Brief introduction of the Project
on China and Global Economy
This is the second policy study supported by the China Economic Research and Advisory Programme (CERAP). The main recommendations of the first study on social security reform were presented to Premier Wen Jiabao in November 2004, as well to a broader audience at a seminar in Beijing. At the meeting with Premier Wen, it was agreed that the next study to be conducted by the CERAP should be on medium-term issues associated with China and the global economy. The counterpart institutions for this study are the Institute of World Economy and Politics in the Chinese Academy of Social Sciences, and the Research Institute of the People’s Bank of China.
A number of prominent economists from different parts of the world were invited to write papers for this study, either on the general topic of China and the global economy or on more specific issues, depending on personal interests and expertise. A number of papers were also prepared by the Chinese counterpart institutions.
This synthesis report was prepared by Edwin Lim, Michael Spence and Ricardo Hausmann on the basis of papers prepared by the following:
A team of economists at the People’s Bank of China, led by Dr Tang Xu, Director of the Research Department, and a team at the Institute of World Economics and Politics, Chinese Academy of Social Sciences, led by Professor Yu Yongding and Dr He Fan.
Olivier Blanchard (French), Professor of Economics, Massachusetts Institute of Technology (MIT), Member of the French Prime Minister’s Economic Advisory Council; Barry Eichengreen (American), Professor of Economics and Professor of Political Science, University of California, Berkeley; former Senior Policy Advisor, IMF; Francesco Giavazzi (Italian), Professor of Economics, Bocconi University in Milan; visiting Professor at MIT; Member of the Group of Economic Policy Advisers to the President of the European Commission; Ricardo Hausmann (Venezuelan), Professor of Economic Development, Kennedy School of Government, Harvard University; former Venezuelan Minister of Planning and Chief Economist, Inter-American Development Bank; Takatoshi Ito (Japanese), Professor of Economics, University of Tokyo; former Deputy Vice Minister for International Affairs, Ministry of Finance, Japan; Senior Advisor, Research Department, IMF; Michael Lipton (British), Research Professor, Poverty Research Unit, University of Sussex; Warwick McKibbin (Australian), Professor of International Economics, Research School of Pacific and Asian Studies; Director of Centre for Applied Macroeconomic Analysis at the Australian National University; Maurice Obstfeld (American), Professor of Economics, University of California, Berkeley; Jean Pisani-Ferry (French), Director, Brussels European and Global Economic Laboratory (Bruegel); Professor of Economics, University of Paris-Dauphine; Member of the French Prime Minister’s Economic Advisory Council; Dani Rodrik (American), Professor of International Political Economy, Kennedy School of Government, Harvard University; André Sapir (Belgian), Professor of Economics, Université Libre de Bruxelles and member of the Group of Economic Policy Advisers to the President of the European Commission; and Anthony Venables (British), Chief Economist, UK Department for International Development; Professor of International Economics, London School of Economics and Political Sciences;
Christopher Allsopp (Reader in Economics, University of Oxford, formerly member of the Monetary Policy Committee, Bank of England), Professor William Hsiao (School of Public Health, Harvard University), Dr Cyril Lin (Managing Director, Development Initiatives, Ltd, formerly University Lecturer in Economics, University of Oxford), and Dr Tan Kim Song (Singapore Management University) also provided inputs to the synthesis paper.
The work of CERAP was guided by the following advisory team, many of whom reviewed and provided comments on an early draft of this report:
Chinese advisors: Liu Zhongli, Chairman, Economic Committee of Political Consultative Committee; Xiang Huaicheng, Chairman, National Council for Social Security Fund; Zhou Xiaochuan, Governor, the People’s Bank of China; Wu Jinglian, Senior Fellow, the Development and Research Center of the State Council; Li Jiange, Deputy Chairman, the Development and Research Center of the State Council; Lou Jiwei, Senior Vice Minister, Ministry of Finance; Guo Shuqing, Chairman, China Construction Bank; and Yu Yongding, Director General, Institute of World Economy and Politics, Chinese Academy of Social Sciences.
International advisors: Stanley Fischer (Governor, Bank of Israel, formerly President, Citigroup International; First Deputy Managing Director, International Monetary Fund, Chief Economist, World Bank, and Professor of Economics, MIT); Caio Koch-Weser (Vice Chairman, Deutsche Bank, formerly Deputy Minister of Finance, Germany; Managing Director, World Bank); Edwin Lim, (formerly Director, World Bank, first Director of the World Bank office in Beijing and founding CEO of Chinese International Capital Corporation), Sir James Mirrlees (Nobel Laureate and Professor of Economics, University of Cambridge); Professor Michael Spence (Nobel Laureate, formerly Dean of the Graduate School of Business, Stanford University and Dean of the Faculty of Arts and Sciences, Harvard University); Sir Nicholas Stern (Second Permanent Secretary, UK Treasury; formerly, Chief Economist, World Bank, and Professor of Economics, London School of Economics); and Teh Kok-Peng (President, GIC, Special Investment Pvte, Ltd, Singapore; formerly, Deputy Managing Director, Monetary Authority of Singapore).
Edwin Lim is responsible for overall management of CERAP.
China and the Global Economy:
Medium-term Issues and Options
A synthesis report[1]
Introduction
China’s economic and social achievements since the beginning of reform and opening is unprecedented in global history. Managing the growth process in this continuously changing environment has required great skill and the use of unconventional economic policy. The approach to economic policy has been characterized by pragmatism, gradualism, innovative experimentation and caution (‘moshi guohe’ or ‘crossing the river by feeling for stepping stones’), avoiding big-bang solutions and risky outcomes. The benefits of this growth have been spread widely, with hundreds of million of people lifted out of poverty.
China, however, has entered a new era in its development process with a set of challenges largely different from those of the recent past. Some of these challenges – such as the continued need to reform and modernize the economy, generate employment and raise living standards – remain outstanding and will always persist in one form or another. But other challenges – such as growing internal and external structural imbalances, increasing income and regional inequality – have arisen from, or been exacerbated by the very pattern and success of high growth since reforms began. And there are still other challenges newly posed by rapid changes in the global economy. These challenges can best be tackled in an integrated and coordinated fashion. Some can only be met by being addressed simultaneously, while responses to others need to be properly sequenced.
This report identifies the major, fundamental challenges facing China today and presents options for meeting them. Following an introductory chapter, Chapter 2 presents a comprehensive program to deal with internal and external imbalances, in ways that are consistent with China’s growth strategy and with the need to address emerging social and economic problems. Chapter 3 discusses the challenge of maintaining rapid growth while continuing to reduce disparity and persistent poverty. Chapter 4 proposes a dual-track approach to building a macro-management system capable of guiding the necessary process of growth and adjustment in the coming years. Chapter 5 examines how China may play a more active role and, in some cases, assume a stronger leadership position in the affairs of regional and international economies. The time frame of these discussions is medium term, say, over the next 3–5 years. Thus, the final chapter takes a longer-term perspective, identifying the emerging trends in the global economy over the next two decades, of which China needs to be conscious now.
Dealing with Internal and External Balances
The global economy faces serious imbalances today. In this context, attention on China has focused on its large balance-of-payments surplus and the latter’s implication for the country’s exchange-rate policy. This is, however, an incomplete and misleading view of the problem. In our opinion, China should deal with its external and internal imbalances simultaneously. What is needed is a package of policy measures which would deal with outstanding issues in a comprehensive and coordinated manner, contribute to the adjustment necessary in the global economy, as well as help China achieve its own priorities.
China’s current-account surplus is a reflection of an excess of saving over investment. This is an unusual and undesirable situation for a low-income country such as China, as it means that the Chinese are forgoing a substantial amount of consumption for low-return assets in rich countries. These resources could be better used to address the ‘social debt’ that has been accumulated over the past decades and to create the conditions for future growth, thus increasing the welfare of the current and future generations of China.
Both saving and investment in China today are very high compared to earlier years or to other countries. Investment, at about 46% of GDP, has reached a point of very low returns in some areas. Although more investment is still needed in some key areas, rapid growth could be maintained through more efficient investment while enabling a reduction in the overall level of investment.
Eliminating the saving–investment gap, therefore, requires that saving be reduced and consumption increased. Since 1990, saving has risen rapidly, reaching 50% of GDP in 2004, one of the highest rates in the world. There is therefore ample room for raising consumption through a reduction in saving. An increase in consumption expenditures that would help achieve a more balanced development strategy would also increase imports from the rest of the world and reduce China’s dependence on external demand, thus achieving a better external balance.
To achieve internal and external balances, consumption in China needs to increase from the current level of only about 50% of GDP to 55–60% in the coming decade, which would approach the average level in the world. Thus, the key recommendation of this report is a comprehensive package of policies with three main elements: (i) reform measures to promote growth of consumption in the longer term; (ii) a public expenditure program to stimulate domestic demand in the short and medium term; and (iii) a managed appreciation of the currency.
Reform Measures to Promote Consumption Growth
Household consumption in China has not risen in line with national income because the household saving rate, although it seems to have stabilized in recent years, remains at one of the highest levels in the world, while the share of household disposable income in national income has fallen. A major cause of the high household saving rate in China is the so-called precautionary saving. Although income has risen substantially, the system of social protection has collapsed to a large extent. This, coupled with the rapid pace of change, has increased uncertainty.
To remedy the situation, the social security system needs to be strengthened. At the core is the reform of the pension system. Recommendations to reform the urban-based pension system, made by an international team organised by this program in 2004, include reducing the fragmentation of the system and introducing pooling and administration at the national level; eliminating early retirement abuses; transferring shares of SOEs still owned by the state to the National Social Security Fund to finance obligations left by the old SOE system; and strengthening individual accounts by switching to a Notional Defined Contribution system. In addition, an urgent task is to provide old-age security for the rural population, strengthen the minimum income (Dibao) program and improve access to and sharing of risks in health and education.
Financial-sector reforms will also be necessary to provide households with efficient instruments of saving which at present go mainly into low-return bank deposits.
Over the past few years, another reason for the slow growth of personal consumption has been the declining share of disposable household income in GDP, which means that household consumption has grown significantly less than GDP, although household saving rates seems to have stabilized or declined somewhat (although still at a very high level). In the last few years, the net income of enterprises has grown sharply. Unlike other market economies, where a substantial share of the net income of enterprises flows to households in the form of dividends to finance private consumption, almost all the income generated by enterprises in China is saved and used for investment, either by the enterprise itself or within the sector, with limited mobility. More listing of enterprises in the stock markets and increased allocation of enterprise income to dividends will be necessary to allow Chinese households to benefit more from growing enterprise income.
Government revenues as a percentage of national income have also increased sharply over the last few years, largely as a result of improved collection. In addition, government administrative reforms have led to a decrease in government consumption, while expenditures on education, health and other public services have not increased correspondingly. The improvement in fiscal balances has gone mostly into investment. Much of the increase in investment, especially by local government, has had low returns. To stimulate consumption in the economy, the government will need to increase the share of income going to households – through lower taxation of household income and increased transfers and subsidies – and to increase government consumption itself.
Special Public Expenditure Program to Stimulate Consumption in the Medium Term
To stimulate domestic demand over the short and medium term and respond to the macroeconomic objective of increasing consumption by 6–10% of GDP, a special public expenditure program covering the coming 3–5 years will be needed. The program should be used to facilitate the transition of the economy to China’s new ‘people-centered’ and comprehensive, coordinated development strategy by supporting social services and consumption. A large legacy of ‘debt’ in social development now exists and requires urgent attention. Such expenditures to support the improvement of health, education and other social services will by themselves help to stimulate private consumption and reduce the need for precautionary saving.
The needs are very large and the following are areas that could be considered:
· improvement in health care, including increased government expenditures and subsidies to poorer regions and population groups;
· increased expenditures in education will be necessary, including the introduction of compulsory nine-year education in the poorest areas and the strengthening of technical education;
· in the same way as China has benefited greatly from its integration in the global economy over the past decade, there are opportunities for efficiency gains and growth through greater internal integration. Priority should be given to improving the quality of the transportation and communication infrastructure in the poorer interior regions, as well as agricultural research and extension, irrigation, rural infrastructure, and greater access to farm inputs and markets via transport and information. Given the rapid urbanization that China will be going through in the coming years, investment in urban infrastructure such as transport, water and sanitation, should also be of high priority in a public expenditure program.
Conditions exist in China to implement such a public expenditure program. The fiscal position of the government is strong. Since the growth rate of the economy – at about 9%– is much higher than the average real cost of debt service of about 2.5%, China can continue to run substantial fiscal deficits over the next few years without having to worry about the debt burden. The challenge is therefore not financial, but more one of whether a fiscal adjustment program can be designed that is compatible with macroeconomic, social and regional objectives, and that also limits the risks imposed by possible government failures. In addition, the adjustment program should not become a permanent feature of the fiscal system. With rising budgetary revenues, many of the recurrent elements of the public expenditure program should be absorbed into the regular budget while still allowing the government to maintain a balanced current account budget.
Managed Adjustment of Currency
An appreciation of the RMB would not only help correct the trade balance, but will also help promote a balanced development of the domestic economy. By its dampening effect on the economy, it would enable the economy to avoid going into a state of overheating and high inflation as a result of the increase in consumption. It would also lead to an increase in the prices of traded goods relative to non-traded goods and thus promote faster growth in the non-traded sectors, such as services.
The magnitude of appreciation desirable is impossible to estimate ex ante. Appreciation of the currency by itself could have adverse effects on growth and income distribution. Adjustment of the exchange rate should therefore be carefully managed and its impact on the economy closely monitored. Possible adverse effects can be overcome or mitigated, and the magnitude of appreciation necessary reduced, if the adjustment in the exchange rate is combined with the measures above.
Over time, the government should be prepared to make substantial adjustments in the exchange rate if market conditions require, and if needed to achieve internal and external balances. The reform of the foreign-exchange regime introduced on 21 July 2005 created the necessary conditions for a gradual and controlled transition to full currency convertibility. The new foreign-exchange regime also provides the opportunity to implement the managed appreciation of the exchange rate itself.
Finally, in the implementation of the above program to restore internal and external balances, the relative timing and magnitude of the different possible elements of the policy package need to be carefully coordinated and balanced. Too small an appreciation of the RMB combined with a large expansionary public expenditure program may result in overheating and inflationary pressure. The public expenditure program needs to be carefully planned also, to be sure that supply will be able to respond to the increased demand. The relative roles of the central and local governments in the financing and execution of this program need to be decided carefully.
There are important lessons of international experience on the need to take advantage of the opportunities this new mechanism provides. In the early 1970s Japan was in a situation similar to China’s today. Instead of allowing a managed appreciation of the currency, Japan chose to increase the money supply in attempting to achieve external balance. This proved to be a major mistake, resulting in hyper-inflation and negative growth when the oil crisis hit in October 1973. The transitional arrangements possible under the new system in China are also consistent with the experiences in other emerging market countries, such as Chile and Israel, which have ultimately achieved healthy economic growth coupled with low inflation, financial stability, full currency convertibility, and a fully floating exchange rate. These should also be China’s goals.
China and Global Imbalances
It is not yet possible to predict how the necessary adjustment in the global economy will take place in the next 3–5 years. It is, however, possible to identify the necessary components of an orderly and smooth adjustment. The United States should increase saving and reduce consumption substantially. Growth needs to accelerate in the EU and Japan. In the rest of Asia outside China, where saving is already high, investment needs to recover from the reduced level that followed the financial crisis of the late 1990s. Currency adjustment will facilitate this process of adjustment, including a significant depreciation of the US dollar and appreciation of the currencies in countries with substantial current account surpluses. In China, consumption should be the new engine of growth while the move towards a managed floating exchange rate will enable the exchange rate to adjust to market conditions. While contributing to an orderly and smooth adjustment of the global economy, this would be consistent with China’s new development strategy and increase the welfare of the Chinese people.
Measures to Reduce the Capital Account Surplus
China’s external imbalance is not limited to the current account surplus discussed above, but also involves the large surplus in the capital account (the so-called twin surpluses). The main element in the capital account is the capital inflows associated with foreign direct investment (FDI ) – amounting in 2004 to about the same level as the current account surplus. FDI has been a major source of productivity and economic growth for China over the past decade. The question for China is how to continue to tap into the technology and management practices of foreign investors as it tries to move into the higher end of the production value chain while reducing the associated capital flows.
The first step is to eliminate the differentiation in tax and other treatments according to sources of capital. At the same time, domestic financing of investment by foreign investors should be encouraged. The objective would be not only to deal with the capital account surplus caused by FDI, but also to move towards a more efficient allocation of savings and capital within China, thereby raising the returns on domestic savings. Foreign investors should be allowed to borrow in RMB locally, either from banks or by issuing corporate bonds. Mature and successful foreign invested enterprises should also be encouraged to sell equity shares in the local stock markets. The listing of foreign-invested enterprises should not have to wait until the current efforts to strengthen the A share market are completed. Assets of foreign invested enterprises now amount to about $650 billion and represent the most dynamic and best-managed part of the Chinese economy. The entry of even a small fraction of these companies will make the A share market much more attractive and bring in more investors. The opportunity to sell shares in the local stock markets once an enterprise is mature and successful will encourage more foreign investors to bring in advanced technology and efficient management practices.
These measures notwithstanding, a substantial inflow of foreign capital associated with FDI will undoubtedly continue as long as China continues to grow at the current rate. Thus, even ignoring speculative capital flows, a surplus in the capital account will continue, and, unless China wants to run a current-account deficit, the build-up of international reserves will also continue, and be of a size significantly larger than that indicated by the usual need for international reserves. The question is then how China can manage its reserves better for the benefit of the current as well as the future population. A possible approach is to put aside part of its reserves – after adequate provision of precautionary liquid reserves – to be more actively managed, with the objective of enhancing the investment returns and providing an additional source of fiscal revenue for the government. In countries such as Singapore, Brunei, Kuwait, Abu Dhabi, Norway and, more recently, South Korea, a separate investment company is set up outside the central bank to manage part of the foreign reserves. These companies behave much like a long-term global endowment fund and try to maximise long-term returns, subject to matching requirements of long-term liabilities.
Of course, the circumstances and needs of China are very different from those of these much smaller economies with limited opportunities for investment domestically. Such an initiative in China will likely be of a more temporary nature, until the economy’s ability to invest efficiently, through financial-sector and other reforms, catches up with the economy’s propensity to save. For the next 5–10 years, however, active management of part of the reserves may be desirable.
Maintaining Growth: Challenges and Opportunities
Despite sustained and rapid growth over 25 years, China today faces broad-based challenges that will tend to slow down the economy. Since China grows faster than the rest of the world it tends to suffer from deteriorating terms of trade. This arises because it increases the supply of its exports faster than the increase in global demand for them, and raises the demand for imports faster than the growth in global supply. This tendency will become stronger as China becomes a larger part of the global economy. Moreover, China will face increasing protectionist tendencies in its major export markets. As China continues to grow, certain factors of production that are fixed – such as land, water, natural resources, clean air – become scarcer relative to those that can be accumulated, such as physical and human capital. As discussed above, ineffective response to internal and external imbalances could also have an undesirable impact on growth.
Rising manufacturing productivity has been the main driver of China’s growth up to date and has been facilitated by its orientation towards exports and the encouragement of FDI. This has created an unusually sophisticated export package: China’s exports are characteristic of countries whose income per capita is triple that of China. This is a major reason why China’s exports have been so dynamic. However, the degree of sophistication of China’s exports has not increased much over the past decade and the country has to make a major effort at continuing to upgrade its exports to avoid deteriorating prices, profits and growth.
Industrial policy should move away from generalized subsidies to export activities. Instead, it should encourage experimentation into new areas and be willing explicitly or implicitly to subsidize the process in order to compensate for the costs of adaptation, labor training and supply-chain development, while at the same time making sure that special requirements in terms of infrastructure, regulation or education are provided. This process of experimentation is bound to generate successes and failures. It is critical to develop the mechanisms to make sure that initiatives that do not work out are abandoned early enough so that resources are not bottled up in unproductive activities.
Promoting service sector growth
Although the service sector has been China’s main source of employment growth since 1990, productivity growth has lagged behind that in manufacturing. However, trade in services provided by highly educated people all over the world will represent an increasingly larger fraction of total world trade in the coming decades. Specific policies to promote the growth of the service sector in China could include revising the list of ‘strategic’ sectors reserved to state-owned enterprises (SOEs); removing restrictions on FDI in services; faster licensing for self-employed businesses and lower licence fees for small enterprises. Business process outsourcing should be stimulated, especially within China, where language barriers are not an issue and where there are ample opportunities to tap the labour supply from Central and Western regions. Little is known about the service sector in China, however, and further research is needed on the factors constraining the growth of the sector.
China’s investment rate is the highest among large countries. The issue therefore is not how to increase the investment rate but how to raise its productivity. The financial system is at the core of the efficiency of investment, as it determines how savings are allocated and monitored. China is in the gradual process of developing a sophisticated financial system. As it does, more of the capital-allocation decisions will be subject to a market test and savings will be allocated across sectors to the activities that promise the highest risk-adjusted returns. It is important to develop an ambitious yet experimental, flexible and gradual policy to promote the development of capital markets and the set of complementary intangible assets. Reforms of fundamental areas such as property rights, company law and bankruptcy law will be essential to the further deepening of the financial system.
In addition, a large part of savings in China does not even flow through the financial system or is subject to any economy-wide allocation. Enterprise saving amounts to about the same level as household saving. A large part of these savings are either invested in the enterprise itself as retained earnings, or paid as dividends to the sectoral-holding companies for investment also within the sector. To improve the efficiency of investment, as much capital as possible must be subject to economy-wide allocation process. Policies should be adopted to break down the sectoral compartmentalization of investment resources in SOEs by requiring that an increased share of enterprise profits be paid to institutions with economy-wide responsibility. In most countries, dividends of SOEs accrue to the Ministry of Finance and are subject to allocation through the overall budgetary process. The proposal that shares of SOEs still owned by the state be transferred to the Social Security Fund would be a step in this direction.
Investment in human capital
While its rate of investment in physical capital has been the highest among large countries, China’s investment in human capital has fallen off significantly in recent years and could seriously undermine the country’s ability to compete in the global economy where trade will be increasingly skill-based services. This imbalance suggests that a major reallocation of the public sector’s investment effort from physical to human capital should be part of the new growth strategy.
Health care is an area which has been adversely affected during the period of the ‘reform and opening’ policy. The problem is most serious in rural areas. In the 1970s, 90 per cent of the rural population was covered by community health insurance, but by 2003 this had fallen to only 20 per cent. The absence of risk-sharing and high medical costs has resulted in serious under-consumption of health care and a declining health status of the population. Priorities in the health area are well known and would include funds to support public health and basic prevention programs in low-income regions; a nutrition program for the poor; expansion of the compulsory urban social health insurance scheme to cover workers employed by small firms and the informal sector, particularly migrant workers, and their families and restoration of a community-based insurance scheme for the rural population. Many of these schemes are under consideration, but their implementation is impeded by an apparent excessive attempt to rely on market forces as well as the inability of a large section of the target population to pay, and of the poorer provinces to contribute their share of the financing.
Agriculture, migration and internal integration
China still has about half of its labor force in agriculture where its productivity is, on average, barely one-eighth of that observed in industry and about one-quarter of that observed in the service sector. A reallocation of labor away from agriculture and rural activities and into industry has been and will continue to be a major source of future aggregate increases in GDP per worker.
China still remains very rural. In 2003, China’s rate of urbanization stood at about 40 per cent of the total population, compared to the 60 per cent that would be expected from international experience, given China’s income level. Recent research on international experiences has stressed the importance of cities for modern growth, emphasizing the agglomeration externalities that arise from the increased depth and variety of the markets for skills and complementary inputs and services.
In the same way as China has benefited greatly from its integration in the global economy over the past decade, there are opportunities for efficiency gains and growth through greater internal integration in the coming decade. There are many provincial and sectoral barriers to internal integration which constrain the ability of resources to move to their most productive use and which limit the competitive pressures that foster greater productivity and innovation.
The process of integration with the global economy has favored coastal provinces over the central and western regions, and cities over rural areas. Much of this is inevitable but it also reflects the fact that for precautionary reasons, policy-makers opened some regions to FDI and not others. A policy to homogenize investment policies should help lower policy-induced regional imbalances, while a policy that improves the quality of the transportation and communication infrastructure would reduce disparities caused by transportation costs.
To promote these developments, the Government should consider policies in a number of areas. First is to increase labor mobility and facilitate migration by gradually eliminating the Hukou policy. Preference might be given to the poorest regions where poverty will persist unless more workers are able to migrate. Labor mobility would also be enhanced by the reform of the social security system to enable portability of workers’ pensions across provinces. The government could also facilitate the urbanization process by investing in housing and urban infrastructure (utilities, urban transportation, social services, etc.) through a program financed by central government resources.
Another potential source of growth and poverty alleviation is increasing agricultural productivity per worker. Value added per worker in agriculture, which amounted to US$349 per annum in 2000, is the lowest of any country at China’s income level. In all successful countries, increases in agricultural productivity and rural incomes have gone together with a rapid decline in rural population and with rising land/labor ratios in the countryside. Thus, policies should be pursued to help develop land rental markets and foster freer land markets, e.g. longer leases, more land security (against community seizures and transfers), more power for migrants to lease out. This should allow greater labor mobility, better use of land assets, and a reallocation of land to its most productive use. Special policies should be designed for the regional poverty islands, including agricultural research and extension, irrigation, rural infrastructure, and greater access to farm inputs and markets via transport and information. Agriculture-specific taxes should be replaced by taxes that are neutral among income sources. Rural finance is crucial for development and reform of the rural credit co-operatives should be a priority.
Energy use and environment
China is already the world’s third largest energy producer and second largest energy consumer, accounting for 10 per cent of global energy use. Under plausible assumptions this share is expected to rise to 15 per cent by 2025. It is aiming for increased energy efficiency through a range of domestic programs, but these are likely to be outweighed by economic growth. In most economies it is common for the energy intensity of GDP to fall over time. This falling reliance on energy reflects a combination of more efficient use of energy in particular sectors and, more importantly, a changing composition of the economy, with more energy-intensive sectors, such as heavy manufacturing, gradually losing share to less energy-intensive activity, such as services. China is likely to experience this transformation over the coming decades. In the near term, however, it is unlikely that Chinese energy supply will rise as rapidly as energy demand, and therefore Chinese energy imports are likely to continue to rise.
With world energy prices reaching record levels, there will likely be significant supply responses in global energy markets in coming years. In particular, alternative energy sources will become more viable. Global energy markets are sufficiently open and regionally diversified that shortages are unlikely to result. However, there could be upward pressure on the level of and volatility in prices over the next few years.
A more important issue may be the environmental consequences of rising energy use in China. In particular, China will continue to rely on fossil fuels (particularly coal) as the primary source of energy for many decades into the future, the environmental impact of which is a concern to China as well as regionally and globally. China accounts for 13 per cent of global emissions of carbon dioxide – a major greenhouse gas that may cause significant global climate change in coming decades. In addition, the emission of black carbon is estimated to be responsible for local climate problems in China, such as increased drought in northern China and summer floods in southern China.
The different environmental issues associated with energy use in China require a mix of direct government intervention and market-based incentives. For example, to improve air quality, sulphur-trading systems that are already being implemented could be expanded. To address carbon-dioxide emissions, a longer-term strategy is required which acknowledges the need for China to continue to grow without a short-term carbon constraint but with clear pricing of the short-term and long-term costs of carbon dioxide. To reduce black carbon, a direct technology innovation in how households burn carbon (and agricultural burning practices) could be developed, with substantial health and economic benefits.
A Dual Track Approach to Macro-management and the Exchange Rate Regime
The challenges that China faces in the coming years – in maintaining rapid growth, in addressing issues of regional disparity and persistent poverty, and in dealing with internal and external imbalances – will place a heavy demand on the macro-management system. Notwithstanding the 25 years of reforms, the management system typical of a developed market economy is not yet fully in place. At the same time, the traditional tools of planning and direct controls are no longer fully effective, as a large part of the economy is now functioning on market principles. Hence the need to consider a new approach to macro-management.
Inflation targeting
There is likely to be little disagreement among economists about the final destination of the new approach. There has been a notable convergence among developed market economies, in their macroeconomic management policy framework, towards a system usually referred to as ‘inflation targeting’. Such a system involves focusing policy on the final objectives of inflation control and growth, and not on intermediate targets such as the money supply or the exchange rate (both of which have either proved of limited short-term use or led to unsuccessful results). Inflation targeting is aimed at achieving stable non-inflationary growth at potential rates – which is consistent with the objectives of China’s overall macroeconomic policy as usually described.
Such a system, however, is not advisable for China in the short term. There would be a serious danger of a loss of control – the opposite of what is intended by adopting inflation targeting. Accordingly, the proposed dual-track approach would have the following two main elements:
§ the maintenance of capital controls, but within an increasingly more flexible exchange rate system; and
§ the continuation of credit controls (and other direct methods of influencing aggregate expenditure) whilst moving increasingly but gradually towards using the indirect instrument of interest rate as financial reform proceeds.
This approach is designed to ensure that existing control systems are only given up when better methods are available and the direct methods are no longer needed. In the short term, the longer-term model of inflation targeting would be an important guide for policy making.
Evolution of the foreign exchange regime
A critical element of the dual-track approach in the coming years will be the evolution of the foreign exchange regime. The 21 July 2005 changes to the exchange rate mechanism, in fact, have created the necessary conditions for a gradual and controlled transition to an increasingly flexible exchange rate regime. The new foreign exchange regime (belonging to the group commonly known as ‘Basket, Band, Crawl’ or ‘BBC’) also provides in principle the opportunity to implement managed changes in the exchange rate itself necessary to achieve internal and external balances as discussed earlier.
Given the government’s stated objective for broader RMB convertibility in the longer run, a regime in which the RMB fluctuates – perhaps in a managed way – against trading partners’ currencies, is necessary. The transition from the present regime to such a regime will require two steps.
The first is a move to a meaningful basket peg in which the currencies of major trading partners receive weights proportional to the value of their trade with China. In practice, a basket peg of this kind is equivalent to a movable peg of the RMB to the USD where the peg’s daily value depends on the USD bilateral rate against the other currencies included in the basket. An advantage of this basket peg system is that it would be a deterrent against speculation by reducing the misalignments that would occur vis-à-vis third currencies under a bilateral peg. If the basket weights are somehow randomized, uncertainty for speculators would also be raised.
The second step should be a progressive widening of the band over time, with the eventual goal of a band so wide that intervention limits are rarely if ever met. Intervention (or monetary policy more generally) could be used to smooth fluctuations within this band. If the band is to be widened slowly, then a system in which the mid-point of the band crawls, or in which both sides of the band are widened asymmetrically over time, could be useful in accommodating a gradual appreciation of the RMB as required to achieve internal and external balances. An advantage of a gradually expanding target range is the limitation of risks while market agents are adjusting to an environment of active currency trading and exchange rate uncertainty.
Capital controls
The development of such a system would be ‘facilitating’, rather than implying an immediate change in policy – unless policy-makers so desired. But, with interest rates directed more and more towards domestic objectives, the capacity to manage the exchange rate (within limits) depends on the maintenance of capital controls.
Indeed, the current health of China’s banking system does not allow a precipitous opening of the financial account. A danger in abolishing capital controls in the near future, especially given the very large amount of deposits held within the banking system, would be the risk of very large outflows if conditions were to deteriorate and sentiment about the RMB were to worsen. Another danger is the possible loss of control. An open capital account would mean that the authorities either have to let the exchange rate float subject to the vagaries of the market, or divert monetary policy away from domestic objectives of macro control to exchange rate management, and in this last case take the risk of speculative attack. Indeed, there are arguments for tightening capital controls, whilst pursuing a more flexible exchange rate policy
With capital controls in place and the possibility of intervention, macro policy (including, potentially, interest rates) can be assigned, as it should be, to the overall control of the economy, whilst at the same time selective intervention is used to control the exchange rate. But the process of exchange market intervention itself should avoid outcomes which may lead to pressure on the exchange rate caused by, for example, market perception of an undervaluation or overvaluation of the currency concerned. The need to deal with exchange rate pressure – manifested in huge speculative inflows of capital – could divert policy, undermine the development of indirect methods of macroeconomic management and hamper other aspects of financial and overall economic reforms. Alleviating or avoiding exchange rate pressures would allow interest rate policy – monetary policy more generally – to concentrate increasingly on its overall macro control function.
China and Global Economic Governance
For its own national interest and that of the global economy, China should play a more active role and in some cases, assume a stronger leadership position than it currently does in the affairs of regional and international economies. The global economy faces various risks whose containment and resolution require determined, joint actions from the major economic powers including China. To increase the effectiveness of its global and regional economic engagements, China should strengthen its own institutional and technical capacities at various levels of government.
China is already a full member of various formal multilateral bodies such as the WTO, the IMF, the World Bank and the Asian Development Bank etc. Its presence and influence in these organizations will grow over time. In the near term, however, China should try to play a stronger role in informal groupings like G3, G7/G8 and G20 etc (at the international level) and ASEAN+3 and APEC etc (at the regional level). It should aim to join the G7/G8 Group of Finance Ministers and Central Bank Governors as a full member by the end of the decade, to help ensure that its own interests are sufficiently represented in any joint policy responses to global issues among the major economic powers and to strengthen the forces of ‘multilateralism’ in global economic governance. China should also help forge consensus on various longer-term issues facing the global economy among some of the largest developing economies (e.g. Brazil, India etc.) through a more active participation in G20. It can also help strengthen the global monetary and exchange rate arrangements by engaging more closely in the confidential, informal consultation process among the senior representatives (‘deputies’) of the G3 group thereby extending it to become a G4 Group.
On regional matters, China has been actively pursuing free trade agreement (FTA) negotiations with various countries or sub-regions in East Asia in recent years. But given its fast broadening and deepening economic ties with the region, it should help establish a formal East Asia-wide free trade grouping. To avoid undue concern over China’s dominance in such a grouping, the grouping could be centered on ASEAN. ASEAN has vast experience in forging consensus and integration among economies which for various historical, political and cultural reasons may find it difficult to negotiate on a bilateral basis. China could nevertheless enhance the free trade momentum in the region through bold, exemplary leadership, as it did when it offered the ‘early harvest’ program to ASEAN countries in the China-ASEAN FTA negotiations.
Compared with the Sino-East Asia or even China-US ties, the China-EU economic relationship could potentially be filled with more tension. Production in the newer EU member economies, for example, remains largely labor-intensive, making for a more competitive economic relationship with China than exists between China and the USA, or for that matter, East Asia. Moreover, the EU labor markets are much less flexible than that of the USA, further increasing the likelihood of political pressure that trade liberalization with China may entail. China’s quest for more energy and raw materials, including using strategic foreign investment in some cases to secure access to such resources, would likely put pressure on the EU, which is just as import-dependent on these raw materials. Meanwhile, China’s rising economic strength could imply a diminished role for the EU in multilateral institutions and informal groupings.
While many of these structural problems have to be solved by the EU itself, closer consultation and joint actions between China and the EU could help ease the pain. In some cases, tackling the problems requires significant policy adjustments for both. It is in the interest of both China and the EU to step up the dialogue process as early as possible, so as to identify potential tensions that could otherwise derail the continued expansion of the trade, investment and financial ties that have brought great benefits to both in the last two decades.
Long-term Trends in the Global Economy
Changes in the global economy are occurring at a very rapid pace and are already beginning to have profound implications for the future sources, patterns and rates of growth for developed and developing countries alike. It is therefore important for Chinese policy-makers to also anticipate the threats and opportunities posed by long-term trends in the global economy and to adopt a pro-active strategy for addressing them. The on-going preparation for the 11th Five-Year Plan (2006–10) and other policy-making arrangements provide Chinese policy-makers with a major opportunity for doing so.
The world is entering its third century of growth driven by science and technology. Following eight hundred years of virtually no growth, average per capita global income in real terms grew by about 20 per cent in the nineteenth century and almost 90 per cent in the twentieth century. These impressive growth rates however obscure large differentials among countries. While we cannot see clearly far into the twenty-first century, it is reasonable to predict that the growth in the global economy will dwarf even that in the twentieth century while the differential may continue, with a sizeable number of poor being left behind.
The global economy have quite clearly entered a period of more rapid growth and productivity gains, based not solely but largely on the exploitation of information technology (IT) to increase dramatically the efficiency of markets, supply chains, the delivery of services and the accessing of valuable human resources without reference to or bounded by geography or time. Played out over several decades, these technologies are quietly revolutionary. In addition to increasing the efficiency of all domestic economies, the larger effect in the medium to long run is to transform the global economy. Trade in services provided by highly educated people all over the world will increase both absolutely and as a fraction of total world trade. Research and development (R&D), business services and financial services will be sourced globally. Trade as a fraction of global GDP will continue to rise, increasing interdependence.
As a result, human resources are much more valuable in the context of the global economy. It is as if the boundaries of labor markets were partially breaking down. Neither the magnitude nor the importance of this can be overstated. Anticipating and preparing to participate in these new trends and possibilities represents an additional source of growth. It also offers the opportunity to move up the technological ladder more quickly than would otherwise be possible.
These trends driving the global economy represent huge opportunities for those developing countries, including China, that are able to make large and continuing investment in human capital. Though it is less often talked about, they represent large opportunities in the domestic economy. For example, in large countries like China, educated but under-used human resources in less developed provinces can be employed to deliver services in more advanced locations where the balance of labor demand and supply is very different and labor costs are much higher. This may reduce some of the pressures created by high rates of migration from rural to urban and from central to coastal areas.
China, with its size and dynamism, could, with a sustained effort to build the institutional and human capital infrastructure required for modern financial and capital markets, become one of the leading financial centers in the world. In 25 years, China, with another two to three doublings of its GDP, it will be a major economic power and a leader, along with the USA, the EU and Japan, in setting international economic policies. China’s international economic policies and its frame of reference in formulating them will increasingly influence the evolution of global economic policies.