is twofold: getting Pyongyang to buy into the idea of economic reform and the reluctance of Chinese businessmen to venture into one of the world’s riskiest investment destinations.

While China is frustrated with Pyongyang over its threats to wage war on South Korea and the United States, its efforts to build economic links with North Korea from places like Jilin help explain why Beijing is unlikely to crack down hard on the reclusive state.

Since then-Premier Wen Jiabao went to North Korea in 2009 – just months after Pyongyang’s second nuclear test – China has sought to stabilize the Korean peninsula by stepping up its effort to steer the North toward economic reform. China is not about to give up that goal even though it’s under U.S. pressure to get tough after North Korea’s third nuclear test, on February 12.

“It’s not even shepherding anymore. It’s more of just inundating North Korea with all of these influences from the Chinese side where the idea is to essentially corrupt them, show them what it tastes like to make money,” said John Park, a North Korea expert at the Massachusetts Institute of Technology and the Harvard Kennedy School.

WEN’S VISIT A CATALYST

Chinese investment in North Korea was paltry before Wen’s visit, according to researchers.

Recent statistics are hard to find, but his trip breathed life into two economic zones: one at Rason, 50 km (30 miles) inside the North Korean border, opposite Jilin, and the other near the Chinese city of Dandong, further south in Liaoning province. Some factories and farms are operational in Rason. The zone near Dandong is still being built.

Wen’s trip opened the door to mining deals and allowed China to help expand the small port at the North Korean city of Rajin, the northernmost ice-free port in the region. His visit also paved the way for more North Korean state trading firms to do business in China, Park said.

Annual two-way trade is estimated at around $6 billion, making China the North’s biggest trade partner.

After Wen’s trip, then North Korean leader Kim Jong-il visited China three times before his death in December 2011. Among the places he saw was a flat-screen TV maker, an industrialized farm and a high-tech research and development center. Current ruler Kim Jong-un, the elder Kim’s son, has not visited China since taking power.

But doing business with North Korea is frustrating, even for those in Jilin’s ethnic Korean prefecture of Yanbian, where many residents speak Korean and have links to the North.

The owner of a car company in Yanji, the region’s main city, would love to see truckloads of his vehicles head along the G12 and into North Korea. In an advertisement, the firm is billed almost exclusively as an exporter, but the reality is different.

“Most of our business is in China now,” said the company owner, who declined to be identified because he was concerned it would make it even harder to work with North Korea.

The manager of a Yanji Korean trade association who sells food packaging bags to North Korea also said it was difficult.

“We are doing less and less business with them now,” he said.

While China has halted some overland tourism into North Korea in the wake of the recent tensions, businessmen in Yanbian said most curbs came from North Korea.

“Their demands are higher and higher. Visas are difficult to get, crossing the border is difficult and they limit the things that can go across,” said the trade association manager, who also declined to be identified.

Some Chinese firms were also starting to lose confidence in investing in the Rason zone, said an official at the Jilin government who had knowledge of the matter. South Korea’s Yonhap news agency said last year the zone would get $3 billion in investment from Beijing.

JILIN’S KOREAN SPEAKERS WORK IN SOUTH KOREA, NOT NORTH

While decades of market reforms sparked an economic boom in China’s coastal regions, the dismantling of many state firms as part of those measures took a toll on northeastern provinces such as Jilin and Liaoning.

China has embarked on a program to revitalize its rustbelt northeast, but some economists say a turnaround will partly rely on when Jilin and Liaoning can tap the potential mineral wealth and cheap labor of North Korea.

That, in turn, depends on Pyongyang.

“For the relatively impoverished North Korean government, China’s northeasterly drive ought to represent a golden opportunity,” Adam Cathcart and Christopher Green, editors of SinoNK.com, a website that specializes in ties between North Korea and China, wrote in an article this month.

“However, the response to date has been a complex mix of enthusiasm, investment and retrenchment, fear, and paranoia, abject confusion and even a certain strategic ambivalence.”

China shares a 1,400 km (870 mile) border with North Korea, roughly two-thirds of which belongs to Jilin. More than a million ethnic Koreans live in the province. The government hopes they can one day act as a bridge with North Korea but has instead exported Korean-speaking labor to work in South Korean factories since the early 1990s.

Jilin accounts for 28 percent of Chinese investment in the North, with 34 percent from Liaoning.

Experts say one of Beijing’s top objectives in hosting Kim Jong-il multiple times from 2000 to the time he died was clear: to showcase the fruits of China’s economic reforms.

Indeed, a source with ties to both Pyongyang and Beijing told Reuters last July that the North was gearing up to experiment with agricultural and economic reforms. However, nothing was announced and then North Korea conducted a long-range missile test in December and its third nuclear test in February, prompting fresh U.N. sanctions.

A pro-Pyongyang newspaper last week said North Korea, which has suffered chronic food shortages, had a surge in agricultural production due to a new pay-based incentive system for farmers last year.

The World Food Programme, which has an office in Pyongyang, said it was not aware of any changes in agricultural policy.

LUXURY CARS AND FANCY WATCHES

Across the border, it’s hard to gauge the impact of deepened economic ties with China.

A child nutrition survey in 2012 carried out by North Korea with U.N. assistance showed results in North Hamgyong province, which abuts Jilin, that appeared better in some cases than in South Hamgyong, next to Pyongyang. The usual assumption is that North Koreans live better the closer they are to Pyongyang.

Marcus Noland, senior fellow at the Washington-based Peterson Institute for International Economics, said that might suggest an impact from increased interaction with China. There was also talk of a building boom in Chongjin, North Hamgyong’s capital and the country’s third biggest city, he said.

“The economic integration with China is proceeding,” said Noland, an expert on North Korea’s economy.

“If it really appears that the Chinese are having an impact up in North Hamgyong I think that will probably spur some sort of internal debate, though probably not a very public one, about what should North Korea’s relationship to China be.”

One recent Chinese visitor who has done business in Chongjin said well-connected North Koreans preferred to ride in Mercedes Benz cars, wore fancy watches and spent hundreds of dollars on mobile phone bills each month.

Park said the North Korean elite were finding ways to tap into China’s economic might.

“If you look at the most senior members of the North Korean regime they are really engaged in business and commerce. You have a situation where, in a way, the elites in North Korea are now trying to leverage their positions of power to monetize them,” he said.

END OF THE ROAD

After the Chinese border city of Hunchun, the four-lane G12 expressway narrows into a smaller road leading to the Quanhe border crossing.

On the other side of the Tumen River that divides the two countries, the dirt road from the Rason economic zone to China was finally paved last summer. Chinese state media called it a big step in Rason’s development.

Jin Qiangyi, director of the Center for North and South Korean Studies at Yanbian University, said he believed the two-lane rural road was originally slated to be a highway. Its downgrade reflected uncertainty about the ability of companies to transport enough cargo to make it economical.

“From the economic angle I don’t think there are many people very enthusiastically investing in North Korea. There’s too much risk,” said Jin.

Still, China’s leaders have little choice but to stick with the economic integration strategy, Jin said, even as North Korea pushes up tensions on the Korean peninsula to their highest in decades.

Work is even under way on multi-billion dollar projects to extend bullet train lines to Dandong and Hunchun. The Dandong link is slated for completion in 2015.

“You can’t say they’ve failed yet,” Jin said. “But they haven’t succeeded.”

(Additional reporting by Charlie Zhu in HONG KONG. Editing by Dean Yates)

Kim and his partners even got the beer flowing after workers
strapped equipment onto a truck in the Chinese border town of
Tumen and drove it to the North Korean coastal city of Chongjin.
Chinese engineers taught the locals how to brew. City officials
loved the taste, he said.

But the small Chinese-North Korean venture ran aground
within months after failing to get final approval from
authorities in Pyongyang.

Kim’s experience is an illustration of both the challenge
and the potential of doing business in North Korea, which has
grabbed global attention in recent weeks with its threats to
wage nuclear war on South Korea and the United States.

“It wasn’t rejected. We just waited. The central government
didn’t come and say ‘no’, but the documents were just never
issued and so we eventually gave up,” said Kim, a Chinese
national of Korean descent living in Tumen in China’s
northeastern Jilin province.

AT EDGE OF GLOBAL INVESTMENT FRONTIER

Building a brewery in Chongjin, North Korea’s third biggest
city, made good business sense.

Domestic beer has to be trucked up from Pyongyang, 460 km
(285 miles) to the southwest. Terrible mountain roads and the
journey takes its toll on the cargo, said Kim, speaking at a
restaurant he owns, a few blocks from the icy Tumen River which
divides the two nations. One tour operator said North Korean
beer in Chongjin was twice as expensive as in Pyongyang.

Chongjin and provincial officials supported the project.
Factory space was available in the rustbelt city, 130 km (80
miles) to the south of Tumen. The local water was crystal clear,
too, promising a clean and tasty product.

And to hedge the obvious risks, the local business partner
arranged for the Chinese to buy North Korean seafood to sell in
China at each stage they invested in the beer venture.

“The problem isn’t that the people are hard to deal with,”
said Kim. “These are all firsts. It’s not that the nation does
not want to do it, but rather that it’s the first time.”

Indeed, North Korea lies at the very edge of the global
investment frontier. Subject to years of U.N. sanctions over its
nuclear and missile programmes, few have tried to make money in
the country apart from Chinese companies as well as South Korean
firms in an industrial park near the North-South border.
Pyongyang effectively closed that factory zone this week amid
its threats of war.

Between 2003 and 2009, Chinese investment in North Korea was
a paltry $98.3 million, according to Chinese data cited in a
2011 report by Drew Thompson, a Korea specialist now at the U.S.
Department of Defense. Analysts say Chinese investment has risen
more recently following a push by Beijing, North Korea’s only
major diplomatic ally, to boost economic links.

Examples of failed Chinese investments abound. Last year,
the Xiyang Group said it had been “cheated” in a failed deal to
refine North Korean iron ore. In public comments, the miner and
steelmaker said doing business in North Korea was a “nightmare”.

HEINEKEN AND CORONA ON SALE

There is little public information on North Korea’s beer
market but one thing seems clear – demand outstrips supply.

Troy Collings, a director at Young Pioneer Tours, a travel
operator based in China which takes groups into North Korea and
has organised brewery visits, said there were probably less than
a dozen locally made beers available in the country.

In Pyongyang, two hotels concoct their own microbrews. The
Rakwon department store creates its own eponymous beer, too, he
said.

“They can’t produce enough for the domestic market,” said
Collings.

The opportunity was clear – and reinforced for Kim when he
saw the elite in Chongjin drinking a lot of Heineken and Corona.

So, in mid-2011, Kim and two friends joined up with a North
Korean businessman to put the brewery plan in motion.

Approval from Chongjin city came easily, he said. The
province, North Hamgyong, gave the green light too. And the
first of three investments in equipment and supplies – the
initial one worth about 200,000 yuan ($32,200) – was made.

Since North Korea has no system of credit and the risks of
investing were high, Kim and his partners tied the beer project
to seafood exports.

Before each investment was made, they were allowed to buy a
cargo of North Korean seafood to sell in China. The first was
about 50 tonnes of squid, he said.

North Korean seafood, hauled from the frigid, pollution-free
waters off the coast in the Sea of Japan, is a delicacy in
China. In Hunchun, a Chinese city near the northeastern tip of
North Korea, wholesalers of North Korean crabs line one street.

SQUID HEDGE HELPED BUSINESSMAN BREAK EVEN

It took about nine hours to drive from Tumen to Chongjin
with the brewery equipment, including stops at customs.

The equipment was installed quickly and Chinese engineers
showed the North Koreans how to brew. Soon, suds were flowing.
The product was dubbed Wongang, or ‘river source’, beer.

On the first day of business the investors invited senior
city and provincial leaders to the brewery for a sample. All
approved, Kim said.

But the new brewery could not ramp up production without
authorisation from Pyongyang, which never came despite months of
waiting. There was never a response and the investors never got
an explanation.

“If you push too hard it could raise suspicions,” Kim said.

It was a pity, because the North Koreans were good workers,
he said, citing how the investors overcame the frequent power
cuts which made it hard to use a computer to monitor the brewing
process.

Instead, the investors stationed North Korean workers at
each of the pressure gauges on the brewing equipment in 12-hour
shifts. The workers were told if the dial reached a certain
level they should turn a knob to let off pressure.

“They got chairs and sat there looking at the gauges, not
sleeping all night, one person at each position,” said Kim.

Thanks to the squid hedge, the Chinese investors basically
broke even. Kim now runs his restaurant in the space where the
brewing equipment was stored before it was hauled to Chongjin.

Some day Pyongyang may give the green light, Kim says, but
he is not holding his breath.

“As I was leaving they said ‘It’s not that we don’t want to
do it, and it’s not that our senior leaders or the central
government don’t want to do it, but we just don’t have practical
experience with this kind of thing’.”
($1 = 6.2033 yuan)

(Additional reporting by Daum Kim in SEOUL. Editing by Dean
Yates)

Authorities have found traces of a common pig virus in some of the animals floating in the Huangpu River this week, and industry insiders say farmers likely dumped them, common in an industry which has no system of compensation for losses from disease.

“There is no mechanism by which, whenever diseases are found among pigs, the government compensates pig breeders so as to control the spread of diseases or compensate pig breeders for losses,” said Feng Yonghui, general manager at pig-industry research organization Soozhu.com.

To make matters worse, Feng said insurance companies were unwilling to insure pig breeders because the risks were so high.

On Wednesday, workers on barges and on the riverbank used pitchforks to drag bloated dead pigs out of the river.

Pork is China’s staple meat and the swine population is the world’s largest at 475 million head at the end of last year.

At market, margins on pork are thin and for hog farmers unwilling to spend money to incinerate or bury dead animals, the Huangpu River may have offered a tempting alternative.

While there was no proof any sick animals had been butchered and sold for meat in this case, media have reported several scandals involving sick or dead livestock being butchered and sold for meat.

Early this year, state media accused a supplier of chicken to KFC and McDonald’s of selling them sick poultry. The supplier denied it.

While authorities have not confirmed a disease, or the death of unusually large numbers of pigs, talk of pigs dying would seem to suggest an outbreak of some sort.

One Jiaxing farmer, 69-year-old Jiang Lie, said about 30 percent of his pigs had died of disease since January.

Reuters witnesses visited three reeking swine disposal pits in Jiaxing which appeared to have been just filled up and had signs saying they were at capacity.

“TOUGH JOB”

Dumping pigs into a river is not unheard of.

“We don’t think it is individual case. Many similar cases were just not reported,” said Wang Xiaoyue, an analyst with Beijing Orient Agri-business Consultant Co Ltd.

Villager Yan Lan’e said there were always pigs in the Huangpu, and aside from the number, the only difference this week was that authorities were clearing them out along with the trash.

“Before, they just cleared out the garbage,” she said.

Rather than blaming the farmers, Lin Rongquan, a veterinary health expert in Shanghai, pointed the finger of blame at the local government, a major link in the chain of agencies overseeing farms.

“It’s definitely the problem of the local government, which should bear the main responsibility. They do not regulate the pig business well,” he said.

On Sunday, the central government unveiled restructuring plans aimed at improving efficiency and cutting out graft. The changes came as parliament sat in Beijing for a session at which complaints of corruption and red tape were common.

The restructuring included bundling the responsibilities of several agencies into a ministerial-level General Administration of Food and Drug in response to the scandals.

Analyst Wang said that should help but it would not change things overnight given the problems from feed additives, the use of antibiotics and pollution.

“It’s a tough job to improve things,” he said.

Many people took to the internet to complain. Others sought solace in grim humor.

In one joke posted online, a Beijing resident boasts about the air pollution in the capital, saying if he wanted a smoke, he just had to open the window.

A Shanghai resident retorts: “That’s nothing, when we turn on the tap, we get free rib soup.”

(Additional reporting by Jane Lanhee Lee, Anita Li and Jiang Xihao in JIAXING; Editing by Robert Birsel)

Li’s appointment would be a sign that new Communist Party leader and incoming president Xi Jinping’s clout is growing, a source with ties to the leadership said. Xi fended off a bid by influential former president Jiang Zemin to install propaganda tsar Liu Yunshan in the job, the source said.

Jiang was a major power behind the scenes in the administration of outgoing President Hu Jintao.

The post of vice president is largely symbolic. However the job would raise Li’s profile, give him a role in foreign affairs and further bolster Xi, who took the top jobs in the party and military at the Communist Party congress in November.

The promotion of Li may also signal a willingness on the part of Xi to pursue limited reforms that Li is known to have advocated in his previous posts, such as making the selection of Communist officials more inclusive.

Leadership changes in China are thrashed out behind closed doors through horse-trading between new leaders and outgoing or retired leaders anxious to preserve their influence and protect family interests, but reshuffles must go through a choreographed selection process.

Two other sources, who declined to be identified because it is sensitive to discuss elite politics with foreign media, also confirmed that Xi had decided to make Li his vice president rather than Liu.

The National People’s Congress, China’s rubber-stamp parliament, will vote in Xi and Li as president and vice president respectively on March 14. Li Keqiang, the party’s new No.2 official, will succeed Wen Jiabao to become premier and oversee the economy and day-to-day running of the cabinet.

“Li Yuanchao will be vice president, not Liu Yunshan,” the source with leadership ties said.

“It was Xi’s decision and a sign he is strong and able to say ‘no’ to Jiang,” the source told Reuters.

CONSOLATION PRIZE

In November, Liu was promoted to the seven-man Politburo standing committee with responsibility for propaganda and ideology. He has also taken over two of Xi’s previous positions: president of the Central Party School, which grooms up-and-coming cadres, and top seat on the Secretariat of the party’s elite 205-member Central Committee.

Liu served as propaganda minister from 2002 to 2012, keeping a tight leash on domestic media and China’s Internet, which has more than 500 million users.

His rival, Li, had been widely considered a top contender for a spot on the standing committee in November but party elders led by Jiang used a last-minute straw poll to block him from joining the body, sources have said.

The vice presidential appointment “in part is compensation for him not getting into the Politburo standing committee”, said Guo Liangping, a Chinese politics expert at the National University of Singapore’s East Asia Institute.

“That position has high exposure to the world, it’s high profile, probably more prestigious, but in terms of real power it’s limited.”

If Li makes it, it would mark the first time since 1998 that the vice president is not a member of the standing committee – the apex of power in China. Li sits on the 25-member Politburo, one notch below the standing committee.

But both Li and Liu are too old to be potential successors to Xi.

“This time it’s kind of a holding position,” said Kerry Brown, executive director of the China Studies Centre at the University of Sydney.

Li has been regarded as progressive for advocating incremental reforms in how the party promotes officials and consults the populace on policies, but how much influence he has as vice president will be, to a large degree, decided by Xi.

“If Xi wants a pro-active, tightly-allied kind of vice president, then the vice president will have power. If he wants a purely symbolic figure who is there to do absolutely nothing, then that’s what the vice president will do,” said Brown.

The vice presidency was created by a change to the constitution in 1982. President Hu served in that role from 1998 to 2003 which formally anointed him as heir apparent to Jiang. Xi also served in that role from 2008 until the present.

The duties of the vice president include assisting the president and taking over the presidency in the event the president resigns or dies in office.

Li, a “princeling” whose father was a former vice mayor of Shanghai, earned mathematics and economics degrees from two of China’s best universities and has a doctorate in law. He also spent time at Harvard University’s Kennedy School of Government.

(Editing by Raju Gopalakrishnan)

The hukou system, which dates to 1958, has split China’s 1.3
billion people along urban-rural lines, preventing many of the
roughly 800 million Chinese who are registered as rural
residents from settling in cities and enjoying basic urban
welfare and services.

Critics have called for changes for years and a government
researcher told Reuters a “unified national residence permit
system” would be adopted as policy in a document to be published
after the current annual session of parliament.

Benefits and entitlement under the new system would be
“basically equal”, he said, although the changes would be eased
in slowly. He did not say how long it would take.

“The trend is to dilute the urban-rural household
registration divide”, said the researcher, who was briefed on
the details but declined to be identified because the plan has
not yet been made public.

Previous administrations have experimented with reform on
the fringes of hukou for years but have not delivered on calls
to overhaul the system, which affords different welfare and
civic services to urban and rural citizens.

In a speech to parliament on Tuesday that laid out the
blueprint of the new leaders, outgoing Premier Wen Jiabao said
hukou reforms should be accelerated to drive an urbanisation
effort that he said would underpin economic development.

Zhang Ping, head of the National Development and Reform
Commission, China’s main economic planning agency, said on
Wednesday that guidelines for the urbanisation plan would be
launched in the first half of 2013.

“Urbanisation is the biggest potential force driving China’s
domestic demand in the years ahead,” Zhang told reporters.

China plans to spend 40 trillion yuan ($6.4 trillion) to
bring 400 million people to cities over the next decade as the
new leadership of president-in-waiting Xi Jinping and
premier-designate Li Keqiang seeks to turn China into a wealthy
world power with economic growth generated by affluent
consumers.

Wen said consumption was the key to unlocking the full
potential of domestic demand in the economy and would reduce
excess, inefficiency and inequality. It would also help deliver
growth of 7.5 percent in 2013 – a level China barely beat in
2012 when growth eased to 7.8 percent, its slowest pace in 13
years.

Hukou reform can also unlock the funds of about 200 million
rural residents who work in cities as migrants and spend much of
their incomes on benefits like medical services and education
for their children, which are given free to urban dwellers.

If policymakers successfully harness this demographic shift,
China will enjoy continued economic strength, analysts say. If
not, it could lead to social and political instability.

UNDERCLASS

“If they don’t get it right, instead of growing a middle
class, they are going to grow a huge underclass in the city, and
that’s very scary,” said Kam Wing Chan, a population expert at
the University of Washington.

“Without granting urban hukou to rural urban migrants it is
very hard to turn them into the middle class. They will always
be second class,” he said.

One of the main reasons the reform has been delayed is
money. Local city governments have dragged their feet on plans
to give migrants equal welfare, saying they lack the fiscal
means to foot the bill.

“If the central government is serious they’ve got to talk
about how to finance this,” said Tom Miller, an analyst with GK
Dragonomics and author of the recently published book “China’s
Urban Billion”.

The state researcher who declined to be identified said the
urbanisation plan would broadly put the burden of funding on
central and local governments, enterprises that employ migrants
and individuals. He did not discuss specifics.

“In doing so we can ensure that some people can transition
from being rural to urban citizens and ensure basic public
services for this segment of people,” he said.

Another key reform needed in the urbanisation plan would be
new rural land management rules, although the researcher said
there would be few details on this.

Peasants now do not have the freedom to sell their land at
market prices, which has exacerbated China’s wide rich-poor gap
and made many reluctant to fully abandon their rural plots.

Officials like Chen Xiwen, head of the Central Committee’s
rural working group, have cautioned against urbanisation, saying
it could lead to a shrinking of farms as land is converted to
other uses.

Migrant workers have for years lamented inequalities in the
hukou system, like the lack of local medical coverage or equal
access to higher education.

“In the countryside we generally want to change our rural
hukou for city hukous,” said Wang Baiqiang, an 18-year-old who
left a village in Henan province last month for a job in an
Adidas factory in the coastal province of Jiangsu, 14 hours away
by bus.

“It’s just better if you have a city hukou (if you live in a
city),” he said.

(Editing by Raju Gopalakrishnan)

Spending on the People’s Liberation Army (PLA) will rise 10.7 percent to 740.6 billion yuan ($119 billion), while the domestic security budget will go up at a slightly slower pace, by 8.7 percent, to 769.1 billion yuan, according to the budget released at the opening of parliament’s annual meeting.

The numbers underscore the ruling Communist Party’s vigilance not only about territorial disputes with Japan and Southeast Asia and the U.S. “pivot” back to the region, but also about popular unrest over corruption, pollution and abuse of power, despite robust economic growth and rising incomes.

The number of “mass incidents” of unrest recorded by the Chinese government grew from 8,700 in 1993 to about 90,000 in 2010, according to several government-backed studies. Some estimates are higher, and the government has not released official data for recent years.

“It shows the party is more concerned about the potential risks of destabilization coming from inside the country than outside, which tells us the party is much less confident,” said Nicholas Bequelin, a researcher at Human Rights Watch, a New York-based advocacy group.

“A confident government that is not afraid of its population doesn’t need to have a budget for domestic security that is over defense spending,” he added.

In his “state of the nation” address to the largely stamp legislature, Premier Wen Jiabao listed maintaining social harmony and stability as one of the government’s priorities for this year.

“We should improve the mechanism for assessing potential risks major policy decisions may pose for social stability … The purpose of this work is to preserve law and order and promote social harmony and stability.”

CHINA’S MILITARY AMBITIONS

Still, defense spending is contained at about 5.4 percent of total expenditure, up from 5.3 percent last year, and remains at about one-fifth of the Pentagon’s outlays. But even with its worries about domestic problems, China has become increasingly assertive on the world stage.

Wen said the government “should accelerate the modernization of national defense and the armed forces … (and) should resolutely uphold China’s sovereignty, security and territorial integrity and ensure its peaceful development”.

China has advertised its long-term military ambitions with shows of new hardware, including its first test flight of a stealth fighter jet in early 2011 and its launch of a fledgling aircraft carrier – both trials of technologies needing years more of development.

Beijing is also building new submarines, surface ships and anti-ship ballistic missiles as part of its naval modernization, and has tested emerging technology aimed at destroying missiles in mid-air.

China has repeatedly said the world has nothing to fear from its military spending which is needed for legitimate defensive purposes, and that the money spent on the PLA pales in comparison with U.S. defense expenditure.

The Pentagon’s base budget under the current funding mechanism is $534 billion.

“It’s not good news for the world that a country as large as China is unable to protect itself,” parliament spokeswoman Fu Ying said on Monday. “China’s peaceful foreign policies and its defensive military policies are conducive to security and peace in Asia.”

Asian neighbors, however, have been nervous about Beijing’s expanding military, and this latest double-digit rise could reinforce disquiet in Japan, India, Southeast Asia and self-ruled Taiwan, which China considers part of its territory.

Japan and China have locked horns over islands each claims in the East China Sea. Vietnam, the Philippines and other nations have challenged Beijing over claims to swathes of the South China Sea that could be rich in oil and gas.

Over the past six months, China’s stand-off with Japan over a series of uninhabited rocky islands in the East China Sea known as the Senkaku in Japan and Diaoyu in China has become more acrimonious.

The increase announced in the national budget is at a slightly slower pace than the 11.2 percent rise planned for last year, though actual spending in 2012 reached 691.3 billion yuan compared with the budgeted 670.3 billion yuan.

Beijing’s public budget is widely thought by foreign experts to undercount its real spending on military modernization, which has unnerved Asian neighbors and drawn repeated calls from Washington for China to share more about its intentions.

“Traditionally, space development and the development of new weapons have not been included in defense spending in China. Even though China spends a lot in (defense-related) space programs, it would not show,” said Toshiyuki Shikata, professor at Japan’s Teikyo University professor and a retired general.

(Additional reporting by Kiyoshi Takenaka in TOKYO and Paul Eckert in WASHINGTON; Editing by Raju Gopalakrishnan)

They issue radio warnings to leave the area, but are ignored.

Visual wing-tipping signals go unheeded.

The Japanese pilots consider their last option: firing warning shots – a step Beijing could consider an act of war.

That hypothetical scenario, described by a former Japanese air force pilot, shows how the risky game being played near a chain of rocky, uninhabited isles at the heart of a row between China and Japan could quickly escalate to the danger point.

“China would be furious. They would regard it as war, although it is not by international law,” the former pilot, who declined to be identified because of the sensitivity of the subject, said of the scenario over the East China Sea.

A long-simmering row over the islands, known as the Senkaku in Japan and the Diaoyu in China, has in recent months escalated to the point where both have scrambled fighter jets while patrol ships shadow each other in nearby seas.

Tokyo noted last month that its pilots have the right under global rules to fire warning shots against intruders in its air space, a step Japan has taken only once since World War Two.

Concerns that the increasing cat-and-mouse encounters between planes or patrol ships in the East China Sea will cause an accidental clash are giving impetus to efforts to dial down tensions, including a possible leaders’ summit.

But while hopes have emerged of a thaw in the chill that began when Japan bought the islands from a private citizen last September, deep mistrust, regional rivalry and pumped up nationalism complicated by bitter Chinese memories of Japan’s wartime aggression mean any rapprochement will be fragile.

“Most likely the two sides will eventually find a face-saving formula to step back from this. But I doubt it’s a flash in the pan,” said Andy Gilholm of consultancy Control Risks.

“There seems no chance of a permanent settlement and even a durable setting aside of the issue looks very unlikely. So … we’re advising clients that this kind of friction is part of the new normal, not a fleeting storm.”

With Japanese businesses suffering from a downturn in trade after violent anti-Japan protests last September and jobs and investment in China at risk if the feud drags on or worsens, the pressure is on to find a resolution of sorts.

Japan’s ally the United States, which has shifted its attention to the region in an Asian “pivot”, has signaled it does not want to see a military clash over the islands, which Washington says fall under a two-way security pact with Tokyo.

A string of Japanese politicians including Abe’s junior coalition partner and former Prime Minister Tomiichi Murayama – a socialist who issued a landmark 1995 apology for Japan’s wartime aggression – have visited Beijing in recent weeks.

“These (visits) are being reported in China in an explicit way,” said Yoshihide Soeya, director of the Institute of East Asian Studies at Keio University in Tokyo. “China is telling its domestic audience that it is time to try something new.”

“NIXON IN CHINA”?

Abe, who returned to Japan’s top job in December after his Liberal Democratic Party’s (LDP) huge election win, now says he is open to a summit. LDP Vice President Masahiko Komura may travel to China to try to lay the groundwork, although no meeting is expected until after Xi becomes president in March.

Abe moved quickly to repair Sino-Japanese ties when he took office for a first term in 2006 and Japanese executives and some experts say his nationalist image may mean he is well placed to do something similar again, as then-President Richard Nixon’s 1972 China visit set the stage to normalize Sino-American ties.

Still, setting the stage for summitry will require deft diplomacy. “Both sides want to lower the heat, but they don’t want to look soft to their own nationals,” said the Japanese ex-pilot, now an expert on regional security matters.

Abe’s predecessor bought the islands, located near potentially big maritime gas reserves, last September to prevent their purchase by the nationalist governor of Tokyo. Beijing rejected Japan’s explanation that the move was meant to avoid escalating tensions, and violent protests erupted in China.

Even if the leaders meet, a substantive compromise in which Beijing stops sending ships and planes to the area or Tokyo agrees that the island’s sovereignty is disputed looks elusive.

The row over the islands has caused flare-ups with serious economic fallout in years past, but China’s stepped up efforts to physically challenge Japan’s control – and Japan’s decision to push back – has raised the risk to a new level, diplomats say.

Japanese fighters scrambled 160 times between April and October last year, the latest period for which data is available, more than the total in the 12 months to March 2012, and at least eight times since December 13 when a Chinese turbo-prop plane entered what Japan considers its airspace.

Japan’s defense minister, Itsunori Onodera, said in January that Japan might fire tracer bullets as warning shots, a step its air force has taken only once since World War Two when a Soviet bomber strayed into its airspace over Okinawa.

That incident ended with an apology by Moscow but any similar episode is unlikely to be so easily settled this time.

Another elevated risk is a possible collision between Japanese and Chinese patrol vessels in the area or a boat of Chinese activists that tries to land on one of the islands.

In a sign that Japan sees the tensions persisting, the defense ministry is considering deploying F-15 fighter jets and patrol planes to another island chain closer to the disputed isles to respond more quickly to Chinese vessels and aircraft.

“At least there are efforts to manage the situation,” said former Japanese diplomat Hitoshi Tanaka, head of the Institute for International Strategy in Tokyo. “But the danger remains.” (This story is refiled to make clear pilot is describing a hypothetical situation)

(Additional reporting by Kiyoshi Takenaka and Tetsushi Kajimoto in Tokyo; Editing by Jeremy Laurence and Robert Birsel)

They issue radio warnings to leave the area, but are ignored.

Visual wing-tipping signals go unheeded.

The Japanese pilots consider their last option: firing warning shots – a step Beijing could consider an act of war.

That’s how the risky game being played near a chain of rocky, uninhabited isles at the heart of a row between Beijing and Tokyo could quickly escalate to the danger point, a former Japanese air force pilot said.

“China would be furious. They would regard it as war, although it is not by international law,” the ex-pilot said of the depicted scenario in the skies over the East China Sea.

A long-simmering row over the islands, known as the Senkaku in Japan and the Diaoyu in China, has in recent months escalated to the point where both have scrambled fighter jets while patrol ships shadow each other in nearby seas.

Tokyo noted last month that its pilots have the right under global rules to fire warning shots against intruders in its air space, a step Japan has taken only once since World War Two.

Concerns that the increasing cat-and-mouse encounters between planes or patrol ships in the East China Sea will cause an accidental clash are giving impetus to efforts to dial down tensions, including a possible leaders’ summit.

But while hopes have emerged of a thaw in the chill that began when Japan bought the islands from a private citizen last September, deep mistrust, regional rivalry and pumped up nationalism complicated by bitter Chinese memories of Japan’s wartime aggression mean any rapprochement will be fragile.

“Most likely the two sides will eventually find a face-saving formula to step back from this. But I doubt it’s a flash in the pan,” said Andy Gilholm of consultancy Control Risks.

“There seems no chance of a permanent settlement and even a durable setting aside of the issue looks very unlikely. So … we’re advising clients that this kind of friction is part of the new normal, not a fleeting storm.”

With Japanese businesses suffering from a downturn in trade after violent anti-Japan protests last September and jobs and investment in China at risk if the feud drags on or worsens, the pressure is on to find a resolution of sorts.

Japan’s ally the United States, which has shifted its attention to the region in an Asian “pivot”, has signalled it does not want to see a military clash over the islands, which Washington says fall under a two-way security pact with Tokyo.

A string of Japanese politicians including Abe’s junior coalition partner and former Prime Minister Tomiichi Murayama – a socialist who issued a landmark 1995 apology for Japan’s wartime aggression – have visited Beijing in recent weeks.

“These (visits) are being reported in China in an explicit way,” said Yoshihide Soeya, director of the Institute of East Asian Studies at Keio University in Tokyo. “China is telling its domestic audience that it is time to try something new.”

“NIXON IN CHINA”?

Abe, who returned to Japan’s top job in December after his Liberal Democratic Party’s (LDP) huge election win, now says he is open to a summit. LDP Vice President Masahiko Komura may travel to China to try to lay the groundwork, although no meeting is expected until after Xi becomes president in March.

Abe moved quickly to repair Sino-Japanese ties when he took office for a first term in 2006 and Japanese executives and some experts say his nationalist image may mean he is well placed to do something similar again, as then-President Richard Nixon’s 1972 China visit set the stage to normalise Sino-American ties.

Still, setting the stage for summitry will require deft diplomacy. “Both sides want to lower the heat, but they don’t want to look soft to their own nationals,” said the Japanese ex-pilot, now an expert on regional security matters.

Abe’s predecessor bought the islands, located near potentially big maritime gas reserves, last September to prevent their purchase by the nationalist governor of Tokyo. Beijing rejected Japan’s explanation that the move was meant to avoid escalating tensions, and violent protests erupted in China.

Even if the leaders meet, a substantive compromise in which Beijing stops sending ships and planes to the area or Tokyo agrees that the island’s sovereignty is disputed looks elusive.

The row over the islands has caused flare-ups with serious economic fallout in years past, but China’s stepped up efforts to physically challenge Japan’s control – and Japan’s decision to push back – has raised the risk to a new level, diplomats say.

Japanese fighters scrambled 160 times between April and October last year, the latest period for which data is available, more than the total in the 12 months to March 2012, and at least eight times since December 13 when a Chinese turbo-prop plane entered what Japan considers its airspace.

Japan’s defence minister, Itsunori Onodera, said in January that Japan might fire tracer bullets as warning shots, a step its air force has taken only once since World War Two when a Soviet bomber strayed into its airspace over Okinawa.

That incident ended with an apology by Moscow but any similar episode is unlikely to be so easily settled this time.

Another elevated risk is a possible collision between Japanese and Chinese patrol vessels in the area or a boat of Chinese activists that tries to land on one of the islands.

In a sign that Japan sees the tensions persisting, the defence ministry is considering deploying F-15 fighter jets and patrol planes to another island chain closer to the disputed isles to respond more quickly to Chinese vessels and aircraft.

“At least there are efforts to manage the situation,” said former Japanese diplomat Hitoshi Tanaka, head of the Institute for International Strategy in Tokyo. “But the danger remains.” (Additional reporting by Kiyoshi Takenaka and Tetsushi Kajimoto in Tokyo; Editing by Jeremy Laurence)

They issue radio warnings to leave the area, but are ignored.

Visual wing-tipping signals go unheeded.

The Japanese pilots consider their last option: firing warning shots – a step Beijing could consider an act of war.

That’s how the risky game being played near a chain of rocky, uninhabited isles at the heart of a row between Beijing and Tokyo could quickly escalate to the danger point, a former Japanese air force pilot said.

“China would be furious. They would regard it as war, although it is not by international law,” the ex-pilot said of the depicted scenario in the skies over the East China Sea.

A long-simmering row over the islands, known as the Senkaku in Japan and the Diaoyu in China, has in recent months escalated to the point where both have scrambled fighter jets while patrol ships shadow each other in nearby seas.

Tokyo noted last month that its pilots have the right under global rules to fire warning shots against intruders in its air space, a step Japan has taken only once since World War Two.

Concerns that the increasing cat-and-mouse encounters between planes or patrol ships in the East China Sea will cause an accidental clash are giving impetus to efforts to dial down tensions, including a possible leaders’ summit.

But while hopes have emerged of a thaw in the chill that began when Japan bought the islands from a private citizen last September, deep mistrust, regional rivalry and pumped up nationalism complicated by bitter Chinese memories of Japan’s wartime aggression mean any rapprochement will be fragile.

“Most likely the two sides will eventually find a face-saving formula to step back from this. But I doubt it’s a flash in the pan,” said Andy Gilholm of consultancy Control Risks.

“There seems no chance of a permanent settlement and even a durable setting aside of the issue looks very unlikely. So … we’re advising clients that this kind of friction is part of the new normal, not a fleeting storm.”

With Japanese businesses suffering from a downturn in trade after violent anti-Japan protests last September and jobs and investment in China at risk if the feud drags on or worsens, the pressure is on to find a resolution of sorts.

Japan’s ally the United States, which has shifted its attention to the region in an Asian “pivot”, has signaled it does not want to see a military clash over the islands, which Washington says fall under a two-way security pact with Tokyo.

A string of Japanese politicians including Abe’s junior coalition partner and former Prime Minister Tomiichi Murayama – a socialist who issued a landmark 1995 apology for Japan’s wartime aggression – have visited Beijing in recent weeks.

“These (visits) are being reported in China in an explicit way,” said Yoshihide Soeya, director of the Institute of East Asian Studies at Keio University in Tokyo. “China is telling its domestic audience that it is time to try something new.”

“NIXON IN CHINA”?

Abe, who returned to Japan’s top job in December after his Liberal Democratic Party’s (LDP) huge election win, now says he is open to a summit. LDP Vice President Masahiko Komura may travel to China to try to lay the groundwork, although no meeting is expected until after Xi becomes president in March.

Abe moved quickly to repair Sino-Japanese ties when he took office for a first term in 2006 and Japanese executives and some experts say his nationalist image may mean he is well placed to do something similar again, as then-President Richard Nixon’s 1972 China visit set the stage to normalize Sino-American ties.

Still, setting the stage for summitry will require deft diplomacy. “Both sides want to lower the heat, but they don’t want to look soft to their own nationals,” said the Japanese ex-pilot, now an expert on regional security matters.

Abe’s predecessor bought the islands, located near potentially big maritime gas reserves, last September to prevent their purchase by the nationalist governor of Tokyo. Beijing rejected Japan’s explanation that the move was meant to avoid escalating tensions, and violent protests erupted in China.

Even if the leaders meet, a substantive compromise in which Beijing stops sending ships and planes to the area or Tokyo agrees that the island’s sovereignty is disputed looks elusive.

The row over the islands has caused flare-ups with serious economic fallout in years past, but China’s stepped up efforts to physically challenge Japan’s control – and Japan’s decision to push back – has raised the risk to a new level, diplomats say.

Japanese fighters scrambled 160 times between April and October last year, the latest period for which data is available, more than the total in the 12 months to March 2012, and at least eight times since December 13 when a Chinese turbo-prop plane entered what Japan considers its airspace.

Japan’s defense minister, Itsunori Onodera, said in January that Japan might fire tracer bullets as warning shots, a step its air force has taken only once since World War Two when a Soviet bomber strayed into its airspace over Okinawa.

That incident ended with an apology by Moscow but any similar episode is unlikely to be so easily settled this time.

Another elevated risk is a possible collision between Japanese and Chinese patrol vessels in the area or a boat of Chinese activists that tries to land on one of the islands.

In a sign that Japan sees the tensions persisting, the defense ministry is considering deploying F-15 fighter jets and patrol planes to another island chain closer to the disputed isles to respond more quickly to Chinese vessels and aircraft.

“At least there are efforts to manage the situation,” said former Japanese diplomat Hitoshi Tanaka, head of the Institute for International Strategy in Tokyo. “But the danger remains.”

(Additional reporting by Kiyoshi Takenaka and Tetsushi Kajimoto in Tokyo; Editing by Jeremy Laurence)