MR.STARRELS: Welcome, everyone, to today's Economic Forum on China and the Global Economy: Prospects and Challenges. To start things off, it is my pleasure to introduce the moderator of today's event, Steve Dunaway, who is the Deputy Director of the Asia and Pacific Department. He has extensive experience in the IMF, including a stint as the desk economist for China in the early 1990s. Steve has now been the IMF's mission chief to China for the past three years and is eminently well suited to guide today's discussion. So let me with pleasure turn the floor over to him.
MR. DUNAWAY: Thank you, John.
Well, let me start by thanking all of you for coming today. I think the turnout is indicative of the interest in the topic. The recent inclusion of China in the meeting of the G-7 I think is illustrative of the growing importance of China in the world economy. But for China to continue to grow and to fulfill its potential, it faces a number of different challenges. And at the same time as China grows, it creates challenges for its neighbors in Asia, as well as throughout the world. And so some of these issues are what we would like to talk about today, and we have with us, I think, an excellent panel to discuss various aspects of this topic.
We have with us Dr. Albert Keidel, from the Carnegie Endowment for International Peace. We have the chief economist from Morgan Stanley, Mr. Steve Roach. And we also have Dr. Moises Naim, who is the editor of Foreign Policy Magazine. But to start things off, let me call on my colleague Eswar Prasad, the chief of the China Division here at the IMF, to talk about some of the recent research that we've done to set the stage for the discussion.
MR. PRASAD: Thank you, Steve, and good afternoon. The remarks I will make this afternoon will primarily draw upon an IMF study that was published recently. It's called "China's Integration into the World Economy: Prospects and Challenges." Copies are available outside and also on the Web. It's the culmination of about two years of fairly intensive analytical work that the IMF team has been doing on China, and, although all the authors cannot be here today, I at least wanted to give you a glimpse of what a fine looking team of people it took to put all of this together, so here they are.
China's increasing prominence in the world economy has caught a lot of attention, especially in terms of how important China has become in the global trading system. And, of course, it's widely known how fast China's trade has been growing. Nevertheless, when you look at the numbers, it's really quite impressive. If you compare the growth in world trade versus China's trade, it's quite remarkable how much China's share has increased.
China's increasing role in world trade has very important implications, not just for China itself in terms of the benefits it is getting through increased trade integration, but its increasing export orientation has also been matched by an increasing import push. And this means that, both for domestic consumption and for processing trade, China has been drawing in a tremendous amount of imports. And this has very important implications for the regional economies of Asia as well as for other economies that China is fast developing very strong trade linkages with.
This brings up an obvious question whether China's export growth is really sustainable or whether its increasing outward orientation is really going to persist for a long time. Now, this, of course, is a difficult question to answer, but one can look to history for some guide, and at least historical experiences suggest that if you were to look at many of the other emerging Asian economies or those which emerged some time ago, like Japan, they were able to sustain very rapid rates of export growth for extended periods of time. So, at least on a historical basis, China could in principle maintain this sort of growth for some time.
One important perspective that is useful to keep in mind—that is often lost in terms of the Washington debate, especially in an election year—is that there is a very significant compositional effect in China's trade. Just looking at what has been happening to China's exports and imports reveals a very striking picture. If one were to look just at the bilateral trade balances of China with the advanced industrial economies of the United States and the European Union, it certainly looks like Chinese trade surpluses with these two economies have increased enormously, especially over the last five to six years. But the interesting thing is that this has been matched almost exactly by an increasing trade deficit that China runs with other Asian economies. So, in effect, this is emblematic of the fact that China is really becoming a very important conduit for trade from Asia to the rest of the world. And whether or not one looks at China alone or China plus Hong Kong SAR, the results are essentially the same.
So, again, China's importance as a conduit must be kept in mind, and although one hears a lot of overheated rhetoric about rising U.S. trade deficits with China, it's really only part of the picture.
China's increasing prominence in the world economy is, of course, characterized by various numbers, including the fact that China now accounts for more than 6 percent of world trade, remarkable for a developing economy. And as I mentioned, it has had very strong import growth, both for processing trade and for domestic consumption. In fact, over the last two to three years, when the global economy was going through rather weak times, China accounted for almost a quarter of world growth in purchasing power parity terms. So China's influence on the world economy is clearly very important and rising over time. But this makes it even more important that China's growth and stability be maintained because it has much broader implications. And while things look very good at the moment, with rapid growth rates and very substantially rising export orientation, there are still some storm clouds on the horizon.
Let me focus on just a few of the key policy challenges. These are related to the reforms of the largely state-owned banking sector and the state enterprise sector. In addition, one of the key pressures in China is coming from the rising unemployment rates, which I will talk about a little later, as well as widening regional disparities in income. As China opens up, not just through trade but also through financial linkages, and also in terms of maintaining its growth, reform of the banking sector really is one of the key priorities.
In terms of banking sector reforms, a great deal of progress has been made over the last two or three years. One of the pieces of date people typically tend to focus upon is nonperforming loans. The Chinese banking system is largely state-owned, and the nonperforming loans in the state banking sector largely reflect a legacy of policy-related lending. This was lending not done on a commercial basis, but it was directed in a sense by the central planning authority, the government.
There has been a great deal of attention focused on the NPL numbers, but even the NPL numbers do show that there is progress at hand. In this table, what I show is the amount of nonperforming loans as a percent of total loans, as well as a percent of GDP of the major financial enterprises. These are based on official data, and there are, of course, some questions about whether the official data may be understating non-performing loans (NPLs). That is a legitimate question, but what is worth noting is that progress has been made in reducing NPLs. The four largest banks, the state commercial banks, or SCBs, account for about two-thirds of total assets in the banking system in China, and they also account for a substantial fraction of the NPLs. And as you can see, in just the last year the NPL ratios have declined by almost four percentage points. Some of this is related to the very large amount of lending that these banks have done over the last year, meaning that the denominator has increased. But even in terms of GDP, this ratio has declined, suggesting that there has been a decline even in the absolute number of NPLs, and that progress is at hand. This is not to minimize the challenges that lie ahead, and these are really very significant.
Given that this is a state-owned banking system, ultimately the cost of any banking reform is going to have implications for fiscal policy. In that context, China is hardly a typical developing country. It looks very good on this dimension if you compare it with other emerging markets or other developing economies.
For instance, the fiscal deficit is 3.5 percent of GDP, and, in fact, this year it's likely to decline somewhat further. As we know, even many advanced European nations struggle to keep their deficits under 3 percent of GDP, and China seems to be doing it remarkably well. And the stock of public debt, which is an important indicator, is also well within reasonable bounds, at 25 percent of GDP.
The problem is that these explicit fiscal figures do not include some serious underlying fiscal pressures which are mostly implicit in nature. One can think about the contingent liabilities in the banking system. These are contingent liabilities, because if there was going to be a cost to fiscal policy of banking sector reform, that would have to be borne by the budget, but the costs will largely depend on how far and how effective the banking system reforms are. So the exact cost of this will depend on the effectiveness of banking sector reforms.
In addition, there are the unfunded obligations of the pension system, as well as rising expenditures that are going to be driven not just by the unfavorable demographics with a rapidly aging population, but the need for expenditures, social expenditures such as health and education, which are going to be increasingly in demand. So the fiscal situation on paper looks very good, but in a sense, it masks a number of potential future problems.
Now, many of the inefficiencies in the Chinese economy ultimately come home to roost in terms of labor market outcomes, and there the pressures are quite strong. If one were to think about how large the unemployment problem is, official figures suggest that the unemployment rate is only about 4 percent, which seems very small by any standards. But what those numbers mask is the fact that there are an estimated 150 million surplus workers in the rural sector. In addition, there are about 10 to 12 million surplus workers in the state-owned enterprise sector. Plus, given China's population growth, there are about 11 to 12 million people being added annually to the working-age population.
These numbers are by any measure staggering, and they show how important the reform challenges are going to be and how essential it is to get the reform process in gear so that China can maintain the high rates of growth that it has recorded in recent years.
In terms of the various reform challenges, China has now reached a stage of its development where the various reform measures can no longer be delinked. China has traditionally had an incremental approach to reform.But it's very difficult to separate out these reform issues anymore.
For instance, it's difficult to undertake banking sector reform unless you reform the state-owned enterprises. And reforming the state-owned enterprises brings up a number of challenges of its own because many of the provinces are facing problems of low employment, and especially the poorer provinces that are trying to catch up with the faster ones, have been using credit to state enterprises as a means to boost investment and, therefore, employment and output growth. So one has to have center-local fiscal relations being reformed at the same time. So these are in a sense tied together, and, of course, taking any of these reform steps implies that the labor market pressures that I described earlier are, if anything, going to get worse over time. So it is very difficult to get around the fact that all of these reforms are going to have to be undertaken essentially simultaneously.
I spoke earlier about the incremental approach to reform that the Chinese authorities have taken so far. In a large and complex economy like China, it's really very difficult to find a viable alternative. So even if, as economists, we can say what the first best solution ought to be, the process of transition and managing the transition and the risks associated with it are really an enormous logistical challenge.
What is essential for China is not just a reform plan but a set of tools that are necessary to meet these reform challenges and to deal with the additional shocks that the economy could face as China's integration with the world economy continues and it becomes more exposed to external influences. And, in addition, the process of transition itself could mean that there are shocks that could derail the entire process.
One key aspect is that better institutions are necessary. A lot of economic research recently has shown the primacy of institutions in terms of delivering good economic outcomes, not just for industrial countries but even for developing economies that are setting out on the path of globalization. This, of course, is a very broad term, and it covers a number of things under its rubric. It includes a good legal framework, good property rights, sound financial sector supervision. But I think these are essential for China to make progress.
In addition, a good social safety net is going to be essential to deal with the transition. In the process of state enterprise reform, for instance, a lot of workers are likely to be moved on to the unemployment rolls and, in making the transition from a state-led economy to a private sector-led economy, there are going to be transitional issues that will require labor mobility across these sectors and across provinces. A good and efficiently designed social safety net is going to be very important to cushion the transitional effects.
In addition, an independent monetary policy will be crucial to buffer China from the external shocks it's going to be exposed to. Which brings me to the flexible exchange rate regime because, after all, without a flexible exchange rate, it's very difficult to have an independent monetary policy.
Of course, the issue of exchange rate flexibility is one that has received a tremendous amount of attention, so let me speak a little bit about this and be very clear about the IMF position on this issue.
First of all, although a lot of discussion has centered around the effects of an exchange rate regime change on the U.S. trade balance with China, I think the focus should be on China's own interests. And I think it is really in China's own interest to move towards a more flexible exchange rate regime because it would give China an autonomous monetary policy and would help the economy adjust much better as its outward orientation increases. We should also be absolutely clear that what the IMF is suggesting is a move toward more flexibility, not necessarily a revaluation.
The current pressures on the foreign exchange markets suggest that, if more flexibility were to be allowed, the Chinese renminbi would appreciate. But it's equally possible that in the future, if China were to open up its capital account or to take other steps, it's likely that the pressures could very easily reverse. And given the difficulty of pinpointing what the right exchange rate ought to be, we think the focus should really be on flexibility rather than trying to find a particular level of exchange rate that would satisfy all parties. And, in addition, we don't really think an immediate move toward a free float is the desideratum here. What we think is much more appropriate is a more gradual move towards more flexibility, which could take any of a number of forms, including a move to a peg to a currency basket rather than just the U.S. dollar and a widening of the band around that basket.
I should also be emphatic that we do not view exchange rate flexibility as synonymous with capital account liberalization. In fact, given the weaknesses in the financial sector, I think that maintaining capital controls or even selectively tightening them may be very important in terms of protecting the weak financial sector from external pressures in the process of moving towards a more flexible exchange rate.
So, overall, I think there are very good reasons for China to move towards more flexibility. The Chinese authorities themselves view this as a very desirable objective. The question is one of timing, and here it is essential to note that much of the pressure on the currency recently has come from speculative inflows. And in dealing with speculative inflows, there is a problem in the sense that the longer you wait, the larger these pressures could get, especially as the capital account, whether the Chinese authorities like it or not, is going to become de facto more open over time. China's trade linkages are expanding, and trade always gives you a good way of working your way around capital controls through under- and over-invoicing of transactions. So I think the de facto increasing openness of the capital account suggests that an earlier move towards exchange rate flexibility is in China's own interest.
So how do I see the prospects overall? I think there has been significant and notable progress in some parts of the reform agenda, but enormous challenges remain, especially in the areas that I pointed out earlier. And, in good times such as these, it's especially important to be very vigilant to prevent future pressures from building up.
For instance, the very rapid growth of credit that we have seen in the last year and a half or two could mean that a lot of improvements that have been made in terms of banking sector reforms could be reversed if the economy were to slow down and if many of these loans that are being misdirected to sectors that could be experiencing over-investment turn out to be bad loans.
So I think now, when things look good, is not the time for the authorities to rest. And, of course, with China's increasing prominence, it is important that all of these policy reforms are done the right way because, both for China as well as for the Asian and world economies, it is becoming increasingly important that China get it right.
MR. DUNAWAY: Thank you, Eswar.
Let me introduce our first guest speaker, Dr. Albert Keidel of the Carnegie Endowment for International Peace. He recently joined the Carnegie Endowment. Previously, he was Deputy Director of the Office of East Asian Nations in the U.S. Treasury Department. Before that, Bert was with the World Bank in its office in Beijing, and he has worked on China for a number of years, going back into the late 1980s. So he has quite a long perspective on the reform process in China. In addition, he's also done considerable work on Japan and Korea, and he has been widely published in economic journals and in public policy magazines as well.
In his current job, Bert's focus is not only just on the macro economy and economic reform in China, but he's also looking at regional development and issues relating to poverty reduction. So I'd like to welcome Bert Keidel.
DR. KEIDEL: Thank you very much, Steve and Eswar, and I want to express my appreciation for the IMF forum for this opportunity. I'm honored to be included on this panel.
My message today, at a time when we're looking at China's economy as if it is a major force and perhaps a disrupter on the world scene, is to say that I think those impressions are exaggerated. And rather than focus on the impact of international events and trends on China's economy, the real attention needs to be on internal domestic developments within China. International events are important, but they are exaggerated. And if we are really interested in the direction and the sustainability of China's current growth, the domestic economy and policies directed toward the domestic economy have precedence.
Let me just mention a few things. Eswar mentioned the PPP measure of China and that if you weight global growth using China's PPP as China's weight, you get a very large contribution to global growth from China. China's PPP is really unknown. We have no statistics on what the purchasing power parity measure of China's GDP should be. What we do have is a rough estimate made under the auspices of the World Bank in the late 1980s, which an internal study I did for the World Bank showed to my satisfaction was already quite an overstatement. It has been brought forward at the wrong growth rates, using official growth rates instead of growth rates adjusted for their PPP status. And so we're looking at a Chinese economy that in PPP terms is much smaller, in my mind, than the numbers that are usually used. We don't know. That's the important thing to say.
When we hear discussions of base metals or cement or steel or oil and China's potential for disrupting these global markets, you will often see—and note this when you look at the media, you will see a discussion of China's consumption share in the world for these various materials. But we have to remember, China is also one of the largest if not the largest producer in many of these sectors. The important variable is really China's net imports and, therefore, its effect on what is global trade. And in that perspective, it's much smaller. And what we have seen in recent years is not a surge in Chinese presence that is causing disruption but really a return to economic growth in Europe, in Japan, and in the United States, at the same time that there is a war in the Middle East.
So I would encourage you to take with a grain of salt much of what is attributed to China, and this is strengthened, in my mind, by what we see happening on futures markets where a lot of speculation makes rapid changes possible and where China is the perfect scare approach, where if you want to move a market, you play up China's role and then you make some money on the movement.
Another way that the international role is exaggerated reflects the late 1990s. China has a growth slump in 1997, '98, '99, into 2000 that was not reported officially, but if you do GDP growth the right way through expenditure accounts and deflate them, which is not done in official Chinese statistics but it's doable and the IMF has done it in its internal studies of China, you find that growth rates dropped between 4.5 and 5 percent, not the official 7 percent in the late 1990s. And by the same token, growth also surged in the early 2000s, was over 9 percent in 2001 and the high 9 percent range in 2002 and it was 10.9 percent last year. So that this downturn or slow-growth period in the late 1990s was attributed to the Asian crisis, which is a convenient scapegoat for policymakers, but it really resulted from blunders, I have to say, in Chinese domestic policy that led to zero or negative growth in rural consumption for those years, and rural consumption in China is half of China's household consumption, and this affected demand for industrial products, particularly very low end. That affected employment, and you had a Keynesian downturn in the domestic economy. So it was a domestic process, not the much heralded international process that really was responsible for China's slow growth and poor performance in the late 1990s.
Similarly, what's the major risk that China faces now? It's not a risk from international movements or capital flows or exchange rates. It has to do with what may be, as it has been in the past, a delay in raising domestic deposit rates on bank deposits, which are now well below CPI inflation. And in the past, the delay has cost China disintermediation from the banks, that is, people pulling their money out of the banks, putting it into goods that fuels a sudden surge in inflation that happens in an instant. The Chinese are aware of this, but there are domestic political problems that cause resistance to raising deposit rates. That is my main concern, that if that happens, then yes, the Chinese economy, rather than just being very hot, will be overheated.
So what are the key policy imperatives if we really need to focus on the domestic economy? First and foremost, in my mind, is adequate and very large expenditures on urban infrastructure and the development of an urban economy. It's paradoxical, but the solution to China's rural poverty and rural employment areas is the development of cities. And we have seen a large expenditure in this direction, but it needs to be much larger. The Chinese labor force is largely in the wrong places where it has been placed by centuries if not millennia of good weather in the rural areas and also by industrial policies during the 1960s that were afraid of international attack or in the 1950s where the Trans-Siberian Railway was the main contact with the outside world. You need to relocate—China is working on this—relocate its industry and its labor force and its concentrated technology and capital to major crossroads of transport and technology. That's happening but it is an enormous investment, a public goods investment in infrastructure and human managerial talent.
The second—and this is hard to put in second place—is enterprise reform. I think the management and governance of enterprises—and I'm not just saying state-owned enterprises. There's a serious problem with private enterprises. They're opaque. But whether state-owned, state-controlled, or private, it's hard to find out what their accounts are like. It's hard to find out what their business plan is. If you really want to make an improvement in the financial sector, the first concentration has to be in the client base. And if the client base isn't ready for you, then the financial system needs to be arranged in a different way, and I'll talk about that in just a minute.
So this would include major improvements in bankruptcy laws. In China now it's very hard to bring an enterprise to the table and make it pay its debts, and other dimensions of the legal system are pretty inadequate in a civil legal system. If you want to sue somebody because they haven't performed in the way that they're contractually obligated to, it's quite difficult to do, particularly if the local government is on the other side.
My major emphasis for the overall macro economy, number three, is domestic demand. And in this case, government demand is pretty stable. Urban household demand is pretty stable. But the rural demand is this wild Keynesian beast that, if not managed well, can overheat the economy. And if there's an overreaction in terms of public policy towards the real economy, you can hurt badly the domestic growth scene. And that's what happened in the late 1990s.
So I would attribute a large measure of the growth we have seen in the last four years not just to credit expansion—which comes first, the chicken or the egg?—but in the year 2000 China relaxed its grain policies, and this is—it sounds arcane, but China has a grain policy that really resists importing in a major net way staple foods which are easily stored and not subject to spoilage for national security reasons. But the problem is then they have to find a way to force farmers to plant grain, and if you look at all the statistics that you find in rural, provincial yearbooks, you don't make any money on grain. You make money on vegetables. You make money on oilseeds. You make money on animal husbandry. You make money on fisheries, but not on grain. And yet China has through various mechanisms—governor responsibility systems and others—expanded the grain planting area, for example, from 1995 on. This ends up bankrupting the fiscal system and its extension into the public banking system because the prices fall so much that there needs to be a purchase policy, which is never enough, and you get a serious cyclical downturn that can only be reversed by allowing farmers to plant what they want. They get out of grain in an instant. And then you have a problem that we've seen just this winter. The government is again making governors responsible for the supply and demand of grain in their provinces, and that in the past has led to quasi-self-sufficiency efforts. So I think that the macro picture needs to be focused on the rural demand in particular.
This is now a fourth or fifth area of investment, I'm not sure which in my—one, two, three, four—the fifth is rural and interregional transportation. The Chinese are spending a lot of money on highway, on railways, and even on airports. This is needed to allow people to leave the rural areas to get to the cities. It's not just enough to go once. You need to go and come back and go and come back so that you can then make a move to what is a more productive location for you as a worker. And what we have seen is that this is working. You see a large number of people moving, going back home if they have to help with the harvest, getting a job in the cities and supplementing the incomes back home with money sent through the postal transmission system.
If you're a rural household and you only farm, you are really poor in China. And this whole mechanism is by far the most important way to raise living standards in the rural areas where virtually all of the serious poverty in China is.
I would also emphasize reform of the rural fiscal system. There is a reform now that's about three years old called the fee for tax reform in which local arbitrary fees are being replaced with taxes. And what's important is not necessarily this single component, but it includes a whole range of companion reforms that are reducing the size of village and township management teams, combining villages, combining townships, and reducing the burden of fees and taxes for paying local salaries. It also is shifting the burden for paying for education to the county level so that that money doesn't get diverted to other local projects but ends up going to teachers. There are a range of special fiscal reforms that are going on at the local level, and these need to be encouraged and strengthened.
I would also say next that something I call economic federalism is quite important for China to continue to strengthen in major ways. China is not a federal system. Local matters are handled by the center by going through the local government. In the United States and other federal economies, you have a central presence on the ground parallel to a local presence. This is important for legal systems. In China's case, there's been work on this for statistics. We've seen the bank regulatory system introduce this kind of work. There are a lot of other potentials for a stronger presence at the local level directly by the central government, and it's expensive, it costs money, because you don't rely on the local government to pay the salaries and the housing and the schooling of your staff there. But, in fact, it provides a certain control because we're seeing more and more the central government is acting as an agent to protect the rights of citizens economically at the local level, particularly when they're subject to abuse. So for control of corruption, this is handled in a very ad hoc way now, but a more decentralized federal approach to managing the economy I think is a direction that China needs to continue to go. I say it's already going there.
So these are a series of steps, and I've just selected a few that are some of my favorites, because we're seeing the impact on the domestic demand, in particular in the rural areas. Income distribution is still a serious problem. They've stopped publishing, at least in their interim statistical yearbook, the size distribution of income data in the rural areas. But the yearbook for last year for one of the medium-sized provinces, Anhwei, which has about 65 million people in it, 50 million of whom are rural, shows that about—for the bottom 20 percent of that rural population, their average incomes declined in 2003, which was a rapid growth year annually. There was a group in the middle that increased, and then the very wealthy, that number also increased. And this is a heavily grain-producing area. And there was an extraordinary collection of analyses of rural household data that was published early this year. It's 999 pages long, but there's a treatment in there of the fundamental problem that they face in poverty reduction, which is what to do with grain base areas. These are areas that only produce grain. They cannot find a way to increase production of grain and also do something about the low-income status of those households, which are often isolated from urban areas.
So these are areas I think not only important for poverty reduction and income distribution, but they have macroeconomic significance, and they're domestic. They are not heavily influenced by international events, although to the degree that grain became imported at this exchange rate, the world price would make life even more difficult for rural farmers. Rural farmers would like to see a devaluation of the Chinese currency.
Let me go on then to say why I don't think some of the international solutions are perhaps the most critical. Look at the financial sector. How helpful has a highly competitive modern financial sector been, perhaps one dominated by foreign institutions in many developing countries over a period of 20 or 30 years? We have examples of countries in Asia and in other parts of the world that have a very modern financial system, but they have essentially gone nowhere for decades. It's clearly not the answer to the kind of growth issue that China is solving. And so I would say—and here I have a comment. The treatments in the literature on this are understandably saying we don't want to give standards for a financial system that are less than world class. But that's kind of a cop-out. I think a study a few years ago at the World Bank pointed out that you can't build a house on a bed of sand, you need a good foundation, legal foundations, accounting foundations.
But then they go on at the end of the report in the latter chapters to describe that a developing country needs just those standards that have been set for developed countries. And in a statistical work, to show the usefulness of this, they can only get statistical results that are relevant if they include countries in Europe and the period in which they recovered from World War II. If you take out those experiences, you don't get the significance statistically that they claim to have.
So I think we need to look at the importance of a modern financial system in perspective. China is building those institutions. I think you need to go a long way towards creating the skill, the talent, the regulatory structures. But to think that speeding up those reforms is the answer to China's challenge, I have some serious reservations about that. They need to continue at a very rapid pace, but I think that they actually represent one of the potentials for instability and difficulty if they are taken too fast.
Let me say something about capital account reforms. I think we all agree, as Eswar has mentioned, that rapid capital opening when China's financial institutions are so under—are sort of mid-development stage would be a mistake. They are not able to handle what would be the large temptation to borrow money that looks very inexpensive on the short term, but when the economy overheats and you have a change in the exchange rate, it turns into a debt that you cannot repay because of what happens to the local currency terms of the obligation you have in foreign currency.
This brings us to exchange rate reform. Here I think we're largely in agreement except on this little issue of timing. You have a piece that I wrote last week from the Asian Wall Street Journal and the Wall Street Journal Web page. There is, I think, kind of a double entendre when you call for flexibility and say this doesn't mean revaluation, because flexibility would mean that it will move within a band. And I maintain that even if you increase the band, it will still be set where the central bank decides to make it set as it intervenes in the foreign exchange market. So there's no magical adjustment or flexible market-determined movement within that band either. And the difficulty for practitioners in international commerce, particularly in a poor country like China, trying to expand, of not being able to easily hedge your foreign exchange costs becomes an issue.
Now, timing, there is the impression that the longer they wait, the more difficult it will get. My feeling is that they need to wait for the appropriate time. It's not necessarily shorter or longer. Right now we have a period where there is still a strong inflow of capital looking and expecting a revaluation. But China also is experiencing some inflation, 5 percent CPI. It's 10 percent if you look at the products sold by enterprises to other enterprises. We also are seeing major changes in its external trade system. We're having this December the introduction of the ability of foreigners to develop domestic distribution centers within China. This will have a major impact on imports. But if China can introduce a situation where it's no longer such an easy one-way bet to make money betting on a revaluation and have capital flow in so that there's some capital flowing back out again and a portion of this very large set of reserves that have come in—not because of trade but because of speculative capital movements—then I think that might be a better time to begin to introduce some flexibility. But there is no urgency. China is not going to open its capital account. There is some leakage, perhaps, but it can be contained. And so I think the focus needs to be on domestic institutions and that we need to recognize that a lot of the froth in the world discussion about the Chinese economy is exaggeration.
Now let me turn to Dr. Stephen Roach. Steve Roach should be a pretty familiar name to most of you. He's managing director and chief economist of Morgan Stanley. He's very widely recognized, widely read, and is considered one of the more influential economists on Wall Street. Over the years, he has dealt with a number of different topics, and in recent years in particular, he has directed more attention toward China and has played an active part in the policy debate within that country, as well as examining it from an external vantagepoint as well. So, please, let's welcome Steve Roach.
MR. ROACH: Thank you, Steve. Apologies for a cold that I picked up in India about a week ago.
I have to commend you and all those pretty faces you had up there for a terrific report. I think it will really be a valuable point of reference in laying out some key issues and metrics and analytical tools for those of us who are amateurs in delving into China but have a real fascination with the role of China in Asia and the broader global economy. So congratulations.
One, the issue of overheating and that is the issue that I'm going to develop a little bit with the help of some pictures you have here.
Secondly, the issue of macro policy strategy or control. What is China? Is China still a centrally planned, centrally controlled economy? Or is it, as the IMF report alludes to in the introduction, an increasingly vibrant private, market-driven economy? If that's the case, then why aren't the Chinese authorities using more traditional instruments of policy stabilization that we in market-based economies use, like interest rates, like the currency? Why are they relying more so on the administrative edicts of centrally planned economies? It's a huge issue, and certainly the subject for your sequel.
The third issue is the issue of Chinese imbalances. I think there's a statement right in the introduction that you believe that the Chinese economy is on a sustainable course for rapid growth in the years ahead. I worry a lot about global imbalances, and I also worry related to that about a number of imbalances in the Chinese economy that I think draw that assertion into question. I'll just tick off some of the concerns I have about Chinese imbalances.
This huge imbalance between the investment and the consumption sector in China. Last year, consumption as measured by Chinese GDP was 54 percent of GDP. There's no major country that has consumption share that low. Not even close. The disparities in income distribution, urban-rural, are large and getting larger. The disparities between the manufacturing and the services economy in China, just a huge imbalance. The service sector of the Chinese economy is less than 35 percent of its GDP. Again, that's the lowest number I can find of any major economy in the world today. Is that sustainable? And — [tape ends].
— to the private sector. Twenty-five years later into this long march, China is still lacking in world-class companies, a well-developed banking system, and fully functioning capital markets. Bert made the provocative statement that maybe some of these things are overblown. It's possible. But, you know, certainly China is lacking in that regard.
And then, finally, just to bring it home here, China's playing an important role, along with other Asian central banks, in financing U.S. and global imbalances by recycling huge build-ups of foreign exchange reserves back into treasuries, which certainly subsidize U.S. interest rates, and courtesy of subsidized interest rates, American consumers lever their overvalued assets, the homes you live in, and you turn around and buy DVD players made in China. Everybody's happy. Is that sustainable?
So those are issues that are not addressed in this report, but these are issues that certainly are on my mind as a financial market practitioner and very much on the mind of many who are actively involved in following China these days.
Just a few brief pictures here. You know, this is sort of a global view. Just look at the picture on the right. What you see in front of you is a world record disparity between current account deficits, mainly America, and current account surpluses, mainly Asia. You know, this to me is a testament to an unprecedented and extraordinary degree of imbalance in the global economy today. We have never seen anything like this. China is a part of these imbalances, not just as a financier but also as a country that's receiving a tremendous inflow of foreign capital today.
The imbalanced world is right now being driven by two overheated engines, in my view, and I do take the point—I'll take a stand on the point. I think the Chinese economy is seriously overheated right now. And I mean seriously overheated. What you see here are these two engines side by side, not by accident the Chinese producer driving the supply side of the global economy and you all, the American consumer, driving the demand side. Even if you're not American, you're living here and you're participating in this buying binge. Two different ways of measuring it: year over year growth rate and industrial output in China of the left, the consumption share of U.S. GDP on the right. Take a look for yourself.
For China—and, please, you know, I don't mean to be overly critical of the Chinese statistics, but don't look at GDP. Look at industrial output. It's a much cleaner read on what's driving this economy. The growth rate peaked out at 19.4 percent on average in the first two months of this year. It was down to 15.9 percent in August, a deceleration of 3.5 points.
When it was running at 19.4 percent, the import growth rate, the fixed investment growth rate, was in excess of 50 percent. Inflation is accelerating not just at the CPI level, but at the wholesale price level and at the corporate goods price index level as maintained by the central bank. Credit was surging at double the trend rate. There's this construction bubble, property bubble in coastal China, especially in Shanghai, and widespread signs of shortages and bottlenecks throughout the Chinese supply chain, such that when I went to Beijing, as I do every year for a conference hosted by the State Council in February, the China Development Forum, Premier Wen Jiabao made it very clear that from the standpoint of the Chinese leadership, the Chinese economy is overheated. End of story. And everybody is now debating what to do about it.
In my view, the Chinese economy has a long ways to go to cool off, and we've put an arbitrary band here in the 8- to 10-percent zone which would be required to alleviate some of the pressures that I alluded to. I don't think the Chinese have an explicit target in this regard, but that gives you some indication if that band is right—and I think it is—of the distance that still has yet to be traveled on the road to cooling down an overheated Chinese economy.
Just briefly, I'd mention that the American consumer on the right driving the demand side of the U.S. economy, our consumption share of U.S. GDP has averaged 67 percent, and we're not here to talk about America, but we blew up to 71 percent. Americans, as you know, are addicted to shopping, and like all addictions, they usually get worse until they get better. We're in the terminal stages of our disease, and we have just begun to revert back to a more sustainable pace. And that also has implications for China because, you know, China right now derives a lot of its growth by selling things to overly indebted, overly indulgent American consumers.
Now, there is some good news to report on the road to the Chinese slowdown. A lot of numbers here. I'd just draw your attention on the right to a couple of things that are happening. The September import data in particular, the dark line on the right, the year over year growth rate has now slowed to 22 percent. There are always some spikes around lunar New Year time in China that make it hard to read the numbers, but this is a material slowdown from the growth rates that we have seen.
The industrial output numbers have slowed less. The fixed investment numbers have slowed less. The bank lending cycle on the left, the lighter of the gray lines, has also slowed a bit. And I am a believer—and this is where I would disagree somewhat with Bert. I do think China at the margin is having a major impact in the ups and downs of commodity prices, and we are seeing now some moderation in the composite measures of industrial materials prices measured by the Journal of Commerce metric on the right. And last week, the Shanghai Futures Exchange raised margin requirements on trading of a certain copper contract, and commodity prices and commodity stocks collapsed.
Now, just two issues on the China slowdown that we are really focused on in world financial markets here. One is what happens to China's trading partners, and this is very much consistent with some of the work that is in Chapter 3 of the IMF study stressing China's linkages to the rest of the world. On the right you see Chinese imports, the solid line, how closely aligned it is with the ups and downs of the non-Chinese export cycle. And then on the left you see some rather startling connections with just a few key countries around the world for 2003 alone. Again, this is sort of taken from the IMF direction of trade database, but just take a look at Japan, for example. On this basis, last year Japan—about a little less than 15 percent of its exports went to China. But that was a huge increase from '02, so huge that 43 percent of Japan's total export growth could be accounted for by China. For Korea, the number was 45; Taiwan, 68; U.S., 21 percent of our export growth last year could be accounted for by China; Germany, the number was 28.
China's imports are slowing. I just told you in September the number was 22, year on year. That's half of last year's growth rate. So these countries that are exposed to China in terms of Chinese import demand for their products, unless they have an alternative source to sell exports, unless they have domestic demand growth, their growth rates are going to get hit. And Korea's weak now; Japan is weak; Germany is weak again. And the China slowdown has just begun. I don't think that's a coincidence.
And then, you know, this is the point where Bert said take this with a grain of salt. I wish I had China's share of salt consumption in the world, but I don't. But here's China, 4 percent of nominal GDP last year consumed 7.5 percent of crude oil, 25 to 30 percent of industrial materials like aluminum, steel, iron, coal. Last year China consumed 40 percent of the cement in the world. I go to China a lot. To me it looks like they're paving the entire country. And so as Chinese industrial production comes down, it is reasonable to expect a reduction in the demand for industrial materials and a related fall-off in commodity prices. And that commodity price fall-off has begun.
Then just a final point I'd leave you with here is oil. Oil's a big deal for all of us, and it's obviously a big deal for China. And on the left you see the non-oil price and right below it you see the real oil price. And I have no idea where oil is going. I know it's high enough to cause serious damage to the global economy right now if it holds at these levels. And recently at Morgan Stanley we actually cut our global forecast a lot to reflect a fairly weak and worrisome outlook in early 2005.
I'd just draw your attention to the real oil price on the bottom. Everyone said, you know, don't worry about oil because the real price of oil is below where it was in the late '70s and early '80s. That is bad macro. I'm here to tell you that. What matters to macro is not the level but the change in the real price level. And so on that basis, there's been, relative to the average real price of oil that's prevailed, say, since early 2000, today's level is about 70 percent above that. That's a shock in my view, and that will hurt a good deal.
But note also that since 1998, there's been a sustained run-up in the real price of oil for the first time since the late '70s. And maybe it reflects these two graphs on the right where the only countries where the share of oil consumption is rising are China and India, and then you look at the bottom and you look at the oil per unit of GDP in China, which is 2.3 times the industrial world norm, the OECD bar there, India 2.9 times the OECD norm. Maybe as growth continues to accelerate in the Chinese and Indias of the world, you might argue that globalization is going to keep pushing the real oil price higher. We've got to really learn quickly, learn how to live with the real oil prices.
I apologize I went on for too long. Just one last thing. Our forecast of China, for what it's worth, this is our global view; our China line is right down there three rows from the bottom. We did make some changes about a week ago in our China number. We kicked up our '04 number from 9 to 9.5. We kicked down our '05 number from 7.5 to 7. That's a 2.5-percentage-point deceleration on a GDP basis. I told you at the outset pay no attention to Chinese GDP. So you probably should take this with a grain of salt.
The volatility, though, in the industrial production piece of the Chinese economy that's consistent with this is pretty much in line with the soft landing that I sketched out earlier. And the risk is it could be even more of a boom-bust cycle than these numbers lead you to believe.
So that concludes my thoughts. I mean, look, I'm hooked on China. I've spent a lot of time there in the last seven years. It's easy to romanticize and overly dramatize the impact of China. Bert's point is well taken. But China is now a force that we must all think about seriously as we are analyzing other major economies around the world. And, you know, congratulations to you guys. You've done a great job in setting out some important markers along that path.
MR. DUNAWAY: Well, thank you as well, Steve, for the compliment.
Our final speaker is Dr. Moises Naim. He's the editor of Foreign Policy Magazine, which is one of the world's leading publications on international politics and economics. He has served in many different roles over the years. He was Minister for Trade and Industry in Venezuela in the early 1990s. He was an Executive Director at the World Bank. And at the Carnegie Endowment, he has led several teams looking at economic reforms in Latin America. He has written extensively on economic reform, international trade, and globalization. And he's published widely in various media worldwide, in leading newspapers and magazines. So coming from a slightly different perspective, we welcome Dr. Naim.
DR. NAIM: Thank you very much, Steve, as well for the opportunity to be here. Actually, that also gave me an opportunity to summarize my own thinking on this.
I am no expert on China, but as part of my job, I have to follow the global economy and global politics, and, therefore, I do read everything that I can about China and follow it and visit it often. And I agree with my colleagues. Before coming here, we were all commenting that this report is one of the best summaries that we have read. I think that both Bert and Steve and I agree that this report that your team has put together is really one of the great summaries that we now have to take a look at China and think about it.
In thinking about China and how exceptional it is in terms of its growth, size, all of the things that we know, it's so easy to tend to forget or to not pay enough attention to two characteristics that it has.
First is that it's a centrally planned economy. It continues to have a very large—depending on what numbers you take, but it's either between 50 or 70 percent of the economy is centrally planned. And it's an emerging market. So this may be almost banal observations that tend to be lost when we are in awe of this miracle. But we have learned quite a bit about what happens to these specimens, to centrally planned economies and to emerging markets. And I don't need to go into the details, but some characteristics that I wanted to highlight that can help us think about China is that centrally planned economies are prone to shortages. And one central function of government in economies that have great rigidities is to allocate shortages. So shortage allocation, managing and distributing shortages becomes a very central, important part of what the government does.
That has all sorts of political ripple effects. Allocating shortages is very complicated, and it's politically explosive, and it becomes even more politically explosive if there is a growing perception of inequality or if there is a widespread perception of corruption. So distributing shortages is difficult. Distributing shortages when you have a perception that they're unequally and unfairly distributed is even more politically explosive, and doing it in the process—in a context where corruption is perceived to be very important is even more politically complicated.
We have also learned quite a bit about emerging markets, and we know that among the many characteristics is that they are accident-prone. Emerging markets are more or less like—you know, there are certain people who are prone to accidents. And these economies are prone to accidents. They're very volatile. If you just trace any variable—exchange rates, interest rates, growth, inflation—put it in a chart and look and it looks very volatile, a standard deviation of any of those variables tends to be very important, very significant.
But other characteristics that we have discovered that we know—it's almost logical—is that in emerging markets managing that economy and that political system is very demanding, and the demands on excellence and the effectiveness of government is very high. And the efficacy and effectiveness of government grows at a far faster rate than its capacity to be that effective. Too many things have to go well, there are too many things that need to be managed, from education to the health to the water to the traffic to the international financial system to the politics, to everything else. Too many things need to go well.
The third thing that we have learned in emerging markets is that inequality becomes an issue, even if inequality indicators do not change. So countries where the Gini index or the Lawrence curve have not changed significantly, all of a sudden inequality becomes a big issue. So in emerging markets, suddenly the population discovers inequality as a major issue—again, I repeat, even though maybe there have not been significant changes.
And the fourth characteristic is that in emerging markets for a variety of reasons, but partly because reforms tend to open up the political system or the media or access or trade brings opportunities, then corruption becomes an issue, too. And, in fact, it's—I said that the report is very interesting, and I think it's going to be a reference for any debate in China. But I did a search of the report for the word "corruption," and it just shows once. The report does not talk about corruption except when it says that depending on fiscal federalism, the transfer of functions that are a part of the government when they're transferred to nongovernmental organizations, they may create opportunities for waste and corruption. That's the only way where the report—it's on page 41.
The other is I did a search for "inequality." The report is also silent on inequality, except once on page 2 where it says that trade opening and foreign investment may create pressures on inequality. So China is an emerging market. In emerging markets, inequality and corruption become an issue. We know that they are an issue in China. The report says nothing about inequality and corruption.
And that is important because I referred, even if you disregard the economic significance of inequality and corruption, they do have some political significance. And I want to then link it back to the notion that you have to allocate shortages and to the notion that you have to have governments that have to do a lot of things well done. It's a feast of public administration excellence in order to get it right. In China, each year 12 million farmers move to the city. It is estimated that that costs about 4 percent of GDP in terms of infrastructure. Demand for urban infrastructure and social services are growing at a furious pace, and they are building—as Steve said, it seems like, you know, they're paving the whole country and the construction is going on. But that is highly localized and is highly concentrated. But, still, it's very complicated. China's highways, China's roads have been growing at 6 percent per year. Cars have been growing at 10 percent a year.
In the last five years, China invested more in water than China invested in the last four decades. More investment in water in five years than in the last 40 years. Yet water shortages are a daily life for the great majority of Chinese.
You can go on and on, with electricity, with social services in health, in education, in housing. And, again, I then want to link that, the allocation of shortages, to how is it done and what are the political consequences of that when you have an environment where you have growing—perceptions or growing realities of inequality. And inequality in China is becoming a big issue not just because it's a perception but because it is a reality.
First, inequality in China, the Gini index is still in the 40s, it's 0.40 or something, so it's not world class. You know, it does not reach Latin American standards or African standards. It's there. It's in the middle. But it is growing very, very fast. So the reason to be concerned is not its level, but it's the rate of growth. And these are numbers by my colleague, Banco Milanovich (ph), who also follows—these are all his numbers, not mine. And the way in which inequality is growing, it's growing both in between provinces and rural and urban and inside the cities. And some of the numbers are staggering. Eight hundred million rural Chinese make 15 percent of what their counterparts in the cities earn—15 percent. For rural unemployment to stay below 20 percent, the economy needs to grow at 7 percent a year. If the economy slows under 7 percent, rural unemployment will go up. And you can quibble with these numbers. These are World Bank numbers so, you know, assume that they are wrong by a factor of something. They're still—the message is still there. The message that there is growing inequality as we have not seen it before and that there is an unemployment that is unevenly distributed, that there is uneven access to social services and infrastructure, you can argue about what are the numbers, but that's a reality. And that is a reality that has important consequences.
So I feel that the burden to argue that China will not have some sort of growth-impairing accident is very hard. It's a very tall order. I think that it is almost—I consider it—and I may be wrong. I think it's very likely that China will have an accident that will impair its growth in the next five to ten years, and that means nothing. It's like predicting an earthquake in the world somewhere, so it doesn't mean anything. But to be more precise, assuming that China will continue to show the same trend, the same trend lines that we have seen, it's going to—I think the burden of proof is in those that believe that that will happen, they have a bigger case to make that those of us that feel that China will have a growth-impairing accident.
If that happens—and I will conclude here—we need to start—that need not be a debacle. A country can have a slowdown in its growth, and even though it is under such frailties as what I described in China, that doesn't mean that it's a debacle. The country can go on and recover and move ahead. But it may not. And here I have four ways of thinking about China's accident or thinking ahead about China, and they all have—I gave them names of individuals. Which individual is better suited to help us think about China's future? Confucius? Mao? Keynes? Or Stanley Fischer?
DR. NAIM: Confucius is, you know, moderation, and we heard it here, moderation, reflection, and careful management of balances, the fine-tuning of all this management, and then the thing moves ahead.
Keynes is Keynes. It's, you know, you manage all the leverage of fiscal, monetary policy, the exchange rate, the sort of overheating, the fine-tuning, the overheating, what you do when you have an overheating economy, what you do when you have an economy that has imbalances, the sort of thing that Bert writes in his article in the Wall Street Journal and other places, or the sort of prescriptions that derive from Steve Roach's approach. So it's a Keynesian management of the economy.
I would leave Mao for last, but then Stanley Fischer, I just picked him, first, because he's a friend; second, because we are at the IMF. But I do think that he came to epitomize the crashes of the '90s. We were all surprised by those crashes. They were all surprises. And even more surprising than the crashes was how quickly the countries that crashed recovered. Remember that when we had the crashes in Asia and in Russia and in Mexico and in Brazil, if you read the headlines, you know, in all these countries, all the headlines said it's going to take a generation for us to recover, this is forever, we are going to be on the water now for many, many years. And, surprise, surprise, these countries started growing back again very quickly, much faster than anybody had anticipated. So the crises of the 1990s had that character. They were unpredictable or for most of the world, they caught most of the world by surprised, but once they happened, they recovered. It was far more quicker than what anybody had anticipated.
So it may be that China has one of those—it has a 1990s crash, a 1990s vintage crash. But it could also have a 1960s vintage crash in which the economics and the politics get very messy. And that is where Mao comes in, where you start getting—you know, you start with some sort of a banking crisis that then escalates with a foreign exchange situation and imbalances and then there is—this combines with everything I discussed about inequalities and perceptions on inequalities and shortages and the political thing gets very complicated and then the government makes mistakes, because it's very easy to make mistakes in situations like this, and then the politics escalate and become very messy, and then you have ten years of political turmoil that essential makes it very hard to take the right decisions to manage the crisis and, therefore, make it very hard for the sort of prescriptions that we have heard—and they are here in the report. Pay attention to the banking system, pay attention to the state enterprise reform. They're all of those things that we know are necessary but become very difficult to implement when you have a political mess.
So which of the four is going to be the reality? I don't know, and I don't think we need to predict. What I think is that China has a very clear chance of avoiding the mess, but it's very important that in order to avoid the mess, it has very clear ideas of where it's at and where it could be, and also to learn from what we have learned in the '90s about how these things happen.
MR. DUNAWAY: Well, we would like to give the audience a chance to ask some questions. The way that we thought we would handle it is I'll take a number of questions, and then we will ask our panelists to respond to the questions, and if they would like to as well, they could respond to what the other panelists had to say.
The one thing I ask is that if you use the microphones and want to ask a question, please identify yourself and the organization that you are here with.
QUESTION: I am with the Embassy of Japan. I have a question for Dr. Roach about—you mentioned about overheating in Chinese economy, and I'd like to know, do you find any sector or industry which are more heated than other sectors?
MR. DUNAWAY: Okay. Another question?
QUESTION: I am with the office of the Chinese Executive Director to the IMF. I have two comments for Dr. Roach's report. One is Dr. Roach's comment on the Chinese government adoption of the traditional measures to cooling down the overheating economy. It appears to me that it is not the Chinese government's intention to adopt the traditional measures to cooling down the economy; rather, I think to a large extent it is caused by or should be attributed to the nature of the problem. As I said, it's a problem, it's a traditional problem of the overheating, rather than the solution, the traditional one. I might raise the analogy that it's like someone in the United States who has like the psychological problem rather than some other pains. So he must see a doctor, a psychological doctor, rather than to see a surgeon. So it does not necessarily mean that someone needs a psychological doctor, doesn't mean the surgery office (?) is not developed.
A second one is for also the soft landing range that Dr. Roach indicated that China's industrial production growth rate should be like between 10 percent to 8 percent. According to this level, I'm afraid that China's GDP growth rate should be like less than even 6 percent, or even less than 5 percent, according to the historical theories(?). If this is accepted by you that, you know, China—that it will be a very serious problem for China's economy to absorb the labor market as Eswar indicated that China does have a very serious pressure from the labor market, so I wonder if there is—if there should be what I say the Chinese criteria for the growth rate rather than the normal—very normal growth rates.
MR. DUNAWAY: Okay. Yes, please?
QUESTION: I am with the Chinese ED's office of the World Bank. Just a very similar question to the question asked by Mr. (?) , about a soft landing zone. This question is to Dr. Roach. I noted that you characterized the soft landing zone as 8 percent to 10 percent, and this period of time from 1998 to 2002, early 2002, is a period that Chinese economy was, in fact, in a deflationary situation. So I'm just wondering whether soft landing zone should be higher than this 8 to 10 percent.
MR. DUNAWAY: Okay. Other questions? Yes.
QUESTION: I am with the Washington Bureau of China Economic Daily. Definitely leadership in China has a lot of problems concerning economic development and macroeconomic management. Could the panelists name two most urgent issues that leadership in Beijing should pay the greatest attention first and foremost next year?
QUESTION: I am with George Washington University. It seemed to me another phrase or another term that I would have liked to have heard is the Communist Party. How far is that seen as an impediment to reforms of the key institutions that I think all the speakers say are necessary? For example, if we were to have more legality so that contracts, if you like, could be honored, this would mean presumably that the Communist Party would have to retreat a great deal from its control of the appointment of judges, from the influence that the government has—or the party has on all aspects of the legal sphere. Do the panelists think that the Communist Party in that sense can become perhaps like the party of Mexico, the PRI? Is that a way that it can go or not?
MR. DUNAWAY: Okay. I'll take one more question. Yes?
QUESTION: I am with the American Enterprise Institute. Just I wonder whether you could talk a little bit about solving this overheating problem and, in particular, whether you could talk about the limits of the use of interest rates given the exchange rate system that China has, that in the absence of a floating exchange rate, it's difficult for me to see how you could really raise interest rates without attracting additional capital. And my question really is: Is China not condemned to use administrative controls the way in which they're doing that raises the probability of their having a hard landing?
MR. DUNAWAY: Okay. Thank you. Let me start with you, Dr. Naim, first. In particular, I would be interested in your comments on the questions about the urgent issues and also the role of the Communist Party in the future.
DR. NAIM: Thank you. The three most urgent issues I think we all agree—I don't think there's going to be a lot of disagreement—is management of the exchange rate, what to do and how to do it, and it's probably not only the exchange rate level but the exchange rate regime needs to be rethought. I would have a hard time imagining that, well, months from now if we meet we will not have observed or we will not report a change in the way the exchange rate is managed. I think that's the first thing. And that goes—that's why I want to talk about exchange rate regime because, as Desmond said, that is connected to the way you also handle inflows and [inaudible]. The whole regime, not only the exchange rate, I think that's a very important thing.
And second is that it's very hard to manage that and manage the interest rates if you don't touch—if you don't start touching what in effect is a fiscal situation with state enterprises and with all the whole fiscal dimension of state enterprise reform and the links to the banking system. That is another area that is closely interconnected, and, by the way, I think the report does present a very, very good view on that.
And the third that is more political in nature is I think that corruption is everywhere in the world, China does not have an exclusive, and it may even be that China has less corruption than other places. But for the reasons that I described in my comments, I think it's very important that the government conveys a sense to the citizenry that there is not peaceful co-existence with corruption, you know, that there may be corruption but that it is not tolerated, that it's aggressive—and, in fact, they are doing it. They are doing it. I don't know that it can be—that it cannot be done more widely, more aggressively, and more symbolically. And the uses of symbolism in politics, you know, is very important.
So if the government can convey that it's really committed to battle and not to tolerate, I think that would be a very important valve, escape valve for political pressures that unavoidably are going to build once you start touching these hot buttons like the exchange rate and doing things to the fiscal situation associated with enterprise reform.
MR. DUNAWAY: Okay. Steve, since there were a number of questions on overheating, perhaps you'd like to address that.
MR. ROACH: Okay. I'll try to be brief.
Which sectors? That was the first question. The ones that are most overheated are construction and commercial/residential property area and the supply chain associated with those activities, especially in coastal China, residential property, commercial property in particular, in Shanghai.
In terms of whether or not you want to go to, you know, a dentist or a general surgeon, you know, China's overheating in my view has now gotten to the point where it is a macro issue. That was the message from Wen Jiabao last February. And so to deal with a macro issue with the micro tools of central planners, sector-specific, project-specific, I think is increasingly inappropriate. So there needs to be a blend of both micro and macro.
In terms of the comment that 8 to 10 percent industrial output might be consistent with 5 to 6 percent GDP, I'm here to assure you that China will continue to publish 7 percent GDP, no matter what the industrial production numbers will show. And I fully realize that during the '98 to '02 period, when industrial output did hover repeatedly in that zone, there were some issues, supply-demand issues that created some brief, episodic periods of mild deflation. Right now I think those are calculated risks that China needs to take. Its CPI increase is now above five. Its wholesale prices are—inflation rate's above six. Its corporate goods price index is above nine. So it needs to do something here.
And to Desmond's point on what can it do, as long as it keeps the currency regime fixed, it can still use interest rates. There's no rule that says you have to have both simultaneously. China's last serious overheating problem was in the early '90s when the inflation rate got up really high on a measured CPI basis, like 22 percent, I think in 1993. There was a blend of both administrative and macro tightening that was used, and it was successful, and it was orchestrated by a terrific central banker at the time, a guy by the name if Zhu Rongji.
DR. KEIDEL: Thanks. I'll go fairly quickly.
I wanted to make a comment on some of the presentations on the disparities on urban-rural. I kind of think there needs to be some inequality to allow people to move voluntarily to where they'll be most productive. And so I'm interested in the development and the increase to appropriate levels of inequality. What concerns me is not urban-rural so much as rural-per urban. You have a very vibrant economy in the rural areas around major cities, but deep in the rural areas you have people that are stuck without non-farm jobs. And so that's just a comment.
I think a second point is on recycling U.S. treasury bills, this is something a lot of people talk about that we're now dependent on China because it holds so many. The global bond market is so deep, so liquid, that if the Chinese felt they could make any use out of their holdings, they would shoot themselves in the foot and lose a lot of money. And, furthermore, if something—it looks some change in China's need to deal with its treasuries affect U.S. interest rates, the Federal Reserve Board going way beyond an exchange stabilization fund and other—has other resources that it can use. So I think we just want to take that U.S. treasury bill holdings by the Chinese off the table.
Third, the comment that current account surpluses matching the U.S. deficit largely are in Asia, I would take exception to that, Steve. Maybe—I think we've got different data. You're talking current account. I feel it's better to talk about trade in goods and services, which is a large component of the current account, because increasingly we're seeing part of the current account that involves transfers playing a quasi-capital account role. And there, if you take shares of the U.S. deficit, 48 percent is due to Europe, the euro zone, and to oil exporters. The euro zone is 28 percent on its own, and they're the ones that are complaining about the dollar. But they're the ones, if you look at it, that are most responsible.
East Asia is 40 percent. That includes China and Japan. But in that, China is a tiny share, 6.5 percentage points, and it's way down the list. You've got Japan, 15 percent, and non-Japan, non-China Asia, 19 percent of the U.S. deficit. So that's the right way to look at where those imbalances come from, and it's mainly—the largest contributor is the euro zone.
I agree with both speakers from the IMF and World Bank ED that the late '90s was a period of unbearably slow growth. It was a real macro crisis brought on by growth problem in industry too low. I think your landing zone is too low, Steve. I would agree with that.
The two most pressing issues? One, I think they can raise domestic interest rates on deposits, and they need to be ready to do that in a hurry. In the 1993 crisis and also the 1988 crisis, they did it by actually indexing interest rates to inflation, which means you took interest rates and pulled them all the way up into the 20-percent range. I mean, they didn't call it a percentage [inaudible] the regulation was that if you kept your money in the bank, you could get it back at whatever the CPI was in the ensuing period. It — [tape ends].
— their crops and not force them as much to plant grain. That is a critical need for Chinese policy if it's going to have sustained growth.
The Communist Party, it appoints bank heads, it appoints heads of large enterprises. It has a role overseeing the government. I find it a stabilizing force, one—for me, it's not whether it's a power. Look, you had the Kuomintang Party in Taiwan. You had a very central force in Korea. Pretty nasty, both of those. I lived under both of them as a graduate student and as a teacher for a number of years. And yet there was growth.
Now, I think there's a lot to be done in China to promote a civil society, but I wouldn't point to the existence of the Communist Party and the current role that it's playing in overseeing the development process as something that is an impediment by itself.
Solving the overheating problem, I think that, as I mentioned, I don't see that raising interest rates threatens the inflow of capital to that degree. You only have a problem of interest rate dependence on the world if you have an open capital account. So we're talking about the degree to which China's capital account leaks. And this is a question that we have interest in discovering what—how much is it leaking compared to what would happen if you really relaxed the capital account. In my view, if you relax the capital account of China, the flows would be enormous and they would mostly be out.
So I think that they have a good range to deal with the problems of additional capital inflows that leak in if they raise domestic interest rates, and that's the way to go.
MR. DUNAWAY: Thank you, Bert.
Since this, after all, is our house, I guess we take advantage of that, and I'll call on my colleague, Eswar Prasad, for the last words.
MR. PRASAD: Thank you, Steve.
First of all, let me thank all the panelists for their very kind words about the IMF study, and let me assure you that no corruption or bribes were involved.
MR. PRASAD: Also, like a good bureaucrat, I'll toe the middle line and try to agree with all the panelists at the same time. I think Bert is very right that the domestic challenges are the important ones, and in some cases, especially in the overheated rhetoric of Washington, sometimes the importance of China does tend to be exaggerated. And yet Steve Roach also has a point that I think is becoming increasingly relevant that China is a force to be reckoned with and, therefore, what happens in China is going to have much broader implications.
I think the panelists have touched upon a variety of things that this study, comprehensive as it was, could not address in the space we had available, and I agree that issues such as regional income disparities, and the other domestic challenges clearly deserve a great deal of further study.
On the overheating issue, I think we share the concern. But our principal concern is about what is causing the overinvestment. The fact that we've had a lot of bank credit fueling this increase in investment in some sectors of the economy is what concerns us a great deal, because it suggests potential vulnerabilities in the financial system going forward. And I think in terms of what could be done to control the overheating pressures, despite the current exchange rate regime, we've strongly held the view for some time that liberalizing lending rates in particular and allowing them to drift upward would be very important tools not just from the short-term perspective of controlling the overinvestment or excess investment growth, but would also help the reform of the financial sector by giving the banks an incentive to improve the commercial orientation of their lending operations. And, yet again, this sort of reform cannot take place in isolation, so thinking about any specific reform is very difficult unless one thinks about the broader picture. And here I think what the other panelists said about improving institutions is really going to be at the core in terms of the entire reform agenda.
MR. DUNAWAY: Okay. Well, let me once again thank all of you for coming, and particularly thank our panelists for the discussion today.


It seems complicated, but building Boost is really not that bad. First you need to download the bjam tool (SourceForge is a good source). Make sure bjam.exe is in a directory in your PATH.
Type bjam --help to get a list of all your build options.
The results will be placed in C:\boost and you can delete C:\build.