The Chinese Economic Renaissance: Apocalypse or Cornucopia?

The Chinese Economic Renaissance Apocalypse or Cornucopia? Dilip K. Das The Chinese Economic Renaissance Also by Di...

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The Chinese Economic Renaissance Apocalypse or Cornucopia?

Dilip K. Das

The Chinese Economic Renaissance

Also by Dilip K. Das MIGRATION OF FINANCIAL RESOURCES TO DEVELOPING COUNTRIES INTERNATIONAL TRADE POLICY: A Developing-Country Perspective KOREAN ECONOMIC DYNAMISM IMPORT CANALISATION THE YEN APPRECIATION AND THE INTERNATIONAL ECONOMY FINANCING GROWTH: The External Contribution THE ASIA-PACIFIC ECONOMY THE FUTURE OF ASIAN EXPORTS THE GLOBAL TRADING SYSTEM AT CROSSROADS: A Post-Seattle Perspective THE ECONOMIC DIMENSIONS OF GLOBALIZATION FINANCIAL GLOBALIZATION AND THE EMERGING MARKET ECONOMIES REGIONALISM IN GLOBAL TRADE ASIAN ECONOMY AND FINANCE: A Post-Crisis Perspective THE DOHA ROUND OF MULTILATERAL TRADE NEGOTIATIONS: Arduous Issues and Strategic Responses CHINA AND INDIA: A Tale of Two Economies THE EVOLVING GLOBAL TRADE ARCHITECTURE

Edited Books AN INTERNATIONAL FINANCE READER (editor) ASIAN EXPORTS (editor) EMERGING GROWTH POLE: The Asia-Pacific Economics (editor) INTERNATIONAL FINANCE: Contemporary Issues (editor)

The Chinese Economic Renaissance Apocalypse or Cornucopia?

Dilip K. Das

© Dilip K. Das 2008 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2008 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978-0-230-21840-6 ISBN-10: 0-230-21840-7

hardback hardback

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 17 16 15 14 13 12 11 10 09 08 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

To Vasanti, for being the wind under my wings.

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See simplicity in the complicated. Achieve greatness through little things. In the universe difficult things are done by attempting the easy first. In the universe great acts are made up of small deeds. The sage does not attempt anything very big, and by so doing achieves greatness. —Wisdom of Tao Te King

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Contents List of Tables

xiii

Preface

xiv

Acknowledgments

xx

About the Author

xxi

1 A Chinese Renaissance: Three Decades of Inexorable Economic Progress 1.1

1.2

1.3

1.4

1.5

Making an economic U-turn 1.1.1 A unique development model 1.1.2 Why the reform and liberalization program succeeded 1.1.3 Two vital variables: Saving and investment 1.1.4 Demographic bonus 1.1.5 Total factor productivity (TFP) growth 1.1.6 Rapid growth and relentless economic ascent 1.1.7 Downside of relentless economic ascent Comparison with the other Asian high achievers 1.2.1 Larger potential global impact of China 1.2.2 China’s global acceptance Evolution of a large trading economy 1.3.1 WTO accession: Marathon negotiations 1.3.2 Emergence of an export juggernaut 1.3.3 Outer-orientation and economic transformation A magnet for FDI 1.4.1 The quantitative dimension and geographical concentration of FDI 1.4.2 Did China eat ASEAN’s lunch? 1.4.3 Did FDI stimulate growth? 1.4.4 Dawn of a dual economy Multinational corporations (MNCs) in China 1.5.1 Stumbling blocks faced by the multinationals 1.5.2 Multinationals and Chinese trade ix

1 1 5 7 11 14 16 20 25 27 29 32 33 37 39 43 46 48 51 51 53 54 54 55

x

Contents

1.5.3 Multinationals and intensification of R&D 1.5.4 Changing conditions for success Managing the foreign exchange reserves 1.6.1 Merits and demerits of large reserve holdings 1.6.2 Credible alternative usages of the reserves 1.6.3 Launch of a sovereign wealth fund (SWF) Growth pangs and administrative failures Cost of rapid growth: Environmental degradation Future prospects and the growth trajectory 1.9.1 Medium- and short-term growth prospects 1.9.2 Longstanding limitations 1.9.3 Rebalancing the economy: Transitioning to a new growth path 1.9.4 China’s place in the global economy Summary and conclusions

72 76 77

2 A Chinese Renaissance in an Unremittingly Integrating Regional Economy

90

1.6

1.7 1.8 1.9

1.10

2.1 2.2

2.3

2.4

2.5

Introduction China and the Asian economies: Two plausible scenarios 2.2.1 Upgrading the technology base 2.2.2 Expansion of intraregional trade and vertical specialization 2.2.3 Functioning of regional production networks 2.2.4 Effects of vertical specialization on China’s trade configuration 2.2.5 China’s competitive threat in various technology categories 2.2.6 Has China turned into an outlier? China’s trade expansion and the Asian economies 2.3.1 Explanation of the co-movement in trade 2.3.2 Country- and sector-specific differences FDI inflows into China and the Asian economies 2.4.1 China’s ability to entice regional and global FDI 2.4.2 Did China receive excessive FDI? 2.4.3 China and the Asian economies: A zero-sum-game assumption A strategy for coping with China’s economic expansion

56 57 57 60 60 62 63 65 66 67 70

90 91 94 95 96 99 100 101 102 104 105 108 109 111 113 114

Contents xi

2.6 2.7

China’s regional integration posture and recent initiatives Summary and conclusions

3 A Chinese Renaissance in an Unremittingly Integrating Global Economy 3.1

3.2 3.3 3.4

3.5 3.6 3.7 3.8

China and the global economy: A fundamental repositioning 3.1.1 An unprejudiced assessment 3.1.2 Ascendance as a soft-power of global magnitude 3.1.3 The geostrategic stance of peaceful ascendancy 3.1.4 Modest role in the global economic fora China as a source of global growth Channels of impact over the global economy WTO accession and its consequences 3.4.1 Expanding international competitiveness and the global impact Outward FDI and the “Going Global” strategy Modeling China’s global integration How to dance with China: Formulating a functional strategy Summary and conclusions

4 The Chinese Renaissance and the Transpacific Macroeconomic Imbalances 4.1 4.2 4.3 4.4

4.5 4.6

Macroeconomic imbalances in the global economy Persistence and magnitude of the Chinese current account surplus Persistence and magnitude of the US current account deficit China’s bilateral trade surplus vis-à-vis the US 4.4.1 The bilateral trade structure 4.4.2 Product drivers of bilateral trade 4.4.3 Bilateral trade and China’s incentive zones 4.4.4 Exports to the US by the FIEs 4.4.5 The probability of contraction of Chinese exports to the US Transpacific financial imbalances: Stable or unstable Diverse perspectives on transpacific macroeconomic imbalances

116 119

125 125 129 130 132 134 137 140 144 145 147 149 151 154

160 160 163 165 170 173 175 176 176 177 178 181

xii Contents

4.7

Winding down the payments imbalances between China and the US 4.7.1 Multilateral consultations on transpacific imbalances 4.7.2 An accord to unwind the transpacific imbalances 4.8 Summary and conclusions 5 The Chinese Renaissance and Its Currency Conundrum 5.1 5.2

5.3

5.4 5.5

5.6 5.7

Evolution of China’s exchange rate regime Misalignment of the RMB yuan 5.2.1 Undervaluation and Balassa-Samuelson hypothesis 5.2.2 Undervaluation and the BEER, the PEER and the FEER estimates Revaluation of the RMB yuan 5.3.1 Why the revaluation expectations were rife 5.3.2 Why market expectations were belied 5.3.3 Pressure for appreciation on the RMB yuan 5.3.4 The opportunity cost of undervaluation 5.3.5 Finally the miniature revaluation 5.3.6 Life after the reform of the exchange rate regime An unambiguous dichotomy of perspectives Trade response to currency value movement 5.5.1 Consequences for China’s trade 5.5.2 Consequences for the Asian economies 5.5.3 Consequences for the China-US bilateral trade 5.5.4 Generalized currency appreciation with the other Asian economies The subprime mortgage crisis and the RMB yuan appreciation Summary and conclusions

185 186 188 190 198 198 202 202 204 206 206 207 209 212 213 215 216 219 219 221 222 223 224 225

Notes

233

Bibliography

243

Index

261

Tables Table 1.1 Comparative 2006 GDP Table 1.2 Average GDP growth rate, 2006–20 Table 2.1 Inward FDI Performance Index for the AHP economies Table 3.1 Comparative industrialization

xiii

23 69 111 127

Preface A look back at economic history can be revealing and educating. During the first quarter of the nineteenth century, the Middle Kingdom was the largest global economy, larger than the entire economy of erstwhile Europe. However, during the one and a half centuries following this period, China descended into abject poverty. The society suffered from feudal incompetence, leading to political and social disorder and economic turmoil. With the launching of economic reforms and the “open door policy” in 1978 a new era of vertiginous economic growth and global integration dawned. In 2008, the 30th anniversary year, China completed three decades of broad-based market-oriented macroeconomic reforms and restructuring. What China achieved in a short span of three decades is nothing less than stellar. The 2008 Olympics in China aptly mark a justified celebration of its reclaimed international economic stature. During this period of three decades, virtually every indicator of economic and social well-being has improved, in many cases appreciably. China has established itself as a systemically defining economy with the highest long-term average GDP growth rate in real terms in the fastestgrowing region of the global economy. China’s GDP growth remained stable, at a high level, for a sustained period of time. China has moved from the periphery of the global economy to its core. Few economists, ex ante, would have thought of this as feasible. The economy went through multiple and sizeable transformations, namely, from a command economy to a private-sector-led decentralized market-oriented economy, from a ruralagrarian to an urban-industrial society and from an autarkic to an open economy. Based on its past economic performance, some analysts projected China to be the second-largest economy in the world, measured at the market exchange rate, in the not-too-distant future. Such success commands attention, and China has become the cynosure of academic and business communities as well as that of the public-policy makers. Some enthusiastic economists and analysts have begun writing about “the dawn of China century.” A couple of decades ago, this would have been regarded as excessive, but not anymore. During the reform period, China’s rate of saving and investment was remarkably high. Investment was a major driver of growth during this period. The relationship between investment and industrial growth is crucial for comprehending growth acceleration in China. Impressive xiv

Preface xv

total factor productivity increases were recorded in the economy. Also, there was a steady increase in labor productivity, which was instrumental in making China one of the most productive economies in Asia. The economy benefited from the one-child policy by markedly improving the quality-adjusted labor supply growth. The one-child policy caused the population growth rate to decline sharply. Having less young dependents on the working-age population reduced the dependency burden of this demographic group, which in turn provided the economy with a demographic bonus. Supported by a steady inflow of foreign direct investment (FDI) from its Asian neighbors and the industrial economies, the manufacturing sector in China has emerged as strong, large and globally competitive. It became the third-largest recipient of FDI in the world. China is regarded as a manufacturing behemoth that is difficult to compete with in a large range of manufactured products. To be sure, FDI contributed to both the range and the quality of manufactured goods. Recent industrial development has reflected a broad and deep expansion of Chinese production and manufacturing capabilities. It has earned a fond sobriquet like “the workshop of the world.” Rapid growth has made China a progressively important global economy, and its standing among the world economies has continuously improved. Measured by the volume of nominal GDP in current dollars at market exchange rates, China’s rank has improved from the eleventh in 1990 to the seventh in 2003 and further to the fourth in 2005, when China’s total output of goods and services was worth 18.2 trillion renminbi yuan (or $2.2 trillion). At this level of nominal GDP, China edged past Britain in 2005. With 11.5 percent GDP growth rate in the first half of 2007, the Chinese economy surpassed that of Germany in 2007 and became the world’s third-largest economy, when the GDP is evaluated at market exchange rate. Such a rapid-clip ascent of China will influence businesses, employees and consumers all over the world. Business firms will need to devise strategies to remain competitive in this new emerging global business ambiance. Also, with the demise of the hub-and-spoke arrangement, development of the new axes of global business development is inevitable. With the enlargement of China’s global economic presence, the hitherto overbearing authority of the Quad (Canada, the European Union, Japan and the United States) is sure to relatively diminish. In an increasingly multipolar world, business and political leadership will need to develop an authentically global collaborative mindset. In less than three decades China has emerged as a trading economy of global proportion. In 2004, China became the third-largest trading

xvi Preface

economy in the world, after Germany and the United States. Reforms of the external sector facilitated this process and global integration of the economy continued to advance. China’s performance on the external front was comparable to the performance of the other Asian highperforming economies. China has been running large trade balance surpluses, resulting in current account surpluses, which are partly caused by its remarkably high savings rate. The growth of the Chinese economy has been essentially anchored in export-oriented industrial products and investment. Its accomplishment of being a low-cost exporter of world-class consumer products and manufactures was achieved by transforming its economy into a global factory of a substantial range of consumer and industrial products. Yet another meritorious achievement of China was that it became the largest single contributor to global poverty reduction in the global economy. China alone accounted for over 75 percent of poverty reduction in the developing world over the last 20 years. It is well on track to eliminate $1-a-day (measured at PPP) poverty by 2015. According to one view, China’s emergence as a systemically important economy is a major economic threat to the regional and global economies. Protectionist hackles were, and are, rising in many economies. It has been blamed for creating global imbalances. A great deal of trepidation is based on unsound and illogical premises. On balance, China has proved to be a benevolent influence for the global economy. By the mid-1990s, China had begun providing significant impulses to global growth. Its positive supply-side shock to the global economy did not go unnoticed. Although in the short-term the Chinese economy has also caused some dislocation to the established global economic order, its ascendance as an economic power is a constructive, beneficial and welfare-enhancing development. Since the turn of the century China was being seen as the second locomotive of global growth after the United States. What we are witnessing is the sustained growth of a future economic superpower, with unmatched resources and a large business-savvy class having lofty aspirations. As rapid growth further increases China’s global presence, its influence on other economies will rise and with that the need to develop strategies and responses to meet the challenge will also rise. To be sure, the US economy will continue to be an important engine of global growth. However, if the current growth trends in the global economy persist, China and the US will be the two principal sources of future global growth, which is a wholesome development. As noted above, under certain assumptions China may even start

Preface xvii

playing a relatively larger role than the US. After the subprime mortgage woes in the US in September 2007 and a precipitous fall of Dow Jones, a recession in the US became a strong probability. The need for a second engine of growth for the global economy became more imperative. Toward the end of 2007, China was beginning to be seen as that kind of force for stabilization of the global economy. The overarching theme of the book is that China is no longer a peripheral economy that it was; rapid growth of the preceding three decades has turned China into an economy of global prominence—a systemically important economy. It has dexterously acquired the central stage of the global economy and has begun influencing it as some of the largest economies do. It is an accomplishment of historic dimension. Economic decisions made in China and incidents that transpire there sway many subgroups of global economies, including the other emergingmarket and industrial economies. With the progressively increasing global value of the Chinese economy, its importance to the academic, business and public-policy-making communities has also gone on increasing. Not only the theme of its growth and economic achievements so far per se is of enormous interest but it also has lessons for the other economies and public-policy-making communities. As Chinese policy makers took many leafs from the experiences of the dynamic East Asian economies, other developing economies can also try to learn from the Chinese experience and emulate it. Besides, as a member of the academic, business and public-policy-making communities in any part of the world, one possibly cannot afford ignorance regarding the Chinese economy. Knowledge in this area is, and will continue to be, invaluable to all the three communities. Ignorance could have a high cost. An outstanding feature of this book is that, unlike most China-related books, it is written in a comprehensive and authoritative manner and covers large areas of the economy, including macroeconomic, trade and financial sectors. It does not exclude other relevant facets such as agriculture, demographic features and human resource development. The noteworthy areas of focus include China’s relationship and integration with the rest of the dynamic Asian economies as well as the Global economy. In-depth discussions have been provided on saving, investment, and financial, banking and monetary aspects of the economy. Regional integration through expansion of trade, financial flows, FDI and regional production networks through vertical specialization are significant issues that have been focused in appropriate chapters. The currency conundrum has become another area of intense debate and a full chapter has been devoted to it.

xviii Preface

While it provides a multifaceted—and so far as possible comprehensive— perspective of the Chinese economy, perpetuating the folklore about the Chinese economic growth is not the intention of this book. It takes an objective and dispassionate view and delves into the constructive and favorable side as well as the adverse and unfavorable side of the Chinese economy. The deficiencies and imperfections have been neither overlooked nor swept under the carpet. For instance, income inequalities have worsened since the launch of macroeconomic reforms and the Gini coefficient has increased. Lack of a social safety net has aggravated the problems created by income inequality. This book also addresses and discredits the numerous myths surrounding the Chinese economy. The prominent ones include that China’s macroeconomic management is to be blamed for the myriad US macroeconomic malaise; China’s current account has exploded because of its cheap, labor-intensive exports; China is a destroyer of jobs in the industrial economies; until the renminbi yuan is sharply devalued global imbalances will persist; and revaluation of the renminbi yuan will trim down the US trade and current account deficit. Another outstanding feature of this book is that in taking a contemporary, or post–Asian crisis (1997–98), view of the Chinese economy, this book offers the newest knowledge related to relevant themes on the Chinese economy as well as the latest concepts. In a succinct manner, this book deals with the principal normative and positive strands with which one need to be properly familiar in this subject area. As it is essential for a book of this kind, parts of the chapters have been written in a “just-the-facts-jack” style, followed by elaborations on various themes. The picture of both static and dynamic aspects of important economic themes related to the Chinese economy has been painted with a broad brush. The selection and rejection of the thematic strands for coverage in this book has been done exceedingly carefully. The approach is neither overly technical nor highly model oriented. Excessive emphasis on technicalities, equations and econometric modeling discourages many potential readers. These characteristics narrow down the market to a small expert readership. The book is easy to access for the target readership because of its descriptive analysis style, which stops short of mathematical formulations and econometric modeling. Many students and other readers who have good analytical minds and sound knowledge of economic principles feel lost in mathematical formulations. This writing style makes it accessible to a much larger number of readers, at varying levels of knowledge and expertise.

Preface xix

In a pithy manner, this tightly written volume covers a great deal of ground and imparts a great deal of knowledge on the Chinese-economyrelated themes to students, researchers and policy makers alike. It is a worthwhile exercise because a knowledge gap exists among various stakeholders. The five chapters address independent but thematically related themes, with accessible analytical narrative style. Given the significance of the theme, many universities and business schools have started offering courses on Chinese economy. Their number is large and growing. Although this book is written in a reference book style, it can also be used as a textbook. As noted above, students and other readers find the latest knowledge and concepts on several important themes on the Chinese economy in this book, in a manner in which they can appreciate and absorb them as well as use them as input in their decision making. Students, particularly those from business schools, who may hold Chinese-economy-related jobs after completing their studies would find this knowledge extremely relevant, usable and helpful. The target readership of the book is master’s level students in economics, international economics, international political economy, international relations and Asian economy courses as well as MBA students. Ambitious senior level undergraduates as well as policy mandarins and researchers can also benefit from the book. Having a background of initial micro, macro, international trade and monetary economics should be sufficient to comprehend this book because it provides definitions and explanations of terminology and advance concepts used in the text as footnotes. My aspiration is to provide students, business leaders and policy mandarins around the world with a fact base to better comprehend one of the most important transformations shaping the contours of the global economy. I also aspire to bring out that emergence of China as a major systemic economy and a future economic power, while disruptive in the short-term to some economies, is on balance a benevolent and positive force of historic dimension for the global economy. Toronto Dilip K. Das January 2008

Acknowledgments I take this opportunity to thank my son, Siddharth, for providing prompt and efficient research assistance, and three anonymous referees for providing detailed comments on the manuscript. They were as helpful as they were constructive. I am grateful to Taiba Batool of Palgrave Macmillan, UK, for handling the publication and production process of this book in an exceedingly efficient manner. I have been in the business of researching, writing and publishing for over three decades now. I found her level of efficiency an absolutely rare commodity in the publishing industry. I owe profound thanks to Taiba Batool for the care and attention they poured into editing this book. The book’s extremely sharp-eyed copy editor, Philip Booth, is another person who deserves my grateful thanks. Hélène Côté provided first-rate assistance in research; her humor was as supportive as her library research endeavors. To nurture excellence in any area of human endeavor, credit should be given where it is deserved. One neither needs a sword nor a gun to kill excellence in any society. Ignore and it will wilt away. Indubitably, the largest debt I owe is to my wife, Vasanti, for managing the life around me and leaving me to do the research and writing. Dawn-to-dusk days of nonstop working were not feasible without her tireless support. She also meticulously read the first drafts and ruthlessly hunted down faulty syntax and mixed metaphors. Toronto Dilip K. Das January 2008

xx

About the Author Professor Dilip K. Das has been associated with several prestigious business schools around the globe, including the European Institute of Business Administration (INSEAD), Fontainebleau, France; the ESSEC, Paris, France; the Graduate School of Business, University of Sydney, Australia; the Australian National University, Canberra, Australia; and the Webster University, Geneva, Switzerland. He also was Professor and Area Chairman at the Indian Institute of Management, Lucknow, India, and EXIM Bank Distinguished Chair Professor in the International Management Institute, New Delhi. The areas of his expertise include international finance and banking, international trade and WTO-related issues, international business and strategy, and Asian economy, including Chinese and Japanese economies. His most recent interests are globalization and global business environment. Professor Das has worked as a consultant for several international organizations, such as the USAID, the World Bank and the World Commission on Development and Environment in Geneva. He organized 13 large international conferences during the last ten years. Presently he is a Toronto-based consultant to international organizations. He has immense appetite for research. He has written extensively and published widely. He is an author or editor of 26 books. The last two books he authored were entitled Financial Globalization and the Emerging Market Economies (Routledge, London and New York, 2004) and The Doha Round of Multilateral Trade Negotiations: Arduous Issues and Strategic Responses (Palgrave Macmillan, Ltd, Basingstoke, UK, 2007). He has contributed over 70 articles to professional journals of international repute, and 75 of his papers have appeared in prestigious research and working paper series. Twenty-two of them have also been posted on wellregarded web sites of business schools and universities. He was educated at St. John’s College, Agra, India, where he took his BA and MA (economics) degrees. He went on to study at the Institut Universitaire de Hautes Etudes Internationales, the University of Geneva, Switzerland, where he did his MPhil and PhD in international economics. He is fluent in French. The author is regarded as a world-class scholar of Asian economy. A naturalized Canadian, he lived and worked in Asia and Australia for xxi

xxii About the Author

long periods and has had long-term interest in the Asian economies, including Chinese, Japanese and Korean economies. He wrote several books on Asian economy, including two successful textbooks. He has taught Asian-economy-related courses in several Asian and Australian business schools and did a short-term stint at the economic research division of the Asian Development Bank.

1 A Chinese Renaissance: Three Decades of Inexorable Economic Progress

The wheel is come full circle: here I am. —William Shakespeare, King Lear

1.1

Making an economic U-turn

As a political and economic entity, the People’s Republic of China (hereinafter China) is regarded as the oldest country in the world. Since the period of the Qin Dynasty (221–204 BC) and the First Emperor, popularly known as Qin Shi Huangdi, China has been a united and prosperous empire. History credits Emperor Qin Shi Huangdi for initiating a sophisticated government structure that outlasted him for two millennia. For the major part of this period, China was a prosperous and wellmanaged empire. It was economically well-off, had robust domestic and international trade and was highly advanced in knowledge and technology. The Great Wall of China, legendarily 2,200 years old and 4,300-miles long, not only made a confident physical statement but also symbolized China’s belief in itself as an advanced and refined civilization, eager to make an unambiguous distinction between itself and the “barbarians” beyond the border (Lovell, 2006). By the tenth century it had a professional bureaucracy, which administered cities and provinces with impressive proficiency. Its centralized political system was supported by intensive and well-organized agriculture, which brought prosperity to the society (Maddison, 1998). However, China lacked the entrepreneurial prowess and military muscle that the European countries and Japan succeeded in cultivating. A time came when its economic affluence went into a sharp decline and it was reduced to dismal poverty. In 1978, the economy began to make its now-celebrated U-turn. 1

2 The Chinese Economic Renaissance

In the early fifteenth century, during the reign of Emperor Yung Ho, naval and merchant fleets traversed up to the eastern coast of Africa as well as through the Pacific Ocean to Mexico, and trade was brisk. At this point in history, China had the highest per capita income in the world. Abu-Lughod (1989) provided comprehensive accounts of the voyages of the Ming Dynasty (1368–1644) admiral Cheng Ho (or Zheng He) until the early decades of the fifteenth century. The Ming Dynasty navy had over 3,800 ships; many of them were several times larger than their Portuguese counterparts.1 China not only led the world during this era in shipbuilding but was also ahead of Europe in clock-making, hydraulics and iron-smelting. Other Chinese inventions include machines for ginning cotton; weaving silk; and making collapsible umbrellas, paper money and playing cards. Some of the Chinese machinery could “match the 18th century contraptions that launched Britain’s Industrial Revolution” (The Economist, 2007a). The modern government system of hierarchical bureaucracy also originated in China. During the early nineteenth century (1820) China was the largest global economy, accounting for 32.4 percent of the world GDP, measured in purchasingpower-parity (PPP) terms. This made the Middle Kingdom2 larger than the entire economy of erstwhile Europe.3 China of the Manchu (or Qing) Dynasty (1644–1912) was the largest economic power until the late eighteenth and early nineteenth century. Until this point, the global economy was essentially Sino-centric. In 1792, King George III (1738–1820) dispatched the first British trade mission to China, a 700-strong working party of diplomats, businessmen, soldiers and scientists. Packed in three large ships, this trade mission brought the most impressive fruits of Western scientific progress, including telescopes, clocks, barometers, air guns and hot-air balloons.4 It was intended to dazzle Emperor Qian Long (1735–96). The Emperor was urged to open trade with the West.5 Although fraught with selfassurance, Emperor Qian Long’s following message to Ambassador Lord Macartney for King George III was indeed germane: Swaying the wide world, I have but one aim in view, namely, to maintain a perfect governance and to fulfill the duties of the State. Strange and costly objects do not interest me. If I had commanded that the tribute of offerings sent by you, O King, are to be accepted, this was solely in consideration for the spirit which prompted you to dispatch them from afar. Our Dynasty’s majestic virtue has penetrated into every country under Heaven, and kings of all nations have offered their costly tributes by land and sea. As your Ambassador can see

A Chinese Renaissance 3

himself, we possess all things. I set not value on objects strange or ingenious, and have no use for your country’s manufactures.6 However, during the one-and-a-half centuries following this period, China was an abjectly poor country, suffering from feudal incompetence leading to political and social disorder and economic turmoil.7 Sometime between the mid-nineteenth century and the latter half of the twentieth century, it became an epitome for economic and social stagnation. Widely regarded as one of the poorest countries in the world, it was typically thought of as a location for famine, disease, pestilence and backwardness. In the mid-twentieth century, particularly during the 1960s, the Chinese economy suffered from severe famines and its economic fortunes reached their nadir. The Great Leap Forward (1958–60) and the Cultural Revolution (1966–76) were periods of serious domestic instability and disruption. At the time of Mao Zedong’s death (1976), the Chinese economy was one of the poorest and most autarkic in the world. In the facetious, if sterilized, language of international diplomacy, it became an economic “basket case,” deserving to be viewed through the lenses of pity. Even in the early 1980s, China was widely regarded as an “impoverished” low-income economy. In 2008, China completed three decades of broad-based marketoriented macroeconomic reforms and restructuring. During this period, virtually every indicator of economic and social well-being improved, in many cases appreciably. China’s GDP growth remained stable, at a high level, for a sustained period of time. Ascent of China’s economic prowess became a defining global event. Few economists ex ante would have thought of this as feasible. Based on its past economic performance, some analysts projected China to be the second-largest economy in the world, measured at market exchange rate, in the not-too-distant future. Such success commands attention, and China has become the cynosure of academic and business communities as well as of public policy makers. While the transition process still has a long way to go, the Chinese economy underwent multiple and sizeable transformations, namely, from a command economy to a private-sector-led decentralized marketoriented economy, from a rural-agrarian to an urban-industrial society, from a low-income to lower-middle-income income (as defined by the World Bank) economy and from an autarkic to an open economy. During the preceding three decades, China not only became a vigorous manufacturing economy but it also progressively integrated into regional and global goods and services markets, making an imperious


niche for itself. Compared to the other emerging-market economies (EMEs)8 of comparable size, China’s pace of globalization was discernibly more rapid. The EMEs are a subset of the developing economies, and the fact that this EME has emerged as an intense competitor in the global marketplace to both developing and industrial economies alike is fascinating as well as intriguing. Was the reform process unproblematic, straightforward and smooth? An accurate answer will have to be in the negative. On the road to momentous transformation and economic expansion, several structural problems emerged. China faced myriad challenges. A conspicuous malaise is the skewed income distribution between urban and rural populations. The rural-urban income divide continued to be exacerbated. Urban real incomes have been increasing at the rate of 12 percent annually, while in the rural areas the corresponding rate is 5.5 percent. Presently, urban income in China is three times higher than rural. This rural-urban income gap is one of the largest in the world, setting off massive rural to urban migration. Almost 200 million had moved from the rural areas to the urban by 2005; a similar number is expected to migrate in the next 15 years. The other challenges included rising income inequality and worsening Gini coefficient with rising income. The Gini coefficient rose from 0.25 in 1978 to 0.41 in 2006.9 China recorded the highest increase in Gini coefficient in Asia, after Nepal, over the 1990–2000 period (The Economist, 2007b). High rates of unemployment deteriorated with restructuring of the state-owned enterprises (SOEs). Regional economic disparities have gone on intensifying, and deep disparities within and between sectors have been created. Coastal cities in the southeastern part of China have a much higher per capita income than those in the northwestern and interior parts. Overcapacity in several important sectors has plagued the economy, and rapid-growth-led environmental pollution has been deteriorating at an alarming rate. These prickly economic problems can potentially impede economic growth, increase the cost of GDP growth and sow the seeds of social discontent.10 Globalization was not an unalloyed blessing for China. It made the economy more dependent on external demand and rendered China vulnerable to external shocks. The principal institutional deficiencies that policy mandarins face include a weak legal framework, an immature and problem-ridden financial market and banking sector and poor governance. Rapid growth took its toll in terms of defilation of environment and serious spread of industrial pollution. Policy reform process is made more complicated and challenging by the fact that provincial and local governments enjoy a good deal of autonomy in


economic decision making. Thus viewed, policy environment in China was not easy, and disagreements were rife. Reforms, including institutional reforms, could only be undertaken in small steps, incrementally. 1.1.1 A Unique development model The most important recent historic event in the Chinese history was China’s adoption of a comprehensive market-oriented economic reform, liberalization and restructuring program and abandoning of its old autarkic system based on central planning, which China had learned from the Soviet Union. The essential and far-reaching contribution of economic reforms was making capital and labor more productive. They resulted in dramatic improvement in efficiency and significantly increased competitiveness of the economy. The genesis of this reform and liberalization program, which changed China’s economic direction, took place in December 1978. This decision was taken at the highest political level, at the Third Plenary Session of the 11th Central Committee of the Communist Party of China (CPC). China adopted its now-renowned Gai Ge Kai Fang, or “change the system, open the door” or simply the “open-door policy.” This momentous policy move ended China’s three-decade-long economic isolation. The political leadership announced the target of quadrupling of GDP between 1978 and 2000. China succeeded in achieving this goal. This proved to be a defining moment in China’s recent economic history when the economy made a tight U-turn. The open-door policy laid the foundation for China’s impressive economic progress in a short span of three decades. The new economic strategy became famous as the “Deng doctrine,” because President Deng Xiaoping was widely considered the intellectual father of this liberal and pragmatic economic stratagem. However, Zhao Ziyang, the secretary general of the CPC, was the one who had originally conceived this strategy. His economic thinking and policies were progressive for their time and place. He had visualized and developed the “preliminary stage theory,” which in fact was the course for transforming the Chinese socialist system and setting the stage for much of the economic liberalization. It laid the groundwork of the prosperity that China enjoys today. Zhao Ziyang had first implemented his liberal and pragmatic economic theory, economic restructuring and reform policies in the Sichuan province in the early 1970s and had succeeded. He was subsequently able to convince his CPC superiors that this strategy was the most correct to be adopted for the nation if it was to break out of the yoke of oppressive poverty and deprivation.


The uniqueness of the reform program was that it did not comprise a detailed outline of macroeconomic transformation but was based on gradual, incremental and somewhat experimental changes. Deng Xiaoping’s dictums of “doing what works,” “seeking truth from facts” and “crossing the river by feeling the stones” were carefully followed by those who implemented reforms. They were essentially guided by principles of pragmatism and experimentation. Believing in simple concepts such as “It doesn’t matter if a cat is black or white so long as it catches mice,” uncomplicated practicality of reform process was assigned top priority. The reform was christened the dual-rack approach, which implied creation of a mix of plan and market-economy systems. It entailed maintenance of the old planned-economy track and creation of a new market-oriented track. This approach cautiously shunned creation of losers in absolute terms (Das, 1996; Lau, Qian and Roland, 2001). One distinct characteristic of this reform paradigm was its flexibility and adaptability in the face of constraints that reform programs usually face. The dual-track reform program delivered high and relatively stable growth and proved to be a functional growth strategy for China. The sequencing of reforms in China is well known. They were launched in the rural areas with the local reorganization of the agriculture sector in the late 1970s, which resulted in greater autonomy for individual collective farms and those working on them. Subsequently these reforms were codified and developed in the form of the Household Responsibility System in 1978–79. The next step was to replace collective farms by family-farming units in the early 1980s. In tandem, the Township and Village Enterprises (TVEs) were created in 1979; they were also created by local political leadership and turned out to be a successful experiment. The TVEs remained the most vital part of the manufacturing sector in the 1980s. They imparted market-orientation to the rural economy. When these reform experiments in the rural areas seemed successful, confident authorities introduced similar measures in the urban areas in 1984. Managers in the SOEs were given a free hand in a cautious manner and were allowed to retain partial profits. Many institutional reforms followed under the Contract Responsibility System, and individual SOEs were given increasing authority. This was the starting point of China’s economic reform process, which made immense strides. In three decades it refurbished virtually the entire economic structure. Urban reforms continued and resulted in improving the income status of the urban population, which was favored under the administered economy. This led to the creation of the present rural-urban


divide. The urban population enjoyed both food and social security, which were not available to the rural population. The “urban bias” enabled China to undergo industrialization as well as maintain social stability (Yueh, 2008). At the time of the launching of reforms, the Chinese currency was overvalued. It was depreciated in the 1980s. Consequently, the real effective exchange rate (REER) of the renminbi (RMB) yuan declined (Chapter 5). It must, however, be pointed out that the correct calculation of REER during the 1980s was made difficult by data problems and the presence of multiple exchange rates. China’s catch-up process accelerated after 1994. Some analysts regard the post-1994 period of growth as superior to and more rapid than the pre-1994 one. During this phase, market-oriented reforms for the industrial sector and the external sector were accelerated. Company law was introduced for the first time. Accordingly, the long-term average rate of GDP growth, investment and trade expansion were higher during the post-1994 period. This was the result of “a policy package that combined market-oriented, but prudent microeconomic reforms, with aggressive and growth-oriented macroeconomic policies” (Geiger, 2005). Like in the other Asian high-performing (AHP)11 economies in the past, Chinese policy makers paid extra attention to the external sector. Steadily enhancing the penetration of its major export markets enabled China to both grow and accumulate industrial capital rapidly. To be sure, a strategy to promote external-sector-driven growth is not an undemanding task, because there are a number of interacting elements in it. That the policy-making community pragmatically took a leaf or two from the successful growth experiences of the other AHP economies is easy to envisage. 1.1.2 Why the reform and liberalization program succeeded This is a worthwhile query because comprehensive, or so-called big bang, reform and liberalization programs faced numerous difficulties and performed poorly in many centrally planned economies in Eastern Europe and the former Soviet Union. Implementing them proved to be a complex and strenuous struggle and involved high short-term adjustment costs. In the early stages, they resulted in steep negative growth and sharp increases in unemployment rates, which had high social costs and spelt misery for large segments of populations. The fundamental reason why the reform program succeeded in China is that the erstwhile political leadership had vision and was widely regarded as knowledgeable, capable, pragmatic and result –oriented. It was earnestly committed to it and refused to be beguiled by ideological dogmas. They had an open mind


and did not let ideology bog them down. Their pragmatic, no-nonsense attitude, single-mindedness and strong commitment to strategies that foster growth and global integration have been viewed by policy mandarins in other parts of the world with esteem. Their approach to implementation gave high priority to expediency. Consequently, there was nothing of value in the capitalist economic policy repertoire that they did not rationally consider and adopt for China. The most consequential measure was the adoption of partial reforms, which were Pareto-improving, or output enhancing. The basic idea of partial reforms was the adoption of two-track pricing. The old SOE system was allowed to continue as a privileged segment of the economy, having privileged access to inputs. The result was that large layoffs during the initial liberalization era became unnecessary. The old heavy-industry sector was cushioned so that while it did contract, it did not shrink faster than the growth of new light-industry sector which was replacing it (Sachs and Woo, 2003). The SOEs, or noncorporation economic units, were owned by the people and managed by the state. The reduction of the old SOEs sector was so coordinated that it kept on yielding to the economic units created under the new economy, that is, while the latter expanded the former shrank. This partial reform strategy yielded rich dividends. One of its valuable achievements was that the Chinese reforms turned out to be a process without losers (Lau et al., 2001). Unmistakably, the economic policy objectives of the policy mandarins were industrialization, growth, urbanization, globalization and economic modernization, which are imbued with the forces of convergence. Once the high-growth trajectory was achieved, they nimbly and skillfully attempted to move on to the policy framework for growth with equity. As the rural areas are known for income and nonincome disparities, they have become a special focus of policy attention in recent years. The management of outward migration from the rural areas in such a manner that it does not affect the urban quality of life adversely is also being paid policy attention. The reform strategy in China provided incentives to as many economic agents as was feasible. That implies that incentive compatibility was high. Expectations of benefits induced economic agents to take the desired economic actions. This kind of implementation of reforms was the legacy of Deng Xiaoping. When a large proportion of the population saw benefits for themselves, they were supportive of the liberalization and reform program. To be sure, there were disenchanted groups that stood to lose. For instance, the incumbent bureaucrats saw themselves as potential losers. Resistance from this class created innumerable hurdles


in the implementation of reforms in India, East European countries and the Russian Federation. In China reforms did not exclude or neutralize the bureaucrats. They were given opportunities to sponsor private or semiprivate businesses with entrepreneurs. Although this approach resulted in corruption and was subsequently criticized, it was accepted as the price that had to be paid for progress in reforms. Those who conceived the reform process in China believed in creating the new economic system around the old. They did not begin by destroying the old institutions and structures so that the new ones could supplant them. Hindsight reveals that this strategic philosophy served China exceedingly well. Agricultural reforms, enacted in 1979, continued through the early 1980s. Giving each peasant household a long-term lease of land was one of the most significant policy moves. The rural reforms turned out to be highly successful. Under the new system, the farms became essentially private farms with household ownership. Second, on the industrial front, entry of new nonstate firms was the most striking parallel feature of reforms. The private sector, or the nonstate firms, was born, and grew slowly but steadily and made a niche for itself in the economy, without in any way dominating it. The entrepreneurial activity occurred despite impediments created by acute weaknesses in the bank-centric financial system. Third, while the gigantic empire of SOEs continued to shrink, some of the SOEs even recorded some productivity gains. They were the result of the adoption of both economy-wide liberalization measures and incentives. Other than profit retention, new methods of hiring SOE managers were devised, and successful managers were given monetary incentives. They in turn were allowed to reward more productive workers and pay them bonuses and devise their own incentive systems. Rigidity in labor laws was reduced by allowing managers to hire workers on short-term contracts. Fourth, slow reduction in the state’s role in the economy, gradual waning of the state’s support for the SOEs and leaving the SOE sector to compete with the non-SOE sector at a later stage in the reform program helped in moving the economy toward the market system, a much-vaunted objective. Fifth, expansion of foreign-invested enterprises (FIEs)12 played a crucial role in the success of reforms. Lastly, one of the most vital factors for the success of reforms in China was that it unleashed the forces of competition in the economy, albeit after some initial hesitation.13 As set out in the preceding paragraph, as reforms progressed China adopted creative destruction, and with that the size of the SOE sector began to decline. During the 1990s, China began privatizing its SOEs.

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The intent resembled that of other privatization programs around the world. That is, to use capital market pressure to improve the performance of the SOEs, many of which had weak balance sheets and were not as commercially focused as publicly held companies in the other parts of the world (Ahn and Cogman, 2007). In 1995, there were 300,000 SOEs. A wave of closures, mergers and privatizations halved the number of SOEs. There were 140,000 SOEs employing 40 million workers in 2005 (The Economist, 2006). Many of China’s SOEs have been converted into privately owned enterprises. This change in the ownership structure led to efficient deployment of capital, stronger focus on growth and potentially larger returns for investors (Tang, 2007). Between 1980 and 2003, SOEs’ share in fixed-asset investment declined from 80 percent to 40 percent. Over the same period, SOEs’ share in industrial output declined from 80 percent to 13 percent. The non-SOE sector produced over half of the total industrial output in the early 2000s, but it should not be taken to mean that the private sector has recorded robust growth. According to the estimates of the National Bureau of Statistics (NBS), output by privately controlled firms was 59.2 percent of GDP in 2003, compared to 40.8 percent by the public sector (Zeng and Wang, 2007). These firms have now started dominating many industrial sectors, rendering them increasingly market oriented. However, in terms of industrial value-added, SOEs accounted for 45 percent in 2003, down from 54 percent in 1994. These statistical data convincingly demonstrate that although the SOE sector went into dramatic decline and withdrew from many parts of the economy, it still has a significant dimension (Lo, 2005). This sector still accounts for half of total Chinese industrial assets in the economy. What is worse is that a third of the SOEs are not making any return on investment. In a market-oriented economy they would be shut down forthwith. To be sure, closure of SOEs increased unemployment to an uncomfortable level, although some of the unemployed workers were employed by the growing nonstate sector. Two schools of analysts who studied the causal factors behind the success of reforms disagree with each other. The first group, the experimentalists, believed that the reforms succeeded because they were experimental, evolutionary and incremental in nature. The other, the convergence school, believed that reforms succeeded because they were allowed to converge with those of nonsocialist or market economies. This school explains why China took a gradualist approach in its reform implementation. To them, it was due largely to a lack of consensus among policy planners regarding the course of action. As the power was


divided between the new-style market-oriented reformers and the oldstyle socialist reformers, there was little possibility of adopting and swiftly implementing innovative market-oriented reforms (Sachs and Woo, 1997). Thus, gradualism of reforms was forced, not contrived. A good segment of the economy has begun to operate in a market-based manner, exploiting market forces. Their expansion yielded impressive results in terms of growth, particularly productivity growth, in the economy, providing the economy with abounding reform dividends. 1.1.3 Two vital variables: Saving and investment Saving and investment rates are widely regarded as two of the most important variables for a developing economy because together they create productive capital stock, which in turn has material impact on the GDP growth rate, that is, if the domestic macroeconomic environment is conducive to growth and the economy is not distortion ridden. A high saving rate has the apparent benefit of providing cheap and abundant capital that can in turn help in creating physical capital and potentially generating strong growth. A distinguishing feature of the Chinese economy is that it relied heavily on prodigious saving and investment rates for its growth miracle. Even before the beginning of the reform era, the Chinese economy was an exceedingly high-saving and investing economy. Consequently, the rate of physical capital formation was sustained at a commendably high level. Taking saving first, around the period when the macroeconomic reforms were launched, it was the government sector that generated a large proportion of domestic saving. In a centrally planned economy, a government can do so without problem. This trend continued in the early 1980s. At this point the household saving rate, measured as a share of disposable income, was low at 5 percent of the GDP. As the saving rate of the government declined after the early 1980s, the household saving rate steadily climbed and picked up the slack. By the mid-1990s, the household saving rate increased to more than 30 percent of the GDP. Thereafter, it recorded a small decline. This level of household saving is far higher than that in any Organization for Economic Cooperation and Development (OECD) economy. In keeping with the Confucian principles, Chinese households have consciously saved parsimoniously and invested wisely. The only country having a higher household-saving rate than China was India, where the government customarily ran huge deficits, that is, it dis-saves. The corporate or enterprise-sector saving rate in China also remained extraordinarily high. Since the mid-1990s, the household savings rate has recorded a decline.

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The higher saving rate of the economy after this period is attributable to the increased saving of the government and the corporate sectors. Together these three saving rates managed to sustain the national saving rate of China at an exceedingly high level. Thus, in this respect, China’s development experience was analogous to those of the other AHP economies, which as a rule succeeded in upholding high saving rates during their periods of rapid economic growth (Modigliani and Cao, 2004; He and Cao, 2007). Loayza et al. (2000) used the largest data set on aggregate saving measures assembled to date to explore both national and private saving determinants in an economy. Their cross-country empirical work is considered the richest in terms of the types of determinants that influence saving performance in an economy. They identified the following variables: level of development, GDP growth rate, fiscal policy, pension reforms, financial liberalization, demographics and urbanization. Interestingly, these determinants explain only a part of China’s high saving performance. China’s average national saving rate between 1978 and 1995 was 37 percent of the GDP, while the international average for this period was 21 percent. Kraay (2000) ran cross-country regression using the variables identified by Loayza et al. (2000) and found that China’s high saving rates could only partly be explained by high growth rate and, to a lesser extent, by favorable demographic influence. Even the rich set of explanatory variables failed to explain China’s high saving rates, which was found to be ten percentage points higher than what could be expected based on China’s economic characteristics. This trend continued, and in 2004 China’s saving rate remained ten percentage points higher than the average 37 percent between 1978 and 1995 (Kuijs, 2006). In the recent period, China’s national savings rate was found to be 15 percent to 20 percent of GDP higher than what could be explained by traditional determinants of saving performance. One apparent reason why the household and corporate saving rate remained so high in China was that with the advent of the market economy both of these sectors had to plan and provide for their long-term financial security. The old-time security of generous pension provided by the SOE system was no longer available to households as the economy transformed to a market-economy system. In addition, households needed to save for purchasing consumer durables, houses, paying for education of the next generation and old age. In the absence of an effective social safety net, they also needed to save for a rainy day, what is called “precautionary” saving. Also, while the SOEs were bank dependent for finances, the budding private corporate sector needed its own


savings for reinvestment purposes. Therefore, both of these sectors had few alternatives but to turn into high savers, as in the other AHP economies. The immediate impact, and shortcoming, of high and increasing saving was low consumption in the Chinese economy— notwithstanding the boom on the production side (see Section 1.6.3 for more details). The consumption-to-GDP ratio continued to decline since the mid-1980s. While in the other AHP economies the public consumptionto-GDP ratio picked up after the Asian crisis, it continued to decline in China. Judged by the international yardstick, the rate of investment was also markedly high; this happened even before the beginning of the reform era. Investment, or, to be more precise, investment of a significant part of the GDP, has been a major driver of growth during this period. Gross fixed capital formation (GFCF) during the latter half of the 1970s was 34.5 percent of the GDP. It continued to ratchet up to 35.4 percent of the GDP in the 1980s and 38.5 percent in the 1990s. It increased further during the 2000–04 period to 39.0 percent of the GDP (Perkins, 2006). In 2004, the investment rate stood at 45 percent of GDP. High rates of investment partly reflect China’s capital-intensive economic structure and large investment in infrastructure. They also provide a partial explanation for rapid GDP growth. Although the investment in the economy as a proportion of GDP was high even in the 1970s, the GDP growth rate had failed to pick up. Subsequently, as a consequence of macroeconomic reforms, when the GDP growth rate accelerated, it supported both a higher investment rate and growth in the accumulation of capital stock. China essentially depended upon domestic savings to maintain its high rate of physical capital formation. Foreign direct investment (FDI), which unquestionably contributed significantly to China’s growth performance, was only a small part of the net annual investment rate. In nominal terms, GFCF exceeded 40 percent of the GDP in 2005, which was above the previous peak of 37 percent reached in the early 1990s. Also, it was ten percentage points above the trough in the late 1990s. This level of investment is exceedingly high in comparison to that in the OECD countries and the other EMEs; none of them could reach the level of 30 percent of their GDP (Barnett and Brooks, 2006). In the recent past, export-oriented manufacturing, infrastructure and real estate development were the three principal drivers of investment. However, such a rapid pace of investment caused skepticism about the efficiency of productive resource allocation. Not all investment in the Chinese economy is considered efficient and astute. Although progress

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has taken place in the reform of the banking and financial sectors as well as of the SOEs, limitations and weaknesses persist, which have tended to weigh down the efficiency of investment. The relationship between investment and industrial growth is crucial for comprehending growth acceleration in China. Investment, or plowing in of profits, in fresh industrial assets worked as an important driving force behind GDP growth. Increasing investment led to capital deepening, which improved labor productivity and raised the level of potential GDP. For some time, surging investment has caused worries of overheating of the economy. Policy makers have tried to rein investment in by curbing credit expansion and raising the reserve-requirement ratio of commercial banks. Hiking the benchmark one-year lending rate was also resorted to several times. In 2006, the growth of fixed-asset investment dropped from 30 percent in the first half to 21 percent in the second. Investment slowed markedly in the industrial sectors that were known for overcapacity, such as textile, coal mining, power generation, autos, cement, aluminum and steel. Owing to significant overbuilding, efforts to dampen investment in real estate development have continued for several years. Although the growth rate of investment decelerated, it has continued to increase. Weaknesses in the financial sector frequently made it difficult to finetune credit and investment rates through monetary and fiscal policies. Besides, these policy measures work well in a market economy. China’s transformation to a market economy is so far incomplete. Similarly its banking system is not market oriented, and the People’s Bank of China (PBC) is not an autonomous institution, as required in a market economy. There have been sporadic cases of injudicious overinvestment in infrastructure as well.14 Other than monetary and fiscal measures, the government tried to curb the investment rate by administrative measures, which sometimes succeeded. 1.1.4 Demographic bonus China suffered from two baby booms in the 1950s and the 1960s. Like any low-income developing economy, China had distressingly high infant mortality rates during this period. However, on balance birthrates remained high and doubts regarding exhausting natural resources grew in the policy-making conclaves. Therefore, the 1978 reform program adopted the one-child-per-couple policy, which was first implemented in the urban areas and then in the rural areas. It was formalized in the Constitution in late 1982. While implementation was strict, some exceptions were indeed made.


To be sure, the economy benefited from the one-child policy by markedly improving the quality-adjusted labor supply growth. The one-child policy caused the population growth rate to decline from 2.01 percent a year on an average during the 1950–78 period to 1.16 percent a year during 1979–2004. In 2005, the population growth rate was 0.65 percent. The declining population growth rate was responsible for reducing the dependency ratio.15 Having less young dependents on the working-age population of 15–64 years reduced the dependency burden of this demographic group. It provided the economy with a demographic bonus. The one-child strategy, leading to a low population growth rate, helped increase per capita income during the post-1978 brisk-growth period. This period also became one of significant human-capital accumulation. Due to the adoption of the one-child policy, investment in human capital rose steadily, which had a direct favorable impact over advances in education and living standards. The one-child policy increased both public and private investment in education, leading to a qualitative boom in human capital. As estimated by Liang (2005), qualitative improvements in human capital contributed 15 percent to growth over the 1979–2004 period, while labor-force growth contributed 13 percent. Since the late 1970s, China benefited from a strong increase in human resources, that is, raw labor force. Rural areas in China had considerable surplus of unskilled labor, which still persists. Rural areas have had higher unemployment rates than urban; also, large disguised or hidden unemployment has persisted. Therefore, rural areas had, and continue to have, an almost perfectly elastic supply of labor, whose opportunity cost was exceedingly low, almost negligible. This was in keeping with the well-known Arthur Lewis model of economic development.16 Rural to urban movement of labor has been on the rise. It has helped China in building up and reinforcing its manufacturing-based economic success. Evidence is available to show that the growth rate of the labor force will slow down between 2010 and 2030. Rapid aging of population during this period will constrain growth prospects.17 This will be a consequence of increased longevity and the one-child policy, which slowed the growth of young adults in the population. A low number of young people, with the passage of time, will cause a reduction in the size of the working-age population group of 15–64 years, causing an increase in the dependency ratio. China’s dependency ratio has been estimated to start rising in 2010 (Qiao, 2006). This will reverse the demographic equation and turn the above-mentioned demographic bonus into a demographic

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deficit. To be sure, the reversal in the demographic equation will have an adverse economic impact on China. 1.1.5 Total factor productivity (TFP) growth Growth in productivity is essential for improving general living standards as well as for enhancing an economy’s overall competitiveness. The question whether China’s reform period growth was based on factor accumulation or productivity growth ignited an impassioned debate among academics. TFP measures the overall efficiency of an economy. It is also known as the Solow residual, or multi-factor productivity, and is defined as the increase in output growth not accounted for by increases in factor input. Several empirical and econometric studies were conducted to assess the sources of Chinese growth. Although estimates and conclusions differ due to differences in methodologies and assumptions, many of them concur on some of the crucial conclusions, on the TFP growth contributing positively to real GDP growth. Estimates based on the production function reveal that before 1978, almost all output growth could be sourced from capital accumulation, with a small contribution made by labor-force growth (Heytens and Zebregs, 2003). Using data series for the 1980s, several earlier researchers pointed out that growth was brought about essentially by capital accumulation (Chow, 1993; Borensztein and Ostry, 1996; and Sachs and Woo, 1997). These studies used the growth accounting method to estimate Chinese growth. According to Lau and Park (2003), for the 1965–95 period, “tangible inputs” or physical capital accumulation explained 86 percent to 95 percent of output growth and labor increase between 5 percent and 14 percent. They concluded that TFP growth was nil during the period under consideration. Krugman (1994) agreed with the conclusions of these researchers and admonished that if China’s TFP did not rise during the decade of 1990s, mere accumulation of factors of production will not be sufficient to sustain brisk growth. The subsequent set of studies (such as Hu and Khan [1997], Wang and Yao [2003], Wu [2004] and Arayama and Miyoshi [2004]) used the translog production function and focused on the estimation of factor input shares in the process of computing aggregate productivity growth. These studies found compelling evidence of positive TFP growth in the reform period, although estimates of TFP growth ranged between 2 percent and 4 percent. Liang (2005) refuted the conclusions of Lau and Park (2003) and found that their estimated share of capital at 60 percent was too high to be supported by either national income statistics or bottom-up analysis of enterprise financial data.


More recent studies have used different methodologies to ascertain whether China recorded TFP increases, or merely accumulated factors of production to grow rapidly. After the launch of the reforms, China’s GDP growth hovered around 9 percent, that is, a good 3 percent higher than the average for the prereform period and almost three times the average of global GDP growth. Heytens and Zebregs (2003) concluded that this increase was the result of TFP growth. The studies that used the frontier production approach for measuring TFP growth decomposed TFP growth into two components: efficiency change and technological change. Using this methodology, Chen (2001) concluded that during the 1992–99 period, positive TFP growth took place. Also, technological improvement contributed more to TFP growth than any other factor. Likewise, Zheng and Hu (2004) concurred with this conclusion and found that, while there were ups and downs in TFP growth, for a large part of the1979–2001 period technological progress contributed to TFP growth. Kuijs and Wang (2005) used Cobb-Douglas technology and estimated the contribution of accumulation of factors of production and TFP for the 1978–2004 period. They found that since the launching of the reform program in 1978, TFP growth contributed significantly to GDP growth. Their estimates show that while growth in capital stock contributed over half of the GDP growth, TFP growth contributed on an average 3.3 percent per annum to the growth rate during the period under consideration. The balance contribution was made by increase in employment. They divided the sample period into two and compared TFP growth in the 1978–93 period to that in 1993–2004. They concluded that the contribution of factor accumulation to GDP growth was larger in the former period than in the latter. The reason was that the capital-output ratio increased from 2.2 to 2.4 over these two periods. There was rapid increase in investment growth after 1994, while TFP growth recorded a small decline. Shiu and Heshmati (2006) disagreed with these results and reported steady technological growth during the 1993–2003 period. This study found TFP improvements at the economy-wide level, with the highest rate of TFP growth taking place over the 1991–95 period. This study also covered 30 Chinese provinces, which were opening up to industrialization. Owing to greater improvement in infrastructure, the central provinces of China recorded the highest rate of TFP growth during the sample period. The western provinces were at the opposite extreme. The reasons behind increasing TFP included improvement in resource allocation, skill upgradation and learning-by-doing.

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Structural reforms in both agricultural and industrial sectors seem to have been responsible for TFP growth. As indicated above, agricultural sector liberalization progressed in the early 1980s, while marketoriented reforms were accelerated in the industrial sector in the early 1990s. Both were significant factors in TFP growth. Labor movement from the primary sector to the secondary and tertiary sectors was one of the basic causal factors behind productivity growth. This was because marginal productivity of labor in agriculture was exceedingly low, while that in industry and services high. In comparison to the services sector, productivity increases in the industrial sector were found to be much higher, although they were rising. In the industrial sector, by 2003, the TFP in China was among the highest in the world (Kuijs and Wang, 2005). Another confirmation of TFP growth was provided by Dekle and Vandenbroucke (2006). According to the growth-accounting exercise, using adjusted national accounts data, they found that between 1979 and 2003 the principal source of growth was TFP increase in the private industrial sector, while TFP growth in the SOEs sector was close to nothing. Microindustrial data of productivity revealed that TFP growth of private industrial enterprises was more than twice that of the SOEs (OECD, 2005a). This conclusion did not have an element of surprise. The essential reason why TFP growth showed improvement is the evolutionary process of reform policies. One of their crucial contributions was gradual but consistent reduction in the systemic inefficiencies. Besides, the fact that the Chinese economy was at a low point of productivity in the prereform era cannot be ignored. Moving from the central planning mechanism to a market system “was the single most important cause of the on-going expansion in productivity” (Bernanke, 2006). The economy underwent considerable structural transformation in the preceding three decades, and most economic interactions are now governed by market forces. Market forces first began to play a progressive role in the agricultural sector, improving productivity in this large sector. Subsequently, market mechanism gradually extended to industry and then to a good part of the services sector as well. Price controls of the command economy were dismantled step by step. By 1999, approximately 95 percent of retail business, over 80 percent of trade in agricultural commodities and producer goods, was conducted at market-determined prices (Lardy, 2002). The private sector and FIEs that emerged were gradually allowed to compete with the SOEs. Expansion of China’s trade and growth in FDI further improved market discipline in the economy. To be sure, this structural transformation is so far


incomplete but ongoing. As empirical research concluded that the SOE sector was, and continues to remain, far less efficient than the private sector. China can achieve the same high GDP growth rate with much less investment—and hence more consumption—if it allocates capital in an efficient manner to the private sector instead of to the SOEs. Labor productivity is another relevant variable that needs to be focused on. Steady labor productivity gains, or increases in output per worker, played an important role in China’s rapid growth. Three variables (wages, relative prices and labor productivity) combine to determine the unit labor cost. If the productivity does not increase, any increase in wages would lead to a high unit labor cost, which depresses competitiveness of an economy. Conversely, rising labor productivity results in lower unit labor costs and improving competitiveness. It is the labor productivity that makes it possible to increase wages and improve overall competitiveness. Labor productivity improvements are essential for an economy to compete successfully in the global marketplace, as China has been doing. Reallocation of labor from agriculture to manufacturing and services sectors in China is equated with their movement from low-productivity and low-wage jobs to high-productivity and high-wage jobs. A discernable exodus from the rural to urban areas took place in China. In 1970, 80 percent of the population lived in the rural areas. By 2005, this proportion declined to 60 percent. The pace of this rural to urban population movement has increased in the recent past. This entailed a large-scale intersectoral movement of labor by any standards. The productivity gap between the rural and urban workers is one of the largest in the world. GDP per worker in the economy as a whole is three times higher than the value-added per worker in the rural areas. The proportion of the labor force employed in the agriculture sector has steadily declined since 1978, while that in manufacturing and services sectors has steadily increased, albeit the rate of increase declined after 1990. This structural transformation has turned out to be a source of not only significant increase in labor productivity but also growth in general. It also reflects structural transformation of the economy. Intersectoral labor productivity differences in China continue to be large. Estimated output per worker in agriculture in 2005 was measured at $800; the corresponding value of output in industries, manufacturing and utilities was $5,900—more than seven times higher than that in agriculture.18 A projection exercise done by Dekle and Vandenbroucke (2006) showed that labor productivity growth in the private industrial sector—as well as in the entire economy—will continue to be high in the future.

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The employment share of the SOEs will continue to shrink, while that of the dynamic private industrial sector will continue to increase. By 2030, it will account for almost 70 percent of total employment. A recent International Labour Organization (ILO) study provided evidence of China’s steady increase in labor productivity, which was instrumental in making it one of the most productive economies in Asia. In 2000, the Chinese labor force was 26 percent less productive than that in the Association of Southeast Asian Nations (ASEAN)19 economies. However, by 2005 the Chinese workers had become 5 percent more productive. This gap is set to widen. Chinese labor productivity has been growing at the rate of 6.6 percent a year, which is more than double that of ASEAN economies, 2.9 percent. Chinese productivity increases coincided with surging enrollments in secondary and tertiary education. In comparison, Indian labor productivity was some way behind. In 2005, Indian labor productivity was 27 percent lower than that of the ASEAN workers. However, Indian workers are gradually catching up; their recent productivity growth rate is 4.4 percent (ILO, 2007). 1.1.6 Rapid growth and relentless economic ascent China enjoyed vertiginous economic growth in the reform era, without suffering from any major crisis or sharp interruption in the growth process, which were found in the other EMEs. It established itself as an economy with the highest long-term average GDP growth rate in real terms in the fastest-growing region of the global economy. It justly acquired the status of the fastest-growing global economy. In terms of three long-term (1978–2005) growth indicators, average real GDP growth, per capita GDP growth and per worker GDP growth, China was the global champion. Botswana, Republic of Korea (hereinafter Korea) and Thailand stood at the second, third and fourth positions, respectively. Because of its stellar economic performance, in a short span of three decades, China emerged as a major economic presence in the global economy. Its strong growth momentum created new norms in the history of economic development. There are few examples in economic history that rival China’s present growth performance. That this unparalleled success story had a great deal of welfare implication is obvious from the fact that between 1979 and 2005, China’s per capita GDP in US dollars soared five times (Yusuf and Nabeshima, 2006). Among the socialist economies making a transition from their old command economy framework, China is one of the few that made a significantly large transformation to a market-oriented economic system (see Section1.1.2).


The initial attraction of China for businesses around the world was because of its being a market of billion-plus customers, but it also emerged as a primary location for manufacturing products to be sold globally. The manufacturing sector in China has emerged as a strong, large and globally competitive. It became a manufacturing behemoth that is difficult to compete with in a large range of manufactured products. To be sure, FDI contributed to both the range and quality of manufactured goods, “recent industrial development reflected a broad and deep expansion of Chinese production and manufacturing capabilities” (Brandt and Rawski, 2005). Prospects of China sustaining its rapidclip economic growth and global integration in the near future seem strong. Barring sharp slowdown in the global economy, or a major domestic crisis, China is widely expected to uphold its lead in several manufacturing sectors. There are a few clouds looming over the horizon indicating a sharp decline in the short-term. If this scenario pans out and the economy keeps growing in the medium-term at the present clip—say, for a decade more—China’s global impact will be much larger than that of Japan. The long-term (1978–2004) average annual real GDP growth rate in China was recorded at 9.6 percent, impressive both in absolute and relative terms.20 In 1994, China adopted a unified, stable and competitive exchange rate strategy. Until then, China had dual exchange rates, an official exchange rate and a parallel floating one. The latter was the swap market rate. During the 1990s, China followed the policy stance of a low-interest-rate and anticyclical fiscal policy. Because of the adoption of a policy package that combined market-oriented macroeconomic and microeconomic reforms, growth rate accelerated after 1994. After an inflationary episode in 1994, taming of inflation was given high policy priority. Economic performance has remained steady during the recent period. During the seven years between 2000 and 2006, the average annual growth rate of real GDP, valued at constant market prices, was 9.41 percent. Of these, during the four straight years between 2003 and 2006, annual real GDP growth rate exceeded 10 percent.21 Although the target GDP growth rate for 2007 was 10 percent, in the first half of the year GDP grew by 11.5 percent; this enabled China to make the largest contribution to global growth evaluated at market and PPP exchange rates. For 2007, GDP growth rate for China has been projected at 11.5 percent; it was projected to decelerate to 10 percent in 2007 (WEO, 2007).22 If the growth miracle is defined as GDP growth of 7 percent a year, or more, sustained for 25 years, or longer, the Chinese economy has indubitably experienced one. Rapid growth calls

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for superior macroeconomic management, which reduces economic volatility and risk as well as keeps actual GDP growth close to potential GDP growth. China achieved this objective after 1995; its GDP growth rate remained much closer to the potential GDP growth after 1995. The growth of the Chinese economy has been essentially anchored in export-oriented industrial products and investment. Its accomplishment of being a low-cost exporter of world-class consumer products and manufactures was achieved by transforming its economy into a global factory of a substantial range of consumer and industrial products. It earned the fond sobriquet “the workshop of the world.” According to the 2006 statistics, this trend still persists and the external sector and investment have continued to be the principal drivers of growth. The industrial sector was responsible for 7.0 percent, or 65 percent, of total GDP growth in 2006. The services sector contributed 3.2 percent, or 30 percent to GDP growth, while agriculture a paltry 0.5 percent, or 5 percent. On the demand side, it was vibrant investment that propelled GDP growth to the maximum extent, 4.1 percent, or 44 percent, of the total GDP growth. Consumption contributed merely 3.2 percent, or 38 percent, while exports 2.1 percent, or 21 percent (ADO, 2007). Contribution of the external trade and investment-driven recovery in domestic demand coalesced and GDP growth reached 11.5 percent in the first half of 2007. The Asian economic and financial crisis of 1997–98, which indirectly affected China, and the SARS (Severe Acute Respiratory Syndrome) epidemic of the early 2000s, which took its toll on the economic performance, had a noticeable shriveling effect on the GDP growth rate. More importantly, after three decades of brisk growth, the economy is also saddled with structural snags and needs rebalancing. Although the Chinese economy was not badly mauled by the Asian crisis, the economic and social costs to several newly industrialized Asian economies (NIAEs)23 and the ASEAN-424 economies were steep. China extended a helping hand to its crisis-affected regional neighbors (Das, 1999, 2005). In so doing it proved itself to be a responsible global citizen. The government pledged large sums ($83 million) to the Asian Tsunami Relief; millions more were donated by corporate and individual donors. One of the benefits of projecting a gentle and generous image to its neighbors was that China now wields considerable “soft power” regionally (see Section 3.1.2).25 Rapid GDP growth contributed meaningfully to poverty alleviation endeavors and rescued several hundred million from oppressive poverty. Measured by international poverty lines, absolute poverty in


rural areas declined from 250 million in 1978 to 26.1 million in 2004 (OECD, 2005a). This is regarded as the largest single contribution in global poverty reduction in the global economy. Lipsky (2007) remarked that “China alone accounted for over 75 percent of poverty reduction in the developing world over the last 20 years.” It is well on track to eliminate $1-a-day (measured at PPP) poverty by 2015 (Dollar, 2007). Rapid growth also made China an important global economy and its standing among the world economies continuously improved. Measured by the volume of nominal GDP in current dollars at market exchange rates, China’s rank has improved from the eleventh in 1990 to the seventh in 2003 and further to the fourth in 2005, when China’s total output of goods and services was worth 18.2 trillion RMB yuan (or $2.2 Trillion). At this level of nominal GDP, China edged past Britain in 2005 (WDI, 2007).26 In a couple of years China was expected to move up a notch. In the first half of 2007, China was on track to surpass Germany; at the end of 2007 it became world’s third-largest economy, when the GDP was evaluated at the market exchange rate. As seen in Table 1.1 above, according to the 2006 statistics, the United States (US), Japan and Germany were the three largest global economies, in that order. As these measures are at the market exchange rate, they grossly understate the real size of the Chinese economy. However, if adjustment is made for China’s relatively low cost of living and the nominal GDP is measured in purchasing-power-adjusted currencies, China became the second-largest economy in the world in 2004, after the US (The Economist, 2004). In 2006, China’s GDP in PPP terms was $10.04 trillion, while that of the US was $13.20 trillion (WDI, 2007). At market exchange rate and current prices, China is one-fourth as large as the US economy. Thus, by the middle of the decade, China could no longer be regarded as a small player in the global economy by any standard measure. Table 1.1 Comparative 2006 GDP Ranking 1 2 3 4 5 6

Country The United States Japan Germany China The United Kingdom Canada

GDP (in billions of dollars) 13,201 4,340 2,906 2,668 2,345 1,251

Source: The World Bank. World Development Indicators, July 2007.

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To be sure, China is still an EME and there is a lot of scope for China to improve its economic growth model and structure and rebalance its economy. In important areas such as technological prowess, managerial expertise, financial sector strength, industrialization and governance China will continue to play catch-up with the industrialized world for a long while. Also, there is no doubt regarding the pressing need for improvement in living standards in China. Although China’s recent achievement in poverty alleviation was meritorious, in per capita GDP terms ($1,740 in 2005 at market prices and exchange rate) it has a long way to go in becoming an equal of the major industrialized economies of the OECD.27 This level of per capita GDP is a sure indicator of the fact that while China is on its path to reaching its more fully developed potential, it will take a long while to reach this objective. According to the projections made by Keidel (2006), in 2010 China’s GDP per capita, at current market exchange rate, will be less than the GDP of those of Brazil and Mexico. In 2010, China’s per capita GDP will be one-tenth that of the US at market exchange rate and one-seventh in PPP terms. In 2010, China’s GDP will be less than a quarter that of the US at market exchange rate and less than half, if PPP measures are used. China’s present per capita income in PPP terms is higher at $6,600, which must be indicated here. While growing briskly, China integrated with the regional and global economies at a rapid clip. A 2001 World Bank study on globalization ranked developing economies by the extent to which they increased trade relative to income over the 1977–97 period and compared the top third with the bottom two-thirds (WB, 2001). This study puts China and other EMEs such as Argentina, Brazil, India, Mexico, Malaysia, the Philippines and Thailand among the rapidly globalizing economies. China’s massive import demand both for processing and exporting as well as for meeting domestic demand has become an important source of growth for the regional and global economies. Therefore, China’s contribution to global GDP growth became sizable. Since 2000, in PPP terms, its contribution has been more than half as large as that of the next three largest EMEs, namely, Brazil, India and Russia, combined (The Economist, 2006). Indubitably, this materially increased China’s global presence. During the global economic slowdown around the turn of the century, China became an important source of growth for the world economy. During the 2000–03 period, China accounted for 22.77 percent of world growth annually; this is based on PPP-based GDP computations. In 2004, this proportion declined to 20.6 percent (WEO, 2005). Taking a longer time horizon, between 1990 and 2005 China


accounted for 28 percent of global GDP growth, measured at PPP (Dollar, 2007). 1.1.7 Downside of relentless economic ascent There is another side of this coin. The velocity of growth has led to domestic unrest of different kinds. Both intensity and the number of public protest instances have been on the rise. Political leadership realizes that internal stability can be a challenge in the future. Continued economic growth is their recipe to resolve and rectify it. In 2003, Zhu Rongji, the outgoing premier, has called continued economic growth “the key to resolving all problems” facing China.28 Furthermore, the ongoing rapid-clip growth, with globalization of the Chinese economy, became the source of a degree of trepidation and consternation for the other economies. Should the economic emergence of China be a cause for ringing alarm bells for the other regional and global economies? Global integration and rapid growth of the Chinese economy and its endeavors to move toward the center of the global economic stage is being referred to as the “China syndrome” and “China effect” in the industrial economies in a disapproving, if not disdainful, manner. Sinophobia is brewing not only at the Capitol Hill but also in the other industrial economy legislatures as well.29 The erroneous belief is that such rapid growth in China may cause serious and painful dislocation in the global economy, including significant loss of manufacturing and services sector jobs in the mature industrial economies. The apprehension is that this would result in declining living standards and collapsing industrial and services sectors in the mature industrial economies. These anxieties in public policy communities and the popular press in the industrial economies are acutely exaggerated. Zero-sum thinking is out of place, if not completely incorrect, because this is not a nonzero-sum game. The alarmist pronouncements of politicians seem déjà vu all over again. When the German economy emerged as a large and vigorous industrial economy in the nineteenth century, it caused anxiety in the other industrial countries of that period in Europe because it was perceived as a disrupter of the established economic order. Likewise, when the US economy came into its own in late nineteenth and early twentieth centuries, it was similarly considered a devastating development for the established economic order of that period by the European economies. The US was portrayed as a villain that disturbed the economic status quo. Large increases in cheap grain exported from the US farms prompted a protectionist response from the European countries. The emergence of China with an inexhaustible capability to supply a large

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array of manufactured products is creating a similar situation once again for the global economy. Recent experiences of the AHP economies, other than China, have a lesson in this regard. Japan’s output and exports started exhibiting substantial growth after 1955. At this time point, the three-year moving average of export growth at constant-prices exceeded 10 percent for the first time for Japan. For the NIAEs and the ASEAN-4 economies this time point was reached in 1967 and 1973, respectively (Prasad and Rumbaugh, 2003). All these economies also generated similar anxieties in the public policy communities and popular press in the mature industrial economies. When the four NIAEs emerged as industrial economies, the OECD secretariat in Paris launched a research project to examine its deleterious effects on the OECD economies, which quantified all the negatives of this new development in the global economy. Notwithstanding the short-term disruption, such periods of transition bring with them enormous opportunities for all the economic players in the global economy. The rise, and integration with the global economy, of Japan, the four NIAEs and subsequently the ASEAN-4 economies, in the latter half of the twentieth century, provided a significant lift to both Asian and global economies. Their integration with the global economy, like a tidal wave, eventually lifted all boats. China’s ascent is having comparable impact over the global economy. It is erroneous and illogical to regard China’s ascent as an occasion to toll alarm bells for the global economy. If anything, it is a time to rejoice. By the mid-1990s, China had begun providing a significant positive supply-side shock to the global economy. Indeed, in short-term the Chinese economy will also cause some dislocation to the established global economic order. Whether it should be a source of anxiety is a moot point. One tangible gift of the globalizing Chinese economy was the “inflation discount,” which benefited the global economy. Competitively priced imports from China in the industrial economies have managed to save them a good deal, leading to a wealth effect. Lower inflation raised the purchasing power of consumers. In the US alone, the saving amounted to $600 billion between 1995 and 2004 (Lo, 2005). Central bankers cannot be given all the credit for defeating global inflation. China provided a helping hand. Its exports of manufacturing products kept global inflation rates, including those in the industrial economies, tame. The Chinese economy has affected the structure of the global economy and “can continue to offer dis-inflationary benefits to the world …” (O’Neill et al., 2006). The disinflationary influence of a rapidly growing Chinese economy also contributed to low short-term interest rates in the global economy. The Chinese economy is


also partly responsible for the low level of long-term bond yield. The Economist (2005) takes this argument to its limit and credits China for creating a global liquidity bubble by holding down interest rates. In 2004 and 2005, global liquidity rose at its fastest rate (adjusted for inflation) in three decades. Thus, it is often concluded that the housing boom, particularly in the US, was indirectly created by China (Hormats, 2007). Stellar economic performance of three decades left the structure of the economy somewhat skewed. Therefore the economy is ripe for rebalancing. How and in what direction should it be rebalanced is a matter of contemporary deliberation and debate. In 2006, the real GDP growth was 10.7 percent, which was a ten-year high. It was also the fourth year of double-digit growth. This was the first year of the 11th Five Year Plan (2006–10), for which the indicative average annual growth rate was determined at 7.5 percent. Thus, the materialized GDP growth rate was much higher than the one that was planned by the Chinese policy makers. They do have reason to be concerned about overheating of the economy. Policy measures were repeatedly taken to moderate the growth rate. They were not always successful.

1.2

Comparison with the other Asian high achievers

Although China’s contemporary economic success and its success in global trade expansion have been widely discussed and incessantly analyzed and appreciated in the academe and policy-making circles, when it is compared to the annual rate of GDP and export growth in constant dollars for the other successful Asian economies, China’s growth rate does not appear so extraordinary. In comparison to the AHP economies, China does not appear to be an outlier because its Asian neighbors had performed as well, often better, during their corresponding periods of growth. While China’s growth rates were not found out of line, with those of the other AHP economies, it succeeded in sustaining them for a longer period. For instance, over the 1954–81 period Japan’s annual average export growth rate averaged 14.2 percent. For Korea, during the 1960–95 period it was 21.5 percent, while for Malaysia over the 1968–96 period it was 10.2 percent. For the four NIAEs it averaged 13.1 percent for the 1966–97 period. Against this backdrop, China’s export growth rate of 11.9 percent for the 1978–2002 fails to appear exceptionally remarkable or excessively favorable (Prasad and Rumbaugh, 2003). On the import side, as China prepared for accession to the World Trade Organization (WTO), its statutory tariffs rates—both levels and dispersion—steadily

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plummeted, which led to rapid increase in its imports. Once again, growth rates of China’s imports are comparable to those of Japan, the NIAEs and the ASEAN-4 economies. In terms of the share of world trade, China used to be below Japan and the NIAEs, but slightly above the ASEAN-4 economies, at corresponding phases in their growth and integration process (OECD, 2003; WEO, 2004). Thus, it is safe to conclude that China merely followed the Asian economic tradition of outer orientation, and kept up with its energetic neighbors in devising a competitive traded goods sector, which resulted in its successful real GDP growth and trade performance. A comparison of long-term real GDP growth rates also leads one to conclude that China’s growth performance is not extraordinary when compared to those of the other AHP economies. In its high-growth period between 1955 and 1995 Japan’s average annual GDP growth rate was 8.5 percent. During the 1965–95 period, Korea and Taiwan also recorded the same average annual GDP growth rates. If another indicator, per capita GDP growth at PPP exchange rate, is chosen for comparison, China’s performance once again appears in line with those of the other AHP economies. Between 1978 and 2004, China’s per capita GDP rose by 370 percent, implying an annualized growth rate trend of 6.1 percent. In Japan, between 1955 and 1975, the per capita GDP soared by 460 percent, implying an annualized growth rate trend of 8.2 percent. Between 1965 and 1995, Korea’s per capita income leapt by 680 percent, which meant 7.6 percent annual growth. In Taiwan this indicator soared by 600 percent for the same period, meaning an annual growth of 7.1 percent (Lo, 2005). Thus, all these comparable AHP economies performed better than China during their respective high-growth periods. This statistical evidence leads one to conclude that by Asian standards, China’s growth performance has not been exceptional. China has been attracting large amounts of FDI. Yet China’s receipt of FDI, when compared to those of Japan, the NIAEs and the ASEAN-4 during their comparable periods of growth and global integration, is not impressive. Measured as a percentage of GDP as well as per capita, the AHP economies received higher proportions of FDI than did China during the comparable period of growth and integration. In per capita terms, China was behind the NIAEs and the ASEAN-4 economies in the early 2000s; Malaysia and Thailand were far larger recipients of FDI. In terms of other measures, like value added by FIEs as a percentage of the total value-added in the manufacturing sector, the NIAEs and ASEAN-4 were ahead of China during their corresponding periods of growth (Lemoine, 2000). It is partly explained by the slow development


of the Chinese financial markets, particularly the problem-ridden banking sector and slow stock market development. In terms of magnitude of FDI, Singapore and Taiwan were the champions, attracting the highest amounts of FDI measured as a proportion of the GDP. Similarly, in terms of domestic rate of investment China kept in line with the Asian tradition. To be sure, in the global context the rates of investment of 35.4 percent of the GDP in the 1980s and 38.5 percent in the 1990s can be understandably regarded as outstanding. These rates are comparable to those of the Asian neighbors. For instance, Japan’s average investment rate during the 1961–53 period was 33.1 percent of the GDP. In case of Korea, the investment rate reached 31.5 percent of the GDP between 1983 and 1991. China’s domestic investment rates remained relatively higher and steady during the 1980s and 1990s. Likewise, the trend in real domestic consumption in China was not very different from those of Asian neighbors during their comparable growth periods. The consumption growth rate was slower than the GDP growth rate at the beginning of the acceleration episodes in Asia and it remained stable. During the catch-up period, it remained 8 percent or above per annum on an average in all the AHP economies, including China. Real private consumption expenditure increased at an annual rate of 9 percent in China, which closely reflected the trends in Japan and Korea. This growth rate in consumption in the AHP economies, including China, was associated with growth rate in real wages (Geiger, 2005). The foregoing exposition reveals that China’s GDP growth, trade expansion, FDI inflows, investment and consumption rates, and its impact over the global economy have been more or less in line with those of Japan, the NIAEs and the ASEAN-4 economies. China is not an outlier. If anything, Chinese policy mandarins picked more than a leaf or two from the development strategies of the other earlier successful cases of the other AHP economies. China essentially abided by the Asian traditions of economic growth and turned out to be a miracle like them. 1.2.1 Larger potential global impact of China I noted above that in comparison to the other AHP economies, or en masse the NIAEs and the ASEAN-4 during their comparable period of growth, China’s growth rate cannot be called extraordinary. For the most part, the global impact of the Chinese economy has not been dramatically larger than that of the other comparable economies of Asia. What does the future hold? There are good reasons to believe that it is not likely to be so in the future. Going down the road China is likely to cast a much-longer shadow over the global economy than did

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Japan, the NIAEs and the ASEAN-4 economies. This could be due to the following factors: First, this is an economy that has much catching up to do. Second, measured in terms of the current market exchange rate, China is a large economy. It is growing larger by the year at a steady and exceptionally rapid pace. In 2005, it accounted for almost 4 percent of the global output, making it one-and-a-half times bigger than the Canadian economy (Krueger, 2005). Third, China’s large low-wage workforce has entered the global economy and has increased the global return on capital. Close to 250 million of this is yet to move from the rural to the urban areas. This is the extent of unemployment and disguised unemployment in rural China. Even if 20 million to 25 million move annually, its effect will amount to addition of a small-to-mediumsized economy to the global economy. Fourth, it is an unusually open economy for its size and it has embraced globalization with remarkable enthusiasm. Owing to openness to trade and investment, few sectors of the economy escaped the direct influence of international market pressures, which modernize and update an economy. Globalization became a driving force behind steady accumulation of industrial capital and expansion of export-oriented manufacturing capabilities. As globalization and growth are expected to continue for an extended period, China’s global stature in a couple of decades will be much larger than it is at present (Deng and Moore, 2004). As convergence in China continues, the economy will grow larger than that of Japan and much larger than those of the NIAEs or the ASEAN-4. China will eventually “represent a larger shock to world factor endowment and to the global economy than previous integration episodes” (WEO, 2004). There are indications that China has had some impact over the global economy that was greater than the impact of the other AHP economies during their comparable rapid-growth periods. It bears repeating that, in PPP terms, China’s contribution to global GDP growth since 2000 has been much larger than the three biggest EMEs, namely, Brazil, India and Russia, combined. In addition, when the information and communication technology (ICT) bubble burst in 2001, global economy escaped serious downturn due largely to China’s robust growth, which boosted global export expansion. The global recession of 2001–02 was modest and the recovery was strong. This was partly due to China’s contribution to global GDP growth. Since this point in time China was being seen as “an engine of growth for the rest of the world,” particularly for Asia (Stiglitz, 2006). China began to be regarded as the secondary global growth engine after the US. Also, China’s purchase of the US treasury securities enabled the US to keep its interest rate low and sustain rapid


GDP growth during the early 2000s. These are globally significant contributions. Human capital formation has been going on in China for a while, but its level is still substantially lower than that in the comparable AHP economies. China’s acute shortage of line managers is well known. It can be rationally expected that human resource development is to continue to grow for many more years until it at least reaches the level achieved by Japan, the NIAEs and the ASEAN-4 economies. Human capital formation is known to make a decisive contribution to economic growth. Furthermore, China’s GDP growth was driven, inter alia, by reallocation of human resources from low-productivity employment in the rural-primary sectors to high-productivity employment in the urbanindustrial sectors. This reallocation is only in its preliminary stage and has to go much further. These two parallel developments are likely to contribute to growth and expansion of the Chinese economy for the next quarter century, in turn strengthening China’s global stature. Besides, China’s convergence process has to continue for a long time to come, at the end of which it will have a larger economy than any of the AHP economies, or subgroups among it. By this time China’s emergence will make a much-larger impact on the global economy. As it is a highly diverse, resource rich and continent-size economy, its internal dynamics can sustain growth for much longer than the small AHP economies can. Its factor endowments are much larger than those in many of the AHP economies, which will make its global impact larger than previous three episodes of global integration. At this point in time China may potentially have a sizable impact over some sectors of the global economy, several economies themselves as well as the regional economies.30 In the early years of the twenty-first century China was making its presence felt in the global markets of several commodities by affecting their prices. China’s domestic market has significantly grown in size. Its needs for energy, natural resources and industrial raw materials have grown markedly. It will continue to boost prospects of resource-exporting countries. Prices of oil, minerals and commodities as well as shipping prices have had a large impact of increasing Chinese demand. Some of the products in which growing Chinese demand is affecting the world markets and prices are soybean, soy oil and palm oil, whose consumption has increased at the rate of 15 percent, 20 percent and 20 percent a year, respectively. In oil and minerals Chinese imports accounted for 40 percent of world market growth since 1995 (Streifel, 2006). High metals prices in 2007 reflect the strength of the Chinese economy.31 Owing to rising

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incomes, Chinese consumers are buying more consumer durables than they did in the past. As per capita income grows further, household consumption is bound to rise. Opportunities for other exporters of goods and services will also expand. 1.2.2 China’s global acceptance Awareness of the Chinese economy coming into its own in the industrial countries of the West grew in the early 1990s. Universities began organizing lectures on this theme, while major media networks such as the BBC and CNN televised well-researched documentaries. Recognition of China’s emergence as an industrial and export powerhouse grew in the academic, public policy and business conclaves, and deliberations over its status as a probable economic power of global proportion became serious. Prominent opinion leaders, such as Bill Clinton, began publicly voicing ideas about “how China would show its greatness.”32 Bill Gates (2005), another important opinion leader, raved about China’s “new capitalism” in a seminar in Davos, Switzerland, and elucidated on its numerous strengths. Kofi Annan, the UN Secretary General, remarked, “What China does and how China fares, will have an increasingly profound effect over the global economy.”33 Some analysts argued that China was destined to be the “next economic super power” (Fishman, 2005). The Time magazine called this the “China century” in early 2007.34 Dani Rodrik (2006), the eminent Harvard University professor, called China “the great economic miracle of the last quarter century.” In academic and business clusters, debates over whether China’s escalating economic prowess can be regarded as a threat or an opportunity for the global economy started in right earnest. China does seem well on its way to acquiring the status of an economic super power peacefully. Bijian (2005), a noted Chinese strategic thinker, referred to its growth as peaceful ascendancy, and called it heping jueqi35 (see Chapter 3). China’s international behavior was that of a responsible global citizen, and the “China threat” theories have been waning and going out of favor. One felicitous example is China’s reaction to the Asian crisis when it refused to depreciate its currency and extended a helping hand to the problem-ridden Asian economies. China realized that its continued development depends on world peace. Chinese political leadership has shown that being a good global citizen matters immensely to its country. The target that the current political leadership has given itself is to quadruple China’s per capita GDP by 2020 and attain xiaokang, or relative comfort, for the Chinese population.36 Chinese political leadership that committed to the reform program was


eager to achieve xiaokang without seriously disturbing the global balance of power and starting another cold war. They wished to avoid making the mistake that led the US and the Soviet Union into a dangerous, protracted and exceedingly wasteful Cold War (Funabashi, 2005). China has created an impression in the global community of nations that it intends to support the concept of peaceful and harmonious coexistence and mutual benefit and that it is interested in dialogue on equal footing with other nations. This policy objective has as much foresight as it is full of sagacity. It reflected the maturity and mellowness of the past and present corps of Chinese political leadership. The outcome of such an international posture is greater approval and acceptance by the global community of nations. A recent poll conducted jointly by the Japan Economic Foundation and Chicago Council on Global Affairs in India, Japan and the US found that only 23 percent, 28 percent and 29 percent of those surveyed, respectively, believed that China’s increasing influence should be actively contained. While 40 percent of those surveyed in India, 72 percent in Japan and 65 percent in the US hoped to build friendly and cooperative relations with China (Qing, 2007).37 Far larger proportion of those surveyed saw China’s newfound economic vigor as an opportunity to develop their own economy. While occasionally China still does draw both envy and ire from the industrial countries, the “China threat” assessment has been by and large retreating.

1.3

Evolution of a large trading economy

For a long period (1948–78) China remained a marginal trading economy and its share in world merchandise exports hovered at around 1 percent. In 1953 it was 1.2 percent; it declined to 0.6 percent in 1977 (Lardy, 1998). That is, during this period the Chinese economy was virtually autarkic; its foreign trade (imports ⫹ exports) in 1978 was paltry, at $21 billion. Under the centrally planned economic structure, China traded through its state trading organizations, which were trading monopolies and in turn were controlled by the Ministry of Foreign Trade. Bureaucrats had complete control over trade; they determined its quantitative guidelines. This bureaucratically determined trade was ad hoc, having no link with the economy’s comparative advantage. Little wonder then that China was regarded as an insignificant trader, with an inconsequential presence in the multilateral trade arena. After the adoption of the reform and liberalization program, the economy began the external sector liberalization exceedingly slowly. Although the hold of the state trading monopolies was relatively

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loosened, it was supplanted by a complex and highly restrictive regulatory structure of statutory tariffs, non–tariff barriers (NTBs) and licenses. In 1982, average unweighted tariffs were 55.6 percent, in 1984 they declined to 43.3 percent and in 1991 they were a trifle higher at 44.1 percent (Rumbaug and Blancher, 2004).38 Like the other AHP economies, China adopted an export-led, investment-dominated growth model (see Section 1.1.1). The initiation of China’s emergence as a trading powerhouse occurred in the latter half of the 1980s, when textile, apparel, toy, leather goods and other labor-intensive light manufactures moved from Hong Kong to Shenzhen, in the Gungdong province of Southern China, essentially to exploit low wages. These firms exported a large proportion of their output to the global markets. Since then, China’s exports gained increasing market shares abroad, and, its imports, rising at a slightly slower rate than that of its exports, supported the performance of the regional and global economies. In 1990, China was still a partially open economy. Substantial reform of its external sector did not start until the early 1990s. Unilateral liberalization of the trade policy regime accelerated a fortiori after 1994. Extensive and far-reaching reforms opened the external sector. Between 1992 and 1999, the number of tariff lines subject to quotas and licenses fell from 1,247 to 261 (Lardy, 2002). The import coverage of all NTBs in China fell from 32.5 percent in 1996 to 21.6 percent in 2001 (Ianchovichina and Martin, 2006). Various estimates of declining NTBs are available. They vary according to the source, but one common theme is that they did fall steadily, as did the license requirement and designated trading, one of the less intrusive forms of quantitative restriction employed in China. Consequently, the trade policy regime was far more open a decade later in 2000. Judged by the norms of an EME, the post–WTO-accession tariff levels were low. In 2001, average tariffs on all products were 9.8 percent, while weighted tariffs were 6.8 percent. At this stage, average tariffs on manufactures were 9.5 percent, while weighted tariffs were 6.9 percent.39 An equally important feature of trade policy reforms was a sharp decline in the dispersion of tariff rates, with the standard deviation in tariffs declining from 32.1 percent in 1992 to 10 percent in 2001.40 Trade policy liberalization benefits an economy in a fundamental manner. It enables the economy to exchange goods and services produced at world market prices, which in turn realigns its economic structure with that of the global economy, preparing it to benefit from its genuine comparative advantage. This policy measure has enormous welfare implications.


With liberalization of the trade regime, the structure of China’s exports was transformed. It became something akin to that of neighboring Taiwan. To a lesser extent, it was also comparable to that of Korea in 1990. In addition, liberalization of the external sector was one of the causal factors behind steady increase in China’s share in the global merchandise exports. It was 1.2 percent of the total merchandise trade in 1983 and 2.5 percent in 2003. In 2006, China accounted for 8.0 percent of the total multilateral exports and 6.4 percent of total imports. In 2006, the US accounted for 8.6 percent of total multilateral exports and Germany 9.2 percent (WTO, 2007). Its three largest trading partners are the European Union (EU), the US and Japan, in that order, accounting for 51 percent of China’s exports. They also make up 34 percent of its import bill. China’s trade grew at an average rate of 15 percent annually between 1978 and 2006, compared to the 7 percent average annual growth rate for the multilateral trade over the same period (Lipsky, 2007). Also, the structure of its exports underwent a dramatic transformation. In 2005, the only two larger exporters than China were Germany (9.3 percent) and the US (8.7 percent).41 In a short span of three decades China emerged as a trading economy of global proportion. Reforms of the external sector facilitated this process, and global integration of the economy continued to advance. Between 1990 and 2006, China’s mercantile exports grew 12-fold in nominal terms, compared with a tripling of multilateral trade. China has been running large trade balance surpluses, resulting in current account surpluses, which are partly caused by its remarkably high savings rate. China’s performance on the external front was comparable to the performance of the other AHP economies. The other AHP economies that delivered growth miracles before China also had the external sector as the principal driver of their rapid growth (Amiti and Freund, 2008). According to the World Development Indicator 2007, in 2005, China’s exports of goods and services accounted for 37.5 percent of the GDP and imports 31.9 percent of the GDP. Thus, trade (export ⫹ import) accounted for 69.4 percent of the GDP in China in 2005; the corresponding proportion was 39.6 percent in 2000.42 By the middle of the 2000s, it became the most open economy among the comparable large EMEs. In comparison to China, trade accounted for 25 percent to 30 percent of the GDP for the EU, Japan and the US. These statistics compellingly demonstrate that openness of the Chinese economy is historically unprecedented. Like the three previous episodes of integration into the global economy ( Japan, NIAEs and ASEAN-4) during the latter half of the twentieth

36


century, China’s rapidly expanding trade was directly resulting in expansion of its market share in all of the three major global markets, namely, the EU, Japan and the US. Imports from China as a percentage of total imports expanded from 3.1 percent in 1980 to 18.5 percent in 2003 in Japan. In the EU this increase was from 0.7 percent to 8.9 percent and in the US from 0.5 percent to 12.5 percent during the period under consideration.43 Initially, during the 1980s, China’s exports to these markets were essentially concentrated in labor-intensive and primary products, which included textiles and apparel, shoes, toys, leather goods, footwear and light manufactures. Until 1990, almost half of Chinese exports were confined to these items. Initially China did not export high-value-added products. However, its share of world manufactured exports increased steadily. In the 1990s, the export structure was upgraded to include medium-technology products such as furniture, office and telecommunications equipment, transport equipment, electrical machinery, industrial supplies and small electronics products. Importance of primary products in exports steadily dwindled. By the early 2000s, exports had become much more diversified and included a range of high-technology products. Remarkably impressive growth was observed in the exports of the following categories of manufactured goods: travel goods, automated data-processing equipment, sophisticated consumer electronics, sound equipment, kitchenware, car tires and circuit boards. None of these are products of sunset industries. Besides, China has established itself as a global exporter of low-cost manufactured goods. The textiles and apparel sector has had a special place in the Chinese economy. It was one of the largest exporters of textiles and apparel even during the Multi-Fiber Arrangement (MFA) era (1974–2004) and faced the largest number of quotas and the biggest share of binding quotas under the MFA regime (Buelens, 2005). Soon after the launching of reforms, it became the largest exporter of a number of Harmonized System 10-degits products and the largest exporter of textiles and apparel. It is well endowed with raw materials and has the largest production capacity in production of cotton, silk and man-made fibers. Chinese textiles and apparel firms also enjoy the skilled and low-cost labor advantage (Delpeuch, 2007). During the Uruguay Round of multilateral trade negotiations (MTNs), the eighth round of MTNs under the sponsorship of the General Agreement on Tariffs and Trade (GATT), it was decided to dismantle the MFA on January 1, 2005. After this point, China’s exports of textiles and apparel enjoyed a veritable boom; this happened despite application of safeguard measures by both the EU and the US against Chinese exports.


Over the last three decades, as noted above, China’s export composition transformed out of recognition. China moved up the technology ladder, significantly upgrading its export structure. In the past consumer products dominated exports; their proportion has declined steadily and sharply. Gradually high-technology exportables supplanted low-technology ones within the set of manufactured exports. Electronic products and ICT hardware and software formed more than 20 percent of China’s total exports in the early 2000s. This trend is expected to be strengthened in future, and China’s export structure would continue to move up further toward technology- and knowledgeintensive products. China is likely to become more competitive in the lower end of high-technology exports. This dynamics would in turn move China’s exports up the value-added chain. Lately China displaced exports of high-wage economies, particularly in Latin America. Upgrading of the export structure was partly done with the help of import of sophisticated parts and components and partly through improvements in the domestic industrial structure. Exports of capital equipment and intermediate products rose sharply in the recent period. This category accounted for over 40 percent of total exports (Cui and Syed, 2006).44 To a great extent, China’s composition of exports was influenced by FDI—this influence was both qualitative and quantitative. The importance of the FIEs sector to exports and imports went on increasing. FIEs accounted for 15 percent of exports in 1990 (Tseng and Zebregs, 2002). In 2003, about 57 percent of total exports came from joint ventures,45 FIEs and wholly owned foreign subsidiaries (Hsiao and Hsiao, 2004). Another study computed that during 2003 and 2004 these enterprises accounted for 50 percent of exports and 60 percent of imports; the FIEs contributed over 20 percent annually of Chinese GDP (Whally and Xin, 2006). 1.3.1 WTO accession: Marathon negotiations When China formally applied for accession to the GATT in July 1986, it was still essentially a centrally planned economy with an opaque trade regime, having high tariff barriers and surfeit of NTBs. The USSR and Yugoslavia were its two most important trading partners. The WTO accession procedure took China 15 years (1986 through 2001) of arduous and thoroughgoing negotiations, which was the longest for any WTO member (Das, 2001a). China acceded to the WTO in November 2001, as its 143rd member.46 This was a watershed point in the evolution of China’s trade policy regime. One of the major reasons for China’s

38


eagerness to join the WTO was to ensure a secure and predictable trading environment, which could help it promote its various businesses and also give confidence to its global business and investment partners. Accession was followed by dramatic trade expansion. In the three years following the accession China’s exports doubled. The postaccession period has so far been smooth. Many negative effects of accession that were apprehended did not materialize. China has been commended by the General Council of the WTO for sincerely meeting its obligations and abiding by its accession commitments. China’s five-year period as a WTO member officially ended in 2005. According to the office of the US Trade Representative (USTR), China fulfilled many of its accession obligations by 2005, although some fundamental reforms remained incomplete. These included vigorous intellectual property rights (IPR) enforcement and the provision of greater market access to foreign firms (USITC, 2007). China’s Protocol of Accession has a provision for a Transitional Review Mechanism (TRM) for monitoring compliance annually for 8 years, with final compliance in 2010. The report of the TRM did not find any deviations in the compliance for 2002 and 2003, although there were some areas where technical problems existed. In a recent review, Branstetter and Lardy (2006) gauged China’s progress in compliance and found it “reasonable.” China bound all its import tariffs in goods. However, the WTO rules forbid imposing any performance requirements on TNCs and foreign investors, but until 2004 China did persuade them to increase local R&D, deepen local content and strengthen domestic industrial linkages. This was an abrogation of WTO regulations. The EU, Japan and the US made frequent use of the TRM; they did so in 2005 as well. Under the TRM they continuously questioned China’s product- and sector-specific trade policies. Other trade partners used the TRM only sparingly. China’s banking sector commitments came in for frequent inquiry and scrutiny. Some of the problem areas identified by the TRM were industrial programs, standards, technical regulations and other NTBs, market access for services and enforcement of IPRs (Overmyer, 2006). A comparative study of developing and industrial economies conducted by the OECD Secretariat concluded that China’s trade regime was still restrictive in important services areas such as banking, insurance and mobile telecom (OECD, 2005b). A 2006-USTR investigation emphasized discrepancies in trade in services and IPR areas (USTR, 2006). The principal commitments that were to be implemented in 2006 included allowing foreign firms in the areas of architecture, engineering


and integrated engineering services to operate; allowing foreign banks to operate without geographic and customer restrictions; allowing foreign wholesalers and commission agents to distribute chemical fertilizers, processed oil and crude oil; and allowing foreign insurance companies to engage in reinsure. These market-opening commitments were implemented in a timely manner. The principal focus in implementation in 2006 was on the banking sector, which China had protected from competition. Trade partner firms and countries looked at subtle barriers to trade and pressured China to open its markets more than what it had committed to during the accession agreement. The preparatory phase for the WTO accession had begun in the early 1990s. During this period China lowered its tariffs. For instance, weighted average tariffs were reduced from 40.6 percent in 1992 to 9.1 in 2001, while weighted average tariffs on manufactured goods were dropped from 47 percent in 1992 to 13 percent in 2001. China also dismantled many NTBs. After the accession the liberalization process has continued. China has committed to further phased reduction in NTBs by 2005, but no later than 2010. Trade reforms and commitments made by China as a part of the Protocol of Accession were, inter alia, instrumental in integrating the economy with the regional and global economies. This integration process proceeded rapidly and is ongoing. Accession also liberalized important components of the services sector of the Chinese economy (Rumbaug and Blancher, 2004; Das, 2001b). Opening of the economy to trade and investment accelerated since China’s accession to the WTO. 1.3.2 Emergence of an export juggernaut China’s pace of export expansion—particularly since 1990 when it accounted for mere 1.9 percent of global merchandise exports—has been striking; in fact, it was nothing short of spectacular. That 1990–2000 was a distinctive period for export growth is convincingly brought home clearly by export statistics, particularly those of manufactured exports. The export growth rate in this important category was 16.9 percent per annum for China, against the world average of 6.4 percent for the period under consideration. The developing country average was 12.0 percent and that for the rest of East Asia 10.3 percent (Lall and Albaladejo, 2004). Therefore, China’s share of manufactured exports soared from 1.7 percent of the total to 4.4 percent between 1990 and 2000. Also, its share of developing country export of manufactured exports rose from 11 percent to 20 percent over this period (WTO, 2002). As in the growth process of the other AHP economies that achieved economic miracles,

40


exports became one of the prime movers of growth in China as well. A noteworthy development about China’s export prowess for the 1990s was that China recorded high rates of average annual increase (32.7 percent) in the export of high-technology products, of which exports of electronics products increased at the average annual rate of 36.1 percent.47 According to the latest WTO statistics (WTO, 2007), China’s merchandise exports in 2006 were $976.9 billion and imports $791.5 billion, making the value of its total merchandise trade $1.760.4 trillion. Its exports of commercial services were worth $91.4 billion and imports $100.3 billion, making the value of its total trade in services $191.7 billion. The annual growth rate of export expansion in the recent period has remained in 30 percent to 40 percent range. These large trading volumes made China a force to reckon with in the arena of multilateral trade. According to the 2004 statistical data, China was the third-largest trading economy in the world after Germany and the US, in that order. Japan was the fourth-largest trader.48 Surpassing Japan, a much-larger economy, was a noteworthy achievement for China. Its economy is merely two-fifths the size of Japan and one-fourth that of the US, at the market exchange rate. China was at the periphery of world trade in the early 1980s, but in 2004 vaulted to the status of the third-largest trading economy in the world. This happened in only three years after its accession to the WTO. Judging by its past performance, it can be expected to move up a notch, to the second place, in the short-term. As in the other AHP economies, the export sector acted as a major high-growth driver for the Chinese economy. To achieve export-led growth China followed a two-pronged strategy. First, as it is extra rich in labor endowment, it focused on promoting labor-intensive exports. This was in accordance with the HeckscherOhlin theory of trade. By manufacturing labor-intensive manufactures for its export markets, it succeeded in creating employment for its large labor force and made a dent in its high unemployment rate. Second, it also produced and exported higher-technology goods, which supported industrial development and the economy moved up the value chain. The second strategy helped upgrade the technology level in the economy. As noted above, not only did the export structure continued to evolve but it also went on to become more geographically diversified. Although the EU, Japan and North America continued to be the principal export markets in the 2000s, exports to Africa, Eastern Europe and Latin America increased more rapidly than those to the traditional


export destinations. Another noteworthy development was that traditional exports rose faster than the process goods exports, which were the result of fragmentation of manufacturing processes, the so-called slicing the value chain. For this category of exports, the production network entailed manufacturing plants in China, which imported parts, components, intermediate goods and subassemblies. All the imports for process goods were made free of tariffs. The final finished product was completed in China for export to the EU, Japan and the US markets. Thus, China emerged as a manufacturing hub for re-exports from the region.49 Terms like the processing center or reprocessing center are also used for this “triangular” trade movement. Almost half of China’s exports are the subject of “triangular” trade. China ran a trade deficit with its Asian neighbors, which continued to widen even in 2006. This was consistent with the development of supply chains and fragmentation of the manufacturing process in Asia, noted above. China’s participation in production networks in manufacturing processes deepened production fragmentation and integrated it with the other AHP economies of Asia (Haddad, 2007).50 Production networks created for process goods exports expanded at a brisk rate. Joint ventures and FIEs were the principal sources of process goods exports. China’s low unit labor cost was only partially offset by lower labor productivity. The trend in geographical distribution of exports noted above persisted. In 2007, exports to the US and Japan declined, while those to the EU picked up. Exports to the other markets, namely, Africa, Eastern Europe and Latin America, continued to rise monotonically. China’s export prowess partly stems from its investment in fresh production capacity in the past. This was evident in sectors such as steel and machinery, where China turned from an importer to an exporter. Another idiosyncratic feature was that China’s export growth rate was consistently higher than its import growth. Consequently, in 1990 its current account surplus was $11.99 billion, while in 2000 it was $20.51 billion. In 2004, it increased to $68.65 billion, or 3.6 percent of GDP, and in 2005 it spurted to $161 billion, or 7.1 percent of GDP. In 2006, the surplus soared further to $250 billion, or 9.5 percent of GDP.51 China enjoyed bilateral trade surpluses with both the EU and the US, which have been on the rise. In 2006, to restrain exports to these two destinations, the government slashed export incentives, like export-tax rebates given to exporters. In June 2007, rebates were reduced or eliminated on 2,831 product categories. China also agreed to impose quotas on textile and apparel exports to the EU and the US. Although these

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export restraints on textile and apparel will reduce China’s benefits from quota elimination under the Agreement on Textile and Clothing (ATC) significantly during the period the restraints are in effect, that is, until the end of 2008. However, by 2010 the losses would largely be eliminated ( Jianwu and Shantong, 2007). The objective of the policy makers in consenting to apply various export-restraining measures was to reduce burgeoning trade surplus, which was stoking tensions with many of the biggest trade partners. The Chinese policy makers also hoped that higher taxes would mitigate the economy’s dependence on exports and encourage investment in higher-value-added manufacturing. However, these export-restraining measures did not succeed in restraining or reducing trade surplus, which continued to increase unabated in 2007. The trade surplus makes up the bulk of the balanceof-payments surplus; it has been adding to high domestic liquidity growth. For the month of June 2007, the trade surplus was $26.9 billion, a record not only for China but also worldwide. While its WTO membership protects China from tariffs and quota restrictions on its exports, importing countries can impose NTBs, such as technical and safety standards. Although these NTBs also come under the WTO surveillance, they allow national governments a good deal of leeway. As long as the regulations regarding these NTBs are uniformly applied to domestic producers and to all trading partners, they are legal and can stay. There is a good possibility of safety and phytosanitary barriers rising against Chinese exports over the coming years. Protectionist arguments will be reinforced by China’s weak record on quality and health standards. This could potentially sour global trade relations and the negotiation process of the Doha Round of multilateral trade negotiations. The processing trade is concentrated in relatively high-technology products and is essentially dominated by FIEs.52 It was largely responsible for expanding China’s exports of high-value-added products and creating trade surpluses. All the imports of intermediate goods were customarily made free of tariffs. In 2005, processing trade accounted for 42 percent of China’s total imports and 55 percent of its total exports (Dean, et al., 2007). The processing trade helped China in integrating into the regional and global supply chains. A large segment of the processed export industry was the result of investments made by the neighboring EMEs seeking lower cost assembly of final products. This observation applies to electronics manufacturers from Korea, apparel manufacturers from Hong Kong and computer manufacturers from Taiwan. The current account surpluses with the EU and the US continued to widen in 2006. Exports of processed goods were


essentially responsible for it. Swelling trade and current account surpluses became the principal drivers for the accumulation of foreign exchange reserve. 1.3.3 Outer-orientation and economic transformation Outer-orientation has been a successful development strategy for China. In this respect, the 1990s was the most important period because during this period the external sector liberalization gathered momentum, trade expansion accelerated and diversified, and FDI inflows and consequential FIEs expansion picked up momentum. Furthermore, the regional and global production networks that became responsible for a large segment of China’s trade came into their own in the 1990s. China’s trade and FDI expansion and global integration benefited all of the three— the Chinese, the Asian and the global—economies. First, the Chinese economy benefited through improved export performance, productivity increases and innovation. Second, neighboring Asian developing economies have emerged as China’s principal source economies and, as noted above, have become partners in China’s supply chain and production networks. Third, other economies that are exporters of capitaland resource-intensive products have benefited from China’s economic and trade expansion. However, economies that had a comparative advantage in labor-intensive products, similar to those produced by China, faced serious competition and had to make a significant adjustment in their trade and production structures. Also, trade expansion caused some domestic problems in China, like the rise in regional income disparities between the coastal and inland provinces and the worsening of income distribution. As mentioned in the preceding paragraph, outer-orientation tends to work as one of the causal factors behind increased productivity at the microlevel. In a cross-country empirical analysis, using identically specified models, Wagner (2007) compared microlevel data for 14 economies to conclude that exporting firms were more productive than nonexporters when observed and unobserved heterogeneity were controlled for. Export productivity premia were found to increase with the share of exports to total sales of the product. There was strong evidence in favor of self-selection of more productive firms into export markets. To be sure, exporter premia differed across the sample economies. This meta-analysis also found that economies that were more open and had effective governments had higher export premia. Increasing outer-orientation and rapid export growth helped increase firm-level productivity in China.

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The outer-orientation strategy paid richly off and in 2005, with a share of 7.3 percent in multilateral exports, China loomed larger than Japan (5.7 percent), albeit with a share of 9.6 percent in the world exports the four NIAEs were ahead of China. However, China’s exports were almost twice those of the ASEAN-4 economies (3.7 percent). Also, its accomplishment in the external sector must be compared to the other large EMEs. In comparison to the two large EMEs, Brazil (1.1 percent) and India (1.0 percent), China’s share of world exports was a great deal higher, so much so that a comparison appears extraneous (WTO, 2007).53 One vital characteristic of China’s trade evolution is its greater specialization in production within the Asian region, particularly its integration with the other AHP economies and its increase in intraindustry trade. In the recent past, China’s trade, particularly imports, with the other AHP economies grew at a much faster pace than that with the EU and the US. Consequently, China has emerged as one of most important trade partners of the other developing economies in the region, particularly of the other AHP economies. China’s composition of imports from these economies displays a high degree of vertical specialization, which occurs when countries specialize only in particular stages of a good’s production sequence. A significant share of imports for processing for export is convincing proof of this fact. Vertical specialization in trade has led to growth of trade not only in Asia but also multilaterally (Yi, 2003; Jones, et al., 2004). According to Rumbaug and Blancher (2004), the ratio of imports for processing to total imports rose sharply in China. Between 1990 and 1997 this ratio soared from 35 percent to 50 percent, and hovered around this level since. Also, these imports are embodied in 40 percent of China’s total exports. Large imports of electronic integrated circuits and microassemblies, which are vital components in electronic products, are part of the vertical specialization process. Efficient supply chains have been created between China and different regional trade partners. These economies have become skillful managers of such supply chains. This newly evolved production configuration allowed exploitation of a comparative advantage not only at the product level but also at the subassembly and process levels. Rising trade surpluses with the industrial economies pari passu with rising deficits with the other AHP economies, elaborated above, is the consequence of this pattern of production and trade. A noteworthy—in no way surprising—development is that after a decade of explosive growth in the electronics sector, in 2004 China


overtook the US as the world’s largest exporter of advanced-technology products such as laptop computers, information technology products, cellular phones and digital cameras. In 2003, the US was the global leader in this category with exports of $137 billion, followed by China with $123 billion. In 2004, China notched up another first. It exported $180 billion worth of high-technology equipment in 2004, compared to the US exports of $149 billion, making China the leading global economy in the exports of high-technology products (OECD, 2005c). By 2005, China’s high-technology exports had reached $220 billion (EIU, 2007). This is a veritable landmark in China’s technological upgradation and industrial diversification. It moved up the ladder from being a country of low-technology sweatshops to one having sophisticated electronics factories. China’s total trade (imports ⫹ exports) in both advanced-technology and ICT products in 1996 was $35 billion. What has been particularly impressive is the speed of China’s emergence as an exporter of high-technology products. Growing at the rate of 38 percent a year, it soared to $329 billion in 2004 (OECD, 2005c). It must be clarified that FIEs overwhelmingly dominated both the advanced-technology and ICT manufacturing and exports. In 2005, they accounted for 90 percent of advanced-technology exports (EIU, 2007). This category of exports from the FIEs has been growing twice as fast as those from the domestically owned companies. It is apprehended that the dominance of FIEs in the advanced-technology and ICT products would constrain the efforts of domestic firms in raising their level of homegrown technological standards. The domestic firms in China are a long way from developing new technologies and becoming global leaders. They need more time and resources to develop their own technology. China is following the pragmatic path taken by postwar Japan and the other AHP economies; they encouraged foreign firms to take the lead in developing high-technology products and gradually worked on developing their own technological prowess. Reasonably priced and high-quality Chinese consumer products and low-priced manufactures became popular in the industrial economy markets. An important effect of this was that China helped in appreciably reining in inflation in these economies. Direct sourcing by large global retailer chains made China’s exports of consumer products grow at a swift rate. Global retailers directly bought $30 billion worth of consumer merchandise in 2001 (DR, 2003). The US consumer giant Wal-Mart, the French chain Carrefour and the British retailer Tesco were among the major direct buyers in China. This should be regarded as a small beginning because most large foreign retail chains still do not

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have strong sourcing bases in China. The federal government was trying to play the matchmaking role by bringing together large Chinese companies with foreign retailers. To this end, it also organized regular trade fairs.

1.4

A magnet for FDI

Before the launching of reforms, FDI could not be made in China. In 1979, with the passage of the Law on Joint Venture, a basic legal framework for inviting FDI and operation of foreign firms was created. With that the local and provincial government authorities were empowered to determine the FDI strategy in their respective jurisdictions. Four pioneer special economic zones (SEZs) were created, where foreign firms were offered generous tax concessions, preferential administrative treatment and free hand in operations. The first four SEZs were Shenzhen, Zhuhai, Shantou and Xiamen. The first two were across the border from Hong Kong and Macao, respectively, while the other two were on the Chinese side of the Taiwan straits. The objective was to encourage FDI from investors based in Hong Kong, Macao and Taiwan. When these four SEZs succeeded in achieving their objective, the SEZ concept was expanded geographically in 1984 to 14 more centers in the Pacific coastal belt of China and the Hainan Island. The previously received modest levels of FDI began to take off after this development. The FDI regime was further liberalized in several stages.54 Local and provincial authorities were given greater freedom to make their own plans and administrative procedures for attracting FDI. Up to $50 million in FDI could be handled by the local authorities. The next change came in 1986, with the so-called 22-regulations, which liberalized FDI further and made it easier for foreign investors to invest and established a streamlined FDI approval process. Some of the ad hoc tax concessions of the past were made nationally applicable. Enterprises with FDI were given more managerial autonomy, and controls over repatriation of profits were removed. In 1992, 1994 and 1996 more FDI liberalization policy measures were taken, further facilitating their inflows and eventually making China a premier FDI destination. During this period, two kinds of FDI projects, namely, export-oriented and technologically advanced projects, were offered more welcoming treatment by authorities by giving them additional benefits. The former category of export-oriented enterprises was required to export 50 percent of their output by value. The second category of projects was required to upgrade domestic production capacity and technology standards.


This astute FDI management had far-reaching ramifications. It significantly helped inbound technology transfer, which in turn extensively improved the growth potential of the economy by strengthening the manufacturing sector and enhancing its competitiveness. For attracting foreign firms in technologically advanced areas, coastal cities established their own Economic and Technological Development Areas (ETDAs). These ETDAs offered a meaningful array of privileges to foreign firms for investing in advanced technology projects. Likewise, the federal government established a few High Technology Industrial Development Areas (HTIDAs) of its own with parallel incentives. By 2002, 34 ETDAs were operating in the capital cities of different provinces and 53 HTIDAs were created. The next policy move was the establishment of Bonded Areas (BAs) to further stimulate foreign investment. BAs became prominent because of their authority to receive duty-free imported parts and components for process goods (Hammer, 2006). One clear consequence of the FDI liberalization measures was that the flow of FDI from Hong Kong and Taiwan increased steadily (until 1990). The approval of FDI peaked in 1993, and went into a decline after that, while FDI inflows continued throughout the 1990s. The investors from Hong Kong, Taiwan and the other Asian economies were largely driven by expectation of exploiting low labor costs in the SEZs. This FDI was largely concentrated in export-processing areas and in those industries in which China had a comparative advantage. Although FDI from Hong Kong was the largest during this period (until 1992), it was a tad illusory because this FDI generally came from Hong Kong and many other countries. A part of it was also domestic investment that “round-tripped” from Hong Kong. Until 1996, the EMEs around China dominated the FDI flows to China. Also, until this point FDI was channeled more into labor-intensive industries essentially because exports in this sector were high and rising. FDI in these industries came from firms based in Hong Kong, Korea, Macao and Taiwan. FDI from the industrial economies (the EU, Japan, the US) also increased, particularly after 1996. The dominance of the neighboring EMEs began to decline. As noted above, the original focus of FDI was the traded goods sector. As FDI from the industrial economies continued to increase, they began to dominate the FDI inflows. In quantitative terms it was larger than that from China’s Asian neighbors. After 2002, the industrial economies accounted for over 60 percent of the total annual FDI inflows. In 2005, China accounted for 60 percent of all FDI flows from OECD to non-OECD countries (Whally, 2006). These flows were qualitatively different from those made by the Asian neighbors. A lot of

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this FDI was made in high-technology sectors for producing exportables, or the so-called platform production. However, the industrial economies did not ignore the Chinese domestic market, which in their view had large future potential. Theoretically, it is logical to expect external capital inflows to favorably influence growth rate in the recipient economy. Their direct influence can be made through augmentation of domestic savings, lower cost of capital and transfer of technological know-how. Also, the recipient economy can benefit from important indirect influences like inducement for better domestic policies offered by capital account openness. Empirical evidence is available to show that FDI stimulated domestic investment in China and enhanced the efficiency of domestic investment (Xu and Wang, 2007). 1.4.1 The quantitative dimension and geographical concentration of FDI FDI is regarded as a preferred form of external capital inflow for an EME. During the five years between 1979 and 1983, China received a trifling amount of $1.8 billion, or $360 million annually. Over the 1984–88 period, FDI flows increased to $10.3 billion, averaging $2.2 billion annually. This uptick disappeared in 1989 because of the Tiananmen Square incidents. Thereafter, the first watershed year in FDI flows was 1992, when the FDI flows spurted to more than $10 billion a year, and in 1993 crossed $30 billion.55 This surge took place, inter alia, due to the selective opening of China’s capital account. China became the largest developing-country recipient of FDI in the second half of the 1990s, when the FDI flows hovered around $40 billion per annum. In absolute terms China began attracting large swaths of FDI. The FDI flows peaked at $45.46 billion in 1998. The Asian financial and currency crisis of 1997–98 disrupted the FDI inflows not only into China but also into the rest of the Asian region. After a decline in 1999 and 2000, FDI flows again picked up in 2001, when China acceded to the WTO. This was the second watershed point. Interestingly, while during the 2001–03 period global FDI flow weakened substantially and declined, China continued to record annual increases (UNCTAD, 2005). In terms of flow, FDI soared from a low level in the mid-1980s to $72.4 billion in 2005, which was a 20 percent increase over the 2004 level (UNCTAD, 2006). As regards other kinds of external capital inflows, China followed the strategy of keeping its external debt to low levels. Therefore, non-FDI private capital flows remained limited, until recently. The FDI-heavy composition of capital inflows was planned with the tax and other incentives. By allowing the


FDI inflows to overwhelmingly dominate the external capital inflows China benefited greatly by improving its risk-return trade-off. Since the early 2000s, the NIAEs and the ASEAN-4 economies expressed concern regarding an increasing amount of FDI flowing to China. Many of these governments publicly expressed their apprehension regarding not only diversion of FDI flows but also worried about domestic investors from their own countries investing in China instead of at home. This led to a disturbing weakening of the manufacturing sector and loss of jobs in these economies and became known as the “hollowing out” phenomenon. In 1990, China’s FDI stock was merely $19 billion, while in 1999 it rose to over $300 billion (Graham and Wada, 2001). An important characteristic of post-1992 flows was that FDI was directed essentially into greenfield investment. Evidently China was creating an enormous capacity to absorb FDI. One of the reasons for FDI concentration in the eastern and southern coastal cities and provinces was creation of a sound investment climate for foreign private investment. The coastal areas received 80 percent of the total FDI inflows. The southern province of Guangdong—which is to the north of Hong Kong—alone accounted for a third of the total FDI and had attracted $140 billion by 2003. Initially it was treated as a laboratory for market-oriented reforms. The other coastal provinces, namely, Jiangsu, Shanghai and Zhejiang, were ignored. However, over the past few years, this scenario has changed and Jiangsu Province, which is next to Shanghai, has emerged as a big winner. As market-oriented reforms progressed in the Jiangsu Province and it improved its investment climate, FDI inflows increased. In 2003, it received 25 percent of all FDI inflows to China; it has displaced Guangdong from its high perch. The other reasons for geographical concentration of FDI included the fact that coastal provinces of China had relatively superior industrial infrastructure. Also, it was easier to export from here. Therefore, only a small proportion, 20 percent, of FDI traveled westward and northward. But the fact that it was a significant amount when put in perspective of the size of the economy of these provinces cannot be ignored. These provinces have much smaller economies than those in the southern and eastern provinces. Throughout the 1990s, FDI received by these interior provinces amounted to 10 percent of their GDP. Thus, FDI played a large role in the economies of the interior provinces as well (Huang, 2003b). China has grown to be one of the largest host FDI economies. In 2005 and 2006, it was the third-largest recipient of FDI in the world after the United Kingdom (UK) and the US, in that order (UNCTAD, 2007).

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Both of these are mature industrial economies. At end of 2006, it was estimated a $699.5 billion by the World Investment Prospects (2007). Unlike many EMEs, it has succeeded in building a critical mass in FDI. As the economy has been growing faster than FDI inflows, FDI as a share of GDP has been declining. As regards in which geographical region an investing economy invested, it was determined by the country of origin of the investing enterprise. Investors from Hong Kong preferred Shenzhen, which was to the north of Hong Kong, in the Guangdong province of China. The Taiwanese firms’ favorite locations were Dongguan, Xiamen and the urban parts of Shanghai. The Japanese and Korean firms favored Liaoning and Shandong. Large corporations and transnational corporations (TNCs) from the EU and the US made their investments in Beijing, Guangdong, Shanghai and Tianjing (Hsiao and Hsiao, 2004). These centers emerged as geographical clusters of FDI, having industries with high technological capabilities, which in turn resulted in an agglomeration effect, attracting more FDI. For some time authorities have used carrots and stick approach to persuade advanced-technology investors to transfer it to domestic firms. One method was to encourage joint ventures. The National Reform and Development Commission (NRDC), the apex economic planning agency, announced an FDI policy at the end of 2006 for the 11th Five Year Plan (2006–10). The new strategy emphasized that China needs to shift from quantity to quality approach in FDI approvals. The key NRDC recommendation is that China needs to encourage FDI only in the high-value-added sectors, high-technology industries, advanced manufacturing and energy-conserving industries. The NRDC unmistakably discouraged the local and provincial governments from accepting FDI indiscriminately. FDI proposals that bring in advanced technology and have significant R&D components should be encouraged, while those that emphasize low-value-added, export processing goods must be discouraged. The new FDI proposals will also be scrutinized more closely for their environmental impact. How stringently is the new strategy going to be implemented remains to be seen. According to different surveys, China continued to be ranked as a highly preferred host location by investing firms. According to the projections made by the World Investment Prospects (2007), over the 2007–11 period China will maintain its position as the third-largest recipient of FDI after the US and the UK. On an average, it is projected to receive $87 billion annually over the period under consideration. Gradual opening of FDI in domestic commerce, financial services and


tourism is underway. China is obliged to do so to meet its WTO accession obligations. 1.4.2

Did China eat the ASEAN’s lunch?

Yes, but there is more to it than just this. Since the early 1990s, the ASEAN economies, which attracted a great deal of FDI from the industrial economies, began to move their manufacturing capacity to China. As infrastructure and labor skills improved, this process continued to be strengthened. Chinese wages continued to remain relatively low. Investors from Japan, Korea and Taiwan as well as the Chinese Diaspora in the Southeast Asian economies saw this opportunity and exploited it by shifting much of their manufacturing capacity to China. This was a new paradigm of intraregional FDI flows. It helped China to integrate into the regional production networks, which facilitated China’s technological integration in the regional and, subsequently, the global economy. In 1990, China could attract barely 18 percent of total FDI that was made in Asia, a lion’s share (61 percent) went to the smaller and dynamic ASEAN economies. By 1999, tables were turned and the ASEAN economies received 17 percent of the total FDI flows to Asia, while China received 61 percent (Das, 2007a). Thus, China’s FDI expanded at the expanse of the ASEAN economies. This trend was expected to accelerate because several large TNCs were finalizing plans to invest more in China. Toshiba was finalizing a multibillion-dollar investment program and Motorola was planning a global production base and research center in China. PepsiCo, Sara Lee Corp and Electrolux were the other investors with large investment plans in China (DR, 2003). To be sure, the ASEAN economies suffered a direct loss in terms of FDI receipt. However, they gained by closely integrating with the much-larger Chinese economy by way of increased trade and production network arrangements (see Section 2.4 for an in-depth analysis of this issue). 1.4.3 Did FDI stimulate growth? Domestic saving for the most part financed a high level of domestic investment. Foreign savings investment in China ranged around 3 percent of the GDP. Therefore, while the financial or macroeconomic contribution of FDI was not large, it is possible that it did make a contribution in improving the productivity of investment and eventually TFP growth. FDI not only brought capital but also ushered in new technologies, products and business methods and marketing networks, which have a favorable influence on TFP. It contributed about 2 percent

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to 2.5 percent to GDP growth over the 1990s, or approximately half of the TFP growth. Stock of FDI and TFP displayed remarkable comovement for the Chinese economy; therefore, Tseng and Zebregs (2002) asserted that it has been “a driving force” behind China’s rapid growth. FDI expansion was found to be responsible for more than 20 percent annual expansion in real GDP growth during 2003 and 2004. Its absence could have caused reduction in annual GDP growth rate by 3.4 percent during the years under consideration (Whally and Xin, 2006). FDI succeeded in generating a lot of positive externalities in the economy. Progressive opening of the economy and FDI expansion enabled China to import high-value capital goods and the advanced technology embodied in them. It is also known to transfer managerial expertise. Opening of the economy to FDI intensified microeconomic competition among firms, and the Darwinian law of survival of the fittest operated. The old incompetitive firms and industries withered away, and were supplanted by dynamic, strong and competitive younger ones. This happened to several old beer firms in China that were wiped out by the competitive new firms. Consequently, the dynamic and competitive firms and industries expanded and prospered, even attempted for global leadership. The television and ICT hardware industries in China are cases in point. Competition is a constructive force. It is value creating and leads to better exploitation of productive resources and factors of production. It also goes a long way in propping up the organic process of growth by re-engineering the industrial landscape. Imports of higher-level technology contributed not only to TFP but also to labor productivity increases in the economy. Although labor productivity increased in general, it was found to be the highest in the traded goods sector. These increases were partially reflected in wage rises. FDI also altered the pattern of industrial production, expanding its variety, which was in keeping with the economy’s comparative advantage, which has had the Ricardian growth-enhancing impact over the Chinese economy. Two recent studies have concluded that the higher growth rate in the coastal provinces of eastern and southern China benefited from FDI (Lemoine, 2000; Dayal-Gulati and Husain, 2000). The Dayal-Gulati and Husain (2000) study used a modified version of Mankiw, Romer and Weil (1992) version of the Solow growth model to come to this conclusion. In their modification, they ignored some variables of the standard model. Using a truncated version, they focused on one basic query, that is, whether higher real GDP growth rate of the coastal eastern and southern provinces could be attributed correctly to higher FDI. Their


answer was that higher rate of FDI inflows portend to higher openness of these provinces, which in turn meant higher rates of convergence, or access to different technologies, leading to a convergence to a higher steady state. Empirical results of Dayal-Gulati and Husain (2000) robustly established that FDI in coastal provinces is positively associated with higher rates of per capita income growth. 1.4.4 Dawn of a dual economy Essentially due to progressively large flows of FDI, by the late 1990s, China developed a distinct dual economy. The first subeconomy comprised the FDI-supported FIEs sector, which included joint ventures between foreign companies and domestic enterprises. New foreignfunded enterprises and joint venture firms have been the principal mode of absorbing FDI in China. The foreign investing firms also made joint ventures with the SOEs and township and village enterprises. As set out in the preceding section, the foreign investor brought in capital, technology, product design and strong marketing networks. These networks of the investing firms helped in increasing penetration of Chinese products in overseas markets. Manufacturing was the principal, albeit not exclusive, focus of this subeconomy. The second part of the dual economy was the non-FDI fragment of the manufacturing activity and agriculture and services sector. To be sure, the first part of the dual economy was much smaller than the second part but it made a significant contribution to the Chinese economy. It was essentially due to the fact that it had considerably higher productivity. For instance, labor productivity in it was estimated to be nine times higher than the non-FIEs subeconomy. Using crosssection firm-level data Hale and Long (2007) found that for the most part domestic firms were involved in providing inputs and intermediate goods to FIEs. They also manufactured final products according to the specifications of the foreign firms. However, domestic firms invested very little in innovation and R&D; it was conveniently regarded as the domain of FIEs. The domestic firms also played a passive role in global division of labor. The contribution of the FIEs sector to exports and imports went on increasing. Section 3 presents statistical data regarding the increase in exports from the FIEs. They accounted for 15 percent of total exports in 1990. This proportion increased to almost a half of the total exports in 2003. By 2004, the FIEs accounted for more than half of Chinese exports and imports, and contributed a fifth of the GDP. This sector also accounted for almost a third of total industrial output. As the essential

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focus of FIEs was manufacturing for exports, their products were designed abroad and foreign distribution systems of the investing firms proficiently distributed them globally. The FIEs preferred to operate from the coastal eastern and southern provinces of China because they were superior export bases. As the efficiency and TFP in the two subeconomies are so starkly different, their growth rates also differ significantly. If China’s growth rate is decomposed into two parts, one notices that the FIEs subeconomy has been growing at a much faster clip than the non-FDI part of the economy. Its growth rate was 18 percent per annum, while that of the non-FDI-subeconomy was close to 6 percent in 2006 (Whally and Xin, 2006). Thus viewed, FDI made a decisive contribution to Chinese growth.

1.5

Multinational corporations (MNCs) in China

Over the preceding two decades, a great many MNCs from the OECD economies have set up operations in China. Close to 470 of the Fortune 500 companies presently operate in China. While they made an increasing contribution to the Chinese economy and businesses, particularly to its external sector, in this short time span, their experiences have varied and their role has undergone a transformation. 1.5.1 Stumbling blocks faced by the multinationals China’s integration with the global economy predominantly transpired through the FIEs. They played a vital, versatile and multifaceted role and have come to have a pivotal place in China’s industrial structure. It would be wrong to believe that foreign investors did, or do, not have problems in investing in China. Both the central and the provincial governments in China control FDI inflows and devise the strategy to attract it. In the early stages, foreign investors were welcome as long as they could fit into the domestic industrial policy objectives, which were determined by the central and provincial governments. If not, they found themselves facing numerous entry conditions. Some of them included making use of the domestic suppliers or locating facilities in designated areas or organizing joint ventures with Chinese firms. Even after several stages of reforms and liberalization, FDI inflows faced obstructions. Foreign investment projects are still divided into encouraged, restricted, permitted and prohibited categories. Interestingly, the category of permitted project is not a published list but it consists of all the investment projects that are not listed in the other three categories, which are published separately. After the WTO accession prohibited and


restricted categories have been shortened, although foreign investors feel that these two categories need to be further shortened. Another weakness of the FDI strategy was that, on the one hand, China needed capital and technological know-how that FDI brought in and, on the other, it bended over backward in the past to ensure that FIEs, which are run more efficiently, do not out-compete the SOEs. This was a shortsighted strategy which deprived Chinese firms of the dynamic gains from FDI. There has been considerable softening in this strategy, which is a step in the healthy direction. Internal local regulations (or neibu) that govern the process of FDI approval still persist. They were never published but coexisted with national legislation and regulations (or gongkai), which were well publicized in the beginning of the reform period. The former category is more restrictive and because they have never been published, the FDI decision-making process is rendered confusing. The central government needs to streamline this mystifying process by first publishing the internal local regulations and making them consistent with the national legislation as well as international regulations. A clear and consolidated regulatory framework needs to be drawn out and issued for public use so that foreign investors can take informed and intelligent decisions in an efficacious manner. In addition, undue delays often take place in FDI approval because local authorities cannot sanction an FDI project without referring to the various departments of the central government. Foreign investors feel that the government should raise the value of the FDI projects that local authorities can approve without having to refer to the central government. Also, a one-window FDI evaluation operation can be created by merging the various steps of the appraisal process. 1.5.2 Multinationals and Chinese trade Multinational firms tended to go a long way in influencing the quality or nature of Chinese trade. It is acknowledged that higher growth rates and increasing per capita incomes are positively related to the variety of exports from an economy (Hallak, 2006). Owing to this association, which is based on finely disaggregated trade data, one can determine the economic factors that enhance a country’s ability to export higherquality products or to increase the density of its trade linkages. Chen and Swenson (2007) examined the exports of Chinese firms to learn how proximity to MNCs operating in China influenced the quality or nature of Chinese trade. Usually proximity of MNCs improves a domestic firms’ ability to enter export markets. In addition, the presence of

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MNCs and their interaction with the domestic firms engender opportunities for positive spillover affecting export capability and quality of products of the Chinese firms. Using disaggregated Chinese trade data for the 1997–2003 period, they concluded: First, domestic firms located close to MNCs benefited from a “new dimension of export spillover— the extensive margin at the product level.” The unit value of the exports of the domestic firms was higher when they were located near MNCs. Second, multinationals reduced informational barriers to trade in industries where informational barriers to trade were the greatest. Third, domestic firms succeeded in establishing more new trade linkages due to MNC presence. 1.5.3 Multinationals and intensification of R&D The R&D operations of MNCs from industrialized countries progressively increased. This R&D activity accounted for 30 percent of all commercial R&D in China (OECD, 2007). Many MNCs made large investments in setting up R&D centers for focused research. A good part of MNCs’ R&D was in the ICT sector, including software, telecommunication, semiconductors and other ICT products. Other sectors that attracted MNC R&D investment were equipment and components, biotechnology and drugs, and automotive industries. Beijing and Shanghai were the preferred locales, but of late Guangdong Jiangsu and Tianjin have attracted large MNC investments in R&D operations. Both small and large MNCs contributed to this process of globalization of R&D. Between 2000 and 2004, the R&D expenditure of MNCs as well as patent applications for inventions more than doubled (OECD, 2007). If experts’ opinions and anecdotal accounts are any indicators, these operations have been gaining momentum and are likely to expand further. The government policy has been to proactively promote MNC R&D operations in China. They were suitably regarded as a means of upgrading domestic technology and skills by importing and internalizing advanced technologies. Some skeptical academics and politicians have recently argued against promotion of MNC R&D activities. They begrudged the MNCs’ license fee for patents and argued that they tended to be unduly high. They also believed that MNCs crowded out domestic firms in the market for highly skilled scientists and researchers. This group alleged that MNCs dominated standards and technology platforms and reduced the role of domestic firms in the technology advancement, finally turned them into low-profit earners. Public opinion in the industrialized economies has also been against setting up R&D operations in China because it is seen as thwarting the R&D in the EU and the US.


1.5.4 Changing conditions for success Over the years, importance of China for MNCs has increased. Hexter and Woetzel (2007) correctly point out that if an MNC is not turning in a stellar performance in China, it “may be in trouble—globally.” Of the US multinationals operating in China, 64 percent reported that they were either profitable or very profitable. One-third of these reported higher profit margins than their global operations, while the other third reported profits on par with their global average. The business and operational environment in China has been constantly evolving and transforming, and with that the functioning of the MNCs. The size of China’s emerging middle class was projected at 290 million by 2010 and at 520 million by 2025 (Farrell, et al., 2006). With expansion in the size of the middle class, many MNCs have begun moving in the interior to smaller cities and towns. These expansions have expanded their sales and marketing costs and new organizational challenges have materialized. More importantly, MNCs have begun encountering unforeseen competition from national and regional domestic Chinese rivals. Thus, their future profit margins will indeed be affected. As the manufacturing-labor costs in China are much lower, almost a fifth of those in Europe or the US, MNCs from the EU or the US were running their operations less efficiently than they ran their native operations and were still earning attractive profits. A recent McKinsey study of MNC manufacturing operations in China concluded that waste reduced profits by 20 percent to 40 percent.56 Inefficiency was neither caused by insouciance nor was it premeditated. Often waste was inhered through partnership or acquisitions. Also, in a good profit climate MNC managers rationally focused on growth, not on operational improvements. However, with competition on the rise, operational efficiency will have to improve. Aggressive MNCs, such as Danfoss, GE, KFC, Johnson and Johnson and Nokia, have demonstrated that efficient execution counts as much in China as anywhere else. They set high performance standards for themselves and in so doing they successfully overcame both domestic and global competition.

1.6

Managing the foreign exchange reserves

Steadily rising current account surpluses became the principal drivers of foreign exchange reserve accumulation. The other contributors were FDI inflows, increasing non-FDI inflows after 2001, inflows of speculative capital, interest income on invested foreign reserves and increased

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income from tourism. At the time of launching the reforms, China’s foreign exchange reserves hovered around $2 billion; even in 1980 they were $2.5 billion. In 1990, the reserves rose to $29.5 billion, while in 2000 to $168.2 billion, which was a high amount for an economy of the size of China. Other economies of comparable size had much lower levels of reserves. Notwithstanding this, the reserve level soared to $403 billion in 2003 and $819 billion in 2005. In February 2006, China’s reserves were $853.7 billion versus Japan’s $850.1 billion. China surpassed Japan and became the largest holder of foreign exchange reserves in the world. At the end of August 2007, its reserves were $1,400 billion.57 One factor that has inspired the policy makers to accumulate such an outsized amount in reserves was the memories of the volatility during the Asian crisis (1997–98); the economies that had run down their reserves (Indonesia, Korea, Thailand, etc.) suffered and had to pay a high price for not having access to a large pool of foreign exchange reserves, while those that maintained high levels of foreign reserves (China, Hong Kong, Taiwan, etc.) were able to ride out the storm. Thus, in the event of currency crises, reserves serve as a functional shield. Large accumulation of foreign exchange reserves is generally welcome because they help protect an economy against the volatility of global marketplace. It provides liquidity for exchange-rate management. But how large should they grow? As a rule of thumb, an economy needs enough foreign exchange reserves to cover three months of imports, or enough to settle its entire stock of outstanding short-term foreign debt. The latter parameter is called the Guidotti-Greenspan rule (Rodrik, 2006a). Debt maturing in one year is defined as short-term. China’s reserves can cover more than 16 months of imports. They are also over seven times the short-term debt level. Judged by these norms, China has accumulated an excessively high level of reserves, both in absolute and relative terms. As a percentage of China’s present GDP, it is close to 55 percent, which is an unprecedented level and half of all the reserves for Asia. It is another first scored by the Chinese economy. Such a handsome sum can create problems for the PBC. It creates excess liquidity in the economy, leading to a high inflation rate, asset price bubbles and imprudent bank lending. Such large reserves were accumulated in several phases, some accounting for steep increases others for sluggish periods. During the 1978–88 phase, foreign exchange reserves accumulated slowly, reflecting initial steps of the reform process. Although the level of reserves was low, it was sufficient to cover the requirement of imports, which were also low. The second phase (1989–91) was the period of moderate


accumulation. The economic slowdown of this period resulted in a sharp decline in imports. As the exports began to rise after a fall, the current account moved from deficit to surplus, which resulted in accumulation of foreign exchange reserves. Unlike the second, the third (1992–96) phase was marked by rapid accumulation of reserves. Many reform measures were taken during this time. Consequently, accelerating FDI, not current account surpluses, contributed more to the rising level of reserves. During 1997–99, they stagnated but picked up momentum again in 2000–05 and soared. This rapid acceleration reflected the strong economic performance of this period as well as China’s WTO accession. The WTO membership contributed to an increase in China’s imports, on the one hand, and it promoted FDI inflows, on the other, which contributed to building up foreign exchange reserves (Yi, 2006). A huge accumulation of forex reserves after 2000 testified to China’s progressive economic and financial globalization. While they represent China’s overall economic strength, they have also created internal and external pressures on the balance of the economy and introduced risks to the financial system. According to one estimate, foreign exchange reserves of approximately $400 billion in 2005 would have been appropriate for an economy that has a managed floating exchange rate regime, with capital control (Zheng and Yi, 2007). China’s actual reserves at the end of 2005 were $818.9 billion, which far exceeded its normal demand for forex reserves. The large forex reserves in China portend to the transforming structure of the global economy. It has undergone a dramatic and discernible transformation with respect to the surplus and deficit economies. Until the mid-1960s, the US was the largest surplus and creditor economy. It has turned into the largest debtor economy, and China, Japan and a small number of EMEs have emerged as surplus and creditor economies. In this changing global economic setting, the Bretton Woods institutions need to consider how they can contribute to deploying the funds of China. Time has come for the creation of an international facility in which surplus countries such as China and the other EMEs could transfer their excess reserves so that they are invested in a business savvy manner, providing them optimal returns. This facility can operate in all the leading global financial centers. If such a facility can attract a part of the excess reserves of economies such as China and charge a modest—say, one-half percent—fund management fee, a significant sum can be generated for the assistance of the least developed economies (LDCs) to be used as a grant, debt relief or expenditure for global public good.

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1.6.1 Merits and demerits of large reserve holdings A sizable part of these reserves have been invested in the US treasury securities, which are low yielding but ultrasafe and liquid assets. They could be sold quickly if the central bank had to prop up the currency— a lesson from the Asian crisis era. The PBC has diversified into mortgagebacked securities and corporate bonds. In mid-2007, the US securities portfolio of the PBC was estimated at $920 billion. The PBC owned $420 billion of US treasuries and $500 billion worth in the securities of US agencies, that is, dollar-denominated issues of the World Bank and corporate bonds. Foreigners hold almost half of all US treasury securities. These investments of the PBC have made China a significant contributor to rising liquidity in global financial markets. They are large and can sway the global financial markets. However, there is a disadvantage in it as well. High-grade government securities and money market instruments typically earn the investing central bank approximately 1 percent in annualized return.58 This implies that China is lending to the US at approximately 1.5 percent nominal rate of returns. It was 1 percent in the past. In real terms the rate of return will be less than 2 percent, and if real exchange rates are likely to appreciate then domestic returns in real terms will be even lower (Summers, 2006). Therefore, it was widely felt that a more active management of such a stupendous amount of international reserves was sorely needed, so that they could either be more productively utilized domestically, or at least earn better returns by being invested in a global menu of assets. One cannot ignore the fact that if a Chinese firm borrows from a US bank, it pays close to an 18 percent interest rate. The PBC might consider investing these reserves into nondollar assets. Such a decision, if taken on a large scale, may prove to be disruptive to the global financial markets. It is sure to spark off a major realignment in global exchange rates, causing volatility in the global economy. 1.6.2 Credible alternative usages of the reserves Gradual and managed liberalization of the capital account and promoting outward investment can be one way of utilizing this sizeable stockpile of reserves. A less active mode of reserve management could be allowing the State Administration of Foreign Exchange (SAFE) to simply invest in more diversified foreign assets. It would at least increase the present exceedingly low rate of real returns measured in domestic terms. Low returns represent a substantial cost to the Chinese economy. If the same amount is invested in fully diversified long-term assets in the global capital markets, an estimated 6 percent to 7 percent return can


be easily earned. By this modest estimate, the Chinese economy has been incurring a loss of $100 billion a year. Therefore, this course of action was adopted and a scheme was devised to invest in a small and watchful manner in the global capital markets. However, it was found inadequate. The Qualified Domestic Investor Initiative (QDII) scheme was launched to manage the reserves in a more active manner. It was intended to promote controlled outflows of foreign exchange assets by encouraging banks to invest in the international capital markets. This investing activity was limited to investment in foreign fixed-income products. In the early 2007, QDII quotas were increased and the scheme was broadened by allowing securities firms as well to invest abroad. In an endeavor to broaden investment by purchasing stocks listed in global bourses, China Asset Management Co. Ltd (CAMC), the largest mutual fund, launched its own QDII in September 2007. Numerous other options were debated for more rewarding utilization of these resources. Domestic utilization of foreign exchange assets was also considered. For instance, capitalizing the social pension fund, cleaning up the problem-ridden banks and restructuring the SOE sector, investing in and removing infrastructure weaknesses, building up reserves of vital inputs like oil were some of the options. Other than these, investing them in high-yielding instruments like stocks, derivatives and private equity were also on the table. The PBC did not think highly of these options but supported creating an entity like Huijin in 2006, which could utilize the financial resources for the much-needed domestic objectives, like recapitalization of banks. Another pragmatic move that the PBC considered seriously was creation of a government corporation, modeled on Temasek Holdings of Singapore, which is an investment company created in 1974 by the Government of Singapore. In terms of the percentage of GDP, Singapore’s reserve holdings can match that of China. Singapore did not park too much of its dollar reserves in the US Treasury securities. The express objective of this corporation is to manage reserves by investing them overseas in a business savvy manner, and earn high returns. Temasek Holdings bought stocks in Microsoft, Standard Chartered Bank, Singapore Airlines, China Construction Bank, the ICICI Bank of India and other highprofile businesses and banks. If this method of investment is adopted by the PBC, such a move will help deployment of forex reserves in a broader set of foreign assets, which could significantly improve their yield.59 China’s political leaders, Premier Wen Jiabao and Vice President Zheng Qinghong, called for utilization of reserves for domestic social objectives, like medical care, rural education and environmental protection.

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However, meeting these policy objectives will not reduce the large stockpile of forex reserves. The mechanism would work as follows. Suppose that the forex reserves are diverted to the rural areas for the above-noted objectives. The local rural authorities will have to sell the dollars to a local bank for RMB yuan, which in turn will sell them to one of the authorized foreign-currency-dealing banks. This process will create a downward pressure on the $/RMB exchange rate. To keep the RMB yuan exchange rate from depreciating, the PBC will buy the dollars for RMB yuan. Thus, the PBC will retrieve its dollar assets and the reserve level would remain stationary. 1.6.3 Launch of a sovereign wealth fund (SWF) With an initial capital of $200 billion, China launched a state-owned investment company in October 2007. The publicized objective of the China Investment Corporation (CIC) is to seek minority stakes in large MNCs to ensure higher returns on assets. Other than improvement in yield, the CIC is a sagacious means of reducing China’s risks related to exposure to the depreciating dollar, which considerably reduced the value of China’s stock of foreign exchange reserves in the latter half of 2007. There are no indications of disinvestment from the dollardenominated assets. It could destabilize the foreign exchange markets, which is not in anybody’s interest. The CIC can be seen as an essentially risk-reduction vehicle for China; its launch is likely to contribute to further weakening of confidence in the depreciating dollar. The concept of SWFs is not a new one. Countries having large forex reserves, held in dollars, euros and yens, tend to create SWFs to manage their “extra” resources. SWFs have existed in a small way since the 1950s; economies with large balance-of-payments surpluses customarily launched them. Since the early 1990s their operations expanded at a dramatic pace. In the early 1990s, SWFs held close to $500 billion. According to one estimate, in 2007 they held and managed well over $2 trillion. Based on their current growth trajectory, their operations could cross $10 trillion in 2012 ( Johnson, 2007). With $200 billion to invest, CIC is one of the largest SWFs in the world. This investment vehicle could turn China into a major player in the global financial markets. Operations of the CIC could have a discernible impact over the existing market players. The large liquid resources managed by the CIC could potentially be used for acquiring controlling stocks in large MNCs, in the process changing the basic relationship between developing and developed economies. Some industrial country governments may find this unacceptable and may create barriers to


investments by SWFs on the basis of flimsy pretexts. The EU announced considering strategies to keep SWFs at bay unless their investment strategies and rationale are well publicized.

1.7

Growth pangs and administrative failures

That rapid growth can lead to deleterious influences on the economy is evident from the litany of problems, some of them serious, in the Chinese economy. After the Fifth Session of the tenth National People’s Congress,60 held on March 15, 2007, in an uncharacteristic display of candor, Premier Wen Jiabao remarked, “The Chinese economy has some major problems, namely, it is unstable, unbalanced, uncoordinated and unsustainable. It is not a time for complacency.”61 During the inaugural speech at the World Economic Forum, in Dalian, on September 6, 2007, he repeated the same sentiments, stating that China is a “developing country with a large population, weak economic foundation and underdeveloped productivity. This is a reality that has basically remained unchanged.”62 These statements reflect the disposition and apprehensions of the top political leadership. In a remorseful lamentation he went on to publicly enumerate the shortcomings as follows: excessive investment and growth in the economy, excessive credit expansion, excessive environment pollution caused by rapid growth, weak domestic consumption, extravagant use of energy and inadequate technological innovation. He saw colossal foreign exchange reserves and a runaway stock market as potential sources of economic setbacks, volatility and unpredictability. These observations were that of a hard-nosed realist. He was au point beyond any shadow of doubt. Other than these major structural and strategic issues, glaring instances of administrative failures abound (Engardio, et al., 2007). Despite good intentions, the government was unable to enforce product safety regulations. The same went for environment and copyright regulations. Despite state-of-the-art technology, stock exchanges suffer from flaccid regulations. Green initiatives by the government failed to improve the heavily polluting factories due to laxity in enforcement of pollution regulations. Local and foreign experts questioned and warned about the substandard quality of seafood, toothpaste, car tires, toys and medicines repeatedly. Exports of these and other shoddy products tarnished the image of China’s exports. In mid-2007, the government finally cracked down on both manufacturers and exporters of these products. The former administrator of State Food and Drug Administration was executed for accepting bribes from the drug companies and giving them prompt product approval.

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Some of these drugs later on killed the patients. Major trade partners banned certain categories of imports from China. That more embargos could be slapped, which would have adverse impact over the Chinese economy, became a serious official concern. A government commission was appointed to examine the tainted image of Chinese foods and other products at home and abroad. Measures were also taken to strengthen the food safety system, tighten controls over chemical use by large seafood chains and meat producers and create a system that held producers more accountable for selling unsafe products (Barboza, 2007). The power structure and policies that succeeded in spurring GDP growth and industrialization undermined initiatives that could move China to a higher level of economic growth. While the central government holds a monopoly over policy and strategic direction, local Communist Party officials enjoy wide latitude over economic and social policies and their implementation. They are also known to routinely divert financial resources.63 This is where the roots of venality lie. The bureaucratic machinery at the local level often seems impervious to the pressing need of reforms in the areas that have been enumerated above. As 70 percent of an official’s annual performance is assessed on the basis of contribution to GDP growth, officials generously shower local businesses with favors like cheap bank credit, land, licenses, protection from competitors and exemption from regulations. This creates endless opportunities for venality, graft and corruption. In China’s ersatz capitalism, powerful and wealthy elite has emerged that has an enormous stake in preserving the status quo. According to the Global Corruption Report 2007, which computes corruption perception index for 163 countries on the basis of primary data generated by surveys of several thousand firms, China was ranked 71st, almost in the middle of the rankings, while Finland and New Zealand were the least corrupt countries and were at the top of this index. It also calculates a bribe payment index for 30 countries; China was placed at the 29th position. Switzerland was at the top of this index, with the lowest bribing tendencies. Premier Wen Jiabao’s melancholy remarks were not out of place because the CPC has so far not been successful in coming to terms with these problems. To be a modern industrial society, China needs an effective and efficacious administrative system. The contemporary one falls short by a large margin. The other AHP economies, particularly Korea and Taiwan, also suffered from these malaises and took some time in overcoming them. The Philippines still suffers from this so-called crony capitalism.


1.8

Cost of rapid growth: Environmental degradation

No country in the history could industrialize without bequeathing a legacy of environmental degradation. It is one of the perennial costs of economic growth. Experience shows that in most countries environmental pollution worsens in the early stages of industrialization. As growth picks up momentum, the GDP rises and the economy becomes prosperous, the priorities of the policy makers shift. They recognize the value of natural resources such as clean air, safe water, fertile topsoil and abundant unspoiled forests. To protect and nurture these resources laws are enacted and resources are committed to tackle difficult environmental problems. Consequently, air quality and other environmental conditions start improving. China exemplifies this scenario. Its robust industrial revolution is in full swing, and with that its pollution problems have increased at a swift rate. Its status as the factory of the world was achieved at a high ecological cost. Severe environmental degradation is having both domestic and global repercussions. Coal-burning furnaces are one of the biggest sources of pollution in China. According to a recent exhaustive World Bank study (WB, 2007), which was jointly conducted by international and Chinese scientists, total energy consumption in China increased by 70 percent during the 2000–05 period. To meet this demand, coal consumption went up by 75 percent over the same period. China is the second-largest energy consumer in the world. Coal is the primary energy source in China; it provides 68 percent of total energy consumption. This study also revealed that the tenth Five Year Plan (2001–05) targets regarding sulfur dioxide and soot were not met and at the end of the plan they were 42 percent and 11 percent, respectively, higher than the targets. In fact, China was not able to meet 10 of the 13 Plan targets in the area of environment. Excessive coal use is the principal culprit that has made China the largest producer of sulfur dioxide in the world. Likewise, water pollution is also an equally serious concern. China has traditionally suffered from a severe water shortage because in 45 percent of the national territory, annual precipitation is low, less than 400mm. The rapidly growing economy took its toll and the limited water resources were contaminated by the large discharges of industrial and domestic wastewater. River water was considered unfit for human consumption in 54 percent of the seven main rivers in China. This was a 12 percent increase since the early 1990s. The most polluted river water was found in the northeastern provinces, which are densely populated. Many of the polluted rivers have been devoid of fish for many years.

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Pollution of lakes and seawater has also been serious. Over 30 percent of the sites, where seawater quality is monitored, were found to have extremely poor-quality water. The same was the state of lake water; 75 percent of lakes show some degree of eutrophication (WB, 2007). Epidemiological researches were constantly done in China to explore consistent links between air pollution and various health hazards. Direct links were established between air pollution and reduced lung function, respiratory symptoms, chronic bronchitis, and cardiovascular and cerebrovascular diseases. Consequently absenteeism in schools and places of work was rampant. Outdoor air-pollution-related diseases frequently caused premature deaths. A Ministry of Health study, cited by Watts (2007), which covered 30 cities and 78 rural counties, concluded that air and water pollution led to a sharp surge in tumors in China and has caused a spurt in cancer cases.64 Cancer has recently become the main cause of death. It has started causing more deaths than cerebrovascular and heart ailments. Along with air and water pollution, this study blamed widespread use of pesticides for this trend. The public health system is reeling from the pressure of unparalleled environmental degradation. China has come to acquire the dubious distinction of having 16 of the 20 most polluted cities in the world. Many industrial cities often seem enveloped “in a toxic gray shroud” around the year. Incidence of different kinds of pollution is so widespread that catastrophic environmental accidents are regarded as commonplace and overlooked. For instance, industrial cities where the sun never dawns, infant mortality due to lead poising, sick children due to local pollution, large sections of oceans not being able to sustain marine life due to algal red tides are not regarded as environmental calamities (Kahn and Yardley, 2007). China’s environmental problems affect other part of the globe. Sulfur dioxide and nitrogen oxides spewed out by coal-fired power plants in China fall as acid rain on Seoul and Tokyo. The source of a large part of particulate pollution over Los Angeles is China. It is ironic that rapid economic growth, which is China’s most notable achievement, has also become its biggest burden because of its injurious impact on the environment.

1.9

Future prospects and the growth trajectory

The landscape of the global economy has changed. In 2005, China became the fourth-largest economy in the world as well as an alternative locomotive for the global economy. Only the US economy was thus


far considered a locomotive economy. In the foreseeable future, China’s may account for larger share of global economic growth than that in the past. If the growth rate of different regions remains by and large the same, China could account for close to half of all growth in the global economy by 2020 (Dollar, 2007). The reason that the same growth produces larger share in global growth for China is that its share in the global economy has been steadily increasing. China also has the distinction of being the third-largest trader and holder of largest foreign exchange reserves. The rise in China’s economic prominence was beyond most expectations. Slowly but surely, it will also become progressively more important geopolitically (Keidel, 2006). While there are little prospects of it becoming a geopolitical super power, in a multipolar world, it is on its way to be an equal of the other heavyweights like the EU, Japan and the US. An East Asian economy, dominated by China, will be a force to reckon with not only in the global economy but also in the geopolitical arena. While dreams of Pax-Asia-Pacifica may be premature, if not irrelevant, there may soon be an opportunity for China to restructure the post–World War II global economic and geopolitical orders. 1.9.1 Medium- and short-term growth prospects On the external side, sharp macroeconomic imbalances exist in the global economy. Reference here is to large current account deficits in the US and their mirror image of surpluses in China and the other AHP economies. In the event of a disorderly adjustment, the Chinese economy will be vulnerable. Policy endeavors for engineering a small decline in both investment growth and dependence of GDP growth on the external sector have gone on for a while, but to no avail. Softening of some export market in 2007 and withdrawal of value-added tax (VAT) rebate for exporters may reduce growth rate of merchandise export.65 Owing to anticipated small decline in the contribution of the external sector to growth, the GDP growth may decline a little in the medium-term. The authorities are likely to continue their efforts in this direction. Short-term policy measures were underway for moderating the GDP growth rate, because it has been higher than planned for the 11th Five Year Plan period (see Section 1.1.7). These measures did not produce the desired results so far. As rebalancing measures, discussed below, are taken by the government in right earnest and as they intensify, they are likely to influence the trade and current account surpluses. The Growth rate

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of current account surplus in China is likely to decelerate. Also, the declining trend in consumption is likely to reverse itself in the mediumterm; consumption is likely to benefit, inter alia, from rising household incomes. Government spending in the rural areas (see Section 1.9.3) as well as grain price increases and guarantees may help in boosting the rural income. In 2007, retail sales picked up both in the urban and rural areas. Therefore, both in the short- and medium-term domestic demand will be higher than that in the past. In 2007 domestic economic conditions were favorable to growth. The 2006 GDP growth rate was much higher than planned and the firstquarter growth in 2007 was 11.1 percent. No extraordinary reason could be given for this higher than expected GDP growth performance. The external sector performance was as responsible for this economic buoyancy as was investment. Investment-tightening measures were apparently having inadequate effect, and policy measures taken to moderate GDP growth were not yielding desired results. In the short-term, it would be normal to see macroeconomic policy measures, both fiscal and monetary, being tightened. Also, the PBC is likely to continue with its present policy stance it took on interest rates, reserve-requirement and open-market operations. Whether these orthodox measures will have the desired effect of holding back overheating and constraining the investment rate was open to skepticism. High profit rates and ample liquidity in the system may well thwart the effect of the policy measures. It is likely that investment would grow and drive the growth rate higher than planned in the short-term. What does the future hold for China? For sure, the economy cannot be expected to maintain a GDP growth rate of 10 percent indefinitely. That said, China has successfully laid the basic foundation for rapid economic growth and its potential to continue growing at a rate between 6 percent and 8 percent per annum—a vigorous pace for an EME—cannot reasonably be doubted. Using a Computable General Equilibrium (CGE) model of the Chinese economy, developed by the Development Research Center of the State Council of China (DRCCGE Model), Jianwu and Shantong (2007) projected different GDP growth scenarios. They used the recursive dynamic version of the model to estimate three growth scenarios: a baseline scenario in which current economic trends and conditions for domestic and global economic environment prevail, a more favorable or optimistic scenario in which trends and conditions are superior and a risk scenario in which inferior trends and conditions prevail. They also assumed three different plausible levels of TFP growth in the economy,

A Chinese Renaissance 69 Table 1.2 Average GDP growth rate, 2006–20

Baseline Scenario Optimistic Scenario Risk Scenario

2006 –10

2011 –15

2016 –20

2006–20 (percent)

8.9 9.5 8.4

8.3 8.8 7.1

7.0 7.6 5.8

8.1 8.6 7.1

Source: Jianwu and Shantong (2007). Gleaned from Table 3.1.

with each scenario. The results of this projection exercise are shown in Table 1.2 above. The above projections of China’s GDP growth rate show that, under all the three scenarios, the growth rate is likely to dampen down a trifle compared to what was achieved between 1978 and 2005. Capital accumulation is projected to be the principal driver of GDP growth, although its contribution will progressively decline with the passage of time. Contribution from the growth of labor supply will be small. By 2020, the contribution of labor force to economic growth will be close to zero. Strong growth of TFP will account for an increasing share of GDP growth during the period under consideration. In another projection exercise, based on China’s growth of capital, labor, education and TFP, the range of GDP growth rate for the 2005–25 period was forecasted at between 6 percent to 8 percent. In this scenario, the growth rate will peak at 2015. There are two reasons for the decline in 2015–25: First, the TFP growth rate will decline during this period and will only be able to support a GDP growth rate between 5 percent to 7 percent. Second, in many previous miracle growth experiences (for instance, in Japan, Korea, Taiwan), it was observed that after recording China-like high GDP growth rates during the initial decades, growth rates declined in each one of these economies as per capita income rose above $13,000, measured in 2005 prices using the PPP method. In 2005, China’s per capita GDP in per capita terms was $6,600. If the growth rate is assumed to be between 6 percent and 7 percent, it will surpass $13,000 in 12 years (Perkins and Rawski, 2007). The officially publicized plan of the Chinese government is to quadruple its 2000 GDP by 2020 to $4 trillion, at current prices and exchange rate. This would make its per capita income $3,000 per annum. If China’s growth performance remains similar to what it achieved over the last three decades, attaining this target should be easy. It assumes 7.2 percent annual GDP growth rate, which is close to what the risk scenario in Table 1.1 predicts.

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As regards the shape of the economy in the near future, we need to know that principal drivers of the economy are the markets of middle-class consumers and the large labor force supplemented by domestic and foreign investment. One recent estimate of the size of China’s domestic middle-class market put it at $1 trillion (Yusuf et al., 2006). The first driver creates a market for industries that have large economies of scale, while the second helps in running the labor-intensive industries and keeps the wages down. It is because of these two economic drivers medium- and high-technology industrial sectors will continue to grow in the economy. To name a few, autos, electronics, domestic appliance are the ones aptly suited for the present, while pharmaceutical and engineering will be the sectors of the near future. As a dual economy operates in China, a low-skill, labor-intensive sector will continue to operate, particularly in the northern and eastern provinces where a large surplus of labor persists, wages and manufacturing costs are lower (see Section 1.4.5). Some of these low-technology sectors may move to the other low-wage countries such as India and Vietnam. Tertiary education is a rapidly expanding sector in China, with science and engineering attracting a large segment of students. Also, Chinese students that are trained in industrial countries of the East and West do not linger after completing and show a strong preference for returning. This makes it possible for China to succeed in skilland knowledge-intensive, high-technology sectors in the future. However, one conspicuous dearth is of general management personnel, which could keep China from developing innovative leadership for some time to come. The process of rebalancing the economy would entail an increase in public investment in the priority areas such as agriculture, education and health services. Spending on rural infrastructure is also likely to rise. In the medium-term, as rebalancing measures advance, the two principal drivers of economic growth, the export-led industrial sector and investment growth, may hold back. 1.9.2 Longstanding limitations Chinese economy suffers from some medium- and short-term challenges that need to be addressed. First, notwithstanding the recent efforts to upgrade the financial sector, need for a comprehensive reform looms large. The large Chinese savings are deposited in the four state-owned banks (SOBs), which have traditionally done a poor job of financial intermediation. They were responsible for low interest credit disbursement leading to overinvestment and overcapacity in several sectors of the economy, leading to inefficient use of capital. They hold large portfolios


of nonperforming loans that the authorities need to address. The SOBs continued lending to SOEs, many of which were marginally viable. This implied that the banks followed a poor risk-assessment system and were creating unproductive assets by funding domestic-oriented firms. The government recently took measures to encourage banks to take commercially oriented lending decisions. However, what was needed was a thorough restructuring of banks, development of a broad-based financial sector and equity and bond markets. The banking and financial sector has long remained the Achilles’ heel of the Chinese economy. Second, it was legitimately and recurrently felt that the rate of investment per se in the economy was excessive; therefore policy measures to rein it in were instituted. Lower growth rate of investment was considered a necessary condition for efficient use of investable resources. Investment-tightening measures instituted in 2006 included tightening of the monetary policy. They did have some impact in the early 2007, and the economy did not give an indication of being in imbalance. Third, infrastructure weaknesses, particularly in transport and energy, existed for a long time. Investment in these sectors is needed and the government is determined to continue making it. Fourth, surging trade and current account surpluses do point to a macroeconomic imbalance (Chapter 4). China’s banking sector was originally created for a centrally planned economy. It continues to be dominated by the SOBs, which have remained burdened with nonperforming loans (NPLs). Although there are varying estimates of the NPLs, it is generally agreed that they are huge. Banks accumulated RMB yuan 4 trillion of bad debts, mostly as the result of loans made in the period before 1999 to SOEs. Banks were insufficiently capitalized; there was a pressing need for recapitalization. Although efforts to repair the banking system have been underway for a while, they were not as rapid and sure-footed as the credit-rating agencies would prefer. According to Standard & Poor’s estimate , $656 billion were needed in 2004 to resolve the NPL problem of these four largest banks.66 A lion’s share of bank credit going to the SOEs-created systemic inefficiencies. SOEs traditionally dominated bank investment due to noneconomic reasons. This misallocation of productive resources was injurious to the economy. According to the estimates of the McKinsey Global Institute (2006), non-market-based allocation of financial resources reduced the potential size of the GDP by $321 billion a year, which is approximately 14 percent of the present GDP. Non-marketbased allocation reduced the average real return on saving to a mere 0.5 percent over the last decade. Monitory authorities did not bury their heads in sand and constantly attempted to reform the banking sector.

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While a good deal needs to be done, years of banking reforms, including recapitalization of the Big Four state commercial banks, led to noteworthy improvements by 2007. The NPLs of the Big Four have been sharply reduced with the help of the four asset management companies. Recapitalization of the banking system was attempted on several occasions. By 2006, almost 70 percent of it was recapitalized. Although banks started modernizing their loan-making practices, their risk management practices continued to be poor. A well–laid out program for making the banking sector market oriented and commercialize is sorely needed so that its lending operations can be made proficient, so that the efficiency of resource allocation in the economy can be improved. Their profitability standards in the Chinese banks remained mournfully low from international standards. In addition, capital markets need to be developed. This structural deficiency has existed for a long time. Although some steps in this direction have been taken and the process of establishing a sound banking system in two of the major banks was in an advanced stage, there is a pressing need to improve banks’ risk management, internal controls and governance structure. A culture of pricing risk needs to evolve, which does not exist at present. 1.9.3 Rebalancing the economy: Transitioning to a new growth path Sustained GDP growth and improvements in per capita income discernibly improved the quality of life of millions. The flip side of the coin is that a long list of economic and structural imbalances has also emerged. The economic structure, and flaws therein, that emerged over the preceding three decades has attracted a good deal of attention. Premier Wen Jiabao candidly enumerated them (see Section 1.6). The Government is committed to structural rebalancing of the economy and to this end, in December 2004, during the Annual Central Economic Work Conference, prepared a series of strategies. The fundamental objective is to alter the sources of economic growth, without upsetting the strong growth trajectory of strong noninflationary growth. To this end, there is a fairly long list of short- and mediumterm objectives that policy makers need to address. This inventory includes diminishing the rural-urban development and income gap, reducing the development and income gap between the coastal and interior cities, addressing the worsening income distribution and rising the Gini coefficient (see Section 1.1), addressing social development indicators, taming the high unemployment rate, establishing a social safety network for both urban and rural households, improving and


increasing the quantity and quality of public goods and services, strengthening domestic technological standards and innovation capacity, enhancing efficiency of resource utilization by reining in investment rate, restructuring the financial and banking sector and becoming more considerably more environment conscious. Environmental standards need to be paid more attention to so that people and nature can live in harmony. Thus, rebalancing is a daunting task. How China manages these challenges will have a large effect on the Chinese and global economies. Although intractable, these problems are not beyond solution. China’s growth and transition to a market economy has been based on the adaptability of its strategies. As one set of problems was resolved, another one presented itself. Rebalancing of the economy is the latest set of problems, which will take altering the growth model that China has successfully followed for three decades. This would mean addressing both the demand-side variables as well as the supply-side ones. That is, first, emphasis on export and investment needs to be reduced. Secondly, industry-led growth needs to yield to services-led growth. These transformations are of elemental nature. There are three principal ways of rectifying the multiple imbalances listed above. First step toward some of them can be taken by appropriate fiscal measures, that is, by spending more public resources on public services, namely, health, education, social security and R&D services. Second, the production structure of the economy needs to be so altered that the services sector grows faster than the industries. Third, on the demand side, emphasis needs to be shifted from investment and export to consumption. As noted earlier (see Section 1.1.3), despite a production boom, the consumption side of the economy remained sluggish and consumption has continued to decline since the mid-1980s. Consumption growth rate remained significantly slower than output growth rate. Measured as a proportion of GDP, consumption shrank from 47 percent of GDP in 1995 to 37 percent in 2005. This is indeed a striking fall. For all the economic achievements, China’s total consumer economy is barely larger than Italy’s, despite having 20 times more population. Its citizens spend on an average $543 per annum per person on consumption, compared to $11,511 in Italy (MGI, 2007). These three strategic shifts will successfully address many of the current discrepancies in the economy. Consequence of these policy shifts would be less capital-intensive growth, which would divert saving from investment to consumption. As this growth will be more laborintensive, it will have a favorable impact over the current high rate of unemployment. A higher rate of urban job creation is essential for

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reducing excess labor in the agriculture and addressing the rural poverty as well as the rural-urban income gap. If the consumption level in the economy edges upward, it will affect overproduction of goods. Although these measures are desirable in their own right, they will also help in bringing down the large current account surplus, which is a short-term macroeconomic challenge. Financial markets in China continue to be repressed; they have not been allowed to play the role that financial markets play in a market economy in determining interest rates and exchange rates. Therefore, a monetary policy is almost missing from the repertoire of tools that manage the macroeconomy. Interest rates on deposits and lending are firmly governed by the authorities, that is, lending rates and interest rates on deposits cannot rise beyond the stipulated levels. Likewise, the exchange rate is controlled even in the new exchange rate regime that was adopted in July 2005, and the RMB yuan continues to be undervalued (Chapter 5). The rebalancing endeavors require termination of financial repression, that is, elimination of the ceiling on deposit rates and floor on lending rates, in a phased manner. With that, the exchange rate needs to be allowed to be appreciated at a more rapid rate, in accordance with the BalassaSamuelson hypothesis (see Section 5.2.1). These policy moves would allow room for the monetary policy to operate. Since 2004, the authorities have attempted to curb the high investment rates using various instruments but did not succeed because of the inadequacy of monetary tools. If the suggested rebalancing measures are adopted in the short-term, the monetary policy can be effectively utilized for controlling overinvestment. Furthermore, over the medium-term “a stronger currency will help curb investments in export and import-substituting sectors, while raising household incomes” (Aziz and Dunaway, 2007). China’s political leadership is aware of the pressing need for such strategic shifts. Although they regard rapid growth as a policy imperative, they hold changing the pattern of growth as an eminent and timely policy move that cannot be ignored for long. Evidence is available to demonstrate that they are convinced about the need of a new growth model. The 11th Five Year Plan called for improvement in economic structure, generating domestic innovation capacity and a move away from the old export-led investment-dominated growth model to one that is based on domestic consumption. China’s policy makers are cognizant of the fact that shifting from industry to services is the need of the hour. In the 6th Plenum of the 16th CPC Central Committee held during October 8–11, 2006, they committed to rebalancing of the economy by shifting the strategic foci of the economy.


At this stage of economic growth, it is easy to move toward a new growth model because the old model has served the economy well and China has learned and benefited a good deal from it. This model provided the basis for innovation in the economy and helped China make up for the knowledge gap in the economy. Second, competition was innate to this model, which spurred efficiency and raised the industrial standards. Third, usually at early stages of rapid growth the capacity to produce outstrips the capacity to consume, leading to capital accumulation. China has benefited from these exploits of the export-led growth model. It can afford to move away from this model because it has learned how to learn and is in the process of establishing a broad-based innovation system in the economy. Chinese firms have become keen competitors, both in the domestic and global markets. Financial markets have improved considerably. It would be possible to expand domestic credit markets, particularly for housing (Stiglitz, 2007). China’s high-saving-low-consumption economic proclivity also became a source of global imbalances. Bernanke (2005) blamed China and the other Asian EMEs for saving excessively in the post–Asian-crisis period; this swing in the saving-investment ratio created a global saving “glut,” which allowed the US to run huge current account deficits, in turn leading to global imbalances. China was conspicuous in this blame game because its domestic saving rate increased from 35 percent of the GDP in 1980 to 50 percent in 2004. Household savings contributed maximum to this increase. Since the mid-1980s, consumption, as a proportion to GDP, steadily declined in China (IMF, 2006). If this trend is reversed and household consumption starts increasing, it will help in rebalancing the domestic economy. As stated above, an important objective of the 11th Five Year Plan is to raise the level of private consumption. Despite good intentions, progress so far made in achieving this objective is inadequate. If China succeeds in raising the level of domestic consumption in a significant manner, it will become dependent on a more sustainable source of growth, namely, domestic demand. Furthermore, as the high saving rate in the economy declines in future, China’s current account surplus will decline pari passu with rising consumption. When this occurs, China’s large investment in the US treasury securities will fall, in the process reducing current global macroeconomic imbalances. To achieve these objectives, the economy needs to turn into a low-saving-highconsumption one in the short-term. The political leadership has turned earnestly toward diminishing the striking rural-urban gaps in development, income and wealth. A phrase oft used by Hu Jintao and Wen Jiabao is building the “new socialist

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countryside.” Although per capita rural incomes increased by more than 6 percent between 2004 and 2006 and food prices have risen, the gaps obstinately persist. Progress was slow in many rural areas that are far from the prospering coastal regions. For the first time ever, farmers have been exempted from tax on land and agricultural production. A new medical insurance scheme has been devised for them. It covers four-fifths of all the rural counties and is also a first. Since 2004, farmers who grow grains have become entitled to farm subsidies. There are plans to increase this subsidy. To be sure, far more efforts are needed than those envisioned in the recent past. The National Congress of the Communist Party of China (CPC) is the highest body within the CPC.67 The 17th Congress of the CPC was held in October 2007. Younger and more aggressive local leaders were promoted to Politburo Standing Committee (PSC) during the 17th CPC, which portends to a more proreforms slant of the new administration in the foreseeable future. The probability of the PSC being more decisive in addressing economic and social imbalances seems to be higher than that in the past. The economic growth objective will increasingly be dovetailed into the relatively newer objective of building a harmonious society. According to the new policy decisions announced, government expenditure on education, medical care and social security net is to be raised, while personal and corporate taxation will be slashed to boost domestic spending. 1.9.4 China’s place in the global economy That China is gradually moving from the periphery to the center of the global economic stage is troubling, even alarming, to those who have a zero-sum mentality of the world economy. This parochial perspective is wholly uncalled-for and imprudent because for the most part China’s success has not been at the expense of others. If anything, it has contributed to a more prosperous and stable global economy. If jobs are being lost in some sectors in the EU and the US, it is largely because of “bad macroeconomic management” (Stiglitz, 2006). That being said, while the positive-sum nature of China’s growth is evident, it will exert some strain on the global economic system, which includes both the industrial and developing economies. If managed well, the global economy will benefit in the long run from China’s emergence as a flourishing industrial economy. As China’s economic presence has grown globally, expectations of a leadership role have increased. It has begun to appear as a credible leader for the developing and the emerging-market economies. In this role it can help in reshaping global economic, financial and trade


architecture in such a manner that developing economies and the EMEs receive fairer treatment. One of the first areas of leadership can be being a role model for the developing economies. They can take a leaf or two from the unique success story of China. While China’s development recipe cannot be transplanted in other developing economies, China’s development strategy decisively is a worthwhile starting point for a policy debate in the other developing economies (Stiglitz, 2006). Second, in the ongoing Doha Round of MTNs and the future MTNs, as a heavy-weight member of the Group-of-Twenty (G-20),68 China can influence trade negotiations in favor of the developing economies and the EMEs. Historically, the large trading economies such as the EU, Japan and the US overwhelmingly dominated the MTNs because they are the largest trading economies and have superior negotiating strength. China’s presence, as the third-largest trading economy, can now change the tenor and substance of the MTNs. In collaboration with the other large trading EMEs and countries such as Brazil and India, China can become an effective balancing force. This could lead to evenhanded trade negotiations and agreements as well as a level global trade architecture, in which all countries can trade according to their comparative advantage and benefit (Das, 2007b).

1.10

Summary and conclusions

In the early nineteenth century, the Chinese economy was the largest global economy. After a precipitous decline it began a renaissance in 1978 with the launching of broad-based macroeconomic reforms and liberalization. In 2008, China completes three decades of this reform process. During this period it posted sustained and high real GDP growth rates and delivered a growth miracle, like its Asian neighbors did in the past. China’s long-term average GDP growth rate has no parallel in the annals of economic development. Many facets of the economy underwent dramatic and sizable transformations, and China has emerged as one of the largest global economies. The most momentous of these transformations was from an autarkic command economy to an open market-oriented economy, although it is far from complete. Economic reforms and restructuring have enhanced the productivity of both labor and capital in the economy. Not only quality of life perked up for millions and abject poverty was markedly reduced but also the economy progressively integrated with the global economy. After three decades of reforms and economic development, China has become an influential global economy. It has made an ineffaceable mark on the

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global economic landscape. In terms of the size of the GDP, it is the fourth largest when measured using the current market exchange rate and second largest in PPP terms. It is the third-largest trader in the world and has accumulated the largest foreign exchange reserves. China is also the largest exporter of advanced-technology products and the thirdlargest recipient of FDI. The synergy created by the size of the Chinese economy, its vertiginous growth rate and its openness and resulting global integration coalesced to make it an influential global economy in a short span of three decades. While it has come to have a discernable sway over the global economy, its influence over, and integration into, the Asian economy is far more. Little wonder it has become the cynosure of academic and business communities as well as that for the public policy makers. The market-oriented economic reforms and restructuring that China implemented were unique and delivered the much-vaunted economic renaissance. The so-called open-door policy, which was instrumental in China’s U-turn, was not a firmly determined blueprint of macroeconomic transformation but was essentially based on gradual, incremental and experimental changes. This reform paradigm was flexible and adaptable in the face of constraints. Pragmatism was its hallmark. The reform was christened the dual-rack approach, which implied creation of a mix of plan and market-economy systems. It entailed maintenance of the old planned track and creation of a new market-oriented track. The old SOE sector was not dismantled but it was shrunk gradually, although its size is still large. Waning of state support for the SOEs and leaving this sector to compete with the non-SOE sector at a later stage in the reform process helped in moving the economy toward the market system, an invaluable objective. Expansion of the FIEs played a crucial role in the success of reforms. One of the most vital factors for the success of reforms in China was that it unleashed the forces of competition in the economy, albeit after some initial hesitation. The economy maintained high saving and investment rates. In the later period there were concerns regarding overinvestment in the economy, leading to inefficient utilization of resources. Efforts were made to rein in the investment rate, but they did not always succeed. The onechild policy was adopted in a timely manner. It had the favorable impact of curbing the population growth rate, increasing public and private investment in human resources and thereby improving its quality and reducing the dependency ratio. It also contributed to improving the per capita income during the reform era. Improvement in human


capital made significant contribution to growth. The downside of this strategy is that the growth rate of labor force will slow down between 2010 and 2030. Rapid aging of population during this period is likely to constrain growth prospects. TFP growth improved during the reform period. These increases grew larger after the early 1990s. Similarly labor productivity recorded significant rise. Moving from the central planning mechanism to a market system was the single most important cause of the ongoing expansion in both TFP and labor productivity. Also, reallocation of labor from agriculture to manufacturing and services sectors is equated with labor movement from low-productivity and low-wage jobs to high-productivity and high-wage jobs. This movement also contributed to rise in labor productivity. While such episodes of brisk economic growth and globalization have occurred during the post-War period in Asia, there are good reasons to believe that going down the road China is likely to cast a much-longer shadow over the global economy than did Japan, the NIAEs and the ASEAN-4 economies. In fact, there are indications that China has had some impact over the global economy that was greater than the impact of the other AHP economies during their comparable rapid-growth periods. China’s contribution to global GDP growth since 2000 has been much larger than the other large EMEs and the AHP economies. While China is being seen as an alternative engine of global economic growth, its impact on the Asian economies is materially higher. As the economy began to liberalize, Chinese economy turned from a virtual autarky to a veritable trading power of global proportions. In 2005 it accounted for 7.5 percent of multilateral exports. By the middle of the 2000s, it became the most open economy among the comparable large EMEs. The initiation of China’s emergence as a trading powerhouse occurred in the latter half of the 1980s, when the apparel and toy manufacturing industries moved from Hong Kong to Shenzhen to exploit low wages. These firms exported a large proportion of their output. China’s trade grew at an average rate of 15 percent annually between 1978 and 2006, compared to 7 percent average annual growth rate for the multilateral trade over the same period. In 2005, the only two larger exporters than China were Germany (9.3 percent) and the US (8.7 percent). With the passage of time not only the diversity of its exports but also their geographical distribution began expanding. WTO accession in 2001 not only increased China’s trade but also influenced its trade structure. China’s imports from the neighboring Asian

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economies recorded sharp increases and it ran large trade deficits vis-à-vis these economies. China’s rapid growth has been identified as a major source of economic dynamism for these neighboring economies. The EU, Japan and the US have been China’s largest export markets for a long time. China’s penetration into their import markets went on increasing from year to year. China has been running trade surplus vis-à-vis the EU and the US. However, the most recent trend is a steady increase in Chinese exports to Africa, Eastern Europe and Latin America. One vital characteristic of China’s trade evolution is its greater specialization in production within the Asian region, particularly integration with the other AHP economies and increase in intraindustry trade. Many of the parts, components, intermediate inputs and subassemblies were imported from the neighboring Asian economies and the final products were exported to the industrial country markets. China’s participation in production networks in manufacturing processes deepened production fragmentation and integrated it with the other AHP economies of Asia. This processing trade was largely responsible for expanding China’s exports of high-value-added products and creating trade surpluses. All the imports of intermediate goods were made free of tariffs. More than half of China’s exports were such processed goods. Close to half of its imports were destined for export processing. This helped China in integrating into the regional and global supply chains. A large segment of the processed export industry was the result of investments made by the neighboring EMEs seeking lower-cost assembly of final products. One of the reasons for running trade deficit with its Asian neighbors was the development of supply chains and fragmentation of manufacturing processes in Asia. The FIEs contributed a great deal to China’s trade performance. They accounted for 15 percent of exports in 1990. In 2003, about 57 percent of total exports came from joint ventures, FIEs and wholly owned foreign subsidiaries. Another estimate computed that during 2003 and 2004 FDI accounted for 50 percent of exports and 60 percent of imports; the FIEs contributed over 20 percent annually of Chinese GDP. A noteworthy development is that after a decade of explosive growth in the electronics sector, in 2004 China overtook the US as the world’s largest exporter of advanced-technology products such as laptop computers, information technology products, cellular phones and digital cameras. Thus, China notched up another first. It must be noted that the FIEs overwhelmingly dominated both the advanced-technology and ICT manufacturing and exports. In 2005, they accounted for 90 percent of


advanced-technology exports. Also, the reasonably priced and highquality Chinese consumer products and the low-priced manufactures became popular in the industrial economy markets. One of the important strategies of the reforms was to attract FDI. To this end, the FDI regime was liberalized in several stages, and SEZs were established. Local and provincial authorities were given greater freedom to make their own plans and administrative procedures for attracting FDI. First, FDI inflows increased at a weak rate but after 1992 and more so after 1996, they recorded steady increases. The WTO accession proved to be a veritable stimulant in this regard. In 2004, China became the third-largest recipient of FDI in the world after the UK and the US. Although FDI receipts were close to 3 percent of the GDP, they did make a contribution in improving the productivity of investment and eventually TFP growth. Essentially due to progressively large flows of FDI, by the late 1990s, China developed a distinct dual economy. The first subeconomy comprised the FDI-supported FIEs sector, which included joint venture between the foreign companies and the domestic enterprises. The second part of the dual economy was the non-FDI fragment of the manufacturing, agriculture and majority of services. In 2007 domestic economic conditions were favorable to growth. However, short-term policy measures were underway for moderating the GDP growth rate, because it has been higher than planned. Efforts to influence the two principal drivers of growth have been continuing. Therefore, in the medium-term, moderation of economic growth is on the cards. After three decades of brisk GDP growth, the economy has developed several structural flaws, the most conspicuous being the weaknesses in the financial and banking sector. They need to be ameliorated. Furthermore, the economy needs to be rebalanced. This calls for strategic shifts which should successfully address many of the current discrepancies in the economy. Making these shifts is a stupendous challenge but has begun receiving attention from the policy makers. Its economic successes are moving China toward the center of the global economic stage. As China’s economic presence has grown globally, expectations of a leadership role have increased. One of the first areas of leadership can be being a role model for the developing economies. They can take a leaf or two from the unique success story of China. Also, in this role it can help in reshaping global economic, financial and trade architecture in such a manner that the developing economies and the EMEs receive fairer treatment. It is being seen as a potential leader for the developing and emerging-market economies. It is also being blamed for some of the economic problems of the global economy.


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A Chinese Renaissance 85 Heytens, P. and H. Zebregs. 2003. “How Fast Can China Grow?” in W. Tseng and M. Rodlauer (eds) China Competing in the World Economy. Washington DC. International Monetary Fund. pp. 8–29. Hormats, R.D. 2007. “Foreign Holdings of US Debt: Is Our Economy Vulnerable?” Testimony in front of the House Budget Committee, the US Congress, in Washington DC, on June 26. Hsiao, F.S.T. and M.C. Hsiao. 2004. “The Chaotic Attraction of Foreign Direct Investment: Why China?” Journal of Asian Economics. Vol. 15. No. 4. pp. 641–70. Hu, Z.L. and M.S. Khan. 1997. “Why is China Growing So Fast?” Washington DC. International Monetary Fund. IMF Staff Paper. No. 96/75. Huang, Y. 2003a. Selling China: Foreign Direct Investment during the Reform Era. New York. Cambridge University Press. Huang, Y. 2003b. “Foreign Direct Investment in China.” Paper presented at the Carnegie Endowment for International Peace, Washington DC, on January 16. Ianchovichina, E. and W. Martin. 2006. “Trade Impact of China’s World Trade Organization Accession.” Asian Economic Policy Review. Vol. 1. No. 1. pp. 45–65. International Labor Organization (ILO). 2007. Labor and Social Trends in ASEAN 2007. Bangkok, Thailand. International Monetary Fund (IMF). 2006. Regional Economic Outlook: Asia and Pacific. Washington DC. International Trade Statistics 2006. Geneva, Switzerland. World Trade Organization. Jackson, R. and N. Howe. 2004. The Graying of the Middle Kingdom: The Demographics and Economics of Retirement Policy in China. Washington DC. Center for Strategic and International Studies. Jianwu, H. and L. Shantong. 2007. “China’s Economic Prospects, 2006–2020.” Washington DC. Carnegie Endowment. Carnegie Paper No. 30. April. Johnson, S. 2007. “The Rise of Sovereign Wealth Fund.” Finance and Development. Vol. 44. No. 3. pp. 56–57. Jones, R., H. Kierzkowski and C. Lurong. 2004. “What Does the Evidence Tell Us about Fragmentation and Outsourcing?” International Review of Economics and Finance. Vol. 14. No. 3. pp. 305–16. Kahn, J. and J. Yardley. 2007. “As China Roars, Pollution Reaches Deadly Extremes.” The New York Times. August, 26. p. 7. Keidel, A. 2006. “China Succeeding beyond Expectations.” Presented at the conference on China and the World Economy organized by the Atlantic Council, in Washington DC, on January 16. Kraay, A. 2000. “Household Saving in China.” World Bank Economic Review. Vol. 14. No. 3. pp. 33–72. Krueger, A.O. 2005. “China and the Global Economy.” Paper presented at the American Enterprise Institute, Washington DC, on January 10, 2005. Krugman, P. 1994. “The Myth of Asia’s Miracle.” Foreign Affairs. Vol. 73. No. 1. pp. 62–78. Kuijs, L. 2006. “How Will China’s Saving-Investment Balance Evolve?” Washington DC. World Bank. Policy Research Working Paper No. 3958. July. Kuijs, L. and Y. Wang. 2005. “China’s Pattern of Growth: Moving to Sustainability and Reducing Inequality.” China and the World Economy. Vol. 14. No. 1. pp. 1–14.

86 The Chinese Economic Renaissance Lall, S. and M. Albaladejo. 2004. “China’s Competitive Performance: A Threat to East Asian Manufactured Exports?” World Development. Vol. 32. No. 9. pp. 1441–66. Lardy, N. 2002. Integrating China into the Global Economy. Washington DC. Brookings Institution Press. Lardy, N. 1998. China’s Unfinished Economic Revolution. Washingon DC. The Brookings Institution. Lau, L.J. and J. Park. 2003. “The Sources of East Asian Economic Growth Revisited.” Paper presented at the Tsinghua University, Beijing, March 26. Lau, L.J., Y. Qian and G. Roland. 2001. “The Dual-Track Approach to Reform.” Journal of Political Economy. Vol. 108. No. 1. pp. 422–27. Lemoine, F. 2000. “FDI and Opening Up of Chinese Economy.” Paris. Centre d’Etudes Prospectives et d’Information Internationale. CEPII Working Paper 2000-11. Liang, H. 2005. “China’s Ascent: Can the Middle Kingdom Meet Its Dreams?” Global Economic Paper No. 133. New York. Goldman Sachs. Lipsky, J. 2007. Paper presented on “Understanding China” at the conference on Global Implications of China’s Trade, Investment and Growth by the International Monetary Fund in Washington DC, on April 6, 2007. Lo, C. 2005. “China’s Economic Threat: Myth or Truth?” Paper presented at the conference on China’s Development and Global Role organized by the Swedish Institute of International Affairs, Stockholm, on 25 November. Loayza, N., K. Schmidt-Hebbel and L. Serven. 2000. “What Drives Private Saving Across the World?” Review of Economics and Statistics. Vol. 82. No. 2. pp. 165–81. Lovell, J. 2006. The Great Wall: China against the World. Toronto. Viking Canada. Maddison, A. 1998. Chinese Economic Performance in the Long Run. Paris. Organization for Economic Cooperation and Development. Development Center. Mankiw, N.G., D. Romer and D. Weil. 1992. “A Contribution to Empirical Economic Growth.” Quarterly Journal of Economics. Vol. 107. No. 2. pp. 407–37. McKinsey Global Institute (MGI). 2007. “From ‘Made in China’ to ‘Sold in China’: A Rise of the Chinese Urban Consumer.” San Francisco, CA. November. McKinsey Global Institute (MGI). 2006. Putting China’s Capital to Work: The Value Financial System Reform. San Francisco, CA. May. Modigliani, F. and S.H. Cao. 2004. “The Chinese Saving Puzzle and the Life-Cycle Hypothesis. Journal of Economic Literature. Vol. 42. No. 1. pp. 145–70. Naughton, B. 1996. “China’s Emergence and Prospects as a Trading Nation.” Brookings Papers on Economic Activity. No. 2. pp. 273–343. Nye, J. 2005. “The Rise of China’s Soft Power.” The Asian Wall Street Journal. December 29. p. 6. O’Neill, J., S.B. Kim and M. Buchanan. 2006. “Globalization and Disinflation: Can Anyone Else Do a China?” Global Economic Paper No. 147. New York. Goldman Sachs. Organization for Economic Cooperation and Development (OECD). 2007. China: OECD Review of Innovation Policy. Paris. Organization for Economic Cooperation and Development (OECD). 2005a. OECD Economic Survey: China. Paris. Vol. 2005/13. September.

A Chinese Renaissance 87 Organization for Economic Cooperation and Development (OECD). 2005b. “Modal Estimates of Services Barriers.” Paris. November 8. TD/TC/WP (2005) 36. Organization for Economic Cooperation and Development (OECD). 2005c. “China Overtakes the US as World’s Leading Exporter of Information Technology Goods.” Paris. December 12. Available on the Internet at http:// www.oecd. org/document/60/0,2340,en_2649_201185_35834236_1_1_1_1,00.html. Organization for Economic Cooperation and Development (OECD). 2003. China’s Tariff Regime. Paris. Center for Cooperation with Non-Members. Overmyer, M. 2006. “WTO: Year Five.” The China Business Review. December. Available on the Internet at http://www.chinabusinessreview.com/public/ 0601/overmyer.html. Perkins, D.H. 2006. “China’s Recent Economic Performance and Future Prospects.” Asian Economic Policy Review. Vol. 1. No. 1. pp. 15–40. Perkins, D.H. and T.G. Rawski. 2007. “Forecasting China’s Economic Growth over the Next Two Decades.” Cambridge, MA. Harvard University. Department of Economics. Available on the Internet at http://post.economics.harvard.edu/ faculty/perkins/papers/Chaptr20.pdf. Prasad, E.S. and T. Rumbaug. 2004. “Overview” in E. Prasad (ed.) China’s Growth and Integration into the World Economy. Washington DC. International Monetary Fund. Occasional Paper 232. pp. 1–4. Prasad, E.S. and T. Rumbaugh. 2003. “Beyond the Great Wall.” Finance and Development. December 2003. pp. 46–51. Qiao, H. 2006. “Will China Grow Old before Getting Rich?” New York. Goldman Sachs. Goldman Economic Paper No. 138. Qing, H. 2007. “China’s Development, An Opportunity, Not a Threat.” The People’s Daily. Beijing. January 23. p. 6. Quarterly Update. 2007. Beijing. World Bank. May. Rodrik, D. 2006a. “Social Cost of Foreign Exchange Reserves.” Paper presented at the American Economic Association meeting in Boston, on January 16. Rodrik, D. 2006b. “What’s So Special about China’s Exports?” China and the World Economy. Vol. 14. No. 5. pp. 1–19. Rumbaug, T. and N. Blancher. 2004. “International Trade and the Challenges of WTO Accession” in E. Prasad (ed.) China’s Growth and Integration into the World Economy. Washington DC. International Monetary Fund. Occasional Paper No. 232. pp. 5–13. Sachs, J.D. and W.T. Woo. 2003. “China’s Economic Growth after WTO Membership.” Journal of Chinese Economic and Business Studies. Vol. 1. No. 1. pp. 1–31. Sachs, J.D. and W.T. Woo. 1997. “Understanding China’s Economic Performance.” Cambridge, MA. Harvard University. Harvard Institute of Economic Research. Working Paper No. 575. Shiu, A. and A. Heshmati. 2006. “Technical Change and Total Factor Productivity Growth for Chinese Provinces.” Bonn, Germany. Forschungsinstitut zur Zukunft der Arbeit. Discussion Paper No. 2133. May. Shiue, C and W. Keller. 2004a. “Markets in China and Europe on the Eve of the Industrial Revolution.” Cambridge, MA. National Bureau of Economic Research. Working Paper 10778. September.

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Shiue, C. and W. Keller. 2004b. “Market Integration and Economic Development: A Long-Run Comparison.” Cambridge, MA. National Bureau of Economic Research. Working Paper 10300. February. Stiglitz, J.E. 2007. “Towards a New Model of Development.” Paper presented at the China Development Forum in Beijing, China, on March 16. Stiglitz, J.E. 2006. “China and the Global Economy: Challenges, Opportunities and Responsibilities” in L.S. Ho and R. Ash (eds) China, Hong Kong and the World Economy. Basingstoke. Palgrave Macmillan Ltd. pp. 17–31. Streifel, S. 2006. “Impact of China and India on Global Commodity Markets.” Background paper for Dancing with Giants. Washington DC. The World Bank. Summers, L.H. 2006. “Reflections on Global Account Imbalances.” L.K. Jha memorial lecture delivered at the Reserve Bank of India, Mumbai, India, on March 24. Tanaka, A. 2006. “Global and Regional Geo-Strategic Implications of China’s Emergence.” Asian Economic Policy Review. Vol. 1. No. 1. pp.180–96. Tang, F. 2007. “Investing in China: A New Era.” Sir Gordan Wu Lecture delivered in Chasen Institute of International Business, Columbia Business School, New York, on May 10. Tanner, M.S. 2004. “China Rethinks Unrest.” The Washington Quarterly. Vol. 27. No. 3. pp. 137–56. Tseng, W. and H.H. Zebregs. 2002. “Foreign Direct Investment in China: Some Lessons.” Washington DC. International Monetary Fund. Discussion Paper No. PDP/02/03. United Nations Conference on Trade and Development (UNCTAD). 2007. UNCTAD Investment Brief. No. 2. New York and Geneva. April. United Nations Conference on Trade and Development (UNCTAD). 2006. World Investment Report. New York and Geneva. April. United Nations Conference on Trade and Development (UNCTAD). 2005. World Investment Report. New York and Geneva. April. United States International Trade Commission (USITC). 2007. The Year in Trade 2006. 58th Report. Washington DC. July. United States Trade Representative (USTR). 2006. “US-China Trade Relations: Entering a New Phase.” Washington DC. February. Wagner, J. 2007. “Export and Productivity: Comparable Evidence for 14 Countries.” Washington DC. The World Bank. Policy Research Working Paper No. 4418. November. Wang, Y. and Y. Yao. 2003. “Sources of China’s Economic Growth 1952–1999: Incorporating Human Capital Formation.” China Economic Review. Vol. 14. No. 1. pp. 32–52. Watts, J. 2007. “Beijing Blames Pollutants for Rise in Killer Cancers.” Guardian. May 22. p. 6. Whally, J. 2006. China in the World Trading System.” CESifo Economic Studies. Vol. 52. No. 2. pp. 215–45. Whally, J. and X. Xin. 2006. “China’s FDI and Non-FDI Economies and the Sustainability of Future High Chinese Growth.” Cambridge, MA. National Bureau of Economic Research. Working Paper No. 12249. May. The World Bank (WB). 2007. “Cost of Pollution in China.” Washington DC. February.

A Chinese Renaissance 89 The World Bank (WB). 2001. Globalization, Growth and Poverty. Building an Inclusive World Economy. Washington DC. May. World Development Indicators 2007 (WDI). Washington DC. The World Bank. April. World Development Indicators 2006 (WDI). Washington DC. The World Bank. April. World Economic Outlook (WEO). 2007. Washington DC. International Monetary Fund. October. World Economic Outlook (WEO). 2005. Washington DC. International Monetary Fund. April. World Economic Outlook (WEO). 2004. Washington DC. International Monetary Fund. April. World Investment Prospects. 2007. The Columbia Program on International Investment. New York. USA. Columbia University. September. World Trade Organization (WTO). 2007. International Trade Statistics 2007. Geneva. Switzerland. November. World Trade Organization (WTO). 2002. Annual Report 2002. Geneva. Wu, Y. 2004. China’s Economic Growth: A Miracle with Chinese Characteristics. London and New York. Routledge. Xu, G. and R. Wang. 2007. “The Effect of Foreign Direct Investment on Domestic Capital Formation.” Global Economy Journal. Vol. 7. No. 2. Article 1. Yi, K.M. 2003. “Can Vertical Specialization Explain the Growth of World Trade?” Journal of Political Economy. Vol. 111. No. 1. pp. 52–102. Yi, J. 2006. “China’s Rapid Accumulation of Foreign Exchange Reserves.” Nottingham, UK. The University of Nottingham. China Policy Institute. Briefing Series No. 10. July. Yueh, L.Y. 2008. “Perspectives on China’s Economic Growth: Prospects and Wider Impact” in N. Dinello and S. Wong (eds) China, India and Beyond: Drivers and Limitations. Cheltenham, UK and Northampton, USA. Edward Elgar Publishing Inc. (forthcoming). Yusuf, S. and K. Nabeshima. 2006. China’s Development Priorities. Washington DC. The World Bank. Yusuf, S., K. Nabeshima and D.H. Perkins. 2006. “China and India Reshape Global Industrial Geography” in L.A. Winters and S. Yusuf (eds) in Dancing With Giants. Washington DC. The World Bank. pp. 35–66. Zeng, D.Z. and S. Wang. 2007. “China and the Knowledge Economy: Challenges and Opportunities.” Washington DC. World Bank Policy Research Working Paper No. 4223. May. Zheng, Y. and J. Yi. 2007. “China’s Rapid Accumulation of Foreign Exchange Reserves and Its Policy Implications.” China and the World Economy. Vol. 15. No. 1. pp. 1–25.

2 A Chinese Renaissance in an Unremittingly Integrating Regional Economy

2.1

Introduction

The vertiginous GDP growth rate of China has been having major ramifications for leading industrial economies, which have been assessing what it will mean for them. However, this process of calculation will be most serious, if not frenzied, in China’s immediate neighborhood because both the national and regional economies in Asia will have to bear the principal brunt of China’s rapid growth. Owing to its economy’s size, its openness and rapidity of its GDP growth, China is certain to sway the growth trajectories of the neighboring Asian economies as well as that of the regional economy. When a significant-size economy is growing almost three times as rapidly as the global economy, the neighboring economies cannot possibly be expected to remain impervious. The question whether China’s rapid growth should be seen as a menace to the regional economies or as an opportunity has been frequently posed in the national and regional fora. Whether individual regional economies will be squeezed out or all the boats will rise due to the tidal wave created by China’s rapid economic expansion is a wholly legitimate concern of the public-policy-making community. The ongoing liberalization of the financial and external sectors in China has been manifestly influencing the Asian economies, many of which are rapidly growing high-performing economies in their own right. Several Asian economies are widely regarded as seasoned high performers. Before China did, they won well-deserved accolades such as “miracle” economies and sobriquets such as “Asian dragons” and “Asian tigers.” Although the region was marred by the Asian crisis a decade ago, it was an aberration not normality.

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China’s re-emergence into the economic world is three decades old. Neither its process of growth has matured nor is China a matured economy as yet. However, in the process of maturing, China is progressively absorbing increasing quantities of primary products, parts, components and subassemblies as well as capital goods and investment from its regional partner economies. An entirely new pattern of regional trade and investment has emerged in this short time span. China’s trade and investment has affected the other regional economies both directly and indirectly. Direct effects arose from China’s bilateral trade and investment relationship with the other individual regional economies. Indirect effects arose from the way in which China’s trade and investment changed the economic circumstances faced by the other economies. That China has been causing a major economic flux in the region has been obvious. In this dynamic scenario regional economies can expect one thing for certain: transformation in their economic circumstances. This calls for an adjustment and thoughtful and well-calibrated repositioning of their economies by regional policy mandarins. Although some Asian economies and some sectors will face adverse effects—short- or long-term—of China’s rapid growth, the apocalyptic predictions are grossly overdone. For the most part, the impact of China’s rapid growth can be mutually beneficial and finally firm up as a symbiotic relationship between China and its neighboring Asian economies. However, this cannot happen without the adoption of policy flexibility and well-timed judicious measures by the individual national governments.

2.2 China and the Asian economies: Two plausible scenarios To answer the query whether China’s economic ascent is a threat or an opportunity, one must begin from the incontrovertible fact that the Asian economies, including the emerging-market Asian economies, have a good deal of diversity among them. They are on differing stages of growth, both in subgroups and individually. Their resource endowments vary appreciably. It is because of this range of variation among them that even after half a century Kaname Akamatsu’s (1961) oft-quoted allegory of “the flying geese paradigm” still applies to the Asian economies. In this benign paradigm, the complementarities among the Asian economies were essentially derived from the level of economic development. Therefore, China’s economic impact will vary from

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economy to economy. As these complementarities created a logical division of labor between the Asian economies, they were not expected to obstruct but support each other’s growth. Accordingly, China’s trade expansion is an opportunity for the other AHP economies. As China grows and integrates with the neighboring Asian economies, it will continue to systematically sway them through various economic channels, in particular, trade and financial. The significance of the trade channel increased after, first, China’s proactive participation in the regional production networks and, second, its accession to the World Trade Organization (WTO) in 2001. According to this viewpoint, Asian economies would mutually prop each other up and reinforce the growth of the region. A flourishing and globally integrated China is good for the region. With Japan, it can become the second regional locomotive for growth. There is a fervent dissenting view that sees Asian economies largely as competing economies. Some analysts do not find the flying geese paradigm correct and applicable to the Asian economies. Ozawa (2003) has criticized the flying geese paradigm for its empirical oversight and ideological flaws. Critics have found discrepancies in the model, which crept in for ignoring the effect of globalization, product cycle and foreign direct investment (FDI) and technological and structural changes. According to this stance, Asian economies do not have large differences in stages of economic development, factor endowment, technological capabilities and production costs. Consequently, they produce products that are close substitutes. Accordingly, competition among them would be keen. They should be logically expected to be rivals for market shares in the third-country markets. If this dissenting hypothesis is correct, China’s emergence is detrimental for the neighboring Asian economies. Harmony of the flying geese formation led by Japan, and followed by the NIAEs, the ASEAN-4 and China, in that order, has been interrupted by the emergence of China as a large economy that is highly, first, grew trade-oriented and, then, intensely competitive. If recent growth in various knowledge and technology indicators is taken into account, international competitiveness of the Chinese economy has been on the rise. The concept of international competitiveness created controversy in economics (Krugman, 1994), but here we are using it in Michael Porter’s (1990) meaning of the term, which implies the ability of a country’s firms to command world markets. The Competitiveness of the Chinese economy has risen markedly among the regional economies and has extensively influenced production and the foreign investment pattern among the EMEs of Asia. It became a concern for the policy


makers in government as well as in businesses (Adams, et al., 2006). Judging by the current trend, in the near future, it will be more competitive than it is at present. The reason provided by this group of dissenting analysts is that in a short span of three decades China has become exceedingly competitive not only in labor-intensive products but also in technology- and skill-intensive manufactured products. China, a high-saving and high-investing economy, has also emerged as the largest recipient of external capital in the region and it still has a large pool of low-wage industrious labor force. Consequently, complementarity among the Asian economies based on the level of development— leading to a division of labor among the Asian economies—will be supplanted by intense competition with China. There is a third possibility, which emerges out of the two possibilities noted above. That is, both the above scenarios many pan out for different Asian economies and for different industrial sectors. Some of them may not be disturbed and the benign “flying geese paradigm” might hold, while others may come under competitive pressure from China and suffer dislocation of some their industrial sectors. Furthermore, China’s competitive pressure may be sector specific and may be felt in some sectors intensely, where the Asian economies are forced to seek a comparative advantage in new industrial sectors, while it may not be severe in other sectors. Generalizations in this regard are fraught with the danger of reaching incorrect conclusions. If the perspective of the dissenting group of analysts is correct, some of the Asian economies, particularly the ASEAN-4, the South Asian and the other low-income economies, will be adversely affected because of their inability to compete with the well-oiled and flourishing exporting mechanism that China has created. China’s growing manufacturing clout is sure to undermine the region’s domestic manufacturing industries, particularly of the above-mentioned group of economies. They will come under pressure to locate new areas of a comparative advantage. China will also deflect and deprive this subgroup of Asian economies of much-needed foreign investment. The ultimate impact would be slackened growth, rendering convergence difficult for this subgroup of economies. Empirical research concluded that China and India competed only in 25 percent of their products that are exported to the third-country markets. In some product categories they can become each others’ export markets. China’s rapid multilateral trade growth and expansion into third-country markets is likely to affect the trade growth of many Asian economies, including India. The general equilibrium model,

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using the Global Trade Analysis Project (GTAP) database, revealed that India will likely experience a fall in its economic welfare, along with a fall in the GDP (quantity) by about $359 million over the shock period. India’s loss of welfare will largely emanate from deterioration in its terms-of-trade in several of its export lines (Cerra et al., 2005; Das, 2006). 2.2.1 Upgrading the technology base I have stated above that competitiveness of the Chinese economy is on its way up. In keeping with neoclassical growth principles, the AHP economies paid a great deal of attention to technological progress. China demonstrated an impressive ability to upgrade its technology to produce increasingly complex manufactured products and has been further investing in technology and advanced skills. Over the preceding two decades, in the processing of becoming the world’s leading manufacturer of mass-produced industrial products, China successfully absorbed a broad range of codified industrial technologies. It proved to be superior to the other EMEs in absorbing and harnessing codified technologies. There were several factors that contributed to it in the past, including a low-wage, reasonably skilled, labor force that has a perfectly elastic supply (see Section 1.1.4); broad-based education reforms; the private sector’s entry into the provision of tertiary education; and the additional emphasis on science and technology education because they are the pillars of future industrial development in sophisticated areas. Large and growing investment in plant and equipment lowered its average age in China to seven years. In the US, the average age of plant and equipment is 17 years (BCG, 2006). To be sure, FDI inflows helped China a great deal in technological upgradation. Going by the trend, it can reasonably expect to go on receiving around $60 billion worth of FDI annually in the foreseeable future. After 1990, China’s R&D investment went on increasing at a rapid rate, and by 2004 it edged past the four NIAEs. In 2006, China went past Japan in R&D spending, with $136 billion compared to $130 billion spent by Japan. On a PPP basis, in comparison to the AHP economies and the EMEs, China’s outlay on R&D is among the highest in the world (Yusuf and Nabeshima, 2007). The four NIAEs are technologically considerably more advanced than China and are R&D savvy economies. Japan is even more so. China has one of the largest pools of scientists and engineers in the world. In terms of the number of R&D personnel (811,000), China is second after the US (1,943,000). Business enterprises have started playing an active role in R&D, both as financers and conductors. Patenting increased dramatically since 1995, both in


terms of patent applications and patent granted. China’s position improved from 15th in the world in terms of the listed scientific publications in 1990 to the 5th in 2003 (Zeng and Wang, 2007).1 The latest trend that is developing in this area is establishment of national laboratories in key scientific disciplines and launching of industrial parks, some of which are world-class. In the context of competitiveness, one cannot ignore that market size is a unique advantage that China has over the other AHP economies. It is exploiting this advantage to realize scale economies, which are beyond the reach of the other AHP economies. With an objective to enhance competitiveness, China has been progressively upgrading its technology. The pressing need to achieve this objective is not only being felt to be able to compete with the other AHP economies but also because the returns on the existing product lines have been diminishing. Domestic technological upgrading is seen by the Chinese firms as a source of augmenting profits and reducing dependency on foreign sources of technology. Its basic advantages also include reduction in energy and resource coefficients of its GDP. As the global energy and resource prices have been on a rising trend, technology upgrading would help offset it (Yusuf and Nabeshima, 2007). The National Congress of the Communist Party of China (CPC) is the highest body within the CPC.2 During the 17th Congress of the CPC, which was held in October 2007, the PSC decided to focus more on promoting R&D and technological upgrading of China’s industrialization process. High-technology sectors such as telecom, information technology, machinery and precision equipment are going to be the focus of policy attention in the foreseeable future. 2.2.2 Expansion of intraregional trade and vertical specialization China’s trade strategy is comparable to those of the other AHP economies. All the AHP economies, at various points in time, adopted export-led growth strategies by creating a supportive macroeconomic environment and providing microeconomic incentives. As these economies grew, their intraregional trade developed at a rapid rate and more than doubled over the last three decades. This intratrade expansion was assisted by falling trade costs due to declining trade barriers (both tariffs and nontariffs), falling transport and freight charges, advances in the information and communications technology (ICT) and development of regional production networks. While in the late 1970s only 20 percent of their total exports were made to each other by the Asian economies,

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the present proportion of intratrade is almost half of their total trade. The average share of total trade growth due to intratrade in the AHP economies soared from 42.5 percent during 1986–90 to 75 percent in 1996–2000. This is much higher than that in the other regions of the global economy. Pari passu economic linkages among the AHP economies continuously strengthened. The robust outer-oriented growth performance of the Chinese economy was also an important causal factor behind the rising proportion of intraregional trade among the AHP economies. Exports of the AHP economies are dominated by manufactures. In 2002, China absorbed 14 percent of the total exports of the other AHP economies; it also accounted for 32 percent of the total export growth of this country group (Zebregs, 2004). While rising intratrade is an indicator of the fact that the reliance of the AHP economies on the large industrial-country markets has been diminishing, the EU, Japan and the US continued to be large markets for these economies, absorbing a third of their total exports. Whether the reliance of the AHP economies has declined or not is partly dependent on how much the rise in intratrade is driven by domestic demand and how much by external demand from the large industrial-country markets. Greater integration through trade would naturally imply that China and the other AHP economies can count on progressively increasing future influence on each other. As briefly referred to in Section 1.3.1, a large part of the increase in intratrade among the AHP economies was the result of ongoing dispersion or splitting of production processes leading to networked production and vertical specialization of trade. It is also known as production fragmentation or slicing the value-chain. Regional supply chains and outsourcing are a part of this process. This phenomenon has transformed the fundamental nature of multilateral trade. Intraregional trade in Asia has been affected more by vertical specialization than the other regions of the global economy. 2.2.3 Functioning of regional production networks Intensification of regional production networks has become a veritable channel for influencing each other’s economies. The genesis of production networks dates back to 1960s, when they were first set up in electronics and apparel industries in the NIAEs. Since then, multinational production networks have evolved and spread into numerous industries. The principal ones being sports footwear, automobile, aircrafts, television, sewing machines, office equipment, power and machine tools, digital cameras, watches, printing equipment and publishing. The beginning


of the process of networked-production is to locate parts of the production process in different countries. The decision regarding locations was made on the basis of the comparative advantage, that is, in the possible locations the lowest-cost country was chosen for manufacturing a certain part or component. The development and growth of well-defined production networks affected both the volume and composition of intraregional trade in Asia. They underlie Asia’s growth, industrial growth and integration. The vertical specialization of the production process divided it in such a manner that assembly operations of products, which are based on standardized technology and are repetitive, are commonly performed in a low-wage country. As opposed to this, a high-wage economy specializes in producing specific parts, components and subassemblies, which are generally technology- or skill-intensive. Production fragmentation has been a continuous dynamic process, which helped China in moving from low-technology manufactures to high-technology manufactures. Although a large part of the latter-category products are assembled from imports of components from the other AHP economies, gradually there has also been considerable deepening of local content. The local component-supplying firms included a large proportion of joint ventures, FIEs set up by foreign firms and the TNCs that were making investment in China (see Section 1.3). China’s integration with the global economy predominantly transpired through the FIEs. They have come to have a vital place in its industrial structure. Further developments in slicing the value-chains have recently resulted in relocating higher-value-added production processes in countries that have a comparative advantage in producing them. This mode of production for exporting is termed “processed exports.” The final product can be assembled from the imported parts in more than one location. Before it could be assembled, the product would cross several national borders, often more than once. Two of the recent trends in the international splitting of production process are: First, due to advances in modular technology some parts of the production processes have emerged as the standardized fragments, which can be effectively used in a number of products or industries. Second, as the international networks of parts and components developed and became definite, producers of final products in the industrial economies began moving final assembly plants of an increasing range of consumer durables to overseas locations so that they can be closer to the final consumer markets. This allowed them to take advantage of the low-wage labor in the new locations (Athukorala, 2006; Brown et al., 2004).

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The rapidly expanding Chinese economy has played a significant role in the growth of networked production and the development of intratrade in the region. A significant share of imports for processing for exports is a convincing proof of this fact. In essence, China’s rise as a manufacturing economy of global prominence is inseparable from the emergence of networked production and regional and global supplychains in a large array of products. During the last two decades, China emerged as the focal point of production networks spanning the other AHP economies. It has become the location of choice for the final assembly of a broad range of products, particularly in areas such as electronics and IT hardware. These final assembly operations are essentially carried out by joint ventures, FIEs and subsidiaries of the TNCs. The destination of the final product that emerges from this mode of production, that is, vertical specialization, is usually the industrial-country markets of the EU, Japan and the US. To be sure, the dependence of the AHP economies on the import demand from these large markets has declined, but only by a small proportion. Fragmentation-based specialization became an important part of the economic landscape in Asia. Vertical specialization has changed the nature of international trade in the AHP economies. It has, inter alia, contributed to the volume of trade. Trade in parts and components has been expanding at a much faster rate than that in conventional finalgood trade. Intermediate goods or fragmentation-based trade make up a significant part of the intraregional trade. For the individual AHP economies, the proportion of intermediate goods in total exports steadily rose. Indeed, it has led to the growth of trade volume not only in Asia, but also multilaterally (Yi, 2003; Jones et al., 2004). While China has been remarkably successful in networked production, it has begun suffering from a limitation of this system. China’s individual firms found themselves locked in a downward spiral of intense cost-based competition with other local firms. In the past, in many areas this competition became intense. The industrial sector comprises a large number of small firms that produce standardized products and compete with each other on the basis of price. These standardized products are manufactured for both TNCs and the large Chinese brandname companies such as Haier, Legend, Changhong and Konka. It is a valid question to ask why Chinese firms became successful at complex manufacturing processes and enter the supply chains, without much success in controlling them. Even firms producing brand-name products could not succeed in achieving a sustainable competitive advantage. Steinfeld (2004) believes that this was due to the fact that the Chinese


firms were structured in such a manner that made them good at competing on the basis of low cost in a low-value manufacturing activity, which could be even in technologically sophisticated areas. This undoubtedly worked for them as their strength, but it did not allow them to move upward into nonsubstitutable, higher-return activities, which included establishing brand names, maintaining their control over brands and providing unique services. Therefore, Chinese managers are often blamed for “limited managerial vision” (Engardio et al., 2007). So long as Chinese firms and managers are not able to inculcate the business savoir-faire in these important areas, they will have to go on manufacturing items as a part of networked production and compete on the basis of prices with each other. This would not only cut their profit margins razor thin but also impede them from moving up and making their mark in the world of business. Without becoming TNCs, they will have to go on participating in networked production for the TNCs. 2.2.4 Effects of vertical specialization on China’s trade configuration Vertical Specialization and China’s rapidly growing trade have been recognized as important economic phenomena, which have enormous regional economic impact. China’s trade went on becoming progressively vertically specialized over time. One of the early estimates made by Rumbaug and Blancher (2004) noted that China’s exports have a high share of imported items from the neighboring Asian economies, which in turn portends to the fact that China’s trade expansion is closely linked to its trade with the regional partners. The ratio of Chinese imports for processing trade to total imports increased from 35 percent in the early 1990s to 50 percent in 1997. As much as 40 percent of China’s total exports contain imports from the other AHP economies during this period. A more recent estimate, based on 2005 statistics, put 42 percent of China’s imports for the purpose of processing trade and 55 percent of China’s exports were the result of vertical specialization (Dean et al., 2007). A product-specific indication of increasing level of vertical specialization is given by a rapid increase in imports of integrated circuits (ICs) and microassemblies, which are key components in the assembly of a range of electronic products. Kwan (2002) concluded that Asian economies stand to gain mutually more by furthering integrating production lines and sharing the benefits of vertical specialization in trade. In 2002, vertical specialization was as high as 30.8 percent in Chinese exports to the US. That is, in every dollar worth of exports to the US,

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intermediate inputs were worth 30.8 cents. For Chinese exports to the rest of the world this proportion was 35.9 percent (Dean et al., 2007). As regards the sources of intermediate inputs, Japan and the four NIAEs accounted for more than half of inputs by value. The ASEAN-4 economies were also among the suppliers, but not as important as the first subgroup. Vertical specialization was maximum, more than 50 percent, in plastic products, steel processing, communication equipment, industrial machinery, metal products and computers. The FIEs were the most active in vertical specialization and trade. There are strong indications that suggest that vertical integration in China’s global trade is on the rise, particularly in China’s exports to the EU and the US. 2.2.5 China’s competitive threat in various technology categories In a short span of three decades China’s export composition moved up the technology ladder, from resource-based and labor-intensive or lowtechnology to medium- and high-technology products (see Section 1.3). This upgrade of export composition took place not only in China but also in the other AHP economies. We need to see how technological upgrading would influence mutual trade and economic relations. The highest share of simple products was to be found in Indonesian exports because of the large presence of resource-based products. The highest share of complex, high-technology products was found in the exports from the Philippines because of large increases in semiconductor exports. In terms of technological depth, the Republic of Korea (hereinafter Korea) had the deepest manufacturing sector, followed by Taiwan and Singapore (Lall and Albaladejo, 2004). As China upgraded its export composition, it entered the product spaces of the other AHP economies. China’s SEZs have begun producing advanced technology exportables. With China’s lower labor cost, it was normal for China to compete with the exports of the other AHP economies, and in some cases displace them. However, exports of the South Asian economies, dominated by India, presented a contrasting picture. While China’s resource-based and low-technology exports as a proportion of total exports were on a decline, for the South Asian economies they were increasing. Also, while China’s export prices in dollar terms rose over the 2003–07 period due to domestic and external reasons, they rose less than the prices of the other comparable exporters. Lall and Albaladejo (2004) selected 230 products at the Standard International Trade Classification (SITC) three-digit level to compare the regional export structure. They found enlightening similarities in


export composition of China and the other AHP economies. Correlation coefficients between the export structures of Chinese and other regional economies revealed that “in 2000, the Chinese export structure was most similar to that of Taiwan in 1990, with significant similarities also to Korea and Hong Kong in 1990.” Hong Kong, Taiwan and Thailand were found to have highly similar export structures. While these similarities implied that there was a possibility for competition among these economies, it did not provide any proof that such competition existed. Also, if it did exist, to what extent the exports of the other AHP were being displaced by China. The SITC product categories are broad and each category includes products that do not compete with each other. Also, when products are same, different economies and producers are likely to specialize in differentiated versions, reducing potential for competition among them. Therefore, assumption of a head-on competition between China and all the other AHP economies may not hold. In the process of expanding its exports in an entire spectrum of technology range of products, China successfully ousted the low-technology products of the NIAEs from the industrial-country markets. The exports of the ASEAN-4 economies in the same technology category were also affected. Because of higher labor costs this country group will continue to find it difficult to compete with China in the third-country markets in low- and medium-technology products. Therefore, the MFA abolition worked against the ASEAN-4 economies. It was difficult for them to advance in terms of quality, design and marketing scale sufficiently to retain their market niche textile and apparel. China’s threat in mediumtechnology products, such as autos, machinery, simple electronics, has also been growing. In the foreseeable future, in the medium-technology product areas, China will be a major challenge to the NIAEs. 2.2.6 Has China turned into an outlier? In the preceding section, I noted that China’s export upgradation from low-technology, labor-intensive exports to high-technology exports was swift. How has the rapid technological upgradation affected China’s pattern of production is a vitally important development to reckon its impact over the neighboring Asian economies. Rodrik (2006) concurs and goes a step further in calling China an “outlier in terms of the overall sophistication of its exports.” He elaborated by saying that “… its export bundle is that of a country with an income-per-capita level three times higher than China’s. It has somehow managed to latch on to advanced, high-technology products that one would not normally expect a poor, labor-abundant country like China to produce, let alone export.”

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If China’s pattern of production and trade was based on the principle of comparative advantage, it would have looked very different from what it presently is. Schott (2006) posited that if composition of exports is squarely based on a comparative advantage alone, China’s export structure should have resembled that of Vietnam closely, not that of Japan or Germany. Obviously, much more than comparative advantage free market forces have played a role in determining the present structure of China’s production and trade. In a rapidly growing developing economy, comparative advantage does not necessarily have to determine the trade pattern. Technological sophistication in such an economy can be above what the principle of comparative advantage indicates and rationalizes. Such an economy is able to generate investment in nontraditional, higher-productivity tradables by successfully adapting advanced technology and creating a macroeconomic environment appropriate for producing and microeconomic incentives for promoting high-technology exportables. By so doing some developing countries are able to produce exports that are appropriate for economies at a much higher level of per capita incomes. They are able to climb the “quality ladder” in what they produce and export (Schott, 2006). In accordance with this line of logic, China’s export profile was found to be skewed toward high productivity goods. In 1992, China’s exports were associated with an income level that was more than six times higher than China’s per capita GDP. China has become a successful exporter of consumer electronics, an area in which countries at China’s level of per capital level are not expected to be successful. Estimates made by the McKinsey Global Institute (2003)3 show that labor productivity in China’s consumer electronics industry is equal to that in Mexico, whose PPP-adjusted per capita income is twice that of China. That said, Chinese high-technology exports or electronics products tend to be low-cost, high-volume products. Their technological sophistication is usually low. The newest trend in this regard is that China is steadily making overtures to move away from being a mere assembler of consumer electronics products for exporting. Progressively, production is being integrated backward, and the supply chain is moving to where the assembly is undertaken. Thus, China’s consumer electronics industry is a proof of it making a productivity leap (Rodrik, 2006).

2.3

China’s trade expansion and the Asian economies

China’s influence over the AHP economies through the trade channel is indubitably going to be enormous. In this section, we shall analyze both its degree and dimension. At the time of launching of reforms, China


was virtually an autarky, accounting for 0.6 percent share in the multilateral trade in 1977 (see Section 1.3). In 2004, it was the third-largest trading economy in the world, accounted for 7.3 percent of the total multilateral exports and 6.3 percent of total imports (WTO, 2006). China’s rapid growth and integration into a regional economy significantly influenced the trade and its composition in the region. China developed into a strong link with the other Asian economies in the fragmented production process discussed above. Owing to its lowwage, hard-working and reasonably skilled labor force it was understandably seen by the other neighboring AHP economies as the most appropriate location for finally assembling their export products, which draws parts, components and subassemblies from the other regional economies. Furthermore, many AHP economies also went on moving those parts of their manufacturing operations into China in which they thought China had a comparative advantage. The final outcome was sizeable increase in intratrade in the region. Several analysts concur regarding the four NIAEs and China having complementary trade structures.4 Therefore, this subgroup of economies benefited directly from China’s brisk trade expansion. In terms of the stage of economic development—and therefore the general technological standard in the economies—China and the ASEAN-4 economies follow the four NIAEs. These phenomena in turn determine the comparative advantage of the economies. As the NIAEs move up the technological ladder, the product space vacated by them should be logically filled by economies that are at a slightly lower rung of development and technology. Both China and the ASEAN-4 economies are the appropriate candidates for filling the product space left vacant by the NIAEs. Accordingly, they have begun manufacturing higher-valueadded products. As noted above, the NIAEs are active participants with China in production chain management in the region. They have been active suppliers of intermediate goods to China, which are then finally assembled into finished products and exported to industrial-country markets. It would be correct to say that this kind of harmonious regional division of labor, which is in accordance with complementarities, was originally visualized by Kaname Akamatsu (1961). The Asian economies that manufacture comparable range of products as China does will have to compete with China, particularly in laborintensive goods. Given China’s intense competitive prowess, these economies are likely to come under intense competitive pressure. The ASEAN-4 would be the highly affected set of economies by such competition. So would some of the South Asian ones, in certain sectors of their exports. In the short-term, China is likely to cause resource

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dislocation in these economies in specific sectors. The textile and apparel is one important contender. However, in the medium- or longterm other sectors in the economy may benefit from association with the Chinese economy and these economies may not end up as net losers. As China has been moving up the value-added chain, the NIAEs need to cautiously expect China to be their competitor in the highertechnology products in the future. Looking back a couple of decades, it is easy to see how China’s exports have evolved. In 1990, when the economy was partially open, China’s export composition was dominated by textiles and apparel and other relatively low-value-added labor-intensive manufactures. As elaborated in Section 1.3, China’s export composition evolved continuously since then. As technology standards improved, its export base diversified into higher-technology, higher-value-added products, and the global dispersion of exports grew. After 2000, China’s global market share increased in an impressive range of high-technology products. In 2004, China overtook the US as the world’s largest exporter of advanced-technology products (OECD, 2005). 2.3.1 Explanation of the co-movement in trade If the growth rate of nominal dollar value of exports of China and Hong Kong SAR5 (excluding their mutual trade), on the one hand, and the Asian economies (both Southeast and South Asia),6 on the other, are graphed for the 1979–2005 period, they display a striking, if not somewhat surprising, co-movement. Such a close co-movement between the exports from China and those from the neighboring Asian economies can only be due to the fact that they operated under the influence of analogous factors (Ahearne et al., 2006). These factors could include (i) the growth rate of the large industrial-country markets, which continue to be significant importers of the products of China and its neighboring Asian economies, (ii) movements in the world market prices of principal traded products (say semiconductor) from this region (iii) performance of the global economy and (iv) movements of the yen-dollar exchange rate. For a long time, many Asian economies had pegged their currencies, implicitly or explicitly, to the dollar. Therefore, exports in all these economies would react identically to changes in the yen/dollar exchange rate. Thus viewed, the indistinguishable trend in export growth over the long-term can be taken to mean that exports of both China and its Asian neighbors were determined more by common determinants during the period under consideration. If so, competition between the two had a lesser effect on them. Had competition between the two been the determining factor


behind exports, the co-movement would not have been as close as it appears. No doubt they competed in the US market, but competition was a minor variable. In addition, growth in vertical integration between China and the Asian economies, discussed above (see Sections 2.2.1 and 2.2.2), further provides an explanation for the close co-movement. Vertical integration of trade would logically contribute to similarity in growth rate of exports. To be sure, one can itemize China-specific factors that helped in growth and strengthening of its external sector. They include the post1978 macroeconomic reforms and restructuring, the external sector reforms which were accelerated after 1994, high rates of saving and investment, FDI, VAT rebates for exporters, currency devaluation of 19947 and the WTO accession. While they had a definite qualitative and quantitative impact over China’s export performance, it were the common shocks to the external sector that resulted in striking similarity in export trend between China and the neighboring Asian economies. 2.3.2 Country- and sector-specific differences Anxiety regarding China ousting its Asian neighbors from their export markets is rampant in some policy-making conclaves. If considerable loss of markets or market shares is the cost to the other AHP economies of China’s aggressive trade expansion, it is indeed something to worry about. Whether China’s aggressive trade expansion would crowd out its Asian neighbors from their markets can be judged from a close analysis of their trade data. Several empirical and econometric exercises were attempted to reckon the impact of China’s rapid growth, including export growth, on its Asian neighbors. A post-WTO accession study of China’s trade expansion was conducted by Ianchovichina and Walmsley (2003). This simulation exercise simulated a multicountry, multisector model of international trade and found that China’s exports were going to increase but those of Indonesia, Malaysia, the Philippines and Vietnam were going to decline due to a negative impact on their textiles and apparel exports. However, exports of Japan and the NIAEs were found to increase due to increase in their exports to China; processed goods exports from China were going to play a role in this increase. As important suppliers to China, Japan and the NIAEs were also going to experience an improvement in their terms-of-trade (TOT). Ahearne et al. (2003) used annual trade data series for the 1981–2001 period for the four NIAEs, the ASEAN-4 and China to quantify the impact. Their regression analysis, which included country-specific effects and lagged-dependent and lagged-independent variables, found

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that coefficients on Chinese exports tended to be positive. This was suggestive of complementarities between China’s exports and those of Asian neighbors. However, the effect rarely approached statistical significance at standard coefficient levels. It led them to conclude that China’s exports did not reduce the exports of its Asian neighbors. Indeed, it appeared that the two were positively correlated. Using a CGE model, the IMF (2004) conducted another simulation exercise.8 It was designed to capture the geographical and sectoral trade flows. This study found a negative impact over the NIAES and the ASEAN-4 economies, with the ASEAN-4 losing larger market shares than the NIAEs. The average impact on the South Asian economies was smallest, essentially because these economies are small trading economies. As stated above (see Section 2.1), the precise effect varies from sector to sector and economy to economy. Economies that are labor-intensive in their export composition and have a large textile and apparel export sector experienced the worst negative impact. Ahearne et al. (2006) juxtaposed large amount of trade data for China, the NIAEs, the ASEAN-4 and South Asian economies (Bangladesh, India and Pakistan) to see if China’s market share increased in the US market vis-à-vis the other three groups in any of the 47 industrial categories they picked up as a sample, during the 1989–2005 period. They compared the aggregate and sectoral statistical data. The changing trade shares provided a long-term perspective on budding trends. This comparison revealed that, first, China’s market share in the US market increased in 41 industries, while that of the NIAEs in only 4 for the period under review. The share of NIAEs declining implied presence of competition with China, leading to shifting market shares. However, it could equally mean NIAEs moving up the value-added chain, into industrial sectors that are not or less labor-intensive. Second, the ASEAN-4 recorded increase in market share in 17 industries. That is, the number of cases of increase of China’s market share and those of the ASEAN-4 economies was almost the same. The number of cases of declining market shares for the two was also similar. However, in cases where the ASEAN-4 economies increased their market share, it was much smaller in magnitude than that of China. Overall market share of the ASEAN-4 slipped. This country group lost a lot of its market share to China. The losing process became particularly conspicuous between 2001 and 2005, which clearly implied that China was successfully out-competing the ASEAN-4 economies in the US market. Third, interestingly the South Asian economies recorded an increase in the market shares in 30 industries, albeit this subregion’s overall share of the US market was very


small. Rising market shares indicated the future possibilities, that is, this subregion was preparing to be a contender of export shares in time to come. The overall market share of this subgroup in the US market did not change and remained small. Four, trade statistics for China did provide an impression of their moving into the product space vacated by the NIAEs. As these are technologically more advanced economies of Asia, they were relinquishing some sectors into which China moved. This is inconsistent with the “flying geese paradigm.” However, as stated above, China has also displaced some Asian economies in the US market, which was symptomatic of strong competition. Changes in methodology usually have an impact on conclusions regarding the country-and sector-specific impact of China’s trade expansion on the neighboring Asia. Eichengreen et al. (2006) used the gravity model, a conventional device for estimating the effect of a variety of phenomena on international trade, to ascertain this impact. Results of this econometric exercise show that China’s growth has a different impact over the better-off Asian economies like the NIAEs from that over the poor economies. Also, exporters of capital and intermediate goods were affected differently from those of consumer goods. The crowding out effect in the third-country markets was felt only by less-developed, lower-income, Asian economies in consumer goods. It was not felt in the third-country markets of capital goods, where more advanced Asian economies were the principal exporters. The machinery and equipment companies from the NIAEs were not adversely affected by China’s exports. This was logical because it was the generic consumer goods markets that were penetrated by the Chinese exporters in the initial stages, not those of advanced-technology machinery and equipment. Although the poorer Asian economies did lose in the third-country markets due to competition from China, their loss was partially made up by increasing Chinese imports from the same group of countries. Asian economies that benefited more and directly from increasing Chinese imports were the NIAEs; they exported capital goods and intermediate inputs to China. Income elasticity for imports for these categories of products is high for China at this stage in its growth. Thus, the so-called China effect over the regional economies is different for more and less developed economies of Asia. The South Asian economies, which so far have not borne the brunt of Chinese competitive pressure in the third-country markets, have significant possibilities of expanding their trade with China and benefit from it. Batra (2004) estimated a gravity model, with a focus on India, using a crosssection equation, confirmed such a conclusion.

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The Global Trade Analysis Project (GTAP) model and database have been extensively used for the purpose of estimating the impact of changes in trends in international trade. Developed at Purdue University, the GTAP is a CGE model that computes in detail the geographic and sectoral structure of trade flows. It is a static model and takes resource endowments and technology as constants. Ianchovichina and Martin (2006) used GTAP-5 database and took into account the production networks between China and the neighboring Asian economies. The results of this exercise show that from the post-WTO accession and trade expansion, the NIAEs, particularly Taiwan, benefit most among the Asian economies. Most of these benefits are associated with domestic trade liberalization in China and MFA quota removal. China’s domestic trade liberalization and expansion will have a mixed effect on the Southeast and South Asian economies. The apparel industry in all the Southeast Asian economies will be hurt with the dismantling of the MFA quotas. The ASIAN-4 and the South Asian economies that cannot compete with China in textiles and apparel may lose from the MFA quota removal. Loss to Vietnam was estimated to be large (1.4 percent drop in per capita income), while that to India small (0.4 percent loss in per capita income). While planned reduction in tariffs and NTBs in China offered a great deal of opportunities to the developing economies of Asia, they lose in some sectors while gain in some others, depending upon whether the competition effect is stronger than the complementarity effect.

2.4

FDI inflows into China and the Asian economies

Establishment of a legal framework for inviting FDI, rapid real GDP growth, improvements in investment climate, establishing and expanding SEZs and multiphased liberalization of FDI regime made China an attractive economy for regional and global FDI-making businesses and TNCs (see Section 1.4). The early 1990s was a period of strong expansion of FDI receipts in China as well as in the ASEAN economies. Before China became a big draw for FDI, the ASEAN economies did exceedingly well in attracting FDI and had a global reputation for having aggressive and attractive FDI regimes. This observation applied particularly to Indonesia, Malaysia, Singapore, the Philippines and Thailand. For all the years between 1991 and 1998, Malaysia, Singapore and Thailand received more FDI than larger regional economies such as Japan, Korea and Taiwan. However, the Asian crisis (1997–98) radically changed the


established mise-en-scène . FDI inflows plummeted dramatically in several Asian economies and never fully recovered. Financial press in Korea, Malaysia, Singapore, Taiwan and Thailand frequently raised the issue of China’s success being at the expense of its Asian neighbors in the local and regional media. The Asia director of the World Economic Forum, Frank J. Richter, warned Asian economies regarding their investment climate in their domestic economies.9 China’s growing FDI inflows, even in periods when the global FDI took a downturn, remained steady. This caused anxiety among the rival neighboring Asian economies, particular the ASEAN economies. In 1990, the ASEAN economies received 51 percent of total Asia-bound FDI; in 2001 this proportion shrank to 11 percent. In the early 1990s, China used to receive close to 18 percent of the total FDI bound for developing economies of Asia, by 2000 China accounted for 30 percent. Statistical evidence of diversion is clearly there. Some of the ASEAN economies even blamed China for “intercepting” the FDI that was destined to them. A valid reason for decline in the FDI to the Asian economies was slowing outflows from the EU and the US. Secondly, the Asian crisis can justly be blamed for exposing the structural weaknesses of the ASEAN and other Asian economies, rendering them somewhat less attractive to global investors. In case of India and the other South Asian economies, the allegation of China’s rapid growth affecting FDI inflows is not made because these economies were not a favorite destination for the regional and global investing firms and the TNCs. For a long time during the post-War period their GDP growth rate remained feeble and these countries maintained an inward-oriented economic policy regime, dominated by a domineering public sector. Policy makers were poorly disposed toward FDI and had a strong bias against exports until recently. Their FDI regime was unwelcoming; its liberalization began late and progressed at a tardy pace. Only in recent years, they have begun their endeavor to attract FDI. 2.4.1 China’s ability to entice regional and global FDI An increasing amount of FDI has been flowing to China because, inter alia, of its labor costs are lower than that of the competing Asian economies. Any foreign investor who is interested in producing laborintensive and low- or medium-technology products for sale in the industrial economies should logically prefer China to the Asian economies. Since the late 1990s, China has been producing and exporting

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high-technology products as well. Also, a large number of foreign investors and TNCs that are already producing these categories of products in China saw it fit to reinvest their profits there because by so doing they could also preclude further geographical diversification of their production facilities, which could potentially affect their cost structure adversely. Japan has been a vociferous critic of China eating the lunch of the other Asian economies. It is interesting to note that even the Japanese firms increased their investment in China substantially in recent past because it offered significant advantages over the other neighboring Asian economies. The most important one was the lower labor cost in China. In a pragmatic manner, China also went on improving its FDI policy regime. In 1992, 1994 and 1996 more FDI liberalization policy measures were taken, further facilitating their inflows and eventually making China a premier FDI destination. Recent FDI increases in China were caused by its WTO accession, which was a noteworthy structural factor. The WTO membership earned China the most-favored-nation (MFN) status, which is an invaluable gain for an economy that attracts large FDI in its export industries. The pre-WTO-membership environment had risks of an important trade partner not renewing China’s MFN status, and in the process obstructing exports originating from China. Accession brought the risk premium in the export-oriented industries down to zero, in the process enhancing the draw of China as a FDI destination. A related factor was that the WTO accession also increased China’s reliability as a source economy for the trading partners. Thus, this one important development caused some loss of FDI flows to the rival Asian economies (Das, 2007). That in the post-WTO-membership period investors’ preference for China increased was apparent from the annual survey that the Japan Bank of International Cooperation ( JBIC) conducts among the large Japanese firms and TNCs. One of the survey questions asked was to indicate in order of preference the ten most favored countries for locating manufacturing industries. Between 2000 and 2001, the proportion of large Japanese firms and TNCs naming China as the most favored location increased from 65 percent to 82 percent. Concurrently, mention of the ASEAN economies steadily declined between 1996 and 2000. Also, the gap between China and US, in terms of favorite destinations for FDI, improved in China’s favor. They were ranked first and second, respectively, in 2000 and 2001 by the Japanese firms. In 2000, this ratio was 65:41, while in 2001 it became 82:32. That is, the gap widened from 24 percentage points to 50 percentage points, assigning China a higher position on their scale.10


2.4.2 Did China receive excessive FDI? In absolute terms, China has emerged as the largest EME recipient of FDI. However, when global averages are compared, China does not appear to be a dominant recipient of FDI. Has it been receiving FDI incompatible with the size of the economy? China is the second-largest economy in Asia. Its FDI receipts so far are compatible with its size and the domestic market. If anything, they are somewhat lower than justified by the size of Chinese economy and natural and human resources. FDI is barely 10 percent of its fixed investment, which is much lower than the global average. In the World Investment Report 200211 a benchmarking tool was devised, namely, Inward FDI Performance Index. It is simply the ratio of a country’s share in global FDI flows to its share in global GDP. It is an instrument of comparing the relative performance of countries attracting FDI. A value of unity means that the shares of global FDI flows and global GDP are equal. A country with an index that is greater than unity is reckoned to have received more FDI than justified by the size of the GDP. This index is an indicator of the country having advantages in production or better growth prospects or superior investment environment. Lower than unity value of the index implies that the country in question is protectionist or technologically backward or has a political or social system that is not conducive to investment, including FDI. Index values were computed for two periods, 1988–1990 and 1998–2000. Table 2.1 below provides the values and ranks for the Inward FDI Performance Index for the Asian economies for both the periods: Table 2.1 Inward FDI Performance Index for the AHP economies Country

Singapore Hong Kong SAR Malaysia Thailand The Philippines Taiwan China Indonesia Korea (Republic of ) Japan Average for Asia

1988–1990

1998–2000

Value

Rank

Value

Rank

13.8 5.4 4.4 2.6 1.7 0.9 0.9 0.8 0.5 0.0 1.07

1 4 8 25 39 58 61 63 93 128 —

2.2 4.9 1.2 1.3 0.6 0.3 1.2 ⫺0.6 0.6 0.1 0.85

18 2 44 41 89 112 47 138 87 131 —

Source: The United Nations Conference on Trade and Development. World Investment Report 2002. New York. Table II.1. p. 25. Note: Value in the above table does not have a denomination because it is a number.

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As FDI tends to be lumpy by nature, these ratios were computed as three-year averages. During the first period, Singapore topped the index value. Its share of FDI was 13.8 times the share of its GDP in the global economy. Hong Kong SAR also did extremely well. Malaysia, Thailand, the Philippines and Taiwan were all in the first half of the index list computed for 170 countries. However, the post–Asian crisis values of the index were markedly lower. Their rankings dropped precipitously in a short period of a decade. Singapore lost its top position and was ranked the 18th, although Hong Kong SAR was one economy that recorded improvement during the second period by improving its ranking to the 2nd place. Conversely, Malaysia and Thailand slid sharply downward with rankings of 44 and 41, respectively. The Philippines, Taiwan and Indonesia slipped to even worse positions. They found places in the lower half of the table with rankings of 89, 112 and 138, respectively. This demonstrates a dramatic reversal in the capability of the ASEAN economies of attracting FDI (as seen in the above table). This country group lost its old status as attractive destinations for the global FDI flows. Both China and Korea managed to improve their rankings over the two periods. Of the two, China recorded an improvement from 61 to 47, an upward motion by 14 places, whereas Korea improved its rank from 93 to 87, an upward motion by 6 places. According to the Inward FDI Performance Index, China’s performance cannot be rated as high or impressive, like that of Singapore and Hong Kong SAR during the first period. No doubt there was an improvement in its ranking, its performance in attracting FDI has been merely above average. China’s index value was 1.2 in the second period, which was a small improvement over that in the first period when it was 0.9, which was even less than unity. Even after the jolt of the Asian crisis, China was ranked below Malaysia, Singapore and Thailand. Computation and comparison of the Inward FDI Performance Index vividly demonstrated that China’s share of global FDI flows has not been out of proportion. Notwithstanding the fact that FDI flows to China dramatically spurted in 1992 and again in the 2000s, they only kept pace with China’s strong real GDP growth performance. Relative to the size of their GDP, during the decade of the 1990s, many neighboring Asian economies had performed better than China in attracting global FDI (Das, 2007). Therefore, the allegation of excessive FDI receipt by China is not reasonable and that it did not receive FDI incompatible with the size of the economy.


2.4.3 China and the Asian economies: A zero-sum-game assumption The general perception of the antagonists that an absolute increase in China’s FDI has been at the expense of its Asian neighbors is based on “the assumption that FDI is a zero-sum game” (Wu et al., 2002). If this assumption is correct, every time there is a rise in the FDI flows to China, there should be a corresponding decline in flows to the ASEAN and the other Asian economies. Casual empiricism fails to establish such a correspondence. Such an assumption is flawed because there were periods when both ASEAN economies and China received higher FDI at the same time. One such period was 1989–97, when both of them shared an increasing FDI trend. In case of China it soared from $3.4 billion to $44.0 billion, whereas for the ASEAN economies it soared from $7.6 billion to $27.0 billion during the period under consideration. This does not justify the assumption that China benefited at the expense of its neighboring economies. A number of empirical studies have addressed different aspects of this issue. Regression analysis by Chantasasavat et al. (2004) attempted to estimate the impact of inward FDI flows into China on eight Asian economies, namely, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand for data for the 1985–2001 period. Their strategy was to control all the standard explanatory variables of FDI in the Asian economies. To proxy for China’s effect, they chose the level of FDI inflows in China. Their estimates show that the value of the coefficient for inward FDI into China was positive and highly significant in all the specifications. They concluded that China’s FDI receipts and those of the Asian economies were positively correlated, not negatively. A 10 percent increase in FDI inflows into China was estimated to raise the level of FDI inflows into the eight Asian economies they considered for their empirical analysis by about 2 percent to 3 percent. Thus, they convincingly concluded that increasing FDI in China was not at the expense of the Asian economies but, if anything, they benefited from it. One explanation for this increase could be the production networks among the Asian economies, of which China is an integral part. In addition, Asian economies are heavily involved in vertical trade specialization with China (see Section 1.3.2), which could lead to increasing FDI in them when FDI flows into China increase. Another detailed empirical exercise (McKibbin and Woo, 2003) concluded that changing direction of FDI in Asia would lead to welfare losses in the ASEAN-4 economies “only if the ASEAN-4 economies fail

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to absorb new foreign technologies quickly and to engage in indigenous technical innovation.” In the past, the ASEAN-4 economies were decidedly and amply technology conscious and one can see no reason why they would not continue to be so in the face of Chinese challenge. Mercereau (2005) tried to estimate China’s share of total FDI to the region to capture whether there was a crowding out effect or not. His regression analysis was performed on data for 14 Asian economies for the 1984–2002 period. This definition of crowding out effect showed that in only two economies, Myanmar and Singapore, there was an evidence of crowding out. A caveat is essential here, that is, these regressions were estimated by panel ordinary least square (OLS) analysis and therefore suffered from the endogeneity defect. A gravity model estimate by Eichengreen and Tong (2005 and 2006) also found China’s FDI inflows having a positive impact on the other Asian economies, leading to an increase in FDI in them. The higherincome Asian neighbors received greater boost in terms of FDI inflows than the lower-income-level neighbors. This could be explained by the increasing vertical specialization of trade in Asia and establishment of supply chains. The first group of Asian economies produced far more parts, components and capital equipment for final production and assembly operations in China than the second. Thus, the better-off Asian economies, which are more integrated with the Chinese economy by way of production networks, benefit more from rising FDI levels in China. This would make the catching-up endeavors of the second group of Asian economies with the high-income economies an uphill task.

2.5 A strategy for coping with China’s economic expansion The above exposition brings to fore that some neighboring Asian economies will need to bear the cost of China’s rapid growth and aggressive trade expansion. They will accordingly need to make macroeconomic adjustments. Increased FDI inflows into China are also being seen by some Asian policy makers as a threat. The flip side of the coin is that there would be some Asian economies that would benefit from China’s rapid growth. A large briskly growing economy is known to affect the neighboring smaller economies favorably. The pull force or locomotive effect of the US economy over Mexico and that of Japan over the Asian economies are the cases in point. As many of China’s neighbors are regarded as high-performing economies in their own right and have earned global accolade for their


post-war economic dynamism, they need not be overly daunted by China’s competitive prowess. Many of them have created successful niches for themselves in the global economy (Das, 2005). Competition from China will affect this dynamic group less because for the most part these high-income Asian economies will be able to cope with it and come up with strategic responses. In fact, given their past alacrity and entrepreneurial drive, they should be able to more than fend for themselves. For the relatively lower-income Asian economies that cannot take China’s competition head-on, one of the best strategies to minimize the cost and maximize the benefits of China’s economic expansion would be to adopt flexibility in movement of productive resources. Flexible factor markets would succeed in adjusting to the changing trade patterns. They can be instrumental in drawing down productive resources from the declining sectors, which cannot face intense market competition, and move them to the expanding sectors that can hold on their own. The second effective line of defense for the Asian economies that have been chafing under intensifying competition from China would be to further advance their reforms of the external sector. Reforms would help exporting industries in accessing inputs at world-market prices, which are necessary to support export expansion in the global marketplace. They would also facilitate growth of new export sectors where competition is not yet intense. Third, the preceding half century of development experience provides evidence of the fact that developing economies having strong institutions and well-thought-out macroeconomic policies are quick to make necessary economic adjustments when needed. Such economies were also found to grow faster and converge in a short period of time (Crafts and Kaiser, 2004). If the Asian developing economies, particularly the low-income ones, ensure that the rule of law works, particularly contract law and company law, ascertain high degree of transparency in the government system, guard against corruption and implement sound macroeconomic policies, they would gradually be able to not only cope with but also benefit from China’s rapid economic expansion. Fourth, to retard the loss of FDI inflows due to competition from China, Asian policy makers can also embark on policy measures that improve their FDI regimes’ competitiveness. In so doing they can take a leaf from China’s successful strategy, although many Asian economies understand this strategy well. In addition, higher investment in education and skill accumulation as well as consciously upgrading technology levels in the economy would indeed prove helpful in attracting global

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FDI. Also, if they succeed in strengthening the link between the academic and business worlds, it should help the Asian economies tackle the Chinese challenge better and also in moving up the industrialization ladder. Fifth, in Section 2.2 I have focused on the concerted endeavors that China has been making to advance technologically and move up the technology ladder. In the foreseeable future, as China advances and catches up with the higher-income Asian economies, namely, NIAEs, the two will become direct competitors in the third-country markets. Also, China’s dependence on parts, components and capital equipment from this group of economies will substantially decline because China would be able to produce them on its own. When this happens, the lower-income economies of Southeast and South Asia will have the necessary space for economic growth. Under these circumstances, it is plausible that China will not be in direct competition with them in the arenas of trade and FDI. China will no longer slow down the convergence process of their income levels and economic structures. Sixth, proactive support for regional cooperation and integration would go a long way in benefiting the regional economies, particularly the low-income ones. So far, the basic drive for de facto regional cooperation and integration has been more between the Eastern and Southeast Asian economies. As the GDP growth rate of South Asian economies, particularly India, has picked up momentum, it would indeed be worth including this subgroup of economies in the regional cooperation and integration designs. This would create opportunities for new complementarities and division of labor between haves and have-nots in the region. Furthermore, it would lead to realistic possibilities of South Asian economies benefiting from the dynamism of China and the other East and Southeast Asian economies. To be sure, such broad-based regional cooperation and integration cannot be expected to take place easily. However, for the first time there is evidence of political will that supports such a broad-based endeavor.

2.6 China’s regional integration posture and recent initiatives Sensitive to the allegation of disrupting and dislocating the performance of the regional neighbors and not oblivious to the need of harmonious and mutually beneficial economic ties with the neighbors, China endeavored to manage its economic relations by proactively endeavoring to create free-trade agreements (FTAs). In the early years of the reform


period, China’s penchant for regional integration was feeble but with the passage of time it embraced regional integration with increasing enthusiasm. The beginning was made by China’s overtures to the ASEAN economies with a proposal for a FTA in 2000. An ASEAN FreeTrade Agreement (AFTA) has existed since 1992, and 90 percent of intraASEAN trade took place at low tariff rates, between 0 percent and 5 percent tariffs (Pangestu and Gooptu, 2004). Low-keyed official efforts to strengthen economic ties between the ASEAN and China and boost mutual trade and investment had begun in 1995, which gave rise to increased economic interaction between them. An ASEAN-China FTA was signed in November 2001, which aimed at establishing a free-trade area by 2010.12 An early harvest package was offered by China in 2003, which slashed tariffs on farm imports from the ASEAN economies. It has progressed further and by mid-2005 China implemented deep tariff cuts on 7,000 products. The principal objective of this comprehensive ASEAN-China FTA was to facilitate and enlarge mutual trade and investment. Mutual reduction first and then elimination of tariffs and NTBs and trade facilitation measures—such as common standards and procedures—were the other priority objectives. This agreement is to include trade in services as well. After the FTA comes into being, member states intend to avoid double taxation, promote e-commerce and encourage business groups to strengthen channels of communications and exchange ideas. Although the ASEAN and China are not regarded as two highly complementary economies, the economic relations between the two have improved. Having an FTA with the ASEAN economies helped China allay regional fears of dominance and reassure its Asian neighbors about how China will use its rising economic prowess. The ASEAN economies were positively disposed to the FTA concept because it allowed them time to induce greater efficiency and productivity into their manufacturing sector during the first few years of the FTA.13 Using the gravity model Abraham and van Hove (2005) show that the trade potential of China’s integration into the ASEAN is very high. An FTA membership with the ASEAN would bring about a large increase in both Chinese exports and imports. These overtures by China encouraged Japan and Korea to make similar proposals to the ASEAN economies. In the Manila summit of 1999, Asian leaders agreed on broad economic cooperation and resolved to promote economic linkages among East Asian countries and the ASEAN region. In 2001, the concept of ASEAN-China FTA was broadened and this FTA began to be seen as a step toward forging an economic

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integration arrangement entailing East and Southeast Asia. That is, it was being regarded as an initiation of a more ambitious East Asia FTA, encompassing the ASEAN, China, Japan and Korea, or the so-called ASEAN-Plus-Three (APT). This FTA combines a good number of highincome Asian economies with several low-income ones. It also brings together the economies of East and Southeast Asia. A de facto APT grouping had emerged after the Kuala Lumpur ASEAN summit in 1997 to take defensive policy initiatives in the wake of the Asian crisis. Since then, the APT group members kept on meeting annually, and APT activities spread at bureaucratic, academic and cultural levels. The first APT summit was held in Phnom Penh in 2002, following the ASEAN summit. However, the downside a plethora of summits and senior official meetings, it has arguably delivered little. Reactionary regionalism in Asia is expanding beyond APT to build a new ground for an East Asian community. To this end, the first East Asian Summit (EAS) was held in December 2005. In the EAS, the APT leaders invited Australia, New Zealand and India. Some of the Asian economies were not comfortable with the inclusion of the three new entrants on the ground of weakening of common regional identity. Thus China became instrumental in giving an impetus to a Pan-Asian regional integration philosophy. China and India have been discussing about reducing tariff and NTBs. An FTA between them in the near future is well within the realm of possibilities. A joint-feasibility study was launched by the two governments in 2003. The mandate of the study group was to identify areas of mutual interest and draw up a program for further development of trade and economic cooperation. Since March 2006, the two countries have had several rounds of negotiations. The two countries plan to complete the joint-feasibility research on Regional Trade Agreement (RTA) by October 2007 and then decide whether to launch the FTA negotiations. If these two rapidly growing Asian economies can figure out a trade agreement, the vast East and South Asian markets would receive a significant boost. Since January 1, 2006, seven South Asian nations, namely, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka, are members of South Asia Free Trade Area (SAFTA). Using a gravity model, Abraham and van Hove (2005) show that China’s joining SAFTA would increase the trade potential of this FTA considerably, with India and Sri Lanka benefiting significantly. An ASEAN-India FTA study was also launched in 2005. In September 2004, the ASEAN and India had trade-ministerlevel talks, and it was agreed to establish an FTA in January 2005, with initially reducing tariffs on 105 tradables, with intentions to reduce them to zero later.


2.7


Owing to its economy’s size, its openness and rapidity of its GDP growth China is swaying the Asian economies as well as the regional economy. When a significant-size economy is growing almost three times as rapidly as the global economy, the neighboring economies cannot possibly be expected to remain impervious. Generalizations regarding the impact are fraught with the danger of reaching incorrect conclusions. Although some Asian economies and some sectors will face adverse effects—short- or long-term—of China’s rapid growth, the apocalyptic predictions are grossly overdone. For the most part, the impact of China’s rapid growth can be mutually beneficial. The intraregional trade in Asia developed at a rapid rate. This intratrade expansion was assisted by falling trade costs due to declining trade barriers (both tariffs and non-tariffs), falling transport and freight charges, advances in the information and communications technology (ICT) and development of regional production networks. China had a definite role to play in increasing intratrade. A large part of the increase in intratrade among the AHP economies was the result of the ongoing dispersion or splitting of production processes leading to vertical specialization of trade, of which China was an integral part. It is also known as production fragmentation or slicing the value-chain. This phenomenon has transformed the fundamental nature of multilateral trade. China’s trade went on to become progressively vertically specialized over time and it has developed a strong link with the other Asian economies in the fragmented production process. A significant part of Chinese imports from the regional economies are related to vertical specialization in trade. Accordingly, China’s exports have a high share of imported items from the neighboring Asian economies. In the preceding section, I noted that China’s export upgradation from low-technology, labor-intensive exports to high-technology exports was swift. They advanced up the technology ladder so rapidly that China is regarded as an outlier in terms of the overall sophistication of its exports. China’s export composition is equal to that of a country with an incomeper-capita level three times higher than China’s. China’s increasing competitiveness in the area of international trade is likely to cause intense competitive pressure for some Asian economies. The ASEAN-4 group would be the highly affected set of economies by such competition. So would some of the South Asian ones, in certain sectors of their exports. The low-income Asian economies are also likely to be adversely affected by China’s labor-intensive exports. In the short-term

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China is likely to cause resource dislocation in these economies in specific sectors. The textile and apparel sector is one important contender. If the long-term export data series of China and the rest of Asian economies are graphed, they display a striking, if not somewhat surprising, identical co-movement. This indistinguishable co-movement in export growth over the long-term can be taken to mean that exports of both China and its Asian neighbors were determined more by common determinants during the period under consideration. If so, the competition between the two has had a lesser effect on them. Estimates from econometric models show that China’s growth has a different impact over the better-off Asian economies like the NIAEs from that over the poor economies. Also, exporters of capital and intermediate goods were affected differently from those of consumer goods. The crowding-out effect in the third-country markets was felt only by lower-income, less-developed Asian economies in consumer goods. It was not felt in the third-country markets of capital goods, where more advanced Asian economies were the principal exporters. The machinery and equipment companies from the NIAEs were not adversely affected by China’s exports. This was logical because it was the generic consumer goods markets that were penetrated by the Chinese exporters in the initial stages, not those of advanced-technology machinery and equipment. The pre– and post–WTO accession reduction in tariffs and NTBs in China offered a great deal of opportunities to the developing economies of Asia; they lose in some sectors while gain in some others, depending upon whether the competition effect is stronger than the complementarity effect. The early 1990s was a period of strong expansion of FDI receipts in China as well as in the ASEAN economies. Before China became a big draw for FDI, the ASEAN economies did exceedingly well in attracting FDI and had a global reputation for having aggressive and attractive FDI regimes. A swift absolute increase in China’s receipt of FDI caused concern in the other Asian economies. However, other measures of FDI inflows show that the allegation of excessive FDI receipt by China is not reasonable and that it did not receive FDI incompatible with the size of the economy. The general perception of the antagonists that an absolute increase in China’s FDI has been at the expense of its Asian neighbors is based on the assumption that FDI is a zero-sum game. However, econometric estimates found that China’s FDI inflows have a positive impact on the other Asian economies, leading to an increase in FDI in them.


The higher-income Asian neighbors received greater boost in terms of FDI inflows than the lower-income level neighbors. This chapter spells out a basic strategy for the Asian neighboring economies for coping with China’s economic expansion. Sensitive to the allegation of disrupting and dislocating the performance of the regional neighbors, China took an initiative to manage its economic relations by proactively endeavoring to create FTAs in the region. The beginning was made by China’s overtures to the ASEAN economies with a proposal for an FTA. An AFTA had existed since 1992, and 90 percent of intra-ASEAN trade took place at low tariff rates. The concept of ASEAN-China FTA became a seed for a larger FTA in the form of APT, which is to bring together East Asian economies and Southeast Asian ones. The next, even large, regional grouping that was negotiated during the EAS in 2005 was to include Australia, New Zealand and India. A China-India FTA was also at an advanced stage of negotiation.

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Unremittingly Integrating Regional Economy 123 Lall, S. and M. Albaladejo. 2004. “China’s Competitive Performance: A Threat to East Asian Manufactured Exports?” World Development. Vol. 32. No. 9. pp. 1441–66. McKibbin, W.J. and W.T. Woo. 2003. “The Consequences of China’s WTO Accession on Its Neighbors”. Asian Economic Papers. Vol. 12. No. 2. pp. 1–38. McKinsey Global Institute. 2003. New Horizons: Multinational Company Investment in Developing Economies. San Francisco, CA. Mercereau, B. 2005. “FDI Flows to Asia: Did the Dragon Crowd Out the Tigers?” Washington DC. International Monetary Fund. Working Paper No. 05/189. Organization for Economic Cooperation and Development (OECD). 2005. “China Overtakes the US as World’s Leading Exporter of Information Technology Goods.” Paris. December 12. Available on the Internet at http:// www.oecd.org/document/60/0,2340,en_2649_201185_35834236_1_1_1_1,00. html. Ozawa, T. 2003. “Pax Americana-Led Macro-Clustering and Flying-Geese Style Catch-Up in East Asia: Mechanism of Regionalized Endogenous Growth.” Journal of Asian Economies. Vol. 13. No. 6. pp. 699–713. Pangestu, M. and S. Gooptu. 2004. “New Regionalism: Options for East Asia” in K. Krumm and H.J. Kharas (eds) East Asian Integration: A Trade Policy Agenda for Shared Growth. New York. Oxford University Press. pp. 39–58. Porter, M. 1990. The Competitive Advantage of Nations. New York. The Macmillan Press Ltd. Rodrik, D. 2006. “What’s So Special about China’s Exports?” China and the World Economy. Vol. 14. No. 5. pp. 1–19. Rumbaug, T. and N. Blancher. 2004. “International Trade and the Challenges of WTO Accession” in E. Prasad (ed.) China’s Growth and Integration into the World Economy. Washington DC. International Monetary Fund. Occasional Paper No. 232. pp. 5–13. Schott, P.K. 2006. “The Relative Sophistication of Chinese Exports.” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 12173. April. Steinfeld, E.S. 2004. “Chinese Enterprise Development and the Challenge of Global Integration” in S. Yusuf, M. Anjum and K. nabeshima (eds) Global Production Networking and Technological Change in East Asia. New York. Oxford University Press. pp. 255–96. United Nations Conference on Trade and Development (UNCTAD). 2005. World Investment Report 2005. Geneva and New York. Woo, W.T. 2004. “The Economic Impact of China’s Emergence as a Major Trading Nation.” Paper presented at the 2004 Forum on WTO, China and Asian Economies jointly organized by the Research Center for International Economics, University of Washington and Renmin University, Beijing, in Beijing, during June 18–20. World Economic Outlook (WEO). 2004. Washington DC. International Monetary Fund. April. World Trade Organization (WTO). 2006. International Trade Statistics 2006. Geneva. Switzerland. Wu, F., P.T. Siaw and Y.H. Sia. 2002. “Foreign Direct Investment to China and Southeast Asia: Has ASEAN Been Losing Out?” Economic Survey of Singapore. Third Quarter. pp. 96–115.

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3 A Chinese Renaissance in an Unremittingly Integrating Global Economy

China’s rapid economic growth has had a great impact on the global economy, but this is not a “zero-sum” game some worry about. —Joseph E. Stiglitz, 2006

3.1 China and the global economy: A fundamental repositioning The role of China in the global economy has radically increased since 1978. Its emergence as a powerhouse economy is unprecedented in its implications for the global economy. During the early reform phase, China’s resolve to globalize appeared feeble. However, with the passage of time the political leadership recognized the invaluable contribution that globalization could make to their economy. Realization of China’s impact over the global economy also dawned on them. This self-reinforcing two-way process is likely to continue in the foreseeable future. Toward the end of 2007, after the post–subprime mortgage crisis in the US economy, it seemed increasingly evident that the global economy was on the cusp of a defining historic transformation; economic power was in the process of making a secular shift from the industrial economies to China and the major emerging-market economies (EMEs). China’s economic presence in several geographical subregions steadily increased. Africa, the Caribbean, Latin America, the Middle East and South and Central Asia were the regions with which China did not have close economic and political relations. However, in the recent past, China has cultivated countries in these subregions, essentially for ensuring reliable supplies of industrial raw materials, energy as well as for 125

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developing trade. Business leaders in China tended to target those regions that were resource rich and neglected by other major economies for political or other reasons. China’s heavy investment in the oil industry of Angola, Nigeria, Sudan and the mining sector in Congo, Zambia and Zimbabwe are some cases in point. China has been assiduously developing these and other African economies as trade partners. Consequently, China’s trade with Africa grew at a rapid pace. China’s re-emergence and economic status is often compared to the growth performance of the “miracle” Asian economies that came into their own during the post-War era and carved a niche for themselves in the global economy (see Section 1.2).1 While there are many commonalities, this comparison is not entirely correct because, unlike them, China’s economic ascent, as it is progressing, is going to be to the status of an economic superpower. It has more in common with the ascent of the US economy, a trifle over a century ago, and the economy of UK, where the industrial revolution took place during 1760–1830. An appropriate comparison should therefore be made between the US and Chinese economies instead of comparing China with its modern Asian predecessors. That China’s present growth performance is comparable to that of the US and the UK is confirmed by the historical growth statistics for these two economies and post-1978 China. In Table 3.1 below, drawing on Maddison’s (2003), the growth differential of China has been compared to that of the UK and the US during the eighteenth and the nineteenth centuries. This reveals that neither the US nor the UK economy has “administered such a large shock to the global economy as has China” (Winters and Yusuf, 2007). Column 1 shows that China started with 2.9 percent of the world’s income; for 26 years its average annual growth rate was 6.6 percent higher than that of the global economy. Column 2 shows that China had an initial income world income share of 4.9 percent and for 25 years its growth differential was 4.4 percent. In comparison to this, historical growth rates of the UK and the US were much lower in terms of the growth differential. Only the US economy came close to China’s performance during the 1820–70 period, when its growth differential was 3.3 percent for five decades. Three decades of macroeconomic reforms, sustained growth and global integration have turned China into a future economic power of global magnitude, with unmatched breadth of resources and a robust manufacturing sector. The proficient political leadership of China is committed to world-class economic achievements and being an economic power to reckon with. Barring a major domestic or global economic crisis, the economy has an enormous potential to be one in the foreseeable future.

Table 3.1

Comparative industrialization

Factor for Comparison

GDP at PPP China, WDI

Industri-alizer’s initial share (%) Industri-alizer’s annual growth (%) Global annual growth rate (%) Growth differential(%) Number of years

1700–1820

UK 1820–1870

US

1978–2003

1820–1870

1870–1913

1

2

3

4

5

6

2.9 13.3 6.8 6.6 26

4.9 7.5 3.1 4.4 25

2.9 1.0 0.5 0.5 120

5.2 2.1 0.9 1.2 50

8 4.2 0.9 3.3 50

8.8 3.9 2.1 1.8 43

Source: Computed by Winters and Yusuf (2007) from Maddison (2003) and World Development Indicators, various volumes.

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1978–2004

China, Maddison

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Numerous macroeconomic projections have been made regarding the time point when the size of China’s GDP will achieve parity with that of the US, or surpass it. Goldman Sachs (2003 and 2004) projected that China could be the largest economy in the world in 2041, if appropriate macroeconomic policies are followed. However, some analysts disagree and argue that China can get there sooner (Shenkar, 2006). Even before reaching that much-vaunted status, China’s surging economy is comprehensively affecting the lives of people around the globe. Such rapid growth in an open economy cannot possibly take place in isolation. Not only China’s exports have gained significant market shares in global markets but also its rapidly increasing imports have supported strong growth performance in many countries. It has been having a good deal of impact over national economies, global businesses as well as over employment and consumption patterns. China has been swaying inflation rates, interest rates, wages, corporate profits, real estate prices in the industrial economies, and commodity and petroleum prices2 in the world markets. In pervasive ways, China has been driving “economic trends that many countries assume to be domestically determined” (The Economist, 2005). As China continues to grow, and even if this growth occurs at a somewhat moderate pace, its global economic impact will continue to ratchet up. Economies and firms in a large part of the world will need to devise their strategies to cope with the impact of China’s rapid growth. Can this be termed “dislocation” caused by Chinese rapid growth? An ingenuous answer will have to be in the negative because it is not a cyclical or transitory change that China’s growth is causing, after which circumstances will be back to normal. Our perspective needs to change. It is a fundamental structural change. Both China’s increasing economic weight and escalating integration in the global economy have been rebalancing the global economy. To be sure, some national economies will face significant challenges in adjusting to it and the adjustment process may not be effortless. There will not be a return to status quo. China’s rapid ongoing growth calls for a fundamental repositioning of both macroeconomics and microeconomies. That is, essential adjustments that are required will need imaginative strategies from both public policy makers and managers of business firms. Even households are being and will be influenced by China’ brisk growth, which has been changing relative prices and incomes. The new global economic and business milieu that is being engendered by China’s rapid growth will call for new ground rules for competing successfully. The positive supplyside shock that it has given to the global economy has far-reaching


implications (see Section 1.1.7). Both global employment and consumption patterns have been changing accordingly and will continue to change. Economies, firms and households will need to inventively prepare for these basic transformations in the global economic structure. China’s future growth trajectory will continue to matter to the global economy. 3.1.1 An unprejudiced assessment China’s rapid clip growth of the preceding three decades has made it an economic force to reckon with, not only regionally but also globally. A tangible outcome of brisk growth in an economy is amplification in the global shares of production, investment and trade. Consequently, this economy endeavors to make a new niche for itself in the global economy and formulates a new role. A lesson of economic history of the last two-and-a-half centuries is that whenever an economy starts growing rapidly, it inevitably causes some disruptions, displacement and imbalances in the prevailing status quo in the global economy. This happens more during the initial phases of vertiginous growth of this economy than in the latter. When the initial phases end, the economy emerges as a more significant global economy than it was in the past. The industrial revolution began in 1760 in Britain.3 Several episodes of such economic expansion have occurred since then. In each case the rapidly growing economy succeeded in locating a new niche in the old global economic order. The rise of a united Germany in the early nineteenth century and the US in the late nineteenth and early twentieth centuries are two cases in point. The rapid growth and global integration episodes of Japan, the NIAEs and subsequently the ASEAN-4 during the post-1955 period are some of the recent illustrations of successfully growing economies making a new niche for themselves in the global economy. China is doing something identical to what several other AHP did in the preceding half century. During their comparable rapid-growth periods Japan, the NIAEs and the ASEAN-4 economies also had similar impact over the global economy. They initially caused some disruptions and even consternation. In case of the ASEAN-4 this disruption was minor, but eventually their emergence benefited the global economy. It led to all the boats rising due to their tidal influence. The Chinese economy is presently in the throes of its initial phase of growth, expansion and global integration. Its pace has been remarkable, comparable to those of the other AHP economies. While it has faced resentment and antipathy from some quarters, a lesson of the history is

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that antagonism is hardly warranted. A realistic and dispassionate estimate of the impact of China’s economic emergence and global integration would lead one to infer that while some short- or medium-term problems are natural and to be expected, the global economy is likely to have a positive impact on balance after the initial phase of disruptions is over. However, the outcome of this problem phase would be far from uniform and its impact will necessarily vary across countries, industrial sectors and socioeconomic groups. An economy’s trade structure and its trade and investment relations with China will determine the nature and magnitude of this so-called China-effect on it. In this chapter we shall explore which countries and sectors will reap the largest opportunities and who may have to bear the heaviest adjustment burdens. As China grew to be the fourth-largest economy in the world (in 2005) in a short time span of three decades, should the other countries be apprehensive of the rapidly growing Chinese economy completely dominating the global economy and thereby inflicting harm on their economies? Let us take one prominent eye-catching variable, trade. China was a marginal trading economy and its share in world merchandise exports was 0.6 percent in 1977 (Lardy, 1998). In 2005, China accounted for 7.3 percent of the total multilateral exports and 6.3 percent of total imports (WTO, 2006). In 2004, China became the third-largest global trader. Startled noneconomists often construe that China will manufacture and export everything soon and the other economies of the world will have nothing left to trade. This is an inappropriate, if simplistic, extrapolation of the past developments to reach an illogical conclusion. In accordance with the classical principle of comparative advantage, China’s rapid growth will change the global division of labor, and it will produce goods in which it has a comparative advantage, which will be determined by its factor and organizational endowments. According to the changing division of labor, China will export goods and subsequently services in which it has a comparative advantage and import those in which it does not. As China’s status as an exporter grew, so did its status as an importer. Economies, large and small, trade on the basis of their comparative advantage, which in turn is a dynamic concept. Therefore, this apprehension is basically futile. However, what a concerned public policy maker or business decision taker needs to know is where is China going to fit in this changing global division of labor. 3.1.2 Ascendance as a soft-power of global magnitude While some government bodies and legislatures in some countries have been aggrieved by China’s economic ascendance and expressed unbridled


indignation, world public opinion does not find it startling and more or less accepts its emergence and global economic impact in an equable matter-of-fact manner. According to a 2007 multination survey conducted jointly by the Chicago Council on Global Affairs and Washingtonbased WorldPublicOpinion.Org, most people in the US and 19 other industrial and developing countries believed that the size of China’s fast-growing economy will one day be equal to that of the US economy, and that they were largely untroubled by the prospects. The survey reported that 60 percent of Americans believe that China will soon reach economic parity with the US. In 19 other countries, more people agreed with that proposition than those who disagreed. In none of the surveyed countries did majority view China’s ascendancy as a negative occurrence to be alarmed about.4 China’s potential catching up with the US is for sure a tectonic geoeconomic and geopolitical occurrence, which was not viewed by the Capitol Hill as a change in the positive direction. This stance is striking because, as noted above, overall the world public’s response to this potential development was low keyed, almost philosophical, and the middle-America concurred (Peseck, 2007). Part of the reason behind the red-meat rhetoric from the Capitol Hill was the fact that 2008 is an election year in the US. In the 1970s and 1980s, Japan inspired similar negative reaction among the US politicians. The hysterical predictions made about the Japanese economy never came true. In the recent past, China has helped the US economy by keeping the interest rates low and containing inflation by providing reasonable-priced consumer goods. Global expectations from China have been on the rise. Public opinion in Russia is not averse to China’s economic ascendance. It was reflected in Russia declaring 2007 as the year of China. A string of cultural, educational, sports and, of course, business events were planned for the year. President Hu Jintao paid a state visit to Russia in April, was warmly welcomed by the Russian political elite, numerous cooperation agreements were signed and the two sides agreed to align their stances in the international fora, including the United Nations. A public-opinion poll found that Russians think of the ascendancy of China, an old adversary, as capable of having “a positive impact on the world.”5 A decade ago, China was not public image conscious and was not accustomed to managing one. It did not have much presence in Africa, Latin America and Eastern Europe. In a small way, China’s self perception began changing under President Jiang Zemin (1993–2003), when China tried for the first time to project an image of an international player of some consequence. Under a younger leader, President Hu Jintao,

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efforts to make a global impact accelerated appreciably. In the recent years China has consciously tried to work on its public image management globally, including in Africa, Asia and Latin America, extending its charm offensive beyond the political leaders, to general public. China’s public image has been steadily improving. Its outreach endeavors included foreign aid, investment, deft diplomacy, tourism and education. In view of large accumulation of foreign exchange reserves, Chinese experts are mulling over spending ideas. An important one is to create a Chinese Peace Corps, with thousands of humanitarian workers (Newsweek, 2006). Although an emerging-market economy (EME), China’s role in the development of sub-Saharan Africa (SSA) has gone on increasing. It has sharply stepped up development assistance to SSA. It is remarkable from a country that is still among the ten largest recipients of official development assistance ( Jacoby, 2007). Chinese aid to SSA takes the form of technical assistance, grants, interest-free loans and preferential loans that have an interest subsidy and debt relief.6 These efforts began to bear fruits, and ordinary global denizens have begun to view China more warmly than ever before. Public opinion polls conducted by the Program on International Policy Attitudes and the BBC revealed that majorities of people regard China as a positive global influence, not as a threat. These sentiments were found to be particularly strong in the developing countries. A similar poll conducted by the Lowy Institute in Australia found that Australians found China as acceptable as the US.7 Historic foes such as India and Vietnam, with whom China went to war not a long time ago, are also being cultivated as future economic partners and have become a part of China’s charm campaign. With its trade surplus, foreign exchange reserves, soft loans and investments increasing, China’s influence has been on the rise and it has been emerging as a soft power of global magnitude (Bersick, 2006). 3.1.3 The geostrategic stance of peaceful ascendancy The geostrategic stance of “peaceful rise” was widely discussed among the Chinese politicians and strategists, who preferred China to be a responsible and benign power of the future. This doctrine basically posits that China can and should rise economically and acquire the status of an economic superpower peacefully. In Zhou Bian’s (2004) terms, China needs to emerge as “a gentle giant.” Notwithstanding the occasional livid threats regarding Taiwan, for the most part, China’s international relations and conduct have been that of a responsible stakeholder in the global community of nations. It did not create an


image of a spiritedly aggressive country, which is incapable of looking beyond its narrow self-interest in its international dealings. China’s political leadership gives an impression of understanding that its prosperity cannot be achieved without support and goodwill of the global community. Therefore the “peaceful rise” doctrine received the endorsement of the highest-level political leadership. So far China has not projected a hegemonic image or a surreptitious future plan of hegemony. “Reassuringly, at least in its relations with America, China for now seems to be guided more by pragmatism than by competition” (The Economist, 2006). Bijian (2005), a noted Chinese strategic thinker and the Vice President of the Central Party School, referred to China’s rise as “peaceful ascendancy,” and called it heping jueqi (see Section 1.2.2). Premier Wen Jiabao publicly discussed it eloquently and it was a part of his Harvard University speech in 2002. Since then President Hu Jintao has further refined the concept and referred to it as peaceful “development” or heping fazhan. The logic behind this change was that even the term rise may appear provocative to some. This concept has remained highly popular with the Chinese academics and strategists and many have contributed serious strategic writings in Western academic and policy journals on this theme. One rationale behind this suave line of thinking was the utterly wasteful power play of cold war era, which Chinese politicians and strategic thinkers were eager to steer clear of. The transition of power has been a complex, even a dangerous, process and needs to be dealt with in a delicate manner. In the past, it was observed that a rising power did not win the conflict because the existing powers became alarmed. If startled, an economically ascending China could possibly be thwarted by the reigning military powers, or the super power. According to this philosophy, both Germany and Japan made mistakes that led to the two World Wars. It was erroneous to aggressively plunder global resources and pursue hegemony as an all-important objective. Learning from these experiences of the last century, China is so far determined not to vie for global supremacy in a cold-war-like manner. If China’s economic rise does not take place peacefully, the other countries may become anxious and impatient to see it stopped in its tracks. Therefore, economic interdependence and the symbiotic relationship— both regionally and globally—have been important for China. It is for these considerate and sensible reasons that the Chinese political leaders “recognize the necessity of having a peaceful international environment

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if they are to achieve a great power status” (Tanaka, 2006). They express these and similar sentiments both in their domestic and international discourses. That China has become economically larger than several of the Groupof-Seven (G-7) countries is, as noted above (see Section 3.1.2), a tectonic shift in the global economy. China should logically be incorporated in deliberations on the global economic issues. This could pose a challenge to countries that dominated the global economy and institutions since the 1940s, meaning primarily the US. Supranational institutions, largely at the behest of the US, endorsed and promoted multilateral trade liberalization, open capital markets and nuclear nonproliferation, ensuring relative peace and prosperity for six decades. However, unless emerging powers like China “are incorporate into this framework, the future of these institutional regimes will be uncomfortably uncertain” (Drezner, 2007). The most telling recent illustration of this was the maladroit handling of the Asian crisis (1997–98) by the International Monetary Fund (IMF). Governments of the AHP economies were absolutely—if somewhat astringently—certain about it. While the EU has made its bilateral accommodations with China and cooperated with the other larger emerging-market economies (EMEs), whether these economies like to see their global clout trimmed and representation in the multilateral institutions pared is a moot point. 3.1.4 Modest role in the global economic fora The influential G-7 was established in 1985 to facilitate global economic and financial cooperation among the largest seven industrial nations. The summit meetings of the member nations, Canada, France, Germany, Great Britain, Italy, Japan and the United States, had begun earlier in 1975. The G-7 has been a dominant forum for deliberations and discussions. It also coordinates its members’ actions on economic, financial and commercial matters and works to assist the economies of other nations. The leaders of the G-7 nations meet annually in member countries. The Group-of-Eight (G-8), which consists of the G-7 nations plus Russia, was officially established in 1998. The US, Japan and Germany are the three largest global economies, in that order. Although in 2005 China was the fourth-largest economy, it was on course to overtake Germany in 2007. As these measures are at the market exchange rate, they grossly understate the real size of the Chinese economy. However, if adjustment is made for China’s relatively low cost of living and the nominal GDP is measured in purchasingpower-adjusted currencies, China became the second-largest economy in the world in 2004, after the US. It provided significant impulses to


global growth. Its impact on the global economy has been pronounced and growing. According to the 2004 statistical data, China is also the third-largest trading economy in the world after Germany and the US, in that order. Surging economic growth is moving the Chinese economy toward the center of the global stage, adversely affecting the hitherto overbearing authority of the Quad (Canada, the EU, Japan and the US). The business world will need to develop new global axes of operations, and in an increasingly multipolar world business and political leaders will need to have an authentically global collaborative mindset. As the realization of China’s global economic significance grew, it was invited to the G-7 deputies meeting in 2003 and to the G-7 meeting held in Boca Raton, Florida, in February 2004. However, the fourthlargest economy and the third-largest trader, China is still not a formal member of the G-7 or G-8. A G-7 without China cannot be rationally regarded as the true representative of the global economy. It does not reflect the present division of economic and financial powers and has become obsolete. Martin Wolf (2007) made a stronger proposal in his Financial Times column to replace the G-7 with a Group-of-Four (G-4), China, the Euro Zone, Japan and the US, so that a “global dialogue among the leading economic players” can take place. I concur with this suggestion. That G-7 was losing its relevance was realized by some global leaders and this realization gave birth to the concept of G-20 during the Cologne Summit of the G-7 on June 18, 1999. The leaders of the G-7 industrial economies declared their intention to work together to establish an informal mechanism for a dialogue among systemically important countries within the framework of the Bretton Woods institutional system. The intention of the G-7 leaders was to broaden the dialogue on the crucial economic and financial issues related to the global economy. The objective was to promote cooperation to achieve stable and sustainable global economic growth that benefits all. The G-20 was formally created at the September 25, 1999, meeting of the G-7 Ministers. It was launched with fanfare in December 1999 in Berlin, where the first meeting of the G-20 took place. Representatives of the EU, the International Monetary Fund (IMF) and the World Bank were made a part of G-20. The French and the Italian governments were opposed to the concept of this G-20. The reason they gave was that it would undermine the authority of the IMF. Instead, they supported the new International Monetary and Financial Committee (IMFC). The US and Japan were very much in favor of the new body. Britain, while supportive, was somewhat reserved, for fear that the G-20 might undercut in practice the prominence of the new IFMC, which Britain’s erstwhile finance

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minister Gordon Brown was chosen to initially chair. Canada threw its weight in favor of the G-20. It was largely because it wished to see a broader consultative structure that was more formalized, linked to other supranational institutions and less controlled by the US. The G-20 was chaired for its first two years by the Canadian Finance Minister, Paul Martin, who declared that the mandate of the G-20 was to “promote discussion and study and review policy issues among industrialized countries and emerging markets with a view to promoting international financial stability.” Its initial 18 country members consisted, in addition to the G-7, of Argentina, Australia, Brazil, China, India, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey. Canada hosted the second meeting in 2000. It was decided that the chair would rotate among participants with two-year terms, and with the initial chairs being chosen from among the G-7 countries. Over the years the G-20 emerged as a valuable piece of global architecture, albeit some of its participants are more active than others (Sobel and Stedman, 2006). A different G-20 was born before the Cancún Ministerial Conference of the WTO in 2003. This G-20 coalition included some developing country members of the Cairns Group (Argentina, Brazil and Thailand) that were interested in improving market access for their agricultural exports. It also included other developing countries (India, Mexico, Bolivia and Ecuador) that were concerned with defending their domestic markets from import surges. The leadership of the G-20 was collegial; it was jointly led by Brazil, China, India and South Africa. China is a larger trader among the G-20. It played a meaningful role not only in Cancún Ministerial Conference but also at the WTO meeting in Geneva, held in the last week of July 2004, which put together the July Package or the July Framework Agreement, which revived the moribund Doha Round. For the members of the G-20, one lesson learned at Cancún was that, to avoid later frustrations, they need to approach future ministerial conferences, MTNs and other important WTO meetings with well-beefed-up teams of trade economists and better preparations in terms of research for negotiations (Das, 2007a). As a G-20 member, China could influence in the formulation of multilateral trade rules more than it has so far done. However, Brazil and India consistently remained more active than China during the Doha Round of MTNs. Established in 1989 by Australian and Japanese cooperation, Asia-Pacific Economic Cooperation (APEC) has emerged as one of the most important regional groupings. This 21-member group spans four continents, home to almost 2.7 billion people. The member countries represent 57 percent of the global GDP and 46 percent of multilateral trade


(APEC, 2007). In 2005 its members committed to achieving the Bogor Goals of free trade and investment in the Asia-Pacific region by 2010 for the developed-country members and by 2020 for the developing-country members. A member since 1991, China is an active member of this tradeenhancing group and is a signatory of the Bogor agreement. Although its economy is growing and importance and participation in the global policy arena has been increasing, China has so far played a modest role relative to its economic weight and heightened status. To be sure, China has abandoned its previous aversion to multilateral organizations. During the Deng Xiaoping (1978–94) period, it was believed that they could constrain China and therefore it was proper either to keep distance from them or be a passive member (Medeiros and Fravel, 2003). As China is a member of virtually all the important supranational institutions, the general expectations of the global community is that it should play a role that is compatible with its global economic status. So far China has lagged behind and projected an image of a reluctant leader. In addition, the principal global economic powers expect China to assume its global responsibilities, get engaged and play an active role in ensuring continued health of the global economic system (USTA, 2006). However, these large economic powers are negligent of not inviting China as a full-fledged member to the G-7 table, although China has participated in the G-7 finance minister and central banker’s meetings. In the late 1980s, China began its drive to expand its bilateral relationships. It normalized and established diplomatic ties with 18 countries and with the successor government in the Russian Federation. In the post–Deng Xiaoping era China’s worldview began to amend. The next step forward that China took was to develop “various levels of ‘partnerships’ to facilitate economic and security coordination.” A crowning achievement of this new approach was signing of the Treaty of GoodNeighborliness and Friendly Cooperation with the Russian Federation in 2001. In bilateral relations, in multilateral organizations and in security issues, China began to adopt unforeseen flexibility and finesse. This change in comportment and approach reflected “an attempt by China’s recent leaders to break out of their post-Tiananmen isolation, rebuild their image, and protect and promote Chinese economic interests” (Medeiros and Fravel, 2003).

3.2 China as a source of global growth The latter half of the twentieth century belonged to the US economy; it gallantly played the role of the principal locomotive of the global

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economy. It was a domineering, trend-setting economy, having deterministic influence over the majority of economic trends. As China has grown into a large-size economy, growing at a rapid pace and steadily globalizing, it has begun influencing the global economic growth trajectory. As an important link in the production chain; a large exporter of numerous manufactured products; an important destination for (and lately a source of) FDI; a consumer of sizeable quantities of energy, raw materials, consumer goods, commodities (such as aluminum, steel, copper, coal) and technology China will significantly affect both supply and demand sides of the equation in the global economy. International commodity prices can no longer be regarded as exogenous for China. It has been influencing them in a discernible manner. In future, they will grow increasingly responsive to China’s growth prospects. This would not just be limited to raw materials and commodities but would apply to high-priced high-technology products such as commercial airliners. In 2007, China was the second-largest market for them after the US. Thus viewed, while it’s positive supply-side shock to the global economy has been conspicuous and widely discussed in the academic and business conclaves, its large array of demands also carries great weight in the global economy. Evidence of China’s influence over contemporary global economic growth is easy to see. Over 1986–2006, China added $2 trillion to the global GDP and created 120 million jobs (Aziz and Dunaway, 2007). These impressive statistics amount to annually adding an economy of the size of Portugal to the global economy and annually creating jobs equal to the total number of people employed in Australia. An oft-cited proof of China’s influence on the global economy was its impact on it during 2000–01. When the so-called IT-bubble burst in the US and the global economy went into a modest recession, China’s contribution to global recovery was significant. Without China’s robust growth, this global recession could be severe and long-lingering because at this point both of the other two large economies, the EU and Japan, suffered from weaknesses and failed to pick up the gauntlet. Since the beginning of this decade, China is being regarded as a secondary engine of growth after the US (see Section 1.2.1). Between 2000 and 2005, China’s contribution to global GDP growth in PPP terms was “more than half as big as the combined contribution of India, Brazil and Russia, the three next largest emerging-market economies” (The Economist, 2006). China’s large and increasing demand for imports for meeting domestic demand and that for exports has become an important source of growth for the global economy. In the first half of 2007,


China made the largest contribution to global growth evaluated at both market and PPP exchange rates and counterbalanced the moderation of growth in the US (WEO, 2007).8 Broad measures like GDP growth rates tend to conceal important trends in the global production. When the US economy grows at a steady pace, it increases per capita income by 2 percent per annum. Although it appears modest, 2 percent of $33,000 is $660 worth of goods and services produced per capita. Conversely, when the Chinese economy grows at, say, 9 percent per annum, it increases per capita goods and services worth around $320 per capita. Over the 1990–2005 period, the era of rapid globalization, China and the US were able to add maximum to per capita goods and services production in the global economy. Taking their respective GDP growth rates, Dollar (2007) computed that China accounted for 28 percent increase in the global GDP during the period under consideration, while the US for 19 percent. Together they generated almost half of all global GDP growth for the 1990–2005 period. Over the 2006–20 period, there is a possibility of China accounting for a greater proportion of increase in the global economy. If China’s annual GDP growth averages 7 percent over the 2006–20 period and the rest of the economies of the world continue performing at the same pace as they did during the 1990–2005 period, China will account for 37 percent of growth in the global GDP during 2006–20. In this scenario, the US will be responsible for merely 16 percent of global GDP growth (Dollar, 2007). Although China’s GDP is still only one-fourth of that of the US at market exchange rate, its growth rate has been steadily much higher. Therefore, China’s contribution to the global GDP growth rate may be higher than that of the US. According to the World Bank (WB, 2007), China’s it may reach 16 percent at the market exchange rate in 2007. China’s contribution to global growth, when considered at the PPP exchange rate, was found to be higher. The PPP exchange rate is a better indicator for commodity demand. To be sure, the US economy will continue to be an important engine of global growth. However, if the current growth trends in the global economy persist, China and the US will be the two principal sources of future global growth, which is an indisputably wholesome development. As noted above, under certain assumptions China may even start playing a relatively larger role than the US. After the subprime mortgage woes in the US in September 2007 and a precipitous decline on Dow Jones, a recession in the US became a veritable probability.9 The need for a second engine of growth for the global economy became more imperative.

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Toward the end of the 2007, China was beginning to be seen as this kind of force for stabilization of the global economy. A second related plausible scenario is that as the Chinese economy is well integrated with those of its dynamic neighbors (Chapter 2), in partnership with the other AHP economies, China may well emerge as the principal growth pole of the global economy in the future. This growth pole, led by China, may become the driving force behind the contemporary global economy. Its influence will certainly be felt during the rest of the twenty-first century in shaping the contours of the global economy. It will not be far-fetched to believe that the global economic environment will then depend more upon how well the Chinese economy performs than how the US economy does.

3.3 Channels of impact over the global economy As trade and FDI have expanded at a remarkably high pace in the recent past in China, these two variables have become important channels through which China has (and would continue to) impinged upon the global economy. The former would affect other economies by way of changes in TOT, while the financial channel can have a wider impact. As China is still a large exporter of labor-intensive light manufactures, the world market prices of this category of products have softened because it became the price setter for this category of tradable goods. The developing economies that were labor-abundant like China and exported labor-intensive light manufactures, and competed against Chinese exports in the third-country markets, found that their TOT turned against them. This country group suffered due to intense competition from China. In an extreme situation, China’s competitive pressure could even create a price deflation in these countries. Often the same logic is extended further, resulting in fears of extreme deterioration in the TOT for this group of developing countries. It is even argued that competition from China may completely eliminate labor-intensive products of the other developing economies from the global markets, for sure a despondent scenario. This kind of thinking led to some analysts arguing that competitive pressure from China was partly responsible for triggering the Asian crisis of 1997–98 (Parker and Lee, 2000; Loungani, 2000). Conversely, this trend has benefited some developing economies that are net importers of laborintensive manufactures. These developing economies would benefit from China’s competitive pricing and the resulting improvement in their TOT. Secondly, China has been liberalizing its domestic markets and has emerged as a large buoyant importer as well. Increase in China’s domestic


demand has benefited those economies that were exporters to the large Chinese market. These economies benefited from price increases, that is, the turn of TOT in their favor. The countries that exported capitaland skill-intensive products, food, energy, minerals, raw materials and other primary products as well as intermediate inputs and commercial services have been the principal beneficiaries of China’s large and expanding import market. The TOT gains for the commercial services sector exporters were large because China’s trade in several services has been growing rapidly. Telecommunications, financial services and information processing were the most rapidly growing services trade areas; their imports were expected to grow fast (IMF, 2004).10 The expanding Chinese demand has firmed up the world market prices of oil and several other commodities. Countries that were importers of oil and commodities have lost because they had to pay higher import prices, meaning an adverse turn in TOT. This is a good example of the negative TOT impact on several economies. Average petroleum spot prices (APSP) were driven high by large Chinese, and other emergingmarket, imports and they crossed $99 a barrel,11 the highest level ever reached. China’s petroleum consumption has been projected to surpass that in the US in 2010. Many commodity prices were also driven to record levels. Countries that exported oil and commodities benefited from the TOT turning in their favor. In addition, economies that were capital goods exporters to China, such as the EU, Japan and the US, gained because of a growing demand from China. This trend is also likely to continue in the short- and medium-term. If its export structure is similar to that of China, a developing economy may lose its export share in the third-country market with expansion in China’s trade. But at the same time this developing economy’s exports to the Chinese market may increase. This would offset the volume losses in export for this developing economy in the third-country market. In addition, China’s competitively priced exports will improve the TOT for this developing country in its own market. It is likely that this developing country’s gains in its own and Chinese markets will outweigh its losses in the third-country markets. However, for this to happen one condition that is necessary is that its exports need to be China’s major imports and its imports need to be China’s major exports (Yang, 2006). Two large empirical studies, despite their methodological differences, have concluded that unskilled–labor-intensive consumer goods from low-income developing countries faced a great deal of competition from Chinese export growth in the third-country markets. At the same time, China’s rapid growth produced little domestic demand

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for the exports of this country group (Eichengreen and Tong, 2006; Ianchovichina and Martin, 2006). The reason was that China had considerable domestic capacity to produce these goods at home. Thus, China’s trade pressurized the trade of low-income developing countries more than that of the high-income ones. The developing economies that find their TOT turning against them and loosing market shares in the third-country markets due to China’s expanding exports can adopt a defensive strategy. If they are being out-competed in labor-intensive manufactures, they should strive to move up the technology ladder and enter into manufacture and exports of technology- and skill-intensive products. Such a shift in productive resources could insulate their trade from the Chinese competitive pressure. To this end, they would be required to invest more in initial imports of technology and its adaptation as well as in human resource development. The TOT changes described above will impinge upon the sectoral composition of output and on income distribution within as well as across countries. China has a surplus of unskilled and low-skill labor, as assumed in the Arthur Lewis model of economic development. As China’s influence increases in the global economy, worldwide return for capital and skilled-labor is bound to increase. China’s trade expansion will also result in worldwide lowering of the reward for unskilled labor. The implication of this impact would be that certain sectors, and socioeconomic groups, in some countries would become highly vulnerable to competition from China. As China has emerged as a highly competitive economy in attracting FDI and it is not likely to quit its high perch soon. Therefore, it is widely believed that China is likely to influence FDI flows to the other developing economies negatively, hurting their growth endeavors. In addition, China’s share in receiving private portfolio capital from the global capital market has been increasing and may continue to rise in future. In 2007, the authorities raised the annual limit for portfolio capital inflows from $10 billion to $30 billion. This would help provide global investors higher returns and portfolio diversification opportunities. However, some developing countries may certainly find it difficult to compete with China in attracting scarce capital from the global resource pool. Policy mandarins in these economies feel concerned about China’s ability to draw large amounts of FDI in absolute terms leaving little for the other developing economies. They can not help seeing a zero-sum game here.


However, this may not be the situation for all the countries. For instance, for foreign direct investors who are assessing the possibilities of investing in Africa, Eastern Europe and Latin America, the so-called China factor will not be even a remote consideration. Second, there can be a group of countries which experiences complement FDI inflows with increasing FDI flows to China. Empirical evidence shows that China’s neighboring Asian economies come under this category (see Section 2.4.3). Evolution of networked production and supply chain development are the principal driving forces behind this trend. There is a third plausible scenario. As the new policy focus in China is on reining in of the investment rate in the economy and increasing domestic consumption, the FDI inflow in future may decelerate. When this policy is implemented, firms and households may move to expand both their portfolio and direct investments abroad. Economies at the receiving end of this capital outflow would indeed benefit from the outward capital flows from China. The working out of this scenario will necessarily depend on China’s timing, pace and form of capital account liberalization. China’s growth and global integration can also have a positive dynamic impact by way of demonstration, which could prove to be significant for the global economy. This demonstration effect may prove to be a sound incentive for the other developing economies to accelerate their factor accumulation endeavors and productivity growth for emulating China’s growth performance. Also, competitive pressure from China may force them to take macroeconomic reforms and restructuring more seriously than before. It was observed in India and the other south Asian economies, which did not take reforms seriously until quite late. When they did launch reform programs, their implementation was tardy and slipshod (Das, 2007b). However, once they observed the tangible results of reforms and liberalization in China, they beefed up their endeavors and became more earnest about implementation, which had a discernible positive impact on output and welfare in these economies. A positive contribution of the rapidly growing Chinese economy has been in dampening down the magnitude of the global business cycle. China’s increasing weight in the global economy and its low or no correlation with industrial-country output growth trends contributed to reducing the cyclical swings in the global economy. Between 1979 and 2003, China’s business cycle displayed almost no relations with those of the world and the US. The correlation between China’s business cycle and that of the global economy and the US economy over the period under consideration was 0.0 and 0.2, respectively (IMF, 2005).

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3.4 WTO accession and its consequences One undisputable result of China’s 2001 accession to the WTO is its continuing, if not intensifying, closer integration with the global economy by way of trade and investment. The WTO membership brought China in the fold of the multilateral trade regime. While preparing for accession and during the implementation phase (2001–06) of the Protocol of Accession, China lowered trade and NTBs on goods and services. This should work toward improving opportunities for both trade and investment by China as well as with China. Under its WTO commitments, China has reduced tariffs on many products that are potential export items for the other WTO member economies. Generally applied tariffs tend to be lower than bound tariffs. As explained in Section 2.3.2, the GTAP is a CGE model that was developed at Purdue University. Notwithstanding its limitations, it is highly functional. It computes in detail the geographic and sectoral structure of trade flows. It is a static model and takes resource endowments and technology as constants. According to computations based on the GTAP-5 database, Ianchovichina and Martin (2006) concluded that the largest gains of China’s WTO membership accrued to the EU, Canada and the US. Almost half of these gains to them were generated by elimination of quotas they had imposed on exports of textiles and apparel from China. These quotas had high costs in terms of efficiency losses in the domestic economy and rent transfer to China. Also, the same countries and Japan gained from China’s reduction in trade barriers, which resulted in efficiency increases in the Chinese economic system rendering it a superior supplier of products as well as a larger importer of products from Canada, the EU, Japan and the US. China’s buoyant demand for many tropical and subtropical products, such as palm oil, coconut oil, rubber, banana and sugar, has increased considerably during the recent years. Therefore, developing economies that are exporters of these products will find their markets expanded and possibly prices higher. During the negotiations for accession, industrial economies, particularly the US, had insisted upon lowering or eliminating barriers against trade in services and China had accepted this condition. Therefore, China’s trade with the industrial economies in the commercial services sector is bound to increase rapidly. Owing to the post–WTO accession liberalization of China’s trade regime, several developing and industrial economies can reasonably expect to export higher volumes to China, albeit there will be no uniformity across exporting countries in this regard. Some will be able to


increase trade volume much higher than in the past, while others none at all. Yang (2006) is correct in assessing that the most significant reduction in tariffs took place “in industries in which industrial countries and the large, more advanced developing countries (for example, Brazil, India and Russia) have comparative advantage.” These industrial sectors, such as automobiles and heavy chemicals, were highly protected in the past. Likewise, the EMEs that are into exports of basic electronics (such as DRAM, SDRAM, motherboards, graphic video cards, PCMCIA cards etc.) will also receive a sharp lift in their export volumes to China because for their own swiftly expanding electronics sectors and rising exports China’s demand for basic electronics will rise appreciably. In the post-WTO accession period industrial economies and the EMEs are likely to gain more from trade than other economies. Tariffs on minerals and mineral products were low in China before the WTO accession. However, following the accession their binding and market opening up increased. This improved the predictability of export market size in these products. The developing economies that export these products will face a better market potential than they did in the past. China’s large demand has firmed up the global market prices for minerals and mineral products and the exporting developing countries have benefited from it. The flip side of this coin is that the developing economies that are net importers of minerals and mineral products had to pay more because of higher world market prices. Similarly exporters of primary products such as Argentina, Australia, Brazil and Indonesia, which export bauxite, timber and other primary products, will benefit from the growth of China. 3.4.1 Expanding international competitiveness and the global impact China’s rising level of international competitiveness, so noticeably reflected in its flourishing export performance, was not only a concern for the Asian economies (see Section 2.2) but it was also an issue for the rest of the global economy. The concept of competitiveness has not been without controversy (Krugman, 1994). Here it implies simply the process of upgrading of an economy, which results in broadening the competitive advantage of its firms. This advantage enables the producers to command world markets (Porter, 1990). Such a rapid increase in competitiveness could not be mono-causal but necessarily emanated from a combination of several factors. They included low wages, an inexhaustible supply of mobile unskilled labor force (see Section 1.1.4), low transportation and communications costs, large FDI inflows, foreign

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management expertise underpinning production capabilities, a large domestic market, opening of world markets and a skillful adoption of an outer-oriented strategy of growth. It is widely believed that the RMB yuan has been undervalued and has propped up China’s competitiveness of exports, albeit the degree of its undervaluation is a matter of serious disagreement (Chapter 5). At this stage, China’s high competitiveness and export growth is more than likely to be maintained even if the exchange rate is no longer undervalued. For quite some time, competitiveness will be supported by the low wages of fresh inflows of mobile labor from the rural areas. Competitive exports from China will continue to displace low-cost export production from different subregions of the global economy. Chinese firms have grown progressively proficient at producing goods that are regarded world-class in terms of the quality and product design. A liberal and well-designed FDI strategy and the large number of FIEs have facilitated this process of honing international competitiveness. The fact that Chinese exports shifted toward technologically advanced, or had higher technology content, at an early stage notably buttressed its international competitiveness. In addition, Adams et al. (2006) regard China’s huge and growing domestic market as an “ace in the hole.” Foreign firms of all breeds sought entry into China not only for taking advantage of its potential as a low-cost export base but also to position themselves well for catering to the potentially mammoth demand. Only a small number of the EMEs have a comparable market potential. The two industrial sectors on which China is going to have a strong negative impact in many developing economies are textile and apparel and electronics. In these two industries China is exceedingly competitive and most developing economies find it difficult to compete with it. This state of affairs is going to continue in future. In the post-MFA era, China’s export expansion in textile and apparel will be at the cost of the other developing country exporters of both Asia and Latin America. Under the ATC some textile quotas were removed in 2002 and then in 2005 the MFA was dismantled. As a result, for these products China’s exports recorded a sharp jump, while many developing economies lost their markets. Countries such as Bangladesh, Costa Rica, Nicaragua, Pakistan and Vietnam that have relatively large and growing textile and apparel sectors will suffer serious setbacks in their textile and apparel exports. A simulation exercise conducted by Yang (2006), using GTAP-5 database, and another by Wang (2003), which utilized the 25-sector CGE model, demonstrated that all the developing economies were hurt and lost market shares due to competition from China in textiles and


apparel. Future is not likely to be very different in this regard. Proximity to the final consumer may play a role here. This implies that China’s competitive strength may affect Nicaraguan textile exports differently from those from Vietnam because of former economy’s closeness to the US market. Some developing countries may specialize in products in which they have a comparative advantage due to proximity to the final market. They may not be affected by China’s competitive prowess. China is also a signatory of the Information and Technology Agreement (ITA) of the WTO. It has been highly competitive in the electronics industry and its exports are expected to continue expanding rapidly. Most developing economies will find it difficult to compete, and China’s success will be at their cost. The silver lining to this dark cloud is that China is a large importer of intermediate inputs in electronics, which will increase its imports of basic and intermediate electronic products from the other EMEs. Countries such as Korea, Taiwan and Singapore export electronic components and subassemblies to China in a big way and will benefit from China’s increasing imports. Gradually China’s demand for higher-end electronics components and parts will increase, which will give an impetus to intraindustry trade between China and other major EME producers of electronics products. The EMEs in this case will be those that are at a higher technological rung than China. Also, the EMEs such as India have been benefiting from significant trade they have been able to develop with China, since the late 1990s, in the ICT sector, IT-enabled services (ITeS), software and other professional services.

3.5 Outward FDI and the “Going Global” strategy During the mid-1980s, Chinese firms began investing in other industrial and developing countries and the EMEs, with their largest investments going to the neighboring Asian economies, Australia, the US and two Caribbean islands that are prominent financial centers. At a later stage, FDI in Latin American and African economies followed. FDI outflows increased from a measly $100 million a year in the mid-1980s to $12.3 billion in 2005. The outward stock of FDI at this point was $57.2 billion, which was 2.6 percent of Chinese GDP. Being a new outward investor, China accounted for merely 0.5 percent of the global outward FDI stock (UNCTAD, 2007).12 With the adoption of the “going global” strategy and the present forex reserves level of $1,400 billion,13 China is vying to become one of the largest FDI source countries in the foreseeable future.

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Chinese firms began with a small investment in neighboring Hong Kong and Macao in the mid-1980s. At this point, they not only lacked knowledge and experience needed for investment abroad but also suffered from a shortage of foreign exchange. The government had stringent control over foreign exchange outflows. In the late 1980s, the government promoted flexible arrangements to promote outward FDI. Chinese firms invested abroad by providing production equipment, technological know-how and raw and processed material. Until 1990, all FDI projects were small, only a handful exceeded $5 million. A dramatic increase occurred after this point, both in terms of the number of projects and the value of investment. By 2000, Chinese firms had invested in 6,296 projects in 140 countries. In terms of the stock of FDI, Hong Kong was the largest destination country in 2005, followed by the Cayman Islands and the British Virgin Islands. Korea, the US, Macau and Australia followed in terms of volume of stock (UNCTAD, 2007). Neighboring Asian economies, in particular Hong Kong, remained the favorite host region for Chinese firms. Latin America stood second, and until recently Africa was marginal. Whether FDI projects were chosen with proper business acumen or not is obvious from the fact that one-third of them yielded a positive rate of return while another third managed to breakeven. FDI outflows are not only a mode of operating and competing in the global markets for Chinese firms but also an integral part of China’s increasingly global economic role. Driven by the objectives of market and asset expansion and resource seeking, Chinese firms have started taking far greater interest in investing abroad. In that, they were being encouraged and supported by the strategy of “going global” that was adopted in the late 1990s. It was a thoroughgoing strategy that included a provision of preferential bank loans for the investing firms, streamlined border procedures, preferential tax policies and special trade laws. In 2004, numerous laws were promulgated to encourage an outward investment. In addition, both the NRDC and the Export-Import Bank of China (EIBC) jointly began promoting outward FDI.14 Chinese authorities were aware that their enormous foreign exchange reserves were to be used in a lucrative and productive outward investment. After investing heavily in low-yielding liquid assets like the US Treasury securities, they were looking for avenues for higher returns on their global investments. High-profile transactions like the acquisition of IBM’s personal computer business for $1.25 billion by Lenovo in 2004 portended to China’s ambitions for better returns as well as to improve its global stature by acquiring high-value, if ostentatious and glitzy,


assets. In 2005, another large global investment made by a Chinese company, China National Petroleum Corporation, was in Canadianlisted PetroKazakhstan; its acquisition was made for $4.18 billion. In the mid-2007, cashed-up giant was trying to acquire the Barclays Bank, Britain’s third-largest lender. The government-run China Development Bank (CDB) announced taking a stake in Barclays (The Economist, 2007). CDB’s total investment in this venture was €9.8 billion, making it China’s biggest overseas investment. Under the deal, CDB took an initial 3.1 percent stake in Barclays for €2.2 billion. Its total stake was expected to be extended further.

3.6

Modeling China’s global integration

Given the importance of the issue and advancing techniques of measurement, the impact of China’s integration into the global economy has been extensively modeled. Numerous studies have attempted to quantify the impact of China’s global integration. Not only new theoretical developments have taken place but also analytical techniques have been devised, which helped researchers in finessing their techniques. In addition, the computational and data processing capability of computers has increased (Piermartini and Teh, 2005). However, due to poor availability of data and information, not many of these studies had tried to assess the impact of liberalization and trade expansion in the commercial services sectors. Space considerations deter me from traversing over this entire landscape and covering these empirical and econometric analyses. Therefore, a brief reference to them and their conclusions is being attempted here. The CGE model is an oft-used tool for economic impact analysis. As noted above (see Section 3.4), GTAP is a useful CGE model. It is adaptable and has several useful adaptations, many of which have been used for quantifying China’s impact over the global economy. Two concise surveys of the earlier impact studies are available, namely, OECD (2002) and Gilbert and Wahl (2002), which reviewed 16 empirical studies and 30 studies, respectively. These can be regarded as somewhat dated. Also, analysts conducting these modeling exercises did not know about the composition of China’s Protocol of Accession to the WTO. While their conclusions differed markedly, one common strand that ran through them was that both China and the global economy will have welfare gains from China’s global integration. Large welfare gains to the Chinese economy stem from reforms, restructuring and unilateral liberalization of the domestic economy.

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A large modeling exercise was conducted by the IMF, with full knowledge of the Protocol of Accession. It used an updated database for 2002 bilateral trade flows and macroeconomic aggregates and used a GTAP-5 model. This study attempted to quantify the impact on TOT and trade flows of different regions of the global economy under various scenarios for a period up to 2020. To this end, a 10-region, 7-sector GTAP was constructed. Under the “fast” Chinese integration scenario, this study estimated that by 2020 China’s share of world GDP and trade would double and in the NIAEs GDP growth would pick up, but the share of the industrial economies would decline by 10 percent. The results of this scenario show China as the largest welfare gainer. Despite deterioration in TOT, China’s overall welfare would increase sharply. Also, labor-abundant regions like South Asia would suffer under Chinese competitive pressure in the “fast” integration scenario and commodity importers would suffer due to higher prices. These regions would be net losers. Africa and the Middle East would gain on average because of their exports of oil and commodities. In Latin America economies would benefit from shifting trade patterns. In all the regional economies, structural adjustments would take place, and 1 percent to 2 percent of the workforce would move to different sectors. Under the “slow” Chinese integration scenario, China’s growth rate had unrealistically declined to 2.5 percent annually. In this case China’s share of GDP would remain the same in 2020, with little difference in shares of world trade (IMF, 2004). The results of the IMF (2004) seem plausible and demonstrate that the over all welfare impact of China’s rapid integration into the global economy will be identical to the three previous historical episodes of integration of Japan, the NIAEs and the ASEAN-4 economies. Long-run projections reveal that “China is likely to play a much larger global role than any of these economies.” The results of this modeling exercise also show that the impact on the rest of the global economy will not be huge, albeit beneficial. While some individual sectors do show significant losses, such costs will typically be offset by gains in other sectors. The bottom line would be net welfare gains to these economies. Finally, China’s “fast” integration could also induce sizeable dynamic productivity gains in the global economy. A recent OECD CGE modeling project on quantifying the impact of China’ rapid growth on the 30 OECD member economies was even more comprehensive and ambitious than the studies attempted so far (OECD, 2006). China’s economic, particularly trade, ties with the EU, Japan and the US are close; therefore it is logical to expect that these economies will engender a good deal of mutual impact. China is Japan’s largest


trading partner. It has close relations with many other OECD economies and is one of the top three trading partners of majority of the OECD economies. This modeling exercise took into account the role of investment, particularly FDI, in the Chinese growth paradigm and included services sector liberalization. This analysis used the GTAP-6.1 Interim Release database and the FTAP model15 to study the impact of FDI. The GTAP 6.1 database covers 57 broad economic sectors and 92 countries. Also, to enable the analysis of liberalization of the services sector, a bilateral capital stock matrix was developed. This modeling exercise included phenomena such as China’s global economic impact through proactive participation in global production networks, impact on the world market prices, rapid productivity growth in the domestic economy and changing TOT of the Chinese and other global economies. The results of this exercise show that liberalization of the analyzed sectors would lead to an increase in China’s real income and per capita welfare by 3 percent. Conversely, it found limited impact for the OECD economies. The maximum direct impact is expected through an improved export performance of OECD countries that have close trade and investment ties with China but still face significant market access barriers. This impact is more important for Japan, Australia and New Zealand. The second impact of China’s liberalization that can affect the OECD economies is through increased competitiveness of Chinese exports into the OECD countries. This will cause TOT improvement for the importing economies. Many OECD economies will be able to import their intermediate goods at better prices. A caveat that must be mentioned is that this analysis did not account for the dynamic impact of China’s growth and therefore it is “likely to provide lowerbound estimates of China’s integration into the world economy” (OECD, 2006).16

3.7 How to dance with China: Formulating a functional strategy This section presents a stylized strategy of living, coping with and possibly benefiting from the rapidly expanding Chinese economy. Prima facie this circle seems difficult to square. However, at the risk of advocating simplicity, I would propose a broad two-step strategy: first, policy mandarins should identify both threats and opportunities emanating from China’s rapid growth and, second, adjust to them in a flexible and creative manner. Flexibility is a high-value policy variable in this situation. To cope with and benefit from China’s brisk growth, macroeconomic

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and microeconomic responses will, inter alia, entail swift movement of productive resources. Policy makers are obliged to create a macroeconomic environment in which firms are “able to experiment, expand on success, and withdraw from failure” (Winters and Yusuf, 2007). While the proposed strategy is a broad and indicative one, it is an intelligent response that has wide-ranging implications. The fine-tuning of the strategy will call for the knowledge of the development status, the income level and the resource base of the country concerned. It is these variables that determine how a country interacts with the global economy. For instance, let us take the group of low-income, natural resource rich developing economies that suffers from the scarcity of human capital. For this group of developing economies, it is possible to build low-technology industrial sectors, which could compete with China due to its lowwages in labor-intensive manufactures. Owing to rapid industrialization, in the southern and eastern provinces of China, wages have constantly been rising, although not the same can be said about the interior provinces of the west and the north. In the medium-term, as the wages in China climb above the level necessary to keep the laborintensive manufacturing sectors competitive, an opportunity will be created for this group of developing countries. A number of developing economies in Africa and Asia come under this category, which sees opportunities in climbing Chinese wages. This is not a unique situation. It has happened in the past. Two decades ago, China benefited from the rising wages in the NIAEs. The preconditions for success in adopting this strategy is that these developing countries will have to improve the level of governance, create or improve industrial infrastructure and eradicate bureaucratic hurdles that stifle industrial growth and efficiency and poison the macroeconomic environment. They will also have to learn to achieve the quality standards required by consumers in the importing countries. Those developing economies in Africa and Asia that succeed in fulfilling these preconditions will indeed find China’s rapid growth as an opportunity. China could become a large import market for their products. As China has become a large importer of energy, minerals, commodities and natural resources, the developing or industrial economies that are exporters of these primary items will experience their real exchange rates appreciating with increasing exports. However, there is a downside of this. If these exporters are developing economies, they will face difficulties in building a labor-intensive manufacturing sector. Some sub-Saharan African economies are in this situation since middle of the decade. The increase in income from the primary sector exports


resulted in stagnation of exports of their low-technology, labor-intensive products. The middle-income countries of Asia and Latin America have been facing a large challenge from China’s economic rise because it is encroaching into their product space. In future, China is likely to continue to encroach more into this product space than at present. Wages in these economies are higher that those in China, albeit their education levels are comparable. Thus, in some sectors in which they enjoyed a comparative advantage in the past, they will have to throw the towel and step out of the ring. However, they need not be defeatists. This group of economies has so far been able to compete with China in the skillintensive products. Sustained improvement in human capital development will enable them to main this competitiveness. Also, moving on to higher-technology products and facilitating FDI in this range of products will be a functional strategy to out-compete China. Many Latin American economies have not been able to face increasing competition from China. This applies to both domestic and thirdcountry markets. It has forced many Latin American firms out of production (Alvarez and Claro, 2007). Investments in skills and technology improvements at the firm level are the correct approach for these Latin American economies. Intense competitive pressure from China failed to perturb the NIAEs because they were ahead of China in both human capital endowment and development and technological sophistication. The NIAEs have been making sustained endeavors to maintain their lead. They are cognizant of the fact that their inability to stay ahead will push them into loss of market shares. The Latin American economies need to take this leaf from the NIAEs’ book and emphasize on building technological capability, diversifying product mix, honing human resources and upgrading the quality of the products. Efforts also need to focus on advancing of design capability of the domestic firms. The high-income industrial economies can face ascending China without ham-fisted, politically motivated interventions in the economy. If they take a realistic view of China’s strengths, for the next two decades they need not be overly concerned about competition in high-technology, skill- and knowledge-intensive industrial sectors and commercial services. The latter is an area of weakness for the Chinese economy. Building of these industrial sectors took industrial economies highly educated labor forces, large accumulations of knowledge as well as innovation supported by long-term heavy investment in R&D. To be sure, this country group has lost its comparative advantage in low-technology products and is a large importer of them from China, in that it is benefiting from

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the low-priced imports. Although the US has been suffering from a large trade deficit vis-à-vis China, a large part of it is due to exceedingly low savings in the US rather than trade barriers in China. Besides, China’s export drive should loose some its momentum in the near future because of rebalancing endeavors in the economy as well as continuing efforts to strengthen domestic consumption.17 Industrial economies cannot be seen as static economies. Over the next two decades they will develop a comparative advantage in new hightechnology, skill- and knowledge-intensive industrial sectors as well as in commercial services. While they will lose their domestic markets at the lower- and medium- technology ends of industries, they will gain in the high-technology, skill- and knowledge-intensive industrial sectors and in commercial services. In these sectors China is likely to become their large market. The industrial history of the last two centuries confirms that such dynamic adjustments have always taken place in the global economy. Lastly, as stated in Section 3.1.1, no country can manufacture everything and produce all the commercial services. A large, resourceful and rapidly growing Chinese economy will also find its areas of comparative advantage and cash in on it. Equally, it will find its areas of comparative disadvantage, where the other economies will have a comparative advantage. This will make China a large market for the other global economies, be they developing or industrial economies. As the present is a period of flux and most economies are adjusting to the high-speed expansion of the Chinese economy from a low level of income and development, the costs for some economies are higher than the benefits. This need not always be the case. Sinophobes need not be believed.

3.8


Over the last three decades significance of China has radically increased and it has traversed from the periphery of the global economy to the core. For all appearances this progress is likely to continue in the foreseeable future. Three decades of macroeconomic reforms, sustained growth and global integration have turned China into a future economic power of global magnitude, with unmatched breadth of resources and a robust manufacturing sector. Its re-emergence and economic status are often compared to the growth performance of “miracle” Asian economies that came into their own during the post-War era and made a niche in


the global economy. A more appropriate simile for China is the economic rise of the US over a century ago. That China’s growth performance is comparable to that of the US and the UK is confirmed by the historical growth statistics for these two economies and post-1978 China. One tangible outcome of its brisk growth is amplification in the global shares of production, investment and trade. China has grown to be the fourth-largest economy and the thirdlargest trader in the world in a short time span of three decades . It is endeavoring to make a new niche for itself in the global economy as well as formulate a new role. This cannot be termed dislocation or displacement, but it is a fundamental structural change in the global economy brought about by China’s vertiginous growth. Both China’s increasing economic weight and escalating integration in the global economy have been rebalancing the global economy. China’s potential catching up with the US is for sure a tectonic geoeconomic and geopolitical occurrence. It seems that the parity will be attained in the foreseeable future. Though in some countries China’s economic rise has caused unbridled indignation, world public opinion does not find it startling and more or less accepts its emergence and global economic impact in an equable matter-of-fact manner. The policy makers in China have made conscious endeavors for ascendance as a soft-power. The geostrategic stance of “peaceful rise” was favored by the Chinese politicians and strategists, who preferred China to be a responsible and benign power of the future. This doctrine basically posits that China can and should rise economically and acquire the status of an economic superpower peacefully. Although its economy is growing and importance and participation in the global policy arena has been increasing, China has so far played a modest role relative to its economic weight and heightened status. To be sure, China has abandoned its previous aversion to multilateral organizations. Yet its eagerness to assume a leadership role is conspicuous by its absence. For some time now, China has become a source of global growth. Evidence of China’s influence over contemporary global economic growth is easy to see. It is being regarded as the second engine of growth after the US. While it will not replace the US as the leading economic power, in partnership with the other AHP economies, China may well emerge as the principal growth pole of the global economy in the future. This growth pole, led by China, may become the driving force behind the contemporary global economy. Its influence will certainly

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be felt during the rest of the twenty-first century in shaping the contours of the global economy. A positive contribution of the rapidly growing Chinese economy has been in dampening down the magnitude of the global business cycle. China’s increasing weight in the global economy and its low or no correlation with industrial-country output growth trends contributed to reducing the cyclical swings in the global economy. As trade and FDI have expanded at a remarkably high pace in the recent past in China, these two variables have become important channels through which China has (and would continue to) impinged upon the global economy. The former would affect other economies by way of changes in TOT, while the financial channel can have a wider impact. One undisputable result of China’s 2001 accession to the WTO is its continuing, if not intensifying, closer integration with the global economy by way of trade and investment. The WTO membership brought China in the fold of the multilateral trade regime. Empirical studies concluded that the largest gains of China’s WTO membership accrued to the EU, Canada and the US. Almost half of these gains to them were generated by elimination of quotas they had imposed on exports of textiles and apparel from China. In their endeavors to go global, Chinese firms began investing in other industrial and developing countries and the EMEs, with their largest investments going to neighboring Asian economies, Australia, the US and two Caribbean islands that are prominent financial centers. At a later stage, FDI in Latin American and African economies followed. Chinese firms also have been making high profile acquisitions of worldclass assets. Several modeling exercises were undertaken to assess the outcome of China’s global integration. This chapter presents their conclusions in a concise manner. A stylized strategy of living and coping with the rapidly expanding Chinese economy has been profiled at the end of the Chapter. At the risk of advocating simplicity, I have proposed a broad two-step strategy: first, policy mandarins should identify both threats and opportunities emanating from China’s rapid growth and, second, adjust to them in a flexible and creative manner. Flexibility is a high-value policy variable in this situation. To cope with and benefit from China’s brisk growth, macroeconomic and microeconomic responses will, inter alia, entail swift movement of productive resources. Policy makers are obliged to create a macroeconomic environment in which firms are able to experiment, expand on success and withdraw from failure.


References Adams, G.F., B. Gangnes and Y. Shachmurove. 2006. “Why is China So Competitive? Measuring and Explaining China’s Competitiveness.” The World Economy. Vol. 29. No. 1. pp. 95–122. Alvarez, R. and S. Claro. 2007. “David versus Goliath: The Impact of Chinese Competition on Developing Economies.” Santiago, Chile. Pontificia Universidad Catolica de Chile. (mimeo.). “APEC at a Glance.” 2007. Singapore. APEC Secretariat. Aziz, J. and S. Dunaway. 2007. “China’s Rebalancing Act.” Finance and Development. Vol. 44. No. 3. pp. 27–31. Bersick, S. 2006. “Making Euro-Asian Soft Power in the 21st Century.” Amsterdam. Amsterdam University. Asia-Europe Foundation. July. Available on the Internet at http://www.civdialogue.asef.org. Bian, Z. 2004. “A Gentle Giant.” Beijing Review. Available on the Internet at http://www.bjreview.com.cn/200414/World-200414(A).htm. September 14. Bijian, Z. 2005. “China’s Peaceful Rise to Great-Power Status.” Foreign Affairs. September/October. pp. 128–42. Das, Dilip K. 2007a. The Evolving Global Trade Architecture. Northampton, MA, USA. Edward Elgar Publishing, Inc. Das, Dilip K. 2007b. “Integration of South Asian Economies: An Exercise in Frustration?” Asian-Pacific Economic Literature. Canberra. Vol. 21. No. 1. pp. 55–68. Das, Dilip K. 2005. Asian Economy and Finance: A Post-Crisis Perspective. Cambridge, UK and New York, USA. Springer Publications. Das, Dilip K. 2004. Financial Globalization and the Emerging Market Economies. London and New York. Routledge. Dollar, D.R. 2007. “Asian Century or Multi-Polar Century?” Washington DC. The World Bank. Policy Research Working Paper 4174. March. Drezner, D.W. 2007. “The New World Order.” Foreign Affairs. March/April. pp. 73–80. The Economist. 2007. “Keep Your T-Bonds, We’ll Take the Bank.” July 28. pp. 75–76. The Economist. 2006. “Balancing Act: A Survey of China.” March 25. p. 6. The Economist. 2005. “From T-Shirts to T-Bonds.” July 30. pp. 61–63. Eichengreen, B.G. and H. Tong. 2006. “How China is Reorganizing the World Economy.” Asian Economic Policy Review. Vol. 1. No. 1. pp. 73–97. Gilbert, J. and T. Wahl. 2002. “Applied General Equilibrium Assessment of Trade Liberalization in China.” The World Economy. Vol. 25. No. 5. May. pp. 697–731. Goldman Sachs. 2004. “The BRICs and Global Markets: Crude, Cars and Capital.” New York. Global Economics Paper No. 118. October 14. Goldman Sachs. 2003. “Dreaming with BRICs: The Path to 2050.” New York. Global Economics Paper No. 99. October 1. Ianchovichina, E. and W. Martin. 2006. “Trade Impact of China’s World Trade Organization Accession.” Asian Economic Policy Review. Vol. 1. No. 1. pp. 45–65. International Monetary Fund (IMF). 2004. World Economic Outlook. Washington DC. April. Jacoby, U. 2007. “Getting Together: New Partnership between China and Africa.” Finance and Development. Vol. 44. No. 2. June. pp. 34–35.

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Krugman, P. 1994. “Competitiveness: A Dangerous Obsession.” Foreign Affairs. April/March. Vol. 23. No. 2. pp. 28–44. Kurlantzick, J. 2007. “China’s Growing Popularity.” Newsweek International. New York. April 9. pp. 45–46. Lardy, N. 1998. China’s Unfinished Economic Revolution. Washingon DC. The Brookings Institution. Loungani, P. 2000. “Comrades or Competitors? Trade Links between China and Other East Asian Countries.” Finance and Development. Vol. 37. No. 2. pp. 1–5. Maddison, A. 2003. The World Economy: Historical Statistics. Paris. Organization for Economic Cooperation and Development (OECD). Medeiros, E.S. and M.T. Fravel. 2003. “China’s New Diplomacy.” Foreign Affairs. November/December. pp. 1–8. Newsweek International. 2006. “Economy: Is China Too Rich?” September 4. pp. 22–24. Organization for Economic Cooperation and Development (OECD). 2006. “China’s Trade and Growth: Impact on Selected OECD Countries.” Paris. November. Organization for Economic Cooperation and Development (OECD). 2002. “Summary of the Studies on the Impact of WTO on China.” Paris. October. Parker, S. and S.H. Lee. 2000. Assessing East Asian Export Performance and Technology Upgrading from 1980–1996. Tokyo. Asian Development Bank Institute. Peseck, W. 2007. “Viewpoint: Is the China Threat another Sputnik?” The International Herald Tribune. May 30. p. 5. Piermartini, R. and R. The. 2005. “Demystifying Modeling Methods for Trade Policy.” Geneva, Switzerland. World Trade Organization. Discussion Paper No. 10. Porter, M. 1990. The Competitive Advantage of Nations. New York. The Macmillan Press Ltd. Shenkar, O. 2006. The Chinese Century. Upper Saddle River, New Jersey. Wharton School Publishing. Sobel, M. and L. Stedman. 2006. “The Evolution of G-7 and Economic Policy Coordination.” Washington DC. The Department of Treasury. Occasional Paper No. 3. July. Stiglitz, J.E. 2006. “China and the Global Economy: Challenges, Opportunities and Responsibilities” in L.H. Ho and R. Ash (eds) China, Hong Kong and the World Economy. Basingstoke, Hampshire, UK. The Palgrave McMillan Ltd. pp. 17–31. Tanaka, A. 2006. “Global and Regional Geo-Strategic Implications of China’s Emergence.” Asian Economic Policy Review. Vol. 1. No. 1. pp. 180–96. United Nations Conference on Trade and Development (UNCTAD). 2007. World Investment Report 2007. Geneva and New York. United Nations Conference on Trade and Development (UNCTAD). 2005. World Investment Report 2005. Geneva and New York. Wang, Z. 2003. “The Impact of China’s WTO Accession on Patterns of World Trade.” Journal of Policy Modeling. Vol. 25. No. 1. pp. 1–41. Winters, L.A. and S. Yusuf. 2007. “Introduction: Dancing with Giants” in L.A. Winters and S. Yusuf (eds) in Dancing with Giants. Washington DC. The World Bank. pp. 1–34.

Chinese Renaissance and Global Economy 159 Wolf, M. 2007. “The Right Way to Respond to China’s Exploding Surpluses.” The Financial Times. May 29. p. 8. The World Bank (WB). 2007. China: Quarterly Update. Beijing. September. World Economic Outlook (WEO). 2007. Washington DC. International Monetary Fund. October. World Trade Organization (WTO). 2006. International Trade Statistics 2006. Geneva. Switzerland. Yang, Y. 2006. “China’s Integration into the World Economy: Implications for the Developing Countries.” Asian-Pacific Economic Literature. Vol. 20. No. 1. pp. 40–56.

4 The Chinese Renaissance and the Transpacific Macroeconomic Imbalances

4.1

Macroeconomic imbalances in the global economy

Global macroeconomic imbalances are not new. The global economy has faced external payment imbalances of disturbing dimensions and related adjustment difficulties before. China has a large and growing merchandise trade and current account surplus vis-à-vis the US. Although the current transpacific macroeconomic imbalance is of an unprecedented magnitude, has persisted for a long while, and threatens to endure further and exacerbate, during the postwar period a substantial number of similar episodes of large and persistent imbalances occurred. Whether the transpacific imbalance could be a threat to the global economy at some time in the present or near future has generated an impassioned debate in the profession. It has generated a good deal of popular interest as well; Martin Wolf of the Financial Times launched a website on this theme under the rubric of “what is happening is extraordinary.” Such imbalances have been facilitated by financial globalization. One of its consequences is a larger and more liquid global financial market. Ongoing financial globalization and the development of new instruments has made it possible for economies to develop significant current account imbalances. In a perfectly globalized financial market, global imbalances need not persist for long periods and should be resolved smoothly by market forces. As the transpacific trade and current account imbalances are quantitatively the largest, they have attracted the most attention from the academic and policy-making communities. Examination of these imbalances, particularly the twin deficits of the US economy and their mirror image in the twin surpluses of the Chinese economy, is the primary focus of this chapter. 160

Transpacific Macroeconomic Imbalances 161

The IMF defined large and persistent imbalances as episodes where the current account balance was higher than 2 percent of GDP in absolute value and persisted for a minimum of 5 years (WEO, 2007).1 Based on these norms, 42 episodes of large and sustained external deficit reversals were identified in the industrial economies during the post–World War II period by the WEO (2007), 36 episodes of large and sustained reversals of external surpluses were identified in the industrial economies, 49 episodes were identified in the EMEs and 15 episodes in the oil-exporting economies. Also, there were 20 cases of large and persistent surpluses in all the different economic subgroups, which included the two-decadelong current account surplus of Switzerland. Thus, it would not be wrong to conclude that imbalances have lived with the global economy for a long time. Such imbalances, that is, deficits and surpluses, usually emerged and persisted due to domestic and external policy miscalculations and conflicts. Although researchers have paid a good deal of attention to such episodes of external imbalances in the industrial and EMEs, for the most part they focused on current account deficits and their reversals.2 When large macroeconomic imbalances emerge, disagreements on burden sharing often force the imbalances to persist for long periods, albeit macroeconomic diplomacy can lead to cooperative solutions. Two of the best-known examples of such macroeconomic cooperation were the Plaza (September 1985) and the Louvre (February 1987) Accords, which were closely studied and analyzed by economists (Das, 1992). By 2000, the transpacific imbalances had grown to a significant proportion, and the World Economic Outlook, a biennial publication of the IMF, had warned about their persistence and deleterious impact. The US economy was running a large current account deficit, as opposed to the economies of China, Japan and some EMEs that were in the surplus. The current account in the Euro area was not experiencing significant imbalances and remained more or less in balance. It is not expecting them either. Currencies in the Euro area have appreciated significantly against the dollar and in effective terms. The European Central Bank (ECB) did not intervene in the foreign exchange market since early 2002 and allowed the euro to appreciate and it did. It was hoped that after the recovery from the 2001 global recession starts, the transpacific and other imbalances will shrink and normalcy will prevail. However, despite a rapid and strong post-2002 global recovery payment, imbalances continued to worsen and reached a new high, leading to apprehension regarding the impending economic and financial instability.

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In this context, the recent tectonic shift that has taken place in the global financial scenario must be mentioned. Accumulation of large reserves of foreign exchange used to be feasible only for the mature industrial economies in the past. Until the mid-1960s, the US was the only large capital surplus economy. Little wonder that it was the principal source of liquidity for the Bretton Woods institutions. A novel feature of the global financial markets is the build up of large foreign exchange reserves first with the OPEC and then with some EMEs—which are a subgroup of developing economies. Transformation of EMEs from net importers of capital to net exporters is incompatible with economic theory. This apparently is the case of uphill movement of capital and goes counter to the historical pattern of capital flows. This novel phenomenon reflects a secular change in the global economy, which gave birth to a new phase in the post-War system of financing global payments. The reason for this secular change is the policy decisions of the EMEs that were concerned about building up their foreign exchange reserves, which could be used as buffers in the event of a 1997–98-like financial market turbulence. In addition, building up significant foreign exchange reserves helps in improving sovereign ratings of the EMEs’ global financial marketplace (Bernanke, 2005). Under the Bretton Woods regime (1948–73) exchange rates were pegged, capital mobility was low and access to private global financial markets was limited to a handful of industrial economies. The IMF, in collaboration with the Bank for International Settlements (BIS) and the central banks, ensured that an adequate amount of balance-of-payments financing was available for the countries that incurred deficits. The only limiting conditions were that the deficits were not massive and the countries followed what was regarded as the norms of good policy behavior. After the recovery from the ravages of the War, the European economies made their currencies convertible and were able to access private global financial markets. Only the developing economies were left to draw from the IMF to maintain their balance –of payments. In the post-1973 era, when the members of the OPEC enjoyed outsized current account surpluses due to quadrupling of petroleum prices, private capital markets, particularly large international banks, became intermediaries for channeling these surpluses to the deficit-running developing countries. This was the beginning of privatization of balance-of-payments financing, and resulted in supplanting official discipline by market discipline. In the world of privatized balance-of-payments financing, IMF’s role as a guardian of the norms or good policy behavior was considerably diluted, causing many of the financial crises of the 1980s and


1990s. Since the late 1990s, several EMEs also began accumulating large export-driven current account surpluses. Since then a sea change has occurred in the global financial markets and the Bretton Woods system. These EMEs became a source of fulfilling the financial needs of the deficit economies. As noted in Section 1.5, China emerged as the largest holder of foreign exchange reserves.3 This new trend in the global financial market was buttressed by the ongoing financial globalization. The present global financial regime is a far cry from the original Bretton Woods system of the post-War era and is often referred to as the post–Bretton Woods regime.

4.2 Persistence and magnitude of the Chinese current account surplus Two of the reasons of the secular change in the global economy, alluded to above, are the post–Asian crisis (1997–98) collapse in investment in the AHP economies and crisis-inspired increase in domestic savings. On an aggregate level, this swing in the saving-investment ratio in the AHP economies from a deficit to a large surplus caused an oversupply of the global saving, which explains the low level of long-term real interest rates in the global economy. Owing to these developments, a new trend in the global saving and investment evolved. Changing saving and investment behavior has considerable implications for the configuration of current account imbalances in the global economy, including those between China and the US. As asserted in Section 1.1.3, China has remained a high saving economy for a long while. In the recent past its saving performance improved further and it saved close to half of the GDP. Owing to rising corporate profits, corporate savings increased further since 2000. The factors that led to an increase in corporate savings in China included strong GDP growth, low interest rates, declining unit labor costs and a diminution in employee benefits. This went hand in hand with increasing gross capital formation and widening current account surplus. China began compiling current account statistics in 1982. Until 1990, there was no semblance of a trend in the current account. It changed from year to year and recorded small deficits followed by moderate surpluses. The last year of deficit was 1989. A surplus of $12.0 billion was recorded in 1990. Moderate, if fluctuating, surpluses continued to be recorded after that. In 1997 a significant, although by no measure large, surplus of $29.7 billion was recorded, which declined to $17.4 billion in 2001. The current account surpluses accelerated

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since 2001, with a modest spurt after 2002. It was $35.4 billion in 2002, $45.9 billion in 2003 and $68.7 billion the next year.4 As a proportion of GDP, current account surplus in 2004 was 2.9 percent. This was an impressive and persistent increase compared to the past, albeit not a disturbingly high level. In 2005, the current account surplus increased more than two-and-ahalf times year-on-year (YOY) and hit a historical high of $160.8 billion, or 7.2 percent of GDP. Between 2005 and 2006 it soared by almost 60 percent, and was $250 billion, or 9.5 percent of GDP. This was more than double the highest ratio Japan has achieved—4.3 percent of GDP in 1986— during the comparable period in Japan’s growth experience. If one adds the balance on flows of long-term capital (outward foreign direct investment) the surplus in China’s “basic balance of payments” reached 12 percent of GDP in 2006 (Wolf, 2007). Even during the period of rising petroleum prices,5 China’s current account surpluses continued to rise. In 2005, China was the second-largest surplus economy, a trifle behind Japan. Owing to a comparative advantage and a strong ability to compete in many industrial sectors, China is expected to run large trade and current account surpluses in the foreseeable future. Its market share has increased significantly in all three major industrial-country markets, namely, the EU, Japan and the US. According to the OECD (2007) projections, China’s current account surpluses are going to rise to 10.2 percent of the GDP in 2007 and 10.6 percent in 2008. A noteworthy characteristic of China’s balance of payments was its twin surpluses—entailing current and capital accounts—which emerged in the mid-1990s. Capital account surpluses were created essentially due to steadily increasing FDI inflows and current account surpluses, largely due to the export-import gap. China’s high rate of saving, that is higher than that of the investment rate, contributed to recurrent current account surpluses. Since the mid-1990s, the saving-investment gap became persistent and grew higher, leading to a strong correlation between the current account surplus and the saving-investment gap. This is just the opposite of the US economy, where the rate of investment has remained higher than the saving performance of the economy. Simply put, this implies that the foreign earning of the Chinese society was higher than foreign expenditure. Chinese people could use these surpluses domestically for myriad purposes. However, they chose to invest in low-yielding foreign assets. Over the preceding two decades, China emerged as a pivotal locale for regional and international production networks. It has come to acquire a momentous position in the regional and global production chains.


Therefore, processing trade has become a dominant part of its manufacturing and trade structure (see Section 2.2). This contributed a good deal to China’s current account surpluses, which gradually have become a structural feature of the economy. They cannot be done away with in a short space of time, even if China plans to do so. The twin surpluses became the raison d’être for an uninterrupted escalation in China’s foreign exchange reserves. A sizable part of China’s stupendous foreign exchange reserves are invested in the US treasury securities. In mid-2007, the US securities portfolio of the PBC was estimated at $920 billion. The PBC owned $420 billion worth of US treasuries and $500 billion worth in the securities of US agencies, that is, dollar-denominated issues of the World Bank and corporate bonds. Foreigners hold almost half of all US treasury securities. These investments of the PBC are so large that they can move the global financial markets (see Section 1.5).

4.3 Persistence and magnitude of the US current account deficit In the recent past, the saving performance in the industrial economies, particularly in the US and Japan, has deteriorated. Relatively, this decline was not pronounced in the Euro Zone economies. The US economy suffered from a secular decline in saving performance since the 1980s, when it was 19 percent of the GDP. The household saving performance continued to decline since 1990 in the US and after mid-2000 it averaged 1 percent. There are several reasons for the persistently weakening saving performance in the US. The principal explanatory factors include the wealth effect of the rising value of housing and rising labor productivity since the mid-1990s as well as financial innovations that relaxed liquidity constraints for households. McKibbin and Stoeckel (2005) noted, “regardless of cause, the key point is that the personal saving rate in the US fell relative to counterparts elsewhere in the world.” In addition, budgetary saving became negative since the 2001 recession, when the budget surplus turned into a substantial deficit. The factors responsible for this transformation in the federal budget were tax cuts which vitiated revenues, homeland security–related expenditure, expenditure on war in Iraq and the large farm support and subsidization operations. It is not out of place to indicate that structural fiscal deficits have plagued the US economy since the early 1980s. After 2003, virtually all the fiscal deficit was financed by nonresidents because the US residents did not increase their net holdings of the US treasuries

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(Roubini, 2006). Some blame the fiscal policy of the Bush administration for the large deficit. For sure it exacerbated a bad situation, yet Greenspan (2005) argued that its impact on the current account deficit was not large. Computations by the US Federal Reserve Board (Fed) show that a dollar worth of reduction in the budget would only succeed in inducing a 20-cent decrease in the current account deficit (Erceg et al., 2005). However, an IMF model estimates put this reduction at 50 cent (Faruqee et al., 2005). A moment of respite came in 1991 when the US current account briefly touched zero, thereafter it slipped into a monotonic deficit. Deterioration in the current account in the US and the accompanying worsening in trade balance was, and continues to be, an unprecedented phenomenon (McKinnon, 2007a). A current account deficit must be financed by an equal and offsetting capital inflow, which could be accomplished either by net borrowing or sale of the US assets to the rest of the world (ROW). Also, a current account imbalance reflects what a country borrows from and lends to the ROW. It is also reflected in the difference between what a country saves domestically and invests. Incongruous as it may sound, the largest economy on the planet has turned into the largest net debtor economy. Economic theory indicates that it should have been the largest lending country. A large and successful EME, namely, China, along with Japan and a small number of other surplus EMEs, has been collectively lending capital to a matured industrial economy.6 This development in the global financial system is unusual and surprising. This was “neither predictable not predicted” and has large ramifications for the global economy (Summers, 2006). Two of the principal factors driving the widening of the US current account deficit included the large consumption in the US, which was fueled by the US government’s deficit-budget spending, debt-financed consumption of the households as well as the surge in US growth since 1995. Secondly, the trade-weighted value of the dollar appreciated which hugely contributed to the swelling of the current account deficit. If the broad index, computed by the US Federal Reserve System, is taken as a measure, the dollar appreciated by 37.66 percent between January 1995 and February 2002. It peaked at this point and depreciation began. Between February 2002 and August 2007 it depreciated by 20.29 percent.7 The broad index is a weighted average of foreign exchange values of the dollar against the currencies of a large group of major US trading partners. Thus, in the middle of 2007, the dollar was not at its sustainable level. It had a long way to decline—say, another 20 percent—before the exchange rate incentive is in place for the deficit to start narrowing.8


If the US saving-investment imbalance continues, the US will continue to be dependent on foreign, including Chinese, capital inflows. Even if the transpacific trade and current account imbalances are eliminated by some dues ex machina, the US economy will continue to suffer the same-sized imbalances with the ROW if domestic saving scarcity remains the same. The only change that would transpire would be that the transpacific imbalances will turn into imbalances with the ROW. If the US wishes to rein in its dependence on external capital inflows and its current vulnerability to sharp interruption, increasing the domestic saving rate is indispensable. Without that, the strong commitment of the US government to the objective of “an adjustment in the dollar/Chinese RMB exchange rate, or any other bilateral measure for that matter, will have negligible effect” (Hormats, 2007). The current account deficit in the US has not only persisted but its magnitude also went on increasing from 0.8 percent of nominal GDP in 1992 to 1.5 percent in 1995 and to 4.2 percent in 2000. The deficit declined in 2001, which was a recession year. However it went into an upswing again the very next year and reached 6.3 percent of nominal GDP in 2005 and further to 6.5 percent in 2006. Between 1996 and 2006, the US current account deficit leaped from $125 billion to $857 billion, that is, almost seven times. In a short span of a decade, the US current account deficits puffed out to a massive and worrisome dimension. Such large current account, and the accompanying trade, deficits are large in both absolute and relative terms. In the history of modern industrial economies, no economy—small or large—ran persistent current account deficits of magnitude posted by the US. Other than the large magnitude, the statistics cited in this paragraph testify to the steep upward trajectory of the current account deficit. Even at the turn of the century, some academics, analysts, researchers and supranational institutions such as the IMF had warned about the unsustainable trend of the US current account deficits (Obstfeld and Rogoff, 2000 and 2004; Roubini and Setser, 2004; Mussa, 2004; WEO, 2000). As equity financing turned into debt financing and private investment into the US gave way to foreign central bank purchases of US assets, the early warnings became increasingly strident. The high external debt levels made the US comparable to Argentina and Brazil, on the brink of their financial crisis. The debt-to-GDP ratio, or net external liabilities, in the US soared from 14 percent of GDP in 2000 to 22 percent in 2004 and to 25 percent in 2005. In the cases of Argentina and Brazil, in 2001, before the financial crisis struck these two EMEs, their debt-toGDP ratios were 33 and 14 percent, respectively. If the US were an EME

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with an over-valued currency, the situation was ripe for a financial-cumcurrency crisis and a liquidity run on government debt would have started in 2005. In 2006, the US current account deficit reached $857 billion. The US trade deficit remained the largest, and the fastest growing component, of the current account deficit. Deficit in trade in goods reached $836 billion in 2006, which is over $2.5 billion daily. The two largest components of this are mineral fuels and manufactured goods. The US is presently running the highest trade and current account deficits in its history, almost twice as high as those in the mid-1980s, which was another period of large imbalances for the US economy. However, at this time the US was a net creditor economy. In the first quarter of 2007, the deficit was still hovering around 7 percent of the nominal GDP.9 As noted above, the current account imbalance reflects the saving-investment gap in the US and runs parallel to the net inflow of investment funds from abroad. This scenario changed in the last quarter of 2007, when due to the subprime mortgage crisis steady depreciation of the dollar imports fell and exports rose. Weaker dollar helped the current account deficit, which improved to 5.5 percent of GDP. As alluded to in Section 1, the US was the only large capital surplus country in the early post–World War II period. No more. As a consequence of large capital inflows since 1992, at the end of 2005 the ROW owned more than $12.7 trillion worth of US assets, while the US owned $10 trillion worth of international assets. Thus, the net international asset position of the US was $2.7 trillion in the negative quadrant at the end of 2004 (Buira and Abeles, 2006). Owing to its long persisting current account deficit, the US became the largest importer of capital from the countries that were running current account surpluses. These surpluses constitute the pool of global liquidity. The financial markets became progressively more globalized, and therefore progressively more flexible and sophisticated. The surpluses straightforwardly reach the global financial markets and enable the deficit economies to import capital to meet their capital account deficits. Consequently, the stock of gross financial assets and liabilities in the global economy increased at a torrid pace, particularly since 1990 (Kose et al., 2006). Between 2001 and 2006, the US absorbed 75 percent of the net capital outflows from countries that ran surpluses (MGI, 2007). This quantum of capital import is over 1.6 percent of the global GDP. One economy absorbing such a large proportion of global savings is a historically unprecedented phenomenon. Besides, such a massive absorption of global capital by the US “is of questionable sustainability and if sustainable, of dubious


desirability” (Summers, 2006). McKinnon (2007b), a respected veteran scholar of international economics, found it a dissatisfactory spectacle that “the richest economy grabbing the lion’s share of international finance that would be potentially available for economic development in much poorer countries.” China, Japan, Korea, Taiwan and the ASEAN-4 economies accounted for 52.3 percent of the US current account deficit in 2006. Although the US ran deficit vis-à-vis every region in the world, China accounted for over a quarter of the total current account deficit of the US, making it a major contributor to the transpacific financial imbalances. In 2006, merchandise trade deficit of the US vis-à-vis China was 28.4 percent of its total. The EU and Japan came next accounting for 14.3 percent and 12.8 percent, respectively.10 These financial imbalances have worked appreciably in favor of the US economy in two ways: First, large external capital inflows increased the prices of US assets. Second, they forced the long-term interest rates down in the US financial market, thereby spurring and financing domestic spending. The US indebtedness, or net external liabilities, was 8 percent of the world GDP in 2006, which was 26 percent of the US GDP. The simulation results of the Global Economy Model (GEM) of the IMF, which were updated with the 2006 as a starting point, show that if serious and credible policy measures to contain the US current account deficit are not taken, although a depreciation of the dollar continued, the net foreign liabilities of the US will rise to 55 percent of the GDP in 2015 (WEO, 2006).11 Eventually, the long-run stabilization of the US economy would take place at the current account deficit level of approximately 85 percent of the GDP.12 The US earns higher returns on its global assets than it pays on its liabilities to the ROW (see Section 4.6). Owing to excess returns on assets relative to liabilities, the US has come to have a “privileged” position in this situation of a persistent macroeconomic imbalance. The return differential matters. Because of this privileged position, the US can sustain large trade and current account deficits. If all borrowing and lending occurs at a constant global interest rate, then a net debtor economy will need a current account surplus to meet its debt obligation. That is, it will not be possible for the US to concurrently remain a long-term debtor and a current account deficit country. But if the net debtor can earn an investment income surplus, as the US does, it has no pressure to balance its trade or current account deficits. This privilege paid off well for the US; it was worth about 0.5 percent of GDP in the years between 1981 and 2003 (Meissner and Taylor, 2006). The yield privilege

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of the US was considerable in the 1960s, when it was at its peak. However, it has been on a decline and has been reduced from 3 percent then to 1 percent in the present period. The subprime mortgage crisis of the US economy that emerged late in the third quarter of 2007 smudged the US image as a great financial center. It further eroded the yield privilege; the US ability to borrow lavishly and inexpensively would be seriously affected. As a result of this crisis, the dollar sharply depreciated vis-à-vis the euro13 and the yen and the Canadian dollar crossed the symbolic threshold and overtook its American counterpart. Future borrowing by the US at low interest rates from the ROW may soon end. An unsavory term that was being bandied about in the academic and financial conclaves is “the balance of financial terror.”14 China, a potential strategic and economic rival of the US, is the biggest financer of the US deficits. Japan, the Russian Federation and Saudi Arabia are among the other large lenders to the US. Two of these three are increasingly authoritarian and potentially somewhat unstable regimes. Being so highly dependent for liquid assets on such regimes should indeed be worrisome for policy mandarins in the US. Another facet of the balance of terror is the postulation that China cannot sell off its investment in the US treasuries because of the risk of collateral damage. In the first wave of the global market reaction Chinese economic interests will be seriously hurt. Owing to their negative wealth effect neither a sharp depreciation of the dollar nor falling prices of the treasuries are in the interest of China. Therefore, to an extent the Fed can afford to take the PCB and its continued interest in the US treasuries for granted.

4.4

China’s bilateral trade surplus vis-à-vis the US

The volume of China-US trade in 1978 was close to $2 billion. It rose to $20 billion in 1990 and soared to $338.7 billion in 2006. It implies a 171-fold increase in a short span of 27 years. In 2006, China was the second-largest source of US imports and fourth-largest export market for the US, after Canada, Mexico and Japan. Since 2003, China ranked as the second-largest import supplier for the US behind Canada (USITC, 2007). If this pace of expansion of exports to China continues, it is expected to replace Japan as the third-largest US market in 2007 (Morrison, 2007). In 2006, China’s trade with the US increased faster than any of the other top five trading partners of the US, representing a 32.9 percent increase YOY. In the recent past, China has been the fastest-growing export market for the US firms. Owing to its large


population and rapidly growing economy, the US firms, particularly those in exporting businesses, regard China as a valuable potential market. In 1985, the China-US trade was totally balanced; imports and exports on the two sides were equal. The trade and the current account imbalance between China and the US were diminutive in the late 1980s. In 1990, the US trade deficit was $10.4 billion. Both bilateral trade and the current account deficit of the US trended upward. In 1998, the bilateral current account deficit was $60.8 billion, in 2000 $90.2 billion and in 2002 $111.4 billion. In 2003, the current account deficit grew to $134.8 billion, with that China acquired the distinction of being the economy with which the US had the largest trade deficit, which began to roil the bilateral commercial relations. The largest global consumer economy and one of its largest suppliers found themselves at odds with each other. The office of the USTR has filed several trade dispute resolution cases against China in the WTO. These cases, inter alia, relate to China’s failure to protect IPR, discriminatory regulations on imported auto parts and import and export subsidies to industries such as steel, wood and paper. In 2005, this situation exacerbated and the bilateral trade deficit reached $218 billion, which was 26 percent of the total global deficit of the US.15 This drew a lot of political attention to China-US trade in the US. Politicians and popular press in the US judged China a mercantilist trader that destroyed manufacturing jobs, a stigma associated with Japan in the past. In 2006, the bilateral trade deficit of the US recorded a moderate up tick to $232.6 billion. These statistics demonstrate that China’s bilateral trade deficits went on increasing at a rapid rate after 1998, “but the US deficits should not be blamed on China” (Frankel and Wei, 2007). In February 2007, the USTR requested consultations with China on nine measures that benefited firms and FIEs operating in China. These measures included fiscal incentives, tariff exceptions and preferential lending arrangements. The USTR asserted that these measures violated various WTO regulations like national treatment, the Agreement on Subsidies and Countervailing Measures, the Agreement on TradeRelated Investment Measures (TRIPS) and commitments undertaken by China in its WTO Accession Protocol. If consultations do not lead to satisfactory results, the USTR can request the establishment of a dispute settlement panel (Hufbauer, 2007). In April 2007, the US filed two more cases against China in the WTO. The first case involved deficiencies in China’s legal regime for protecting and enforcing copyrights and trademarks, while the second involved the barriers China placed on book, music, video and movie imports.

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The reason why bilateral trade balance has gone on worsening is that China’s merchandise export growth to the US was higher than its average merchandise export growth rate. Therefore, the proportion of China’s exports heading for the US expanded from 17 percent of the total to 21 percent over the 1995–2005 period. Conversely, China’s imports from the US expanded at a slower pace than China’s overall import growth rate. Consequently, the proportion of Chinese imports originating in the US declined from 12 percent of the total to 8 percent during the period under consideration (Hammer, 2006). One frequently given public response of the Chinese officials to the US complaints regarding their bilateral trade surplus is that the US does not provide enough licenses to exporters for high-technology export products to China. This argument does not seem to be valid because for the most part trade is free in the US. The list of products that require license for being exported is small. The value of high-technology exports for which licenses are sought is low. In 2005, license applications were made for exports worth $3 billion to the Department of Commerce, of which $2.4 billion worth of licenses were granted. For the rest, applications were returned because they were incomplete. If this requirement is completely eliminated, US exports to China will not increase by even 1 percent, and the bilateral imbalance will remain almost as it has been (Lardy, 2006). In mid-2007, without much publicity, the Bush administration eased some restrictions on the export of politically sensitive technology items to China. The objective was to allow high-technology US firms to increase their exports to China, while guarding the military application of that equipment. This included advanced aircraft engine parts, navigation systems, telecommunications equipment and sophisticated composite materials. Early in 2008, doubts were expressed about this policy measure. Some experts believed that it was an inconsiderate and shortsighted move because some of the equipment could be used in modernizing China’s military. The Bush administration was facing some uncomfortable questions about it (Weisman, 2008). The US-China Business Council (USCBC), a leading organization of large US companies that do business in China, launched an in-depth study of bilateral trade (USCBC, 2006). Premised on this study, the USCBC concluded that the imbalances are healthy and beneficial for the US economy. According to their assessment, there are substantial long-term and enduring benefits for the US from the trade and investment in China. It would be slipshod and neglectful to ignore the positive aspects of transpacific imbalances. Job losses should be seen as


a part of the structural shift in the US economy; losses in the manufacturing sector will be made up by job creation in the services sector. Although displaced workers in the manufacturing sector represent the real cost to those who are affected, the economy as a whole benefits from permanent output and price effects of increased trade with China. However, it cannot be ignored that the structural shift in the US economy is not new; it has been transpiring for the last two decades. Using the Oxford Economic Forecasting (OEF) macroeconomic model, a formal assessment of the impact of trade flows between China and the US was done by the USCBC (2006). The conclusions of this empirical exercise were (i) by 2010 the US GDP will be 0.7 percent higher because of increased trade and investment with China, (ii) average prices in the US markets will be 0.8 percent lower by 2010 as a result of increased trade and investment with China, (iii) together this would amount to an increase of around $1,000 dollars in the real disposable income per US household per year. That is projected to be about 1.9 percent of median or 1.5 percent of the average annual family income in 2010. Thus, trade and investment with China will have a positive impact on the standard of living in the US. The OEF macroeconomic model also forecasted a labor productivity increase in the US by 0.7 percent by 2010. This increase is attributable to improvements in manufacturing productivity, which will be boosted by 0.3 percent per year by 2010. Higher productivity in the manufacturing sector will be the result of, first, increased competition which would force the least productive firms out, while increasing the productivity of those that stay in business to compete with Chinese imports. Secondly, the US firms that source some of their inputs from China will benefit from the price effect; these firms will be able to cut down their costs. Thus, the OEF model concluded that both US consumer and producer prices will significantly trend downward. 4.4.1 The bilateral trade structure China’s five largest imports from the US are semiconductors and electronic components, aircrafts and parts,16 waste and scrap, oilseeds and grain and raisins, and synthetic rubber and fibers. As China is upgrading its infrastructure and modernizing its industrial sector, its demand for US goods and services is predicted to increase substantially in the near future. China’s significance as an export market in consumer goods is also expected to increase as the household income, the purchasing power and the living standard in China continue to improve and the size of the middle class expands. This observation applies a fortiori to

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urban areas in eastern and southern China, which have much higher incomes than the interior parts of China. It has emerged as a major source of US imports, particularly labor-intensive and low- and medium-technology products of a large variety. In 2006, total US imports from China were worth $288 billion, or 15.5 percent of the total US imports. A decade ago, in 1996, this proportion was a trifling 6.5 percent. The five largest import product categories for the US are computers and parts, miscellaneous manufactured items (such as toys and games), apparel, audio and video equipment, and communications equipment (Morrison, 2007). The composition of imports from China underwent a striking change over the years. During the 1980s and 1990s, China principally exported low-value-added, labor-intensive products. As opposed to that, the present range of exports comprises technologically advanced products, such as computers. In 2006, over a quarter of total imports from China fell under the category of advanced technology products. Consumers in North America see and purchase a lot of reasonably priced textiles and apparel and other consumer items manufactured in China in large stores such as Best Buy, Circuit City, Target and Wal-Mart and infer that China’s vertiginous growth is explained by this very visible export boom for which their purchases are responsible. What they falsely assume is that while China is exporting such a large amount of consumer products to their markets, it is keeping its own markets closed to the US exports. This assumption is incorrect because contemporary China is a highly open economy. If the trade-to-GDP ratio is taken as a measure, China is more open than the US. Trade (export ⫹ import) accounted for 69.4 percent of the GDP in China in 2005; the corresponding proportion was 39.6 percent in 2000.17 Not many EMEs of comparable size are as open as is China. If applied tariff barriers are taken as a measure of openness, China is far more open than the many other EMEs such as Brazil, India and Mexico, where tariff barriers are relatively higher. Its tariff barriers are among the lowest in the developing world (see Section 1.3). All import quotas were eliminated by 2005. All through the1990s, China was treated as the new frontier by the US firms in a large array of industries. It was an attractive and rapidly growing export market for them. This trend strengthened after 2000. Exports of the US firms to China rose by 190 percent over the 2001–06 period. This growth rate of US exports was 4.5 times higher than that for the ROW. Therefore, Chinese market accounted for one-quarter of the total export expansion of the US firms during the period under consideration


(Wu, 2007). Thus viewed, no surreptitious policy moves were being made to restrict US exports into China. Allegation of a mercantilist mental makeup of the policy makers cannot be substantiated by any set of reasonable indicators. 4.4.2 Product drivers of bilateral trade Hammer (2006) decomposed bilateral trade data to analyze the structural change that unfolded in bilateral trade over the preceding tenyear period. China’s bilateral trade with the US primarily comprised of large proportion of machinery and electronic products and this proportion monotonically grew. This was largely due to China’s important position in the global supply chains in several product ranges. The strongest recent growth in China’s imports from the US was in yellow soybean. To pinpoint which product categories have influenced the pattern of bilateral trade most, market share gains of important trade product categories need to be identified so that we know which two-digit harmonized system (HS) categories have recorded largest market share gains over the past decade, and presently dominate the bilateral trade. China’s exports were maximum in the following two HS categories: “nuclear reactor, boilers and machinery” (HS 84) and “electronic machinery and sound and TV equipment” (HS 85). By 2004, exports in these categories accounted for almost half of the total. As regards the specific products in these two HS categories, the nuclear reactor, boilers and machinery (HS 84) category comprised predominantly of computers and computer parts, while the electronic machinery and sound and TV equipment (HS 85) category consisted mainly of mobile phones and television parts. These products recorded the largest growth in exports from China to the US. Turning now to China’s imports from the US, the largest increase was recorded in the “oil seed, grain, and fruits/plants” (HS 12) category, which essentially consisted of soybeans, and “electronic, machinery and sound and TV equipment” (HS 85), in which the major product was the integrated circuit. These products essentially drove China’s imports from the US and their market share went on increasing at an impressive pace. China’s soybean imports were $73 million in 1995; they soared to $3,392 million in 2004. An interesting conclusion that emerges is that the HS 85 category proved to be a large and growing component of both bilateral export and imports. This again confirms China’s “increasingly integrated position of global supply chain of electronic goods …” (Hammer, 2006).

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4.4.3 Bilateral trade and China’s incentive zones Although the SEZs have played a significant role in China’s rapid industrialization and external sector growth, in the recent years the ETDAs, the HTIDAs and the BAs have become responsible for increasing bilateral exports to the US (see Section 1.4). Their share in exports to the US has increased markedly over the last ten years. Collectively, these incentive zones accounted for almost a quarter of China’s total exports to the US. As opposed to this, the share of the SEZs has been on a decline and they have lost their dominance of Chinese exports. This happened due to relatively slower growth of the SEZs. Similarly, imports from the US by industrial enterprises in various incentive zones also increased much faster than those from the SEZs. By decomposing the China-US trade flow data, Hammer (2006) found that firms based in incentive zones were more active in importing from the US than exporting. This is demonstrated by the fact that the combined exports from these firms accounted for 25 percent of bilateral exports and 38 percent of bilateral imports in 2004. Of the three incentive zones, in 2008 firms in the ETDAs were the most active in bilateral trade. They accounted for 10 percent of total bilateral exports and 17 percent of bilateral imports. 4.4.4 Exports to the US by the FIEs Although exports from the SOEs to the US increased in absolute terms, their share in total exports to the US went steadily down because the FIEs and other enterprises were more successful at exporting in general and exporting to the US in particular. China has almost 600,000 joint ventures, which come under the rubric of FIEs (Wu, 2007). A large proportion of these are US firms and TNCs operating in China. The FDI from the US firms in China was beneficial to them; it enabled them to utilize low-cost and productive labor force “generating supranormal profits” (Goldstein and Lardy, 2005). The FIEs overwhelmingly dominated the Chinese export performance to the US, as well as that to the other parts of the global economy. Also, since 2002, the FIEs have been the fastest growing source of trade, exports and imports to and from the US. They accounted for 66 percent of total Chinese exports to the US in 2005, compared to 45 percent in 1995. Private Chinese firms have also become a successful, albeit a small, group of exporters. In 2005 they merely accounted for 8.3 percent of exports to the US. In a mirror of exports, the SOEs’ share of total imports from the US went on steadily declining and like exports the FIEs picked up the slack. They became the predominant importer from the US, accounting for almost a half of


total imports from the US in 2005, compared to about a third in 1995. Private Chinese firms also imported from the US, but in 2005 they accounted for a paltry 8.3 percent of total imports from the US. In 2000 this group of firms imported almost nothing (Hammer, 2006). A germane fact in this regard is that an overwhelmingly large proportion, 80 percent, of China’s trade and the current account surplus with the US was generated by exports made by the FIEs. It is obvious that if the US investment in China continues to increase, its manufacturing base for exporting goods to the US, and the ROW, will continue to broaden, which in turn would result in worsening of the bilateral trade deficit. 4.4.5 The probability of contraction of Chinese exports to the US The undervaluation of the RMB yuan is frequently blamed for China’s trade and current account surpluses vis-à-vis the US. While China had maintained small surpluses since the late 1980s, the RMB yuan was substantially overvalued until 1994. In a comprehensive currency reform policy measure, it was devalued by 28 percent in 1994. As it was pegged to the dollar, it began to depreciate after February 2002. Since then its progressing undervaluation worsened the underlying structural imbalances in bilateral trade. This is an indication of the possibility of US bilateral trade and current account imbalances vis-à-vis China continuing even after its global trade and current account deficit contracts to a reasonable level. The evolution and expansion of networked production in the AHP economies has a bearing on the enlarging bilateral trade and current account imbalances between China and the US (see Section 2.2). While China was a latecomer to the networked production, it has evolved as the locale of choice for the final assembly of a wide range of products. Joint ventures, FIEs and subsidiaries of TNCs actively participated in a large proportion of final assembly operations. The FIEs have come to have a pivotal position in the Chinese industrial structure and almost two-thirds of the value of these products originates in the other Asian economies. As the production of such a large array of products is vertically integrated and a good part of these so-called processed exports go to the US, there has been a sharp decline in the US bilateral trade imbalance that originated in the past in Japan, the NIAEs and the ASEAN-4 economies. These countries have moved a great deal of their manufacturing capacity to China. The impact on the trade and the current account balance of this major structural adjustment among

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China, Japan, the NIAEs and the ASEAN-4 is that the US trade deficit vis-à-vis the other East Asian economies declined dramatically. The dynamic East Asian economies accounted for 43 percent of total US deficit in 1997; in 2006 this level plummeted to 17 percent. Thus, it is evident that an increase in the bilateral current account deficit between China and the US was, inter alia, caused by the shift in the structure of US trade.18 Neither this structural shift in the production of manufactures is likely to change in the foreseeable future nor would the FIEs slow down in exporting their products to the US market. Several products that the US imports in a significant quantity from China are no longer produced domestically. Other low-cost EME producers either do not provide them or cannot do so in sufficient quantity to meet the US demand. Appreciation of the RMB yuan cannot be of help in eliminating China’s cost advantage in a large range of its export products to the US. At best, it might reduce it to a limited degree. An appreciation would help spread the adjustment of the US deficit evenly among the other US trade partners. Therefore, it is likely that bilateral trade and the current deficit between the two economies will continue in the near future. No indications of a reversal are in sight for the medium-term.

4.5 Transpacific financial imbalances: Stable or unstable The stability of the transpacific current account disequilibrium has been debated and questioned by many in the profession. Something close to a consensus has gradually evolved among researchers regarding the medium- or long-term transpacific financial imbalances not being a statistical illusion and therefore unsustainable. Krugman (2007) remarked that even if the unorthodox views are “given the benefit of doubt, it is hard to argue that the current levels are indefinitely sustainable.” They can feed back on to real sector behavior, inflicting a serious shock on the global and individual systemically important economies. If credible and comprehensive policy measures are not taken to reduce them to a manageable proportion, market forces may take over the process and the imbalances may be reduced abruptly in a disorderly manner. A lesson of the recent financial history is that market forces often overreact. A hard-landing scenario will essentially entail a rush to exit from the dollar assets, which could cause rapid dollar depreciation. As global investors relinquish their dollar assets, the Fed will be obliged to raise interest rates sharply, adversely affecting the housing crisis, which


began in September 2007, and equity markets in the US. Consequently the GDP growth rate in the US will suffer. An abrupt and disorderly adjustment of major exchange rates and interest rates may follow, which would be at a high cost to all the economic agents (de Rato, 2007). That a disorderly adjustment of the imbalances is well within the realm of possibilities has caused serious concern among the global policy makers. Apocalyptic outcomes—such as financial market turmoil, global economic slowdown or even a recession—have been predicted by several analysts. Obstfeld and Rogoff (2005) compared the imbalances to “the sword of Damocles hanging over the global economy.” They were certain that the transpacific imbalances entail enormous risk of “collateral damage” to the global financial system apart from serious risks of exchange rate instability. Roubini and Setser (2004) predicted that the US deficit will perpetuate “even if the trade deficit stabilizes” and awaited an “explosive debt dynamics that would lead to financial crises.” The external shock generated by a disorderly and abrupt marketdriven correction will adversely affect the global economy. It is sure to lead to an exchange rate conundrum and a higher-than-expected increase in the interest rates in the global financial markets. Some individual economies that suffer from structural and financial sector weaknesses may be badly mauled because of the sudden reassessment of the country risk by global capital markets. China and the other EMEs will also be vulnerable to the disorderly correction of the transpacific imbalances. Other than a negative wealth effect, they will also suffer the consequences of rising global interest rates and declining prices of the US treasuries. Flight to quality will make the financial markets volatile in the EMEs. In addition, the US import contraction would adversely affect China and the other AHP economies. So will the abrupt depreciation of the dollar. Although their dependence on the US market has declined, it is still an import market for China and the AHP economies. However, one salutary contribution of this crisis will be a reduction in servicing the dollar-denominated debt—because of depreciation of the dollar— for the countries that have heavy dollar indebtedness. Several in-depth studies echoed in unison that a correction of transpacific imbalances is inevitable because with every passing year the disequilibrium is worsening and is on a grossly unsustainable course.19 While the transpacific current account deficits are the largest and conspicuous, the US has been running deficits against virtually every region in the world. In early 2007, the US current account deficit was approaching 7 percent of the GDP and its future trajectory was uncertain. It was likely that well before the deficits

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reached such a higher level, investors may decide to rummage around for better returns on their investments or simply turn away from investing in the US assets. Roubini (2006) is absolutely au point in contending that the US “cannot expect to be able to run unsustainable twin deficits for ever and hope for the kindness of strangers” to ensure the smooth financing of its imbalances. The expectation that the PBC and the central banks in the other AHP economies will ignore the deteriorating transpacific imbalances and go on funding the US deficits sine die is utterly unrealistic. Most analysts have therefore agreed for a while that the dollar has to descend from its high perch, but will this happen suddenly or stretch over a number of years remains an open question. As Stein’s law says, “If something cannot go on for ever, it will stop.” It is evident that closing the trade deficit and eliminating the imbalances will at some point start with redistribution of global spending and therefore the global consumption pattern. Spending in the US will shrink, while that in the surplus economies will rise. This redistribution of the global spending and consumption pattern will require a fall in the relative process of the goods and services produced in the US, essentially “because US spending falls much more heavily than spending of other countries on those US-produced goods and services” (Krugman, 2007). The dollar has been on a decline and after the subprime mortgage crisis in the US (September 2007), the depreciation vis-à-vis the major currencies such as the euro and the yen, gained momentum.20 The subprime mortgage crisis failed to destabilize China. Financial markets were not affected by it because the capital account in China is still relatively closed. Massive international reserves and the rapid real GDP growth rate helped. After a brief interruption, the Chinese stock markets also continued their rise. Neither China’s credit spread nor the RMB yuan demonstrated an impact of the US subprime crisis. However, if it triggers a recession in the US economy, its economic impact is sure to be felt by the Chinese and other economies. What is reasonable from the perspective of potential investors is a managed decline in the deficits to a comfortable level. What will this level be? Macroeconomic balance calculations by Rajan (2005) show that the US, with its higher productivity and younger population, can sustain a deficit in the medium-term of between 2 and 3 percent of GDP without exploding. This means the US needs to cut the present (2007) current account deficit by considerably more than a half, almost by threequarters. This would reduce foreign claims on the US to a reasonable level of GDP.


4.6 Diverse perspectives on transpacific macroeconomic imbalances Notwithstanding the ominous consequences predicted in the preceding section, the much-predicted apocalypse has not materialized as yet. Indubitably, the subprime mortgage crisis did tarnish the image of the US financial market. However, the PBC and central banks of the other AHP economies did not stop investing in the US economy. Did the markets become impervious to the stock of conventional wisdom? There were several differing, even contradictory, explanations and rationalizations of the macroeconomic imbalances between China and the US. Some of them regard them as sustainable, while others are certain that they can cause no serious harm to the global economy. One possible explanation is the pivotal position of the dollar; it is at the center of the global monetary system. The US could not have run such large deficits if the dollar was not the definitive international currency. As the global economy is on a dollar standard, the US economy “can borrow abroad indefinitely in terms of its own currency to cover its relatively low level of saving. This is possible as long as the US Federal Reserve Board keeps the purchasing power of the dollar fairly stable so that countries with trade surpluses are loath to appreciate against the currency in which most of world trade is invoiced. Thus, there is no immediate crisis and no need to precipitate action by governments—particularly on the exchange rate front—to ‘correct’ the US current account deficit” (McKinnon, 2007b). Another rationalization was systemic, and explained the disequilibrium as an integral part of the shifting global financial architecture. The Bretton Woods regime remained in a bit of flux, adjusting to the changing circumstances of global finance. In the new global financial regime net capital outflows from China and the other AHP economies to the US are associated with relatively high growth in this group of economies. The US current account deficit supplies international collateral to China and other investing AHP economies, which in turn “supports two-way trade in financial assets that liberates capital formation in poor countries from inefficient domestic financial markets” (Dooley, Folkerts-Landau and Garber, 2004a). According to this stance, the US can continue running large current account deficits simply because China and the other AHP economies prefer to accumulate dollar assets. There is no need for the dollar to depreciate because there is no need for balance-of-payments adjustment. This school of thought is convinced that China and the other AHP economies will resist the notion of appreciation of their currencies vis-à-vis the dollar. In its newest transmutation the financial

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regime was named the Bretton Woods-II, in which China, and the AHP economies, pegged their currencies to the depreciating dollar so that they could keep them undervalued and benefit by way of export-driven growth.21 The US saw a stable and low-cost source of liquid resources in China and the AHP economies, which helped the US in funding its current account deficit. So, there is a significant net benefit to the two sides. This was putatively a concerted mercantilist view of the financial world. The way it saw the financial operations working was as follows: A deliberately undervalued currency created a current account surplus, leading to accumulation of large exchange reserves, which in turn were used in low-interest financing of the US deficits. Being the largest holder of foreign exchange reserves, having the largest pool of surplus labor and receiving the largest amount of FDI among the EMEs, China played a pivotal role in the Bretton Woods-II regime. It was believed that the Bretton Woods-II regime could last for a couple of decades, until it reached its breaking point due to exceedingly high deficits, surpluses and forex reserves. This assumption proved to be incorrect because many analysts believe that the excesses came into being in the middle of the present decade (Dooley, Folkerts-Landau and Garber, 2004b and 2005). Not many economists agreed with this view of the novel global financial regime. Several researchers have identified several weaknesses in the global economic perspective of those who propounded the idea of a Bretton Woods-II coming into being.22 A somewhat direct explanation of the transpacific imbalances, put forth by Bernanke (2005), attracted wide attention in the academic and policy communities. Believing that global factors were responsible for the large US current account deficit, he argued than a combination of diverse forces over the past ten years created oversupply or a “glut” of global savings, which became the cause of increased current account deficit in the US as well as low long-term interest rates in the global economy (see Section 4.1). This so-called saving glut caused a reversal in the flows of credit from economies that should have been borrowers in the global capital markets under normal circumstances into lenders. It has facilitated a symbiotic relationship between the US on one hand and China and other large savers on the other. The second rationale behind the saving glut is demographic. Majority of the industrial economies must make provision for their increasing number of retiring people relative to the number of workers. With shrinking workforce and high capital-labor ratios, these industrial economies face an apparent dearth of domestic investment opportunities. The EMEs also face this problem, albeit not due to demographic reasons (Cooper, 2006).


Therefore, this subgroup of economies sought to lend abroad. According to this view, a near-term shrinking of the otherwise increasing US fiscal deficit will “not eliminate the current account deficit” (Bernanke, 2005). Others differ from the saving glut rationalization and emphasize that a weak saving performance relative to investment led to worsening of the current account deficit in the US (Lee, McKibbin and Park, 2004). During the preceding ten years, while gross domestic investment hovered around 19 percent of GDP in the US, gross domestic savings remained around 14 percent. The US savings remained considerably below its level of investment. Secular deterioration in the US saving performance and the post-2000 increase in the budget deficit are the principal culprits behind the increasing current account deficits. Conversely, the surpluses of China and the other AHP economies essentially reflect their enormously high savings rates relative to investment. The so-called logical theory presents another deviant explanation. How was the US able to borrow such a large amount from the global capital markets with so much of felicity? The answer according to this view is because it has come to have a comparative advantage in selling its securities to those global buyers, particularly the central banks, who have liquid assets to invest. It reflects the “attractiveness of US financial assets” (Cooper, 2004 and 2006). The US economy is a flexible one and has delivered a steady increase in productivity and therefore ensured profitability of investment. As claims on a robust, innovative and high-technology economy, these investments of the PBC and other central banks from the AHP economies are secure, liquid and perceived as stable. Therefore, the PBC and the other central banks have decided on a logical outlet for their excess savings (Backus and Lambert, 2005; Clarida, 2005). This is the rationale behind the capital inflows into the US economy. Therefore, it was argued that the US could run high deficits in the past and is likely to continue to do so in the future. Caballero et al. (2006) provided a model that rationalizes the perspective that an equilibrium can evolve between the forces of growth differentials among different regions of the global economy and heterogeneity in these regions’ capacity to generate financial assets from real investments. Their global portfolio balance model demonstrates that due to the superior economic and TFP growth performance of the US relative to the Euro Zone and Japan, global capital has had a natural proclivity to flow toward the US. A global equilibrium has been achieved by the high growth potential of China and the Asian EMEs on

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the one hand and capacity to generate attractive financial assets by the US on the other. In Section 4.3, it has been set out that the US earns higher returns on its global assets than what it pays out on its liabilities to the ROW. Gourinchas and Rey (2006) took this line of logic a step ahead. Using a newly constructed database they performed a detailed analysis of the historical evolution of US external assets and liabilities at market value since 1952. Not surprisingly, they found strong evidence of a sizeable excess return on gross assets of the US over its gross liabilities. US investors in China and other countries earn substantially higher rates of return than the PBC earns in the US. Therefore, the balance of return has remained in favor of the US. Interestingly, this excess return increased after the collapse of the Bretton Woods fixed exchange rate system. It was mainly due to a “return discount,” that is, within each class of assets, the total return (yields and capital gains) that the US has to pay to foreigners turned out to be smaller than the total return the US gets on its foreign assets. Another valuable finding was the “composition effect,” which implied that the US tends to borrow short and lend long. As financial globalization progressed “the US transformed itself from a world banker into a world venture capitalist.” In accordance with its new role, the US invested greater amounts in high-yielding assets, such as equities and FDI. Thus, while it appears counterintuitive, the US can run large current account deficits and carry large external debts with ease because US foreign investments earn significantly higher returns than the investments of foreign central banks in the US. Therefore, Gourinchas and Rey (2006) assert that US deficits should not be seen as a normal kind of deficit that an economy incurs. As a venture capitalist of the global economy, the US offers to economies such as China low-risk, low-return assets, concomitantly buying high-yielding assets from them. This explanation undermines the apocalyptic scenario of the consequences of the continuing current account deficit. Hausmann and Sturzenegger (2006a and 2006b) took this line of logic one more step ahead and argued that excess returns on US global investments, despite a net debtor position, is due to a conceptual measurement error. In their view, the conventional statistical measures understated the value of US assets. This is because US firms and transnational firms are exporting hidden assets with the liquid assets. These unmeasured assets are in the form of reputation, technological knowhow, marketing and managerial expertise and skills to innovation. They christened it the “dark matter.” The unmeasured assets substantially increase the capitalized value of the US foreign investments. If the


“dark matter” is taken into consideration, the US would be a net debtor economy to a much lesser extent than indicated by the statistics. Thus, notwithstanding the conventional view that the transpacific imbalance entails risk, is unsustainable, and can lead to a global financial crisis, there are several analysts who see differently and believe it as perpetuating without impairing the global economy.

4.7 Winding down the payments imbalances between China and the US Questioning the need for policy action to wind down transpacific payments imbalances in a globalized financial market is quite valid. The reason is that in the globalized financial markets of today, theoretically capital is fully mobile and exchange rates are completely flexible, and therefore there should be no need for taking concerted policy measures for winding down current account imbalances (see Section 4.1). In such a hypothetical world, current account imbalances should be taken as the norm, rather than the exception. In addition, such imbalances cannot lead to large current account crises as they did in the past during the Bretton Woods era, when the pegged exchange rates prevailed. In a highly adaptable world of globalized financial markets, current account imbalances should lead to a smooth rather than an abrupt adjustment in exchange rates until a balance is achieved. Normally payments imbalances should be small and self-correcting, given the market mechanism. Yet we do worry about the payment imbalances because the prevailing imbalances reflect market and policy imperfections as well as interference with the market mechanism (Cotis, 2007). As pointed out in Section 4.5, they are indeed capable of unleashing a market turmoil of large magnitude. China continues to have the largest merchandise trade surplus as well as current account surplus vis-à-vis the US (see Section 4.3). This one economy accounts for more than a quarter of both the deficits of the US and therefore attracts a good deal of attention from the US politicians and invites acrimonious criticism and frequent complaints to the WTO dispute panel. Some critics do not hesitate in going to extreme and volubly, if somewhat groundlessly, blame China for all the economic problems in the US and the global economy (Bergsten, 2007). As opposed to this frenzied penchant, Stiglitz (2006) has considerately noted, “Nothing significant can be done about the global imbalances unless the US attacks its own problems.” Hormats’s (2007) emphasis on the pressing need for domestic policy measures in the US is full of insight

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and will lead the US economy away from it current quandary (see Section 4.3). While there has been some real risk of disorderly market-driven adjustment, most analysts concurred that these risks were more like a medium-term challenge than a short-term policy exigency. Lipsky (2007) observed that “excessively precipitous policy action undertaken for immediate and substantial reductions in imbalances could be unnecessarily disruptive to global growth and could even undermine financial market stability.” Taking a medium-term perspective of this troublesome, conspicuous and much-analyzed global economic quandary did not amount to apathy, inaction and insipidness. It was a carefully considered strategy to shun near-term market stress in the global financial markets and bolster investor confidence. The IMF is an institution with multiple objectives and has a role in rectifying such imbalance situations. Promoting international financial stability is one of the tasks assigned to the IMF by its Article of Agreement. Article I states that the IMF is to “oversee the international monetary system in order to ensure its effective operation, and oversee the compliance of each member with its obligations.” The IMF was slow in reacting to the transpacific imbalances and in coordinating among systemically important economies. It has been criticized for playing an inadequate role in unwinding the transpacific and global imbalances, which became uncomfortably large (Buria and Abeles, 2007). Secondly, in the mid-1980s an identical set of global circumstances had emerged, and the Plaza Accord of September 1985 was arrived at to deal with it in a fairly effective manner.23 For the purpose of identical international policy coordination at present, a Plaza Accord II can also be organized, with the IMF providing technical support in arriving at the appropriate range of currency realignments and compatible policy coordination among the economies that are responsible and affected by the transpacific and other payments imbalances. 4.7.1 Multilateral consultations on transpacific imbalances In 2004, the IMFC of the IMF proposed the strategy of devising and adopting a medium-term policy stance, which was alluded to above. It was christened the “IMF’s Medium-Term Strategy.” In early 2006, the IMF started Multilateral Consultation on Global Imbalances, whose progress was reviewed in the IMFC meeting in April 2007. Such multilateral consultation on global economic issues, under the sponsorship of the IMF, was something of an experiment in international policy coordination. Senior monetary and financial policy makers from five


major countries, which included both China and the US,24 met and discussed the policy options and implementation of a medium-term strategy to wind down the global payment imbalances and promote robust global economic growth. The explicit objective of these multilateral consultations was to reposition the global economy on “an adjustment path towards a more durable and credible pattern of domestic demand growth while maintaining robust global GDP growth” (Lipsky, 2007). While their emphasis was on the transpacific imbalances, other economies with large current account surpluses, such as Japan and Saudi Arabia, are also included. During the consultation, China proposed a thoughtful threepronged strategy: The first policy measure was rebalancing growth toward domestic consumption and reining in both GDP and investment growth rates. Second, continuing deepening the much-needed financial sector reforms. Third, be more flexible in its exchange rate management. China did widen the daily trading band of the RMB yuan, albeit not by a large margin. As China’s current account surplus increased further in 2007, an accelerated currency appreciation would not only be helpful in addressing the transpacific imbalances but also provide the correct price signals for investment. The US announced its plan to focus policy action on raising the domestic household saving rate and eliminate fiscal deficits by 2012. Some success in the latter objective was achieved; the government expenditure deficit declined by 2 percent during the 2004–06 period. Discretionary spending in the US is needed to be controlled much more strictly than in the past. However, the corollary of increasing domestic savings is the policy action to restrain both consumption and investment, which was not included in the US proposal. Ensuring continuing depreciation of the dollar was also not made a part of the proposal. Japan and Saudi Arabia are two other economies with considerable current account surpluses, although not comparable to that of China. Japan proposed undertaking deeper structural reforms, which are expected to catalyze its ongoing recovery. As consumption and investment spending strengthen, the current account surplus is bound to decline. Saudi Arabia began to increase its social outlays and implement an ambitious investment program, and not just in the hydrocarbon sector. In its April 2007 review of progress thus far, the IMFC was positive. Despite some inadequacies, the IMFC noted that as these policies are implemented, they could work as mutually reinforcing and interacting policy actions that will make a significant contribution to reducing global payments imbalances, including the transpacific one. The IMFC

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considered that the experience gained so far demonstrated that the multilateral consultation approach, through discussion and cooperation among member countries, has been useful for addressing problematic global issues (IMF, 2007). 4.7.2 An accord to unwind the transpacific imbalances A precedent of accords, such as Smithsonian (1973), the London Summit (1977), the Plaza (1985) and the Louvre (1987), exists to arrive at a coordinated agreement among the systemically important economies to resolve tangled global economic issues. Not all of these accords achieved desired results. The first two failed to achieve much. However, the Plaza and the Louvre accords demonstrated a strong level of cooperation, coordination and political will among the major industrial economies. That being said, it was evident that sovereign nations had their limits and the extent of coordination that prevailed was often scarce. Given the similarities in the imbalances, nostalgia for such accords has returned. Many researchers feel that a similar macroeconomic coordination exercise is now needed to resolve the issue of transpacific imbalances and for methodically winding down the large surpluses of the other economies (Cline, 2005; Williamson, 2005). While the previous accords were reached among the large industrial economies under the umbrella groups like G-5, the present one will need to involve a larger number of countries because the EMEs that account for huge surpluses are not represented in the G-7. Also, several EMEs have begun to provide significant impulses to global growth. China, India and the Russian Federation accounted for one-half of global growth in 2006 (WEO, 2007). They and the other EMEs have been playing a larger and growing role in the global economy. Furthermore, they are also a critical part of the transpacific and global imbalance equation. Therefore, the G-2025 is the right forum for the present accord. A vitally important point in this accord will have to be an agreement among the participating economies that have presently (2007) pegged their currencies to the dollar and conventionally intervene in their foreign exchange markets by sterilizing the inward flow of foreign exchange to prevent appreciation of their currencies. This market intervention was prolonged and of large scale. Central banks in these countries will need to agree to refrain from such a course of action. Buria and Abeles (2007) suggested that the Bank of Japan (BOJ), the ECB and the other G-20 central banks should agree to sell their dollar reserves and the Fed should agree to purchase the euros, the yens and other currencies of major trading economies. China and the other surplus countries


should be required to follow this policy until their exchange rates vis-àvis the dollar have appreciated and realigned. As for the decision regarding the degree or the range of currency appreciation or depreciation, the IMF can play an active and crucial role. This exercise requires thorough coordination, and the IMF is the ideal supranational institution to provide it. In its role as a coordinator it must determine the ballpark “range of exchange rates for the G-20 currencies that would be consistent with external balance at high level of employment” in the participant economies. Cline (2005) categorized the potential participants, the G-20 countries, into three subgroups. The first would appreciate its currency by approximately 40 percent against the dollar, the second between 15 percent and 40 percent, while the third would not take an initiative until its currency begins to depreciate against the dollar. China would fall in the first subgroup and would gradually appreciate the RMB yuan by approximately 45 percent. As the euro appreciated sharply since 2002, it was placed in the second subgroup. The currency realignment is an intricate process; it cannot be conceived as a short-term exercise. Implementation of various policy measures will have to be extended to a three or even a four-year period and will need to be performed with the finesse and subtlety that such an exercise requires. Given the fact that “flawed US economic policies” were to a considerable extent responsible of the imbalance, the US will need to make a concerted and credible endeavor to carry out its part of the adjustment process (Cline, 2005). A sharp, dollar depreciation may not work as a panacea for the US current account deficits. Dollar depreciation, without fiscal restraint and domestic-demand-curb measures, would frustrate the adjustment process by increasing the domestic output. It would result in inflationary pressure in the US economy.26 If the Fed counters the rising inflation by monetary tightening, the interest rate will start moving north, which would bid the dollar back up, defeating the very objective of the adjustment process and the accord. Thus, if an accord is to yield desired results, full US cooperation is mandatory. The ultimate outcome of this accord will be a shift or correction in the configuration of global demand and supply, that is, demand will shift from the deficit to the surplus countries and vice versa for the supply. This shift will be the key to the process of contraction of transpacific imbalances. If a supply spurt does not occur in the surplus economies such as China, a fiscal contraction in the US, along with a consumer demand decline and continuing depreciation of the dollar, will cause a global recession. This possibility is to be avoided at all

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costs. For this accord to succeed, the domestic policy package in the surplus economies will need to be expansionary. A demand expansion in China and the other surplus G-20 economies will work to counter the contraction of global demand resulting from lower net exports that demand contraction in the US will cause. However, demand expansion in China alone will hardly suffice because in terms of the size of GDP, at market exchange rate China is still a fourth of the US economy. By no stretch of imagination it can offset the fall in global demand that the US demand contraction will cause. An accord to reduce the transpacific and global imbalances and the exchange rate realignment is superior to a market-driven resolution of the imbalances. The reason is that such an accord can effectively “minimize the recessionary bias of alternative adjustment processes, such as abrupt fall in the rate of consumption growth in the US, or the sudden adjustment of international portfolio away from US-dollar assets” (Buria and Abeles, 2007).

4.8


Global macroeconomic imbalances were frequent during the post–World War II period. China’s large and growing merchandise trade and current account surplus vis-à-vis the US is of an unprecedented magnitude, has persisted for a long while and threatens to endure further and exacerbate. Whether the transpacific imbalance could be a threat to the global economy at some time in the present or near future is an arguable point. A tectonic shift that has recently taken place in the global financial scenario is the accumulation of large reserves of foreign exchange first with the OPEC countries and then with some EMEs—which are a subgroup of developing economies. Transformation of EMEs from net importers of capital to net exporters is something novel and incompatible with economic theory. Capital surpluses used to be the prerogative of the industrial economies. Two of the reasons of this secular change in the global economy are the post–Asian crisis (1997–98) collapse in investment in the AHP economies and crisis-inspired increase in domestic savings. China, a high-saving economy, recorded small current account surpluses in the past, which accelerated after 2001. Surpluses increased, although they did not reach a disturbingly high level. In 2005, the current account surplus increased more than two-and-a-half times YOY and hit a historical high of $160.8 billion, or 7.2 percent of GDP.


The US, a low-saving economy, suffered from further secular decline in saving performance. There were several reasons for the persistently weakening saving performance. If the US saving-investment imbalance continues, the US will continue to be dependent on foreign, including Chinese, capital inflows. Trade between the US and China began at an exceedingly low level but expanded rapidly over the last two decades. In 2006, China became the second-largest source of the US imports and the fourth-largest export market for the US, after Canada, Mexico and Japan. Since 2003, China ranked as the second-largest import supplier for the US behind Canada. In 1985, the China-US trade was totally balanced. The trade and current account imbalance between China and the US were diminutive in the late 1980s. However, these imbalances went on increasing. In 2003, the current account deficit grew to $134.8 billion, with that China acquired the distinction of being the economy with which the US had the largest trade deficit, which began to roil the bilateral commercial relations. One frequently given public response of the Chinese officials to the US complaints regarding their bilateral trade surplus is that the US does not provide enough licenses to exporters for high-technology export products to China. However, statistical data do not substantiate this charge. The HS 85 category proved to be a large and growing component of both bilateral exports and imports. This confirmed China’s increasingly integrated position of global supply chain of electronic goods. In the recent years the ETDAs, the HTIDAs) and the BAs have become responsible for increasing bilateral exports to the US. Their share in exports to the US has increased markedly over the last ten years. The FIEs and other enterprises were more successful at exporting in general and exporting to the US in particular. A large proportion of FIEs are US firms and TNCs operating in China. The FIEs overwhelmingly dominated the Chinese export performance to the US, as well as that to the other parts of the global economy. They account for 80 percent of the US current account deficit against China. As the production of such a large array of products is vertically integrated and a good part of these so-called processed exports go to the US, there has been a sharp decline in the US bilateral trade imbalance that originated in the past in Japan, the NIAEs and the ASEAN-4 economies. These countries have moved a great deal of their manufacturing capacity to China. The impact on the trade and current account balance of this major structural adjustment among China, Japan, the NIAEs and the ASEAN-4 is that the US trade deficit vis-à-vis the other East Asian economies declined dramatically. Given these reasons, it is likely that the bilateral trade and current deficit between the

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two economies will continue in the near future. No indications of a reversal are in sight for the medium-term. A study conducted by the USCBC, a leading organization of large US companies that do business in China, concluded that the transpacific trade and current account imbalances are healthy and beneficial for the US economy. According to their assessment, there are substantial longterm and enduring benefits for the US from the trade and investment in China. Stability of the transpacific current account disequilibrium has been debated and questioned by many in the profession. Something close to a consensus has gradually evolved among researchers regarding the medium- or long-term transpacific financial imbalances not being sustainable in the medium-term. They can feed back on to the real sector behavior. Several in-depth studies echoed that a correction of transpacific imbalances is inevitable because with every passing year the disequilibrium is worsening and is on a grossly unsustainable course. Notwithstanding the ominous consequences predicted by many researchers, the much-predicted apocalypse has not materialized as yet, and the PBC and central banks of the other AHP economies have not stopped investing in the US economy. There are several differing, even contradictory, explanations and rationalizations of the macroeconomic imbalances between China and the US. Thus, notwithstanding the conventional view that the transpacific imbalance entails risk, is unsustainable, and can lead to a global financial crisis, there are several analysts who see differently and believe it as perpetuating without impairing the global economy. There is a propensity among some US critics of China to blame it for all the US problems. However, many noted thinkers, such as Stiglitz (2006), believe that nothing significant can be done about the global imbalances unless the US attacks its own problems. They emphasize on the pressing need for domestic policy measures in the US to correct the bilateral imbalances, which would lead the US economy away from its current quandary. What are the various approaches to wind down the transpacific imbalance? First, the IMF is an institution with multiple objectives and has a role in rectifying such imbalance situations. Promoting international financial stability is one of the tasks assigned to the IMF by its Article of Agreement. Somewhat belatedly, the IMF has launched multilateral consultations on transpacific imbalances. They are presently in progress. Secondly, in the mid-1980s an identical set of global circumstances had emerged, and the Plaza and the Louvre Accords were arrived


at to deal with them in a fairly effective manner. For the purpose of identical international policy coordination at present, a similar accord can also be organized, with the IMF providing technical support in arriving at the appropriate range of currency realignments and compatible policy coordination among the economies that are responsible and affected by the transpacific and other payments imbalances.

References Backus, D. and F. Lambert. 2005. “Current Account Fact and Fiction.” New York. Stern School of Business. New York University. (unpublished manuscript). Bergsten, C.F. 2007. “The Dollar and the Renminbi.” Statement before the Hearing on US Economic Relations with China, United States Senate, May 23. Bernanke, B.S. 2005. “Global Saving Glut and the US Current Account Deficit.” The Sandridge Lecture delivered in front of the Virginia Association of Economics, Richmond, Virginia, April 14. Buira, A. and M. Abeles. 2007. “Global Imbalances and the Role of the IMF” in Global Imbalances and Developing Economies. FONDAD, The Hague. pp. 93–123. Buira, A. and M. Abeles. 2006. “The IMF and the Adjustment of Global Imbalances.” Paper submitted to the G-24 Technical Group Meeting, Geneva, March 16–17. Caballero, R.J., E. Farhi and P.O. Gourinchas. 2006. “An Equilibrium Model of ‘Global Imbalances’ and Low Interest Rates.” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 11996. May. Chinn, M.D. and H. Ito. 2007. “Global Current Account Imbalances: American Fiscal Policy versus East Asian Savings.” Madison, Wisconsin. La Follette School of Public Affairs. University of Wisconsin. Working Paper No. 2007-013. Clarida, R.H. 2005. “Japan, China and the US Current Deficit.” CATO Journal. Vol. 25. No. 1. pp. 111–14. Cline, W.R. 2007. “The Fiscal Deficit and the US External Deficit.” Statement before the Budget Committee of the US Senate’s hearing on The Current Account Deficit and the US Foreign Debt, on February 1. Cline, W.R. 2005. “The Case for a New Plaza Agreement.” Washington DC. Institute for International Economics. Policy Brief PB05-4. Cooper, R.N. 2006. “Understanding Global Imbalances.” Paper presented at the conference organized by the Federal Reserve Bank of Boston on Global Imbalances: As Giants Evolve at Chatham, MA, June 14–16. Cooper, R.N. 2004. “US Deficit: It is Not Only Sustainable, It is Logical.” London. The Financial Times. October 31. Cotis, J.P. 2007. “Unwinding Global Imbalances.” Paper presented at the Brussels Economic Forum, Brussels, Belgium, on May 31. Croke, H., S. Kamin and S. Leduc. 2005. “Financial Market Developments and Economic Activity During Current Account Adjustments in Industrial Economies.” Washington DC. The Board of Governors of Federal Reserve System. International Finance Discussion Paper No. 827. Das, Dilip K. 1992. The Yen Appreciation and the International Economy. London, The Macmillan Press Ltd. and New York, the New York University Press.

194 The Chinese Economic Renaissance Debelle, G. and G. Galati. 2005. “Current Account Adjustment and Capital Flows.” Basel. Bank for International Settlements. BIS Working Paper No. 169. de Haan, L., H. Schokker and A. Tcherneva. 2006. “What Do Current Account in OECD Countries Tell Us about the US Case?” Amsterdam. De Nederlandche Bank. DNB Working Paper No. 111. de Rato, R. 2007. “State of the World Economy.” Speech at the Harvard Business School, Cambridge, MA, February 26. Available on the Internet at http://www.imf.org/external/np/speeches.2007.022607.htm. Dooley, M., D. Folkerts-Landau and P. Garber. 2005. “International Financial Stability: Asia, Interest Rates and the Dollar.” Frankfurt, Germany. Deutsche Bank. Dooley, M., D. Folkerts-Landau and P. Garber. 2004a. “The US Current Account Deficit and Economic Development.” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 10727. September. Dooley, M., D. Folkerts-Landau and P. Garber. 2004b. “The Revisited Bretton Woods System: Alive and Well.” Frankfurt, Germany. Deutsche Bank. Edwards, S. 2005. “Is Current Account Deficit Sustainable? And If Not, How Costly is Adjustment Likely to Be?” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 11541. October. Eichengree, B.G. 2004. “Global Imbalances and Lessons of Bretton Woods.” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 10497. May. Erceg, C., L. Guerrieri and C. Gust. 2005. “Expansionary Fiscal Shocks and the Trade Deficit.” Washington DC. The Board of Governors of Federal Reserve System. International Finance Discussion Paper No. 825. January. Faruqee, H., D. Laxton, D. Muir and P. Pesenti. 2005. “Smooth Landing or Crash? Model Based Scenario of Global Current Account Rebalancing.” Paper presented at the NBER conference on G-7 Current Account Imbalances: Sustainability and Adjustment at New Port, June 1–2. Frankel, J.A. and S.J. Wei. 2007. “Assessing China’s Exchange rate Regime.” Economic Policy. Issue 51. July. pp. 575–614. Freund, C. and F. Warnock. 2005. “Current Account Deficits in Industrial Countries: The Bigger They Are, the Harder They Fall?” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No. 11823. Funabashi, Y. 1989. Managing the Dollar: From the Plaza to the Louvre. Washington. DC. Institute for International Economics. Goldman Sachs. 2005. “Do Current Account Adjustments Have to be painful?” Goldman Economic Weekly. No. 05/04. pp. 41–62. Goldstein, M. and N.R. Lardy. 2005. “China’s Role in the Revived Bretton Woods System: A Case of Mistaken Identity.” Washington DC. Institute for International Economics. Working Paper Series. WP05-2. March. Gourinchas, P.O. and H. Rey. 2006. “From World Banker to World Venture Capitalist” in R. Clarida (ed.) G7 Current Account Imbalances: Sustainability and Adjustment. Chicago. The University of Chicago Press. pp. 110–34. Greenspan, A. 2005. “The US Current Account.” Speech at Advancing Enterprise 2005 Conference, in London, UK, February 4. Hammer, A.B. 2006. “The Dynamic Structure of US-China Trade, 1995–2005.” Washington DC. US International Trade Commission. Working Paper No. 2006-07A. July.

Transpacific Macroeconomic Imbalances 195 Hausmann, R. and F. Sturzenegger. 2006a. “Global Imbalance or Bad Accounting? The Missing Dark Matter.” Center for International Development. Harvard University. CID Working Paper No. 124. Hausmann, R. and F. Sturzenegger. 2006b. “Can Dark Matter Prevent a Big Bang?” Harvard University. Kennedy School of Government. (unpublished). Hormats, R.D. 2007. “Foreign Holdings of US Debt: Is Our Economy Vulnerable?” Testimony given in front of the House Budget Committee, the US Congress, in Washington DC, on June 26. Hufbauer, G.C. 2007. “Three US-China Trade Disputes.” Paper prepared for the conference on “The China Balance Sheet in 2007 and Beyond” co-hosted by the Center for Strategic and International Studies and the Peterson Institute for International Economics, Washington DC, May 2. International Monetary Fund (IMF). 2007. “Communiqué of the International Monetary and Financial Committee of the Board of Governors of the International Monetary Fund.” Press Release No. 07/71. April 14, 2007. Kose, A.M., E. Prasad, K. Rogoff and S.J. Wei. 2006. “Financial Globalization: A Reappraisal.” Washington DC. International Monetary Fund. Working Paper WP/06/189. August. Krugman, P. 2007. “Will There be a Dollar Crisis?” Economic Policy. No. 51. July. pp. 436–67. Krugman, P. 2006. “Will There be a Dollar Crisis?” Paper presented at the conference organized by the Federal Reserve Bank of Boston on Global Imbalances: As Giants Evolve at Chatham, MA, on June 14–16. Lardy, N.R. 2006. “China’s Interaction with the Global Economy” in R. Garnaut and L. Song. (eds) The Turning Point in China’s Economic Development. Canberra, Australia. The Asia Pacific Press. Australian National University. pp. 76, 86. Lee, J., W.J. McKibbin and Y.C. Park. 2004. “The Transpacific Imbalance.” Sydney, Australia. The Lowy Institute. Issues Brief. Available on the Internet at http://www.lowyinstitute.org. Lipsky, J. 2007. “The Multilateral Approach to Global Imbalances.” Paper presented at the Brussels Economic Forum, Brussels, Belgium, on May 31. McKibbin, W. J. and A. Stoeckel. 2005. “The United States Current Account Deficit and the World Markets”. Economic Scenarios. No. 10. Washington DC. The Brookings Institution. McKinnon, R.I. 2007a. “Why China Should Keep Its Dollar Peg: A Historic Perspective from Japan.” International Finance. Vol. 10. No. 1. pp. 43–70. McKinnon, R.I. 2007b. “The Transfer Problem in Reducing the US Current Account Deficits.” Stanford, CA. Stanford University. Stanford Center for International Development. Working Paper No. 326. May. McKinnon, R.I. and G. Schnable. 2006. “Devaluing the Dollar: A Critical Analysis of William Cline’s Case for a New Plaza Agreement.” Journal of Policy Modeling. Vol. 28. No. 6. pp. 683–94. McKinsey Global Institute (MGI). 2007. The US Imbalancing Act: Can the Current Account Deficit Continue? San Francisco, CA. Meissner, C.M. and A.M. Taylor. 2006. “Losing Our Marbles in the New Century? The Great Rebalancing in Historical Perspective.” Paper prepared for the session “Global Imbalances: Lessons from History” during a conference organized by the Federal Reserve Bank of Boston, at Chatham, MA, in June 14–16.

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Morrison, W.M. 2007. “China-US Trade Issues.” Washington DC. Congressional Research Service. May. Code RL33536. Mussa, M. 2004. “Exchange Rate Adjustments Needed to Reduce Global Payments Imbalances” in C.F. Bergsten and J. Williamson (eds) Dollar Adjustment: How Far? Against What? Washington DC. Institute for International Economics. pp. 113–28. Obstfeld, M. and K. Rogoff. 2004. “The Unsustainable US Current Account Revisited.” Cambridge, MA. National Bureau of Economic Research. NBER Working Paper No 10864. September. Obstfeld, M. and K. Rogoff. 2000. “The Sustainability of US External Deficits and Chinese External Surpluses.” New York. Stern School of Business. New York University. (unpublished) Organization for Economic Cooperation and Development (OECD). 2007. OECD Economic Outlook. No. 81. Paris. May. Rajan, R.G. 2005. “Global Current Account Imbalances: Hard Landing or Soft Landing.” Lecture given at the Crédit Suisse First Boston Conference in Hong Kong, on March 15. Roubini, N. 2006. “The Unsustainability of the US Twin Deficits.” Cato Journal. Vol. 26. No. 2. pp. 343–56. Roubini, N. and B. Setser. 2005. “Will the Bretton Woods 2 Regime Unravel Soon?” New York. Stern School of Business. New York University. (unpublished). Roubini, N. and B. Setser. 2004. “The US as a Net Debtor: The Sustainability of the US External Balances.” New York. Stern School of Business. New York University. (unpublished). Stiglitz, J.E. 2006. “How to Fix the Global Economy.” The New York Times. October 3. p. 9. Summers, L.H. 2006. “Reflections on Global Account Imbalances.” L.K. Jha memorial lecture delivered at the Reserve Bank of India, Mumbai, India, on March 24. Summers, L.H. 2004. “The US and the Global Adjustment Process.” Speech at the Institute for International Economics. Washington DC. March 23. United States-China Business Council (USCBC). 2006. The China Effect: Assessing the Impact on the US Economy. Washington DC. June. United States International Trade Commission (USITC). 2007. The Year in Trade 2006. 58th Report. Washington DC. July. Weisman, S.R. 2008. “Eased Rules on Tech Sales to China Questioned.” The New York Times. January 2. p. 7. Williamson, J. 2005. “Reforms to the International Monetary System to Prevent Unsustainable Global Imbalances” in The International Monetary Fund in the 21st Century. Geneva, Switzerland. World Economic Forum. Wolf, M. 2007. “The Right Way to Respond to China’s Exploding Surpluses.” The Financial Times. May 29. p. 8. World Bank (WB). 2005. Global Developmental Finance. Washington DC. World Economic Outlook (WEO). 2007. International Monetary Fund. Washington DC. April. World Economic Outlook (WEO). 2006. International Monetary Fund. Washington DC. September.

Transpacific Macroeconomic Imbalances 197 World Economic Outlook (WEO). 2002. International Monetary Fund. Washington DC. September. World Economic Outlook (WEO). 2000. International Monetary Fund. Washington DC. September. Wu, Y. 2007. “Engage in Sincere Dialogue and Seek Common Development.” Speech at the banquet hosted by four American organizations in Washington DC on May 24.

5 The Chinese Renaissance and Its Currency Conundrum

5.1

Evolution of China’s exchange rate regime

After frequent adjustments and fluctuations, the value of the renminbi (RMB) yuan,1 the Chinese currency, remained stable over the 1952–70 period. During this period, the exchange rate was first pegged to the dollar and then to the pound sterling, but it did not have much relevance because the volume of China’s trade and financial flows was tiny and the related decisions were controlled by the ministries and government authorities. Also, in a planned economy, the exchange rate was used as an instrument for financial planning and fixed at at an overvalued level. The convertability of the dollar into gold was suspended in August 1971, and between 1971 and 1973 the Bretton Woods system brokedown. The RMB yuan was pegged to a broad basket of 15 hard currencies instead of a single major currency. It began appreciating gradually after that. This peg endured until 1980. In a major exchange rate reform exercise, a dual currency value system was adopted in 1980, that is, an official exchange rate coexisted with the market-determined, trade-related exchange rate. At this point, the official rate was 1.5 RMB yuan to the dollar and was not intended for trade or financial transactions but for internal settlements. In 1984, the official rate climbed to 2.8 RMB yuan to the dollar (Lardy, 2002). Keeping the currency overvalued was a common practive followed by many developing countries during the post-War period. As the domestic currency was exchanged at the offical rate by the central banks, business firms that exported and earned foreign exchange paid an implicit tax in the form of lower returns in domestic currency. In most developing countries, firms were not allowed to retain their foreign exchange earnings. They had to surrender them to the central banks. 198

The Chinese Renaissance and Its Currency Conundrum 199

As the economic reform and liberalization process moved forward, a formal secondary market creation was approved by the monetary authorities in 1986 and an exchange rate based on free-market foreign exchange swap was established in November. It was the rate agreed between the buyers and the sellers for foreign-trade-related settlements. The Chinese firms that were allowed to retain their export earnings could trade their foreign exchange at this market-determined rate. Foreign investors used the swap rates at over 100 foreign exchange centers established by the monetary authorities. Chinese firms could also make use of this rate in the four SEZs, namely, Shantau, Shenzhen, Xiamen and Zhuhai. In 1988, all the Chinese firms that were authorized to retain foreign exchange were allowed to make use of the swap rates. When the dual rates prevailed, the official price of the dollar was much lower than the open-market swap rate and being market-driven it fluctuated a good deal. This indicated that the RMB yuan was kept artificially overvalued by government fiat. In the dual rate system, the official rate was determined by exchange cost of exported products, plus a small proportion of profit. Owing to the overvauation of the currency, it remained under constant pressure for depreciation and had to be repeatedly devalued. In 1992, when Deng Xiaoping made a tour of the Southern provinces, reaffirming the commitment of the political leadership to the reform and liberalization process, one of the immediate impacts was acceleration of the GDP growth rate, causing increased pressure to depreciate the RMB yuan. The market-determined rate fell and the difference between the two exchange rates widened. After 1992, economic liberalization and the opening-up process also accelerated, which led the economy to overheat, causing the inflation rate to rise and the current account to record a sharp deficit. The official exchange rate was 1.58 RMB yuan to the dollar in 1993. It was devalued to 5.80 to the dollar at the end of 1993, which amounted to 73 percent depreciation in nominal terms (Shuqing, 2004). Taking a lesson from its dynamic Asian neighbors, monetary authorities in China decided to abandon their strategy of keeping the currency overvalued and introduced a new market-based currency regime. A competitively priced currency was imperative for adopting an export-led growth strategy like that in Japan and the other AHP economies. On January 1, 1994, the dual rate system was eliminated; the two rates were integrated and a more market-based and market-managed floating rate system was adopted. The unification of the official and free-market swap rates took place with a large depreciation of the RMB yuan. The exchange rate jumped from 5.5 RMB yuan to the dollar to 8.7 RMB yuan.

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The latter was the free-market swap rate at that time. This amounted to a large currency devaluation of 32.09 percent in nominal terms (Das, 2006). Some analysts regard this megadevaluation as one of the causes of the Asian crisis (1997–98).2 This devaluation gave China’s exports a substantive competitive advantage vis-à-vis the other AHP economies and a surge followed. Overvaluation of the currency was eliminated by unification of the exchange rates, which had a beneficial impact over the economy, particularly the activities of the external sector. McKinnon (2005) noted that as China’s trade, particularly trade in manufactures, was transacted at higher rates during the period of dual exchange rate system, the unification of exchange rate in 1994 overstated the effective currency depreciation. However, because of a spike in the rate of inflation between 1993 and 1995 the real currency depreciation turned out to be small. The nominal currency depreciation exacerbated inflation. However, by 1996, the RMB yuan had appreciated a tad, to 8.2773 to the dollar and the inflation had settled down. The Chinese policy makers regarded stability of the currency as an essential factor for vitalizing the external sector. Between 1994 and 1997, China adopted a crawling-peg currency regime, before adopting its de facto dollar peg in 1997. Since this point the RMB yuan remained nominally stable vis-à-vis the dollar despite rapid real GDP growth, rising TFP, robust export expansion and massive FDI flows. All these four factors are theoretically responsible for currency appreciation. In addition, China has accumulated the largest reserves of foreign exchange. At the end of the August 2007, the reserves were $1,400 billion. Such a large build up per se is an indication of undervaluation of currency. Hindsight is 20/20 and reveals that the de facto dollar peg provided stability of the currency and served the economy well. The Asian financial and currency crisis of 1997–98 had a large impact over the regional currencies. The currencies of the crisis-stricken economies depreciated dramatically, and it was strongly apprehended in the currency markets that other systemically important Asian economies, including China, may depreciate their currencies (Das, 2006). However, to prevent the crisis from exacerbating monetary authorities in China committed not to resort to currency depreciation and adhered to its de facto dollar peg. By adhering to its de facto dollar peg China won international acclaim for its clairvoyance and goodwill for the neighboring regional economies. China let the international financial community know that it is a responsible player in the global financial markets and earned confidence and commendation of international investors. China and the


other AHP economies have increasingly integrated and it is continuing (Chapter 2). China’s adhering to its dollar peg became the key to intraAHP exchange stability. As many other AHP economies also peg to the dollar, it almost amounted to pegging to each other’s currency. It made China’s not depreciating the RMB yuan a significant and prudent policy measure. To offset the crisis-generated external shock, other policy measures, such as giving exporters VAT rebates, were taken. China initiated other regional measures that aimed at underpinning economic and financial stability, including full support to the Chiang Mai Initiative, which was announced in May 2000 by the Finance Ministers of APT countries.3 Not depreciating the RMB Yuan and maintaining its dollar peg helped the Chinese currency to make a place for itself among the most important currencies in the EMEs. However, deflation was the domestic cost of not depreciating the currency in the wake of the Asian crisis. A countercyclical fiscal policy was adopted to counter it. The silver lining of the domestic deflation cloud was that the competitiveness of Chinese exports in the global marketplace was strengthened. By 2001, the economy got out of the deflation. The dollar steadily appreciated during the 1997–2002 period. As noted in Chapter 4 (Section 4.3), the trade-weighted value of the dollar appreciated. If the broad index, computed by the US Fed, is taken as a measure, the dollar appreciated by 37.66 percent between January 1995 and February 2002. It peaked at this point and then depreciation began. Between February 2002 and August 2007 it depreciated by 20.29 percent.4 The broad index is a weighted average of foreign exchange values of the dollar against the currencies of a large group of major US trading partners. Owing to the de facto dollar peg, the RMB yuan also appreciated in both nominal and real terms as the dollar appreciated. Because of the same reason, the RMB yuan began depreciating when the dollar correction period began in February 2002 and the dollar began its southward journey. This development was counter to the movement of the euro, the yen, the pound sterling and the Australian and Canadian dollars, which were all appreciating vis-à-vis the dollar after February 2002. As the RMB yuan had appreciated with the appreciation of the dollar before February 2002, this depreciation of the RMB yuan in nominal and real terms brought it back to its 1998 level by 2003 (Kanamori and Zhao, 2006). By November 2007, the euro, the yen, the pound sterling and the Australian and Canadian dollars had appreciated vis-à-vis the dollar to record levels. Depreciation of the dollar against the euro was precipitous.

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The exchange rate remained de facto pegged at 8.2773 to the dollar until July 2005. This brief analysis of the changes, developments and evolution of the exchange rate regime supports the view that during the reform era, first, the exchange rate system in China evolved pari passu with the liberalization measures taken. Secondly, market forces and external factors had a decisive impact over the evolving exchange rate regime.

5.2

Misalignment of the RMB yuan

That the RMB yuan is undervalued is widely acknowledged and difficult to challenge. The 2006 Article IV consultation report of the IMF (IMF, 2006) also took this position. However, by how much it is undervalued is an area of complete disagreement. The July 2007 value of the RMB yuan was 7.60 to the dollar. The current account surplus in China had risen from 4 percent of the GDP to 11 percent over the 2004–07 period. To most observers, this was the proof of misalignment of the RMB yuan and, therefore, it was widely believed that a currency appreciation was warranted for eliminating the current account surplus. According to the Big Mac Index, which is a facetious, if well-known, indicator of currency overvaluation or undervaluation, based on the PPP theory, it was 58 percent undervalued (The Economist, 2007). However, according to another analogous index called the “Starbucks tall latte index” the RMB yuan was only 1 percent undervalued in 2004 (The Economist, 2004). As these measures of PPP are based on merely one product, they can be taken as fanciful and far-fetched indicators. Recent econometric estimates of undervaluation of the RMB yuan range from modest undervaluation to as high as 45 percent. A general observation in this context is that in developing countries, where per capita income is low, currencies are undervalued. 5.2.1 Undervaluation and Balassa-Samuelson hypothesis According to the Balassa-Samuelson hypothesis the consumer price levels in wealthier countries are systematically higher than in poorer ones. This hypothesis is based on the assumption that relatively higher productivity increases are associated with real appreciation of a country’s currency. According to this hypothesis, rapid economic growth is associated with a real exchange rate appreciation. It is assumed that productivity, or productivity growth, varies more by country in the traded goods sectors than in the nontraded goods sectors (Samuelson, 1964; Balassa, 1964). The Balassa-Samuelson hypothesis is relevant to the assertions of undervaluations of the RMB yuan and the rate at which it


needs to appreciate to correct the undervaluation. According to the 1990 Penn World Central data, China’s price level was only 0.119 of the US price level (Summers and Heston, 1991). More recent estimates made by Frankel (2006b) put the price level in China at 1/10th of the US prices. This gap is only partly explained by the fact that household incomes in China are 1/8th that of the US. Judged by the BalassaSamuelson considerations, the RMB yuan is undervalued by almost 40 percent. The estimate that closing one-half of such gaps takes a decade implies that the RMB yuan should appreciate at the rate of 20 percent per decade for the next two decades. This translates into an approximately 2 percent appreciation annually. In addition, regression analysis for the year 2000 on a cross section of 118 countries yielded a highly significant coefficient of 0.382 on the log of relative income. That is, every 1 percent increase in real per capita income is associated with 0.38 percent in real appreciation. If China continues to grow at its current annual GDP growth rate, it is almost 7 percent higher than that of the US annual growth rate. Therefore, application of these regression results leads one to the fact that the exchange rate should appreciate along the BalassaSamuelson line by 2.8 percent per year. Adding these two, the estimated appreciation of the RMB yuan should be in the range of 4.8 percent per annum. If China’s future GDP growth rate declines from its current high level, this appreciation rate would decline accordingly. However, this exercise was a bilateral comparison of currency valuation, which some feel has a limited utility while others find it completely faulty. Cheung et al. (2007a) expended on Frankel’s (2006b) approach. They based their analysis on data from 160 countries for the 1975–2005 period from the World Development Indicators (WDI). Employing the same approach as Frankel (2006b), they estimated the relationship between real exchange rate and income using pooled time-series OLS regression, where all variables were expressed relative to the US. Many of the results obtained were comparable to the prototype Frankel research. The RMB yuan was found to be undervalued by 60 percent in log terms for 2005–06, and 50 percent in absolute terms. However, these estimates were not robust to specification. Also, they were not statistically significant. In Cheung et al. (2007b), the same analysis was further extended to allow for heterogeneity across country groupings and time period. The second study concluded that while the point estimates indicated that the RMB yuan was undervalued vis-à-vis the dollar, in almost no case the deviation was statistically significant. When the serial correlation was accounted for, the RMB yuan-dollar misalignment was not statistically significant even at 50 percent level.

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Thus viewed, these conclusions highlighted the uncertainty that surrounds the empirical estimates of “equilibrium real exchange rates.” The relationship between real per capita income and real value of a currency in PPP terms was found to be diffused. The results obtained in these empirical analyses were of a tenuous nature. To be sure, such a relationship did and does exist, but the magnitude of the “slope coefficient is subject to substantial uncertainty” (Cheung et al., 2007a). If anything, empirical research on these lines pointed to the difficulty in gauging the degree of RMB yuan undervaluation. The conclusion regarding the RMB yuan being undervalued was difficult to disagree with because it is consistent with conventional wisdom. However, it did not survive close scrutiny of the empirical evidence. Cheung et al. (2007b) made a general remark that “when one implements the standard operating procedure of accounting for sampling uncertainty in making inferences, there is no evidence supporting the claim that RMB is substantially undervalued, using conventional significance levels. Depending on the specification under examination, the actual RMB value is usually within one or two standard errors of its predicted level.” In general, computations based on absolute PPP were found to result in larger degree of estimated undervaluation of the RMB yuan. Several other recent empirical studies (Barell, Holland and Hurst, 2007; Dunaway, Leigh and Li, 2006) either estimated the undervaluation of the RMB yuan at small level or subjected it to a wide margin of uncertainty. Variation in model specifications, explanatory variables or time periods leads to significant variations in the estimates of equilibrium exchange rate. The range of the RMB yuan undervaluation estimated by different econometric exercises was large and has been measured from none at all to 50 percent, depending upon the methodology used. So far, statistical evidence on undervaluation of the RMB yuan is indistinct, unclear, uncertain and indecisive. More elaborate theoretical research is needed to make these exercises reach more meaningful conclusions than they tended to come to. 5.2.2 Undervaluation and the behavioral equilibrium exchange rate (BEER), the permanent equilibrium exchange rate (PEER) and the fundamental equilibrium exchange rate (FEER) estimates The other econometric techniques for assessing the undervaluation of the RMB yuan stem from the concepts of “equilibrium real exchange rate” (ERER). Several researchers have employed the standard equilibrium exchange models for this purpose. While real exchange rates are taken as the mean of a long-term period, there is evidence to suggest


that there can be quite significant and persistent deviations from the ERER in the short- and medium-terms, that is, instances of real exchange rate misalignments are common. Such misalignments can certainly lead to global macroeconomic or transpacific imbalances (Chapter 4). Equilibrium exchange rate is taken as one that attracts the actual exchange rate, that is, it tries to drag the actual exchange rate toward it. The BEER and the (PEER) approaches are modifications of the ERER concept. They are more rigorous in identifying equilibrium exchange rates. They focus on the actual, not the medium-term equilibrium values of the fundamental determinants of the real exchange rate. The two approaches are theoretically similar, although they differ somewhat in technique. Some studies decomposed the fundamentals into transitory and permanent components to estimate the PEER (Clark and MacDonald, 2000). Using the BEER techniques, Funke and Rahn (2005) concluded that after an overvaluation until the mid-1996, the RMB yuan remained constantly undervalued vis-à-vis the dollar. Its overvaluation peaked at around 15 percent. Using the PEER methodology, the undervaluation of the real effective exchange rate was more than 15 percent at the end of 1999. Also, the bilateral PEER estimate suggested that the undervaluation of the RMB yuan against the US dollar was not excessively large; the estimated degree of undervaluation was merely 12 percent. Thus, the general assertions of a high degree of misalignment between the RMB yuan and the dollar were exaggerated. The moderate degree of bilateral misalignment can be corrected by, first, making the RMB yuan more flexible and, second, with the help of a medium-sized (less than 5 percent) currency appreciation, with a widening of currency band to 3 percent to 5 percent range. A third ERER methodology is the FEER, which allows internal and external equilibrium, that is, output growth is at its potential level and at a sustainable current account position. The FEER is expected to generate a current account surplus or deficit equal to the underlying capital flows over the business cycle, assuming that the economy is pursuing internal balance, which implies full noninflationary employment. This makes the FEER a medium-term concept. Using the FEER model, Coudert and Couharde (2005) concluded that the RMB yuan was undervalued by 23 percent in 2003, while its bilateral misalignment against the dollar was 44 percent. However, Coudert and Couharde (2005) indicated flaws in their estimates. They noted that if they had taken unemployment and underemployment in China into consideration, currency undervaluation estimates would have sharply declined. They also noted

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that the dollar’s effective equilibrium exchange rate seemed only “weakly affected by the renminbi’s misalignment. This suggests that a revaluation of the renminbi would have only a small effect on the US external deficit” (See also Section 2.3). Using the same FEER methodology, Rossi (2005) estimated that the exchange rate of the RMB yuan was close to equilibrium in 2000–01. Projecting from these results, she estimated that in 2010 the undervaluation against the dollar would be in the range of 5.5 percent to 7 percent. Thus there is a large variation in estimates arrived at based on the equilibrium exchange rate theories. Before ending this section, it needs to be mentioned that some economists consider equilibrium exchange rate theories unsuitable for the developing and EMEs. The validity of these results is therefore open to question (Bouveret et al., 2007).

5.3

Revaluation of the RMB yuan

Although since the early years of the decade analysts and market participants expected that the RMB yuan will be revalued and the currency regime will be switched from the de facto dollar peg, it was not done for several years. It was not irrational to expect revaluation, but the PBC also had equally cogent reasons for not eagerly resorting to it forthwith. After prolonged speculation, a miniature currency revaluation did take place and the currency regime was shifted. Quantitatively, the revaluation was more symbolic than a substantive currency value realignment that was going to have a discernible impact over the domestic and trade-partner economies. To be sure, it did portend to the fact that a systemic renovation was being initiated. 5.3.1 Why the revaluation expectations were rife Since the dollar correction began in February 2002, speculation has been rife in the currency markets regarding revaluation of the RMB yuan. Expectations of a revaluation became stronger after official statements regarding China’s flexibility toward currency reforms were made and a series of small deregulatory measures were taken by the PBC, the central bank. These measures included allowing foreign trading companies to retain their foreign exchange incomes in full in their foreign exchange accounts, insurance companies and pension funds to invest overseas, Chinese emigrants to transfer their assets out of China, and Chinese tourists and students to take larger amount of hard currency out of China. The currency markets and China analysts expected a one-off currency revaluation, a floating regime and pegging the currency to a basket to be logical options open to the monetary authorities because it was


believed that they would be helpful in combating inflationary forces and in lowering the cost of commodity imports for China’s huge recent demand growth, which hardened commodity prices in the global marketplace. Currency revaluation under these circumstances would have made a meaningful payoff for the Chinese economy. Given its eagerness to burnish its image as a responsible global citizen, China was also expected to react to the large transpacific imbalances, and the US quandary. By revaluing the currency, China could hope to help the US in bringing down its massive trade and current account deficits. They were on a rising trajectory in general and in particular vis-à-vis China (see Chapter 4). After sharp depreciation of the dollar began in November 2004, market expectations of a RMB yuan revaluation strengthened further. Market participants believed that China may maintain its de facto dollar peg until early or mid-2005, and revalue, float or peg the currency to a basket after that point in time.5 When the decision to revalue the RMB yuan was taken, if it was appreciated substantially, the currencies of Asian emerging markets could be expected to follow suite in a full round of currency appreciation. The magnitude of their appreciation would necessarily have been smaller than that of the RMB yuan because these currencies had allowed appreciation of their currencies after the February 2004 meeting of the G-7. However, a small appreciation of the RMB yuan—of say, 5 percent or less—may not lead to this full round of currency appreciation. In addition, if such a round of currency appreciations did take place, it would have depreciated the dollar further vis-à-vis a broad basket of the Asian currencies. 5.3.2 Why market expectations were belied Contrary to the expectations of market participants and speculative pressure, the PBC did not see any pressing or immediate need to disturb its de facto dollar peg. This peg had served the Chinese economy well since its inception, which made it all the more necessary for the PBC to be extra cautious regarding switching to a new currency regime. As indicated above, the options were adopting a managed float, pegging to a trade-weighted basket and adopting a wide band within which the currency could fluctuate. It could range between ⫹10 percent and ⫺10 percent from the peg. If the new regime—be it a managed float or pegging to a basket—did not serve the economy well in the medium-term and caused disruptions by causing a currency appreciation of, say, 10 percent. It was seen as a serious potential disruption to exports and unemployment rate. Employment generation was one macroeconomic policy area where China performed poorly. While China’s economy was growing

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at the highest annual growth rate of any of the world’s principal economies, its increase in employment was only 1 percent annually. For political, social and economic reasons, generating job opportunities for a large number of unemployed and underemployed workers and achieving a high rate of job creation was no less important than achieving high real GDP growth targets. Official unemployment statistics provide a sanitized, incomplete, if somewhat misleading, picture of reality.6 As China is a large exporter of manufactured goods, a sector known to employ a large proportion of labor force, currency appreciation or float would certainly affect exports and employment adversely. The larger the magnitude of currency appreciation, the more would have been the disruption in the manufactured goods sector. China’s comparative advantage would certainly have changed with currency appreciation and it may even have been forced out of several low- medium- and high-technology product lines by other economies, particularly the dexterous Asian economies, which also are successful exporters in their own right. The inefficient SOEs sector will be forced to shrink at a faster rate under an appreciated RMB yuan regime. Little wonder that the PBC did not show eagerness to revalue promptly. A poorly planned currency appreciation could lead to even worse consequences than enumerated above. In 2004, Chinese economy suffered from several sectoral price bubbles. The most conspicuous were the bubbles in property, steel, autos, heavy chemicals and cement sectors. A currency appreciation could possibly pop these bubbles, not only triggering a domino effect in the rest of the economy but also adversely affecting the other Asian economies. Creation of a Japan-like deflationary situation was a high probability. Therefore, it was far from optimal for the PBC to seriously contemplate a currency revaluation in the short-term. Furthermore, weaknesses of China’s financial market infrastructure are well known. It was regarded as too deficient to cope with an appreciable change in the currency regime. A prerequisite for moving toward currency flexibility, say a floating exchange rate regime, is the depth of the derivative market and the availability of hedging products. China faces serious deficiencies in both of these areas. An obvious fragility of China’s financial and banking sector was the heavy burden of NPLs, making it an inappropriate time for a major shift in the currency regime. The four largest state-owned commercial banks, which dominate the banking system, were under a large burden of NPLs. Approximately a half of their assets were considered to be impaired, which put the financial system in a delicate state. Although efforts to reform and repair the system were underway for a while and there have


been discernable improvements, they were not as rapid and sure-footed as the credit-rating agencies would prefer. According to Standard & Poor’s estimate $656 billion were needed to resolve the NPL problem of these four largest banks in 2004 (see Section 1.8.2).7 While a good deal needs to be done, years of banking reforms, including recapitalization of the Big Four state commercial banks, led to noteworthy improvements by 2007. The NPLs of the Big Four have been on a decline. While China was aware of the need of the international community to let the RMB yuan appreciate or float, the PBC rode out the international pressure because an undervalued currency is, inter alia, easier to manage than an overvalued one.8 In the medium-term, an undervalued currency delivers better quality economic growth by providing momentum to exports, generating current account surplus and building up foreign exchange reserves, which can be put to myriad uses. At a later stage, exports can adjust to an appreciating exchange rate by moving up the value-added chain. Conversely, an overvalued currency delivers lower-quality growth and creates economic bubbles by encouraging excessive external borrowing. An appreciating economy can induce a growth slowdown as well as demand for imports. Concurrently, its exportables become more expensive in the global marketplace. As the decline in its imports takes place along with a decline in its exports, the net effect on the trade balance or current account balance is erratic and unpredictable. When the yen appreciated over the 1971–95 period, Japan’s trade surplus went on enlarging. One prediction that can be made with certainty is that “the appreciating country will suffer deflationary pressure” (McKinnon, 2005). Although China was bringing in gradual currency reforms (as stated above), they did not seem to be a part of strategy of short-term currency appreciation. From the Chinese perspective, reform of the currency regime and capital account liberalization seemed to be a medium-term policy objective, in no way a short-term necessity. The monetary authorities never gave an impression of taking on additional risks of a major shift in currency regime. In the short-term macroeconomic and financial policy management and reforms kept the agenda of the policy mandarins full. Expectations of currency markets of an instant revaluation did not pan out, albeit it was not rational. 5.3.3 Pressure for appreciation on the RMB yuan According to 2007 statistical data, the EU was China’s largest trade partner, followed by the US and Japan. Since the summer of 2003, these three trade partners brought to bear mercantilist pressure on China for

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currency appreciation. This is reminiscent of the Japan-US trade friction of the 1970s and 1980s, when Japan’s manufactured goods penetrated the US market.9 One gets a feeling of déjàvu all over again. Demands for currency appreciation by the US from its trade partners are not new; in the mid-1980s the yen and in the late 1980s the Korean won came under similar pressure from the US to appreciate. At the end of 2007, political environment in the US was turning nationalistic and against trade with China, and several anti-China trade bills were snaking through both the Senate and the House of Representatives. Equally, despite booming EU-China trade (€250 billion in 2006), the 10th EUChina summit convened in Beijing in November 2007 was uneasy and the EU, inter alia, demanded RMB realignment. That the RNB yuan was appreciating vis-à-vis the dollar but not the euro antagonized the Euro Zone governments. Chinese explanation was that the euro-RMB yuan exchange rate was determined by the euro-dollar exchange rate, with which the Europeans disagreed. In their view, as an emerging global economic power China needed to consider more than only the dollar in its global economic strategy, particularly its exchange rate regime. New indications of strain in relationship between the two economic giants were unmistakable. Evidence of changing disposition could be found on many levels, public, corporate and governmental. To be sure, ballooning EU trade deficit with China—€128 billion in 2006—and exchange rate were two of the principal reasons. Political pressure from the US on China was particularly relentless and intense because of its large and growing trade and current account imbalances in general and in particular vis-à-vis China.10 A major source of external pressure was manufacturing interests in the US. Taking cue from it, the Fed, the White House and elements within the US Congress managed to maintain an environment of retaliatory threats, roiling bilateral relations between China and the US. Currency matters come under the jurisdiction of the US Treasury Department, which also played a proactive role in the RMB exchange rate regime. Politicians and popular media vociferously accused China of gaining an unfair advantage by holding on to its de facto dollar peg first and then not appreciating the currency enough to gain a competitive advantage in the global markets and blamed it for “currency manipulation” (Goldstein, 2004; Goldstein and Lardy, 2005).11 In their view, China’s continued clinging to the de facto dollar peg regime was having an adverse effect on the global economy. As reported in the financial press, during the G-7 meetings of September 2003 in Dubai, the US Treasury Secretary, John Snow, won the


support of the other G-7 members for pressurizing the Chinese government to revalue the RMB yuan. His meeting with the Chinese leaders in Beijing followed and more pressure was brought to bear on them. The campaign of the US Treasury officials continued and successive G-7 meetings, after the meeting in Dubai, expressed concern about the undervaluation and inflexibility of the RMB yuan. The US Treasury reports to Congress biannually whether any trading partner is manipulating its currency to the detriment of the US economy. Bilateral deficit is one variable that is taken heavily into account by the US Treasury while determining whether a trade partner is manipulating its currency or not. This mode of determination made China vulnerable and it ran the risk of being named a manipulator. Notwithstanding intense lobbying by industry and labor groups, the US Treasury Department was considerate in never accusing China of intentionally manipulating its currency to gain an unfair trade advantage. How important China and its trade and currency strategies are to the US is evident from one incident. In mid-December 2006, top US official Hank Paulson, Treasury Secretary, along with five other cabinet-level officials and Ben Bernanke, the Chairman of the Fed, sat down with their Chinese counterparts for a strategic Economic Dialogue. The central and prickliest question was whether Beijing will keep up its pace of currency appreciation against the dollar. The Article IV of the IMF forbids a country to manipulate exchange rates or the international monetary system “to gain unfair trade competitive advantage over other members” (IMF, 2006). In its role as an impartial global adjudicator on exchange rate related issues, the IMF has conceded that the RMB yuan is undervalued (Section 5.2) but not named China a currency manipulator, or an infringer of the IMF charter. Furthermore, Bernanke remarked that the undervalued currency was “an effective subsidy” to Chinese firms that focused on exporting rather than producing for their domestic market (FT, 2006). If this allegation could be established, China could be taken to the WTO for violating trade laws. A charge of currency manipulation is serious and inappropriate because any country is at liberty to choose a peg for its currency. A presently undervalued RMB yuan could boost the sales of Chinese products in the global marketplace, or could chip away at the market share of other competing EMEs, but it seems unlikely that appreciation of the RMB yuan will either ameliorate the US trade and current account deficits much or improve its employment situation (Zhang et al., 2006).12 In addition, in case RMB yuan appreciation does take place, it is likely to be followed by an appreciation of the currencies in the other

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AHP economies. In such an eventuality, the impact on the US trade deficit and employment may be exceedingly modest at best. That being said, one cannot take the reckless and callous stand that in the international monetary system surplus countries have no obligation to cooperate in eliminating large macroeconomic imbalances. When the circumstances warrant, such countries can be asked to take into account the interests of others for the mutual benefit of improving the international monetary system, which is a global public good that benefits all the systemic participants. However, Frankel (2006a) appropriately contended that “it is not appropriate to use the language of WTO violations for the question of balancing the pros and cons of fixed exchange rates, which is inherently much less clear-cut than the question of balancing the pros and cons of free trade.” Fixing exchange rates to a major international currency has advantages and if economies see them, they have the right to do so. The ire of those who blame China for all the problems of the US economy (see Bergsten, 2007; Goldstein, 2007) needs to be contained because “exchange rate changes are no answer to America’s trade deficits and Asian trade surpluses” (McKinnon, 2005). They fail to see that exceedingly low-saving rates in the US, not the misaligned exchange rates, have been the root cause of US economic problems. 5.3.4 The opportunity cost of undervaluation As an undervalued currency makes imports more expensive, allowing undervaluation to persist for a prolonged period implies foregoing stronger purchasing power over imports. A stronger currency directly influences an economy’s TOT favorably. China is the third-largest trading economy in the world. According to the World Development Indicator 2007, in 2005, China’s imports of goods and services accounted for 31.9 percent of the GDP.13 According to the customs data, close to half of these imports are for domestic purposes. A 20 percent currency appreciation could increase China’s purchasing power in the global marketplace by roughly 3 percent (Garton and Chang, 2005). This opportunity cost is significantly large and is reflected in both foregone consumption by the society and investment by the businesses, which in turn constrains future consumption possibilities. As overinvestment in the economy has been a persistent concern in the recent past; therefore, the latter may be less of a concern for the policy makers. However, an undervalued currency also adversely influences resource allocation in the economy. It promotes excessive and, therefore, inefficient


investment in the traded goods sector. This in turn has long-term ramifications for the economy. It has been noted in Section 1.5, China invested a large part of its foreign exchange reserves in the US treasury securities at a low rate of return. However, interest rate paid on its foreign borrowings by China is much higher. This increases the opportunity cost of undervaluation of currency suffered by the economy. Also, a large part, close to 80 percent, of the foreign exchange reserves is dollar denominated. With the appreciation of the RMB yuan, the value of the reserves would go on declining in terms of domestic currency. This negative wealth effect leads to a significant loss to the economy (Qiao, 2005). 5.3.5 Finally the miniature revaluation Conditional upon reduction in speculative pressure and the government’s policy measures to rectify the macroeconomic and financial limitations, a shift in the currency regime continued to be expected by market participants in early 2005 in the form of either a renewed peg or a link to a currency basket. After years of speculations, waiting and debating, the decision to revalue the RMB yuan was taken after the meeting of the G-7 finance ministers and central bankers14 in the first week of February 2005. The timing of the July 2005 revaluation was correct for China because the second-quarter 2005 GDP growth rate was 9.5 percent in real terms. To be sure, this timing of revaluation was influenced by the protectionist threats from the US Congress as well as from the US Treasury Department. The PBC announced that it is preparing to peg its currency to a basket of currencies in lieu of the dollar, although it will take China much longer to let the value of the currency be determined by market forces. On July 21, 2005, the RMB yuan was revalued by 2.1 percent against the dollar. Its old value was 8.277 RMB yuan to the dollar, while the new value was 8.11 to the dollar. It is important to see the RMB yuan/dollar exchange rate over a long (1988–2007) historical perspective. Relentless political pressure from the US did play a role in bringing on the Chinese decision to revalue. This diminutive currency revaluation was more like a normal weekly change in currency valuation between the free-floating currencies. Only minor repercussions over trade and economy could be expected from this. Also, the de facto dollar peg was abandoned and replaced by a managed float against a basket of undisclosed currencies. The trading band was relaxed from ⫹/⫺0.1 percent to ⫹/⫺0.3 percent within any given day, indicating greater flexibility in future. The trading band for the euro

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and the yen was wider at 1.5 percent within any given day. A slightly wider band around the central rate would give market forces a greater play. The currency could fluctuate within these bands on daily or weekly basis. Future of broadening of these bands would usher in greater currency flexibility. The announcement came in timely to stall the protectionist overtures of the Schumer Amendment in the US Congress. The announcement of revaluation and change of currency regime created a shockwave in the global currency, bond and commodity markets. That China could create tremors in the global economy confirmed the progressively growing significance of the economy. This adjustment in the currency value was trivial by any measure, much smaller than the expectations of the market participants. It was also too small to have any major domestic or global macroeconomic impact. Rapid GDP expansion was not going to be dampened by it. However, it was widely believed that the small currency adjustment was the first of the many steps to be taken in the short- or mediumterm. The shift to a currency-basket peg was going to increase its monetary flexibility for managing the economy. The currencies and their weights in the basket were not announced initially, but in August 2005 the PBC disclosed a list of 11 currencies. The four principal currencies in the basket were revealed to be the dollar, the yen, the euro and the won. Lesser weights were assigned to the seven second-tier currencies of Australia, Canada, Malaysia, the Russian Federation, Singapore, Thailand and the UK. China had meaningful trade ties with these economies as well and they were important for China’s current account. The combination of the small revaluation and the shift to a currency-basket pegging signaled that this was the harbinger of the future policy measures and that more monetary reforms could be in the offing. To be sure, the revaluation was small, it was the start of a series of further RMB yuan revaluations that would bring an alignment of other East Asian currencies by pushing them upward against the dollar up to correct the transpacific trade and current account imbalances. The PBC was expected to build on these two small policy measures. As it did, they would increase international confidence in the Chinese economy, and hence conducive to more long-term capital inflows to both China and Asia, and increasing demand for Asian assets. As the new system was called a “managed floating exchange-rate regime,” it could well mean that it would be more management than floating. The eventual economic and political effects of the revaluation will depend on how far and how fast the RMB yuan moves from now on.


By announcing these two diminutive measures, the monetary authorities managed the soft landing that they were aiming for well. At the time of revaluation, the economy looked well balanced. It was getting more support from consumer spending, alongside fixed investment and exports. Rising household incomes were boosting households’ spending power, lifting retail sales by 13 percent in the first half of 2005, compared with the same period of 2004. The agricultural sector began playing its role. After six years of lackluster growth, rural incomes rose by 12.5 percent in the first half of 2005. The managed floating exchange rate regime adopted by the PBC was not an original Chinese concept. Singapore has used it since the early 1980s. This hybrid system was christened the “basket, band and crawl” or the BBC regime.15 The currency is managed against an undisclosed basket of currencies of the largest trading partners. In this system, the exchange rate floats within a band, which allows the currency to crawl up or down instead of sharply fluctuating. The BBC is widely considered one of the most successful currency regimes in the world. It provided the Monetary Authority of Singapore (MAS) flexibility to respond to changes in both local and global conditions and simultaneously maintain export competitiveness and inflation control. However, baskets are considered less transparent and credible than defining parity in terms of a single currency. The composition of the currency basket is revised periodically to take into account changes in trade patterns. The secret policy band is also regularly reviewed to ensure that it remains consistent with changes in the economic circumstances. It is adjusted after every two-quarters, or sometimes every quarter, if needed. Singapore has guided its monetary policy through exchange rates instead of directly adjusting interest rates. Inflation in Singapore has been relatively low at 2 per cent a year since the early 1980s. More Asian economies can use the BBC system as a template. 5.3.6 Life after the reform of the exchange rate regime As stated in Section 3.1, the currency market expected a revaluation since the fourth quarter of 2003. This was reflected in the forward rates since October 2003. On the eve of the announcement, the forward rate of the RMB yuan was eight to the dollar, meaning thereby that the expectation was of an appreciation of higher magnitude than was actually announced by the PBC the next day. Although a de jure currency basket was announced, de facto weight of the dollar remained high even in the basket arrangement. According to one estimate, it was as

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high as 85 percent ( Jen, 2005; Rossi, 2005). Even after the public announcement of a new currency regime, de facto link to the dollar continued to remain much heavier than to the euro and the yen. While it can be discerned that the RMB yuan strengthened against the dollar, it did so very slowly. Between July 2005 and July 2006, the RMB yuan crawled upward by 3.3 percent. Another clear observation is that the value of the RMB yuan fluctuated far more against the euro and the yen; for the most part it reflects the fluctuation of the dollar against these two major currencies. Some signs of flexibility were visible after spring 2006. In April 2006, the RMB yuan appreciated 12 percent against the yen, while depreciated 2 percent against the euro (Frankel and Wei, 2007). By plotting the first differences in the log, Frankel and Wei (2007) estimated that until spring 2006, the daily movements between the RMB yuan and the dollar was within 0.05 percent range, with an occasional movement of 0.1 percent range.16 However, after this point there has been a discernible increase in the daily movement, with daily movements exceeding 1 percent range.17 A holistic view of the appreciation of the RMB yuan after the announcement of a reformed currency regime emerges as follows: as set out above, between July 2005 and July 2006, the RMB yuan crawled upward by 3.3 percent. In September 2007 it was 7.50 to the dollar, that is, it appreciated further by 4.2 percent. The appreciation seems to be continuing at the rate of approximately 3 percent per annum; apparently it has been tightly controlled. This gradual appreciation seems in line with the cautious approach that Chinese policy makers always tend to take.

5.4

An unambiguous dichotomy of perspectives

Research focus on China’s exchange rate regime and the appreciation of the RMB yuan intensified after the summer of 2003. Whether, when and by how much the RMB yuan should be further appreciated became a passionately arguable issue and little concurrence has so far been reached among the academics, researchers, policy makers and political leaders on this contentious issue. There is a clear and deepseated dichotomy of viewpoints in the profession regarding further appreciation of the RMB yuan and its appreciation. Representatives of the two absolutely contrasting views are McKinnon (2007) and Roubini (2007).


The first perspective, which some international economists support, emphasizes that China should allow its currency to appreciate steeply and should move to a regime of more flexible exchange rate in reality, not merely in principle (Roubini, 2007). As it is easy to comprehend, large exports and current account surplus are the principal indicators for this assemble of economists. The Chinese monetary authorities have succeeded in holding down the currency appreciation by intervening aggressively in the foreign exchange market. International economists who held the first perspective regards protectionist policies in the EU, and particularly in the US, legitimate and foresees intensification in them. They also express concern about the Chinese economy by pointing to the partial sterilized intervention, which has created “excessive liquidity credit and asset bubble, which are fueling the already overheated Chinese economy and exacerbating the risk of an eventual hard landing.” Their arguments are squarely premised on the standard elasticity model of balance of trade. Aided by simple algebra, the microeconomics of this model seems intuitively possible. Given the short-term stickiness in prices in terms of the two currencies of the two trading partners, the nominal price effect of currency appreciation is intuitively seen as going in the right direction for reducing the bilateral trade imbalances. The appreciating country’s exports become more expensive in the importing country and the global marketplace, and imports less expensive in the domestic market. This seems to be a sure-shot formula to improve trade imbalances. Those who support this line of logic do not ignore the savinginvestment imbalances. However, they cannot be dovetailed into the elasticity model. Real currency appreciation still seems like a direct mode of correcting imbalances provided the surplus economy, like China, begins to consume more for the purpose of reducing trade imbalances. According to this approach, appreciation induces the old-fashioned expenditure switching and moves productive resources out of the tradable sectors. As opposed to the above viewpoint, McKinnon (2007) and other monetary-policy oriented economists emphasize the link between national monetary policies, nominal exchange rates and price levels. Based on Mussa (1983), they argue that a floating exchange rate is largely “determined by what forward-looking investors think the national monetary policy and other fundamentals will be relative to those in other countries in the future.” For the purpose of taking any official action on exchange rate—like a peg, an appreciation or a depreciation—domestic monetary policies must be changed to support the official action. If such

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a change is not domestically instituted, the officially determined path of the exchange rate cannot be sustained. Thus, when a country agrees to implement a Plaza type accord, it implicitly agrees to implement a deflationary future monetary policy. Some central banks peg the nominal exchange rates of their country’s currencies to the dollar to anchor their price levels. Both Japan (1949–71) and China (1994–2005) did it in the past. Several AHP economies have also been following this strategy in a soft manner, that is, their pegs are not hard. Those economists who hold the first viewpoint not only disapprove of it but also see in it a surreptitious design to hold the real exchange rate down and thereby stimulate exports. However, the latter group does not subscribe to this undervaluation allegations because when the nominal exchange rate is pegged to the world’s dominant currency in which most of the world trade is invoiced, any undervaluation of this kind will “be washed away by inflation” (McKinnon, 2007). The latter group of economists regards international saving imbalances as the fundamental reason behind transpacific trade and current account imbalances. McKinnon (2007) further unequivocally remarked, “Blaming foreigners for misaligned exchange rates is easier than facing up to the problem of inadequate private saving and large structural fiscal deficits in the United States.” The exchange rate is the wrong choice of instrument for correcting these imbalances. The standard elasticity model of balance of trade, mentioned above, will not work and produce the postulated outcome because of three offsetting effects. First, appreciation-induced decline in exports will cause a fall in domestic industrial production as well as a decline in import substitutes, reducing national income. It will eventually lead to reduced spending in the economy, shrinking imports. Second, currency appreciation will discourage FDI because it will make the host economy a relatively more expensive location to invest and produce in. The profitability of the FDI projects will suffer. Thus, an appreciation could spark a slump in both inward and domestic investment, which could further cause a fall in domestic expenditure as well as imports. Third, as noted in Section 2.4, after the currency appreciation the creditor country’s large dollar claims on foreigners would lose value in terms of domestic currency. This negative wealth effect will dampen down both domestic consumption and investment. Thus, reduced domestic spending could offset the relative price effect of appreciation in the short- and medium-term. Therefore, the net impact of a currency appreciation on trade balance will remain indeterminate.18


In short, this group of international economists considers the position that an RMB yuan revaluation will reduce US trade deficit a complete myth.

5.5

Trade response to currency value movement

The normal impact of currency appreciation is on the overall trade of an economy as well as on trade with its various trade partners. The trade surplus made up the bulk of the balance-of-payment surplus. China’s global trade surplus as well as bilateral trade surpluses and deficits would definitely be swayed by an RMB yuan appreciation. How much of currency appreciation would affect them and by what degree can be empirically computed with reasonable accuracy. In Section 1.8.3, we focused on China’s ongoing endeavors to rebalance the economy during the 11th Five Year Plan (2006–10) period. Some believe that a currency appreciation will contribute to the objective of rebalancing and switching the growth trajectory. In what follows, we examine the plausible influence of the appreciation of the RMB yuan on the Chinese economy, the other AHP economies with which Chinese economy is closely integrated by way of trade and financial flows and production networks as well as the US economy, which has become a politically charged bilateral aggravation. 5.5.1 Consequences for China’s trade Whether China’s success in the arena of global trade can be blighted by the appreciation of the RMB yuan is a debatable point. Although it is difficult to econometrically estimate with complete certainty the loss of export competitiveness due to currency appreciation, Chinese and other EME data have established that it is less than that estimated for the matured industrial economies. A 20 percent appreciation of the RMB yuan was estimated to cause an overall loss of 3 percent in the dollar value of China’s export (Rossi, 2005). A larger price rise due to currency appreciation many even increase the dollar value of China’s exports because importers may be prepared to pay more for a slightly smaller volume of Chinese exports, in the process strengthening China’s TOT. They could do this to avoid switching the trade partners, or purchasing from a domestic producer at higher prices. Presently China’s costs are so low that a 20 percent appreciation would have a small impact over its cost structure. All things considered, a 20 percent

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currency appreciation might cut China’s current account surplus by a maximum of $20 billion (Rossi, 2005). Another estimate made by Marquez and Schindler (2006) took a slightly different route and estimated the impact of RMB yuan appreciation on share of China’s exports and imports in multilateral trade instead of trade volume. Using an autoregressive distributed lag model, they quantified the effects of a real RMB yuan appreciation on China’s trade by applying least squares to a specification that assumes that trade is driven by demand considerations. Their estimation results suggested that a 10 percent real appreciation of the RMB yuan would lower China’s export share in the multilateral trade by one-half of a percentage point. However, the response of import share to currency appreciation varied. In case of the imports of final products, a 10 percent appreciation would lower the share by a percentage point, while for the imports of parts, components and subassemblies for processed goods,19 the same appreciation would raise the share by a tiny amount. Combining these two responses suggested that real RMB yuan appreciation would lower China’s import share of the world trade by a small amount, 0.2 percentage points. The strengths of this technique of estimate included that it disaggregated Chinese trade into processed goods trade and ordinary trade and also used trade as a share of world trade. It also avoided the use of proxies like the consumer price index (CPI) for trade prices. In this technique, the two researchers also controlled for seasonality and the effect of the Chinese New Year. Another study estimated long-run elasticities of China’s imports and exports to changes in the real effective exchange rate. Using a cointegration analysis, Garcia-Herrero and Koivu (2007) reached a similar conclusion that China’s trade as well as surplus would record a minor decline, following a real appreciation of the RMB yuan. This small impact of the appreciation was due to “peculiar import price elasticities.” Contrary to what Marquez and Schindler (2006) concluded, Chinese imports appear to fall following a real appreciation. By estimating bilateral import equations Garcia-Herrero and Koivu (2007) found that China’s imports from the other Asian economies tended to decline after a currency appreciation, while those from some industrial economies, such as Germany, tended to increase because they essentially served the domestic demand. This explained the positive and significant price elasticity found for German exports to China. Decreasing imports from Asia may be explained by the production networks based on vertical integration which have become so prominent in the regional industrial structure, with China having a unique position in them. These networks tend to make products from different Asian economies more


of a complement than a substitute. Therefore, a fall in China’s external demand stemming from exchange rate appreciation also tends to reduce exports from the other AHP economies to China. By estimating long-run elasticities of Chinese exports and imports to changes in the real effective exchange rate of the RMB yuan for the 1994–2005 period, Garcia-Herrero and Koivu (2007) concluded that a 10 percent currency appreciation will in the long run lead to a 26 percent reduction in the trade account. Thus, exchange rate policy is not the right instrument for controlling China’s ballooning trade surplus. Various empirical researches have established its limited impact. 5.5.2 Consequences for the Asian economies To be sure, the trade of the AHP economies, which are successful trading economies in their own right, will also be affected by the RMB yuan appreciation. The conventional wisdom is that because of price effect, the exports of the AHP economies will become more price competitive in the global markets. Therefore, an RMB yuan appreciation will pare down China’s exports and provide a stimulus to the exports of the AHP economies. This may not come to pass and the real impact may well be different from this stylized thinking. Several economies in Asia, and in the other parts of the world, directly compete with China because they are by and large at the same stage of economic growth, have comparable factor endowment, technological capabilities and production costs. An RMB yuan appreciation will indeed reduce the competitive pressure on this group of economies in both China and the ROW. As opposed to this, the other low-income economies that do not compete with China in the world markets but have a complementary trade pattern, the impact of the RMB yuan appreciation will not be significant. Thus far, China’s exports do not compete directly with those of advanced Asian economies such as Japan and the four NIAEs in the third-country markets (Chapter 2). China does not directly compete or crowd out capital goods exports from these countries in the global marketplace (Eichengreen et al., 2004). Therefore, it is a likely possibility that an RMB yuan appreciation will have a minor positive effect, or none at all, over the present trade surpluses of this group of economies. That China has developed production networks and fragmentationbased specialization over the preceding two decades successfully was the focus of Sections 2.2.2 and 2.2.3. This was the route taken by China to swiftly become a manufacturing powerhouse of global proportion. Also, it was indicated in Chapter 2 that 42 percent of China’s present imports were intended for the purpose of processed goods, as classified by the

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Chinese customs. Over a half (55 percent) of China’s exports were the result of vertical specialization (see Section 2.2.4). In the processed goods exports, China’s value-added ranges between 20 percent and 30 percent, with the remainder coming from the intermediate goods imported from the rest of the Asian economies that have become an integral part of the production networks.20 Of the total processed goods exports in 2005, 20 percent went to the EU economies; 20 percent to Hong Kong SAR, which worked as an entrepot center for re-export; 25 percent to the US; and 25 percent to the other AHP economies (Thorbecke, 2006a). The major role played by FIEs in developing and strengthening China’s export sector is another important factor to be taken into consideration. The importance of the FIEs sector to exports and imports went on increasing. They accounted for 15 percent of exports in 1990 (Tseng and Zebregs, 2002). In 2003, about 57 percent of total exports came from joint ventures,21 FIEs and wholly owned foreign subsidiaries (Hsiao and Hsiao, 2004). Another study computed that during 2003 and 2004 these enterprises accounted for 50 percent of exports and 60 percent of imports; the FIEs contributed over 20 percent annually of Chinese GDP (Whally and Xin, 2006). As appreciation of the RMB yuan would affect price competitiveness and lead to decline in export, at this level of generality one can only conclude that China’s consumption of parts, components, subassemblies and intermediate goods from the other AHP economies may experience a fall, adversely affecting their exports. Consumption of industrial raw materials, particularly oil, by the Chinese enterprises and FIEs may also decline. No doubt imports for the purpose of processed goods and industrial raw materials will become less expensive for China, improving its TOT. The Time-series analysis of Hoggarth and Tong (2007) applied to bilateral trade among the AHP economies concluded that the appreciation of the RMB yuan could result in a mixed effect on exports from the other AHP economies. Asian exporters of consumer goods to China and the ROW may not benefit from the appreciation of the RMB yuan; however Japan and the ANIEs, which essentially export capital and intermediate goods to China, may face a decline in their exports. 5.5.3 Consequences for the China-US bilateral trade Many studies investigating the impact of the RMB yuan appreciation over trade with the US found that it will not fix the current trade imbalance (Tatom, 2007). Its impact will at best be marginal. For instance, using a dynamic panel specification and disaggregated trade flows Mann and Pluck (2005) concluded that price elasticities of US imports


from China are wrong-signed and that price elasticities of US exports to China are not statistically significant. This implies that at the end of the day, an RMB yuan appreciation will not succeed in balancing the China-US trade imbalance. Using dynamic OLS methods, Cheung, Chinn and Fujii (2007a) inferred that while an RMB yuan appreciation will increase US exports to China by a small margin, it will not influence China’s exports to the US. An increasing number of researchers agree with Stiglitz (2006), “Nothing significant can be done about these global imbalances unless the United States attacks its own problems. No one seriously proposes that businesses save money instead of investing in expanding production simply to correct the problem of trade deficit; and while there may be sermons aplenty about why American should save more—certainly more than the negative amount households saved last year—no one in either political party has devised a fail-proof way of ensuring that they do so.” An examination of bilateral trade data by Thorbecke (2006b) found that there existed a stable long-run, cointegrating relationship between China’s exports with the US, the real exchange rate and real income. This empirical exercise employed the Johansen MLE and dynamic OLS techniques and controlled for competition between China and the ASEAN-4 economies in the US market. The estimates demonstrated that the long-run RMB yuan exchange rate coefficients for both exports and imports are approximately equal to 1. This estimate implied that had the dollar exchange rate of the RMB yuan been 10 percent higher in 2005, the gap between nominal exports and nominal imports would have declined from 11 percent to 10 percent of Chinese GDP. Thus, prima facie the conclusion is that a currency appreciation would have had a trivial impact over these politically charged bilateral trade imbalances. That said, before reaching such a conclusion it is worth noting that due to the lack of bilateral trade prices, exports and imports statistics were deflated by Thorbecke (2006b) by the US CPI. This leads one to conclude that the real price elasticities of demand are larger than the estimated exchange rate coefficients. If so, an RMB yuan appreciation would help pare down the bilateral trade imbalances between China and the US. 5.5.4 Generalized currency appreciation with the other Asian economies A likely possibility is that an RMB yuan appreciation is followed by a wave of generalized currency appreciation by the other AHP economies. If this comes to pass—and it is not a far-fetched scenario—the impact of

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the RMB yuan appreciation will be larger on both the Chinese and the other AHP economies. Export growth in not only China but also all Asian economies may be adversely affected, causing a deceleration in their GDP growth rates. A generalized currency appreciation in the other AHP economies could affect the cost structure of China’s processed goods exports seriously because their prices in importing country’s currency would rise. Using a multivariate panel data set Rahman and Thorbecke (2007) estimated exchange rate and income elasticities for processed goods and ordinary exports from China to its 33 trade partners. Their conclusion was that a currency appreciation in the Asian economies that are large suppliers for China’s processed goods exports would have a large impact over China’s exports. As opposed to this, a unilateral appreciation of the RMB yuan will not have a significant impact over China’s exports. However, in the latter case China’s multilateral trade surplus would decline. This possibility was first discerned by Greenspan (2005) and mentioned during his Senate hearing. Appreciation of the RMB yuan, a veritable move to a multiple-currencybasket-based regime and a wider band around the reference rate, followed by a generalized currency appreciation in the other AHP economies has some merit. The dual strategy of an appreciation and then adoption of a more flexible currency regime in the AHP economies would help in resolving global trade imbalances. However, a kind of prisoner’s dilemma exists in this case. As all the AHP economies are heavily export oriented, they all are cautiously guarded regarding not losing their competitiveness to the other AHP economies by appreciating first (Ogawa and Ito, 2002). Although free-floating currencies would reflect the economic fundamentals more accurately, many AHP economies are still not mature for it because of the shallowness and narrowness of their financial markets. Adoption of a free float may lead to excessive currency volatility and prove to be a destabilizing force and eventually harmful. Therefore, the twopronged strategy suggested above may contribute to bringing about orderly rebalance in the global trade.

5.6 The subprime mortgage crisis and the RMB yuan appreciation The subprime mortgage crisis of the third and fourth quarters of 2007, which affected the global currency and financial markets, sent the dollar depreciating against the major currencies. The pace of RMB yuan appreciation quickened during this period. It touched 7.210 to the dollar in mid-January 2008, which was almost 13 percent appreciation vis-à-vis the


dollar since mid-2007 (Section 5.2). This was the most rapid pace since July 2005, when the dollar-RMB yuan link was severed. Market forecast for remaining 2008 was for another 8 to 10 percent appreciation (The Economist, 2008). It prima facie appeared that the pressure brought to bear by the EU, Japan and the US on China produced some belated, if desirable, results. However, the actual reason was the new cost-benefit analysis by the Chinese policy makers. The changing domestic and international economic conditions convinced them that the gains from rapid currency appreciation were more than those from maintaining the status quo, that is, following a strategy of creeping currency appreciation. Inflation was emerging as a serious problem in China. Although the PCB had raised interest rates six times during the 2007, toward the end of 2007 inflation rate had climbed to 6.9 percent. Rising food prices were the principal contributor to inflation. Currency appreciation was considered a more potent instrument of dampening down inflation than the interest rate. It was believed that it would reduce the imported food and raw material prices and help in reining in inflation. Domestic policy unease was high and the authorities announced price controls on a range of consumer items in January 2008. Two spin-offs of this strategy were the reduced need to intervene in the domestic market to hold down the RMB yuan and reduction in the rate of build up of forex reserves and monetary growth. Also, in the post–subprime crisis period the cost of sterilization operations for the PBC was constantly rising. In the past the PBC could make profit on these operations because the return on the dollar reserves was higher than what the PBC paid on the sterilization bonds. As the Fed was steadily reducing interest rates in the US due to the subprime crisis, the interest rate in China became higher than that in the US. The PBC began to lose money on its sterilization operations. This interest rate differential between China and the US was expected to rise further, making the loss burden heavier. To the rising cost of sterilization, one needs to add the reduction in the RMB yuan value of the dollar reserves with depreciating dollar. It made intervention a high-cost strategy for the Chinese monetary authorities. It was rational for them to keep away from intervention and sterilization, in effect allowing the RMB yuan to appreciate.

5.7


During the postwar period, the RMB yuan was first pegged to the dollar and then to the pound sterling, which continued until 1970. However, it did not mean much because China’s volume of trade and financial

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flows were tiny and related decisions were controlled by government authorities. A dual currency system was adopted in 1980, that is, an official exchange rate coexisted with the market-determined, trade-related, exchange rate. At this point, the official rate was 1.5 RMB yuan to the dollar and was not intended for trade or financial transactions but for internal settlements. In 1984, the official rate climbed to 2.8 RMB yuan to the dollar. Taking a lesson from its dynamic Asian neighbors, monetary authorities in China decided to adopt a competitively priced currency regime. On January 1, 1994, the dual rate system was eliminated, the two rates were integrated and a more market-based and market-managed floating rate system was adopted. The unification of the official and free-market swap rates took place with a large depreciation of the RMB yuan. The exchange rate jumped from 5.5 RMB yuan to the dollar to 8.7 RMB yuan. The latter was the free-market swap rate at that time. This amounted to a large currency devaluation of 32.09 percent in nominal terms. The de facto dollar peg provided stability of the currency and served the economy well. As the dollar steadily appreciated during the 1997–2002 period, due to the de facto dollar peg, the RMB yuan also appreciated in both nominal and real terms. When the dollar correction period began in February 2002 and the dollar began its southward journey, the RMB yuan also began depreciating. This depreciation of the RMB yuan in nominal and real terms brought it back to its 1998 level by 2003. The exchange rate remained de facto pegged at 8.2773 to the dollar until July 2005. That the RMB yuan was misaligned and undervalued was widely acknowledged. However, different empirical studies came up with different measures of misalignment. One method of assessing its undervaluation is Balassa-Samuelson hypothesis, according to which the consumer price levels in wealthier countries are systematically higher than in poorer ones and rapid economic growth is associated with a real exchange rate appreciation. In keeping with the Balassa-Samuelson principle the exchange rate of the RMB yuan should move up in the range of 4.8 percent per annum. If China’s future GDP growth rate declines from its current high level, this appreciation rate would decline accordingly. The other econometric techniques for assessing the undervaluation of the RMB yuan stem from the concepts of ERER. Several researchers have employed the standard equilibrium exchange models for this purpose. While real exchange rates are taken as the mean of a long-term period, there is evidence to suggest that there can be quite significant and persistent deviations from the ERER in the short- and medium-terms, that is, instances of real exchange rate misalignments are common.


Several recent empirical studies either estimated the undervaluation of the RMB yuan at small level or subjected it to a wide margin of uncertainty. So far, statistical evidence on undervaluation of the RMB yuan was indistinct, unclear and uncertain. Since the summer of 2003, the EU, Japan and the US brought to bear mercantilist pressure on China for currency appreciation. This is reminiscent of the Japan-US trade friction of the 1970s and 1980s, when Japan’s manufactured goods penetrated the US market. Demands for currency appreciation by the US from its trade partners are not new; in the mid 1980s the yen and in the late 1980s the Korean won came under similar pressure from the US to appreciate. As stated in Section 5.3.3, at the end of 2007, political environment and trade relations in the US and the EU were turning ever more nationalistic and against China. On the one hand, one cannot take the reckless and callous stand that in the international monetary system surplus countries have no obligation to cooperate in eliminating large macroeconomic imbalances. When the circumstances warrant, such countries can be asked to take into account the interests of others for the mutual benefit of improving the international monetary system, which is a global public good that benefits all the systemic participants. On the other hand, the ire of those who blame China for all the problems of the US economy needs to be contained because exchange rate changes are no answer to America’s trade deficits and the Asian trade surpluses. They fail to see that exceedingly low-saving rates in the US, not the misaligned exchange rates, have been the root cause of US economic problems. In the first week of February 2005, the decision to revalue the RMB yuan was announced. The PBC announced that it is preparing to peg its currency to a basket of currencies in lieu of the dollar, although it will take China much longer to let the value of the currency be determined by market forces. On July 21, 2005, the RMB yuan was revalued by 2.1 percent against the dollar. While it can be discerned that the RMB yuan strengthened against the dollar, but it did so very slowly. Between July 2005 and July 2006, the RMB yuan crawled upward by 3.3 percent. Another clear observation is that the value of the RMB yuan fluctuated far more against the euro and the yen; for the most part it reflects the fluctuation of the dollar against these two major currencies. Some signs of flexibility were visible after spring 2006. Whether, when and by how much the RMB yuan should be further appreciated became a passionately arguable issue and little concurrence

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has so far been reached among the academics, researchers, policy makers and political leaders on this contentious issue. There is a clear and deepseated dichotomy of viewpoints in the profession regarding further appreciation of the RMB yuan and its appreciation. The normal impact of currency appreciation is on the overall trade of an economy as well as on the trade with its various trade partners. China’s global trade surplus as well as bilateral trade surpluses and deficits would definitely be swayed by an RMB yuan appreciation. How much of a currency appreciation would affect them and by what degree can be empirically computed with reasonable accuracy. As the Chinese economy has been endeavoring to rebalance the economy during the 11th Five Year Plan (2006–2010) period, some believe that a currency appreciation will contribute to the objective of rebalancing and switching the growth trajectory. This chapter also examines the plausible influence of the appreciation of the RMB yuan on the Chinese economy, the other AHP economies with which Chinese economy is closely integrated by way of trade and financial flows and production networks as well as the US economy, which has become a politically charged bilateral aggravation. Whether China’s success in the arena of global trade can be blighted by the appreciation of the RMB yuan is a debatable point. Empirical studies show that even a large currency appreciation will cause only a small overall loss in the dollar value of China’s exports. Following a real appreciation of the RMB yuan, China’s trade as well as trade surplus will record a minor decline. This small impact of the appreciation was due to peculiar import price elasticities of China. China is well integrated into the production networks based on vertical specialization in the region. The appreciation of the RMB yuan could result in a mixed effect on exports from the other AHP economies. Asian exporters of consumer goods to China and the ROW may not benefit from the appreciation of the RMB yuan; however Japan and the ANIEs, which essentially export capital and intermediate goods to China, may face a decline in their exports. The bilateral trade between China and the US and trade imbalances may not have a large impact of currency appreciation. This is due to the fact that the price elasticities of US exports to China are not statistically significant. This implies that at the end of the day, an RMB appreciation will not succeed in balancing the China-US trade imbalance. An RMB yuan appreciation will increase US exports to China by a small margin, it will not influence China’s exports to the US. There is a likely possibility that an RMB yuan appreciation is followed by a wave of generalized currency appreciation by the other AHP economies. If this comes to pass, the impact of the RMB yuan appreciation


will be larger on both the Chinese and the other AHP economies. Export growth in not only China but also all Asian economies may be adversely affected, causing a deceleration in their GDP growth rates. A generalized currency appreciation in the other AHP economies could affect the cost structure of China’s processed goods exports seriously because their prices in importing country’s currency would rise. A currency appreciation in the Asian economies that are large suppliers for China’s processed goods exports would have a large impact over China’s exports. As opposed to this, a unilateral appreciation of the RMB yuan will not have a significant impact over China’s exports. However, in the latter case China’s multilateral trade surplus would decline.

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232 The Chinese Economic Renaissance Tatom, J.A. 2007. “The US-China Currency Dispute: Is a Rise in Yuan Necessary?” Global Economy Journal. Vol. 7. Issue 3. Article 3. Available on the Internet at http://www.bepress.com/gej/vol7/iss3/2. Thorbecke, W. 2006a. “The Effect of Exchange Rate Changes on Trade in East Asia.” Tokyo. Research Institute for Economy, Trade and Industry. Discussion Paper No. 05-E-009. Thorbecke, W. 2006b. “How Would an Appreciation of the Renminbi Affect the US Trade Deficit with China.” The Berkeley Electronic Journal in Macroeconomics. Vol. 6. No. 3. Article 3. Tseng, W. and H.H. Zebregs. 2002. “Foreign Direct Investment in China: Some Lessons.” Washington DC. International Monetary Fund. Discussion Paper No. PDP/02/03. Whally, J. and X. Xin. 2006. “China’s FDI and Non-FDI Economies and the Sustainability of Future High Chinese Growth.” Cambridge, MA. National Bureau of Economic Research. Working Paper No. 12249. May. Williamson, J. 2001. “The Case of Basket, Band and Crawl (BBC) Regime for East Asia” in D. Gruen and J. Simon (eds) Future Directions of Monetary Policy in East Asia. Sydney. The Reserve Bank of Australia. pp. 133–60. Wolf, C. 2004. “China’s Rising Unemployment Challenge.” The Wall Street Journal. July 7. p. 16. Zhang, J., H.G. Fung and D. Kummer. 2006. “Can Renminbi Appreciation Reduce the US Trade Deficit?” China and the World Economy. Vol. 14. No. 1. pp. 44–56.

Notes 1 A Chinese Renaissance: Three Decades of Inexorable Economic Progress 1. In 1492, Christopher Columbus sailed in three ships to discover the sea route to India. The largest ship, Santa Maria, was a 60-footer. Admiral Zheng commanded over 300 ships on each one of his voyages. His flagship was 400 feet long. 2. The Middle Kingdom, in Mandarin Zhongguo, is the Chinese name for China. It dates from c.1000 BC, when it stood for the Chou Empire, situated on the North China Plain. 3. For a detailed treatment, see Maddison (1998); Shiue and Keller (2004a and 2004b). 4. Lovell (2006) provided a well-researched account of this trade mission and its activities. 5. Although received with appropriate courtesy, the British trade mission had limited success. The British merchants and employees of the East India Company were allowed to operate in China in a small way. They were contained in the city of Canton, far away from the capital, Beijing. While China exported tea to Britain in large amounts, it was not interested in any imports from there. China continued to accept payments in silver for its tea exports. Britain ran an increasingly large trade deficit. 6. Cited in Tanaka (2006), p. 180. 7. “Beginning in the mid-19th century, China was reduced to dire misery as the country suffered one humiliating defeat after another and the population languished in poverty and starvation as a result of brutal foreign aggressions and corrupt and incompetent feudal rulers” (Hu Jintao, 2005). President Hu Jintao was addressing the corporate elite of Asia and the Western world at the opening ceremony of the 2005 Fortune Global Forum, on May 17, 2005, in Beijing. This text is available on the Internet at People’s Daily on line http://english.people.com.cn/200505/17/eng20050517_185302.html. 8. “Emerging-market economy” is a term coined by Antoine W. van Agtmael of the International Finance Corporation in 1981. It is a subset of developing economies. See Das (2004), Chapters 1 and 2 for an explanation of what emerging-market economies (EMEs) are and how they are defined. 9. The source of these statistics is Dollar (2007). The Gini coefficient measures income inequality of a country; zero is perfect equality where every one has the same income, while one is percent inequality. 10. For a detailed treatment of the dichotomy between rising incomes and growing inequality, see Yusuf and Nabeshima (2006), Chapter 2. 11. The ten Asian high-performing (AHP) economies that turned Asia into the rapidest-growing region of the recent past comprised China, Hong Kong SAR, Indonesia, Japan, Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand. This dynamic group of Asian economies 233

234

12.

13. 14.

15.

16.

17. 18. 19.

20.

Notes was led by Japan. China is the latest entrant to this group of dynamic economies. The term “foreign-invested enterprises” stands for subsidiaries of TNCs and joint ventures. The assets of FIEs are owned in full or in part by foreign firms. This term is somewhat of a misnomer in China. It stands for local affiliates of foreign-owned firms. Many of these local affiliates are joint ventures with Chinese enterprises. Until 1992, almost all FDI in China was in the form of joint ventures. The expression “foreign-invested” was used to reassure that these ventures were domestic firms with foreign participation. Since 1992, a growing proportion of local affiliates of foreign firms are majority-owned or wholly owned by foreign investors, but the use of the term “foreigninvested” continues to be applied to them. Presently FIEs consist of wholly owned FIEs and joint ventures such as Sino-Foreign Contractual joint ventures and Sino-Foreign Equity Joint ventures. See Das (2006), Chapter 3, for a detailed discussion of the reform and liberalization program. The municipality of Jian, in the southern province of Guangxi, built an eight-lane highway in the middle of the city in 2006. The population of Jian is 200,000 and it has less than 10,000 cars. The dependency ratio is computed as the population between the ages of 0 and 14 years and 65 and above, divided by population between the ages of 15 and 64 years. The two-sector model of economic growth, developed by William Arthur Lewis (1915–91), is a classical model of economic growth. Lewis believed that neoclassical economists did not describe the circumstances of the developing economies accurately because they assumed that labor is in short supply. Lewis’s model posited that a developing economy has two sectors, one modern and the other traditional. The modern sector is small and capitalintensive, while the traditional sector is large and non-capital-intensive. A large amount of excess labor exists in the traditional sector; therefore, marginal product of labor is zero. See Jackson and Howe (2004); Cai et al. (2001); and Qiao (2005). Using current market exchange rates, Bernanke (2006) computed these with the help of the statistics provided by the National Bureau of Statistics of China. The membership of (ASEAN) includes the following ten countries: Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam. Cambodia was the last to join (in 1999) the membership of the ASEAN. This study did not include data for the smaller ASEAN economies. In December 2005, the national accounts of China were revised by the National Bureau of Statistics (NBS), incorporating new information made available by the 2004 National Economic Census. The revised accounts showed that not only the size of the economy was larger, but also that it was growing at a slightly higher rate than previously computed. The census also revealed that the services were more important to the economy than previously computed. The 2004 census yielded better estimates of the services sector output. It added $284 billion to 2004 GDP estimates, that is, the GDP for 2004 was revised upward by 16.8 percent. These revisions expanded China’s GDP base. See World Development Indicators 2006, box 4F for greater details.

Notes 235 21. Author’s calculations are based on internationally published statistical data. 22. See Chapters 1 and 2 of the WEO (2007), October. 23. The four newly industrialized Asian economies (NIAEs) are Hong Kong SAR, Republic of Korea, Singapore and Taiwan. 24. The acronym ASEAN stands for the Association of South East Asian Nations, which has ten members. The ASEAN-4 economies are Indonesia, Malaysia, the Philippines and Thailand. 25. The term “soft power” was coined by Joseph Nye (2005) of Harvard University. It implies having an ability to have what you want through attraction rather than coercion. 26. The source of dollar GDP figures is WDI (2007). This ranking measures gross national income converted into US dollars using the World Bank’s so-called the Atlas method of currency conversion. It smoothes out exchange rate fluctuations by using a three-year average. 27. As reported in WDI (2007). 28. Cited in Tanner (2004). 29. Frustration of industrialists in the industrial economies was expressed well by Engardio and Roberts (2004) as follows: “America has survived import waves before, from Japan, South Korea, and Mexico. And it had lived with China for two decades. But something very different is happening (now). The assumption has long been that the US and other industrialized nations will keep leading in knowledge-intensive industries while developing nations focus on lower-skill sectors. That’s now open to debate. ‘What is stunning about China is that for the first time we have a huge, poor country that can compete both with very low wages and high tech,’ says Harvard University economist Richard B. Freeman. ‘Combine the two, and America has a problem.’” 30. See Ahearne et al. (2003), Feyzioglu and Wang (2003) and also WEO (2004), Chapter 2, discusses these issues at length. 31. The other BRIC economies were also responsible for it. (BRIC–Brazil, Russia, India and China). 32. See President W.J. Clinton’s Fifth State of the Union Address delivered on February 7, 1997. 33. See “Anan Hails China’s Role on the World Stage” in China.org.cn. Xinhua News Agency. December 29, 2005. Available on the Internet at http://www.china.org.cn/english/international/153614.htm. 34. See Time, “China Century,” January 2, 2007. 35. In Mandarin heping jueqi means peaceful ascendancy. 36. Deng Xiaoping used the term xiaokang for the first time to mean a well-off society in which people could lead a fairly comfortable life. For him achieving the modest target per capita GDP of $800 by 2000 meant achieving xiaokang. While China did achieve this target and did better, this definition of xiaokang provided essentially basic life. 37. The results of this survey were cited in The People’s Daily, on January 23, 2007, in an article entitled “China’s Development an Opportunity, Not Threat,” written by Huang Qing. 38. Rumbaug and Blancher (2004), see Table 2.7, p. 10. 39. Computed from Comtrade data tapes. See Ianchovichina and Martin (2006), Table 2.

236

Notes

40. Ibid. 41. The source of these statistical data is International Trade Statistics 2006, World Trade Organization, Table I.5 and Table II.2. 42. The source of these statistical data is the World Development Indicators 2007. 43. The source of these data is the WEO (2004), Chapter 2, Table 2.9. 44. See Freund and Ozden (2006), and Branstetter and Lardy (2006) provide detailed accounts of upgradation of the export sector. 45. Joint ventures are often, although not always, between foreign corporations and domestic Chinese firms. 46. China was one of the original 23 contracting parties (CPs) of the General Agreement on Tariffs and Trade (GATT), a status it shares with India, but it relinquished its GATT membership in 1950. 47. Computed from Comtrade data of the United Nations by Lall and Albaladejo (2004). 48. The source of these statistical data is International Trade Statistics 2006, World Trade Organization, Table I.5 and Table II.2. 49. The best example of China acting as a manufacturing hub in Asia is increasing Chinese imports of electronic components from the AHP economies. These imports grew markedly in the recent years, in line with the increase in its electronics exports to the three large industrial country markets. 50. For a detailed scholarly analysis of China’s integration in the supply chains and production networks, see Haddad (2007). 51. Sources of these statistical data are Quarterly Update, Beijing, World Bank, May 2007, and the earlier issues. 52. The term “processed goods” used for exportables that are manufactured with the imported parts and components comes under the rubric of “processed goods,” as classified by the Chinese customs. 53. Source of these statistics is WTO (2007) Table I.5, page. 17. 54. For a detailed treatment of liberalization of China’s FDI regime, which was done in several stages, see Das (1996); Naughton (1996); Huang (2003a); and Das (2005). 55. A noneconomic event that led to a sudden increase in FDI flows in 1992 was Deng Xiaoping’s visit to the Guangdong province, southern coastal areas and the SEZs, indicating that the respected patriarch was fully committed to the strategy of China’s broad-based economic reforms, particularly to inviting FDI to China. His visit was intended to push the reform process forward. 56. Cited by Hexter and Woetzel (2007). 57. These statistical data come from the International Financial Statistics, International Monetary Fund, various issues. 58. As compared to this, the real rate of return on a diversified portfolio, having 60 percent investment in stocks and 40 percent in bonds, is 5 percent or higher. 59. The Quarterly Update, Beijing, World Bank, February 2007, discusses these proposals and recent developments in this area in an in-depth manner. 60. The National Congress of the Communist Party of China (CPC) should not be confused with the National People’s Congress, which is the legislature of the People’s Republic of China. 61. Premier Wen Jiabao’s statement during his annual press conference after the Fifth Session of the Tenth National People’s Congress, on March 15, 2007.

Notes 237

62.

63. 64.

65. 66.

67.

68.

Available on the Internet at http://www.10thnpc.org.cn/english/2007th/ 203204.htm. Address of Wen Jiabao, Premier of the People’s Republic of China, at the Inaugural Annual Meeting of the World Economic Forum on “A Growing China Embraces A Bright Future.” Available on the Internet at http://www.weforum.org/en/events/AnnualMeetingoftheNewChampions/ WenJiabaosaddress/index.htm. In 2006, the Shanghai party secretary was removed for plowing $400 million in pension funds into real-estate projects. The results of this study were made public on May 21, 2007. The Jiangsu province, the richest and most developed, accounted for 12 percent of all cancer cases (Watts, 2007). Chinese newspapers have carried stories of “cancer villages,” where clusters of households with pollution-generated diseases exist near industrial plants. They are also found alongside the polluted waterways. The VAT export was removed or reduced on 2,831 items, or 37 percent of total number of export items. Published on Bloomberg.com on November 30, 2004. See “China Tells Currency Speculators to Get Lost” by W. Pesek. Accessed on December 15, 2004. Available on the Internet at http://quote.bloomberg.com/apps/ news?pid=10000039&refer=columnist_pesek&sid=aDaFXG_.Fn08. The National Congress of the Communist Party of China (CPC) is the apex policy-making body. It meets every five years. The most important policy decisions, including decisions regarding the leadership, are made during the CPC meetings. It is common to make strategic decisions before the meeting but announce them during the National Congress of the CPC. The 17th National Congress of the CPC was held during October 15 through 21, 2007. The so-called Group-of-Twenty (G-20) was born before the Cancún Ministerial Conference in June 2003. The G-20 coalition included some developing country members of the Cairns Group (Argentina, Brazil and Thailand) which were interested in improving market access for their agricultural exports. It also included other developing countries (India, Mexico, Bolivia and Ecuador) which were concerned with defending their domestic markets from import surges. At the time of writing, the G-20 had the following 21 members: Argentina, Bolivia, Brazil, Chile, China, Colombia, Costa Rica, Cuba, Ecuador, Egypt, Guatemala, India, Indonesia, Mexico, Nigeria, Pakistan, Paraguay, Peru, the Philippines, South Africa, Thailand and Venezuela. The role of collegial leaders of G-20 was played by Brazil, China, India and South Africa (Das, 2007b).

2 A Chinese Renaissance in an Unremittingly Integrating Regional Economy 1. 2. 3. 4.

For a more detailed discussion, see also Schott (2006) and UNCTAD (2005). See note 67 above. Cited in Rodrik (2006). See, for instance, Ahearne et al. (2003) and Zebregs (2004).

238

Notes

5. The justification for combining export statistics for China and Hong Kong SAR for the entire period is that many export goods use Chinese labor and Hong Kong management and distribution skills. 6. The Southeast Asian economies included were Indonesia, Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand, while the South Asian economies included were Bangladesh, India and Pakistan. 7. At this point, after a devaluation of 28 percent of the official exchange rate, the new exchange rate was fixed at 8.28 RMB yuan to the dollar, which was held until 2005. In 1994 and 1995, the economy suffered from two bouts of high inflation, which reversed the effect of the moderate currency devaluation. 8. See World Economic Outlook. 2004. Chapter 2. 9. See The New Straits Times, “Future Flows of FDI to Asia to Depend on China,” March 9, 2002. 10. Cited by Woo (2004). 11. Published by the United Nations Conference on Trade and Development (UNCTAD) in 2002. 12. This FTA is between China and ASEAN-6 economies. “ASEAN 6” refers to Brunei Darussalam, Indonesia, Malaysia, the Philippines, Singapore and Thailand. The newer ASEAN members are Cambodia, Lao PDR, Myanmar and Vietnam and are referred to as ASEAN-4. 13. See Yu and Cheng, 2004 as well as Das (2004, 2005) for detailed discussions on this issue.

3 A Chinese Renaissance in an Unremittingly Integrating Global Economy 1. See Das (2005) for a detailed exposition on this issue. 2. The supply-demand fundamentals for crude oil were in clear deficit. Toward the end of September 2007, the average petroleum spot price (APSP) of benchmark West Texas Intermediate (WTI) shot up to $83.90 per barrel and in early November it topped $99. This was 65 percent increase in petroleum prices in one year. On January 2, 2008, they hit $100 a barrel, and a psychological barrier fell. The global consumption of oil has been growing at an average annual rate of 1.9 percent; however the production growth rate is 1.5 percent per annum. The last year, 2007, was the sixth consecutive year of oil price increases. 3. Although there is a disagreement on dates, Professor T.S. Ashton, an authority on industrial revolution and the author of The Industrial Revolution 1760–1830 , regarded it as starting in 1760. 4. The detailed results of these surveys can be accessed on the website of WorldPublicOpionion.org at http://www.worldpublicopinion.org/. 5. Cited in Kurlantzick (2007). 6. As China is not a member of the Development Assistance Committee (DAC) of the OECD, which reports on members’ international aid, information and statistics in this regards are scratchy. 7. Cited in Kurlantzick (2007). 8. See Chapter 1, World Economic Outlook, October 2007.

Notes 239 9. In a BBC interview on October 1, 2007, Alan Greenspan notes, “The most credible worst case scenario is a recession in the US, driven by further fall in US house prices as people feel less wealthy and spend less money.” Even in the best case, “a substantial slowdown in the US, with repercussions across the globe” cannot be ruled out. Available on BBC News on the Internet at http://news.bbc.co.uk/go/prfr/-/2/hi/business/7022117.stn. 10. See IMF (2004) Chapter 2 for a detailed discussion. 11. Toward the end of November 2007, the average petroleum spot price (APSP) of the benchmark West Texas Intermediate (WTI) shot up to $99 per barrel. This, inter alia, reflected imbalance in the supply-demand fundamentals. The demand outpaced supply significantly. Global consumption was growing on average by 1.9 percent per year during this period, while supply growth lagged. The 2007 was the sixth consecutive year of price increases. On January 2, 2008, the petroleum prices hit $100 a barrel. 12. See UNCTAD (2007), Chapter 3, Table III.1. 13. At the end of August 2007. 14. See UNCTAD (2005 and 2007). 15. FTAP stands for Foreign Direct Investment and Trade Analysis Project. 16. For more detailed, country-wise results, see Tables 14, 15 and 16 in OECD (2006). 17. This section draws on Winters and Yusuf (2007), Chapter 1.

4 The Chinese Renaissance and the Transpacific Macroeconomic Imbalances 1. IMF (2007), see Chapter 3. 2. For instance, see Croke, Kamin and Leduc (2005); Edwards (2005); Freund and Warnock (2005); Goldman Sachs (2005); Debelle and Galati (2005); de Haan, Schokker and Tcherneva (2006); and WEO (2002). 3. While here we are basically concerned with the current account surplus of China, such surpluses are also run by the other EMEs of Asia such as India, Japan, Korea, Malaysia, Singapore and Taiwan, and the OPEC economies such as Iran, Kuwait, Nigeria, Saudi Arabia, Venezuela as well as Brazil and the Russian Federation. Several of these economies maintain managed exchange rate regimes and limited capital account convertibility. 4. The source of these statistical data is the National Bureau of Statistics, Ministry of Commerce, the Government of China. 5. Toward the end of November 2007, the average petroleum spot price (APSP) shot up to $99 per barrel. This was 65 percent increase in petroleum prices in one year. On January 2, 2008, they hit $100 a barrel and a psychological barrier fell. 6. China was not the only economy that turned into a net lender. The highsaving East Asian countries, particularly China and Japan, have been collectively running large trade and current account surpluses, largely in manufactures, with the US. 7. The broad index is computed and published by the Board of Governor, Federal Reserve System, and is available on the Internet at http://www.federalreserve. gov/releases/h10/Summary/indexb_m.txt.

240 Notes 8. Using a different index of the dollar value vis-à-vis the value of the major currencies, Cline (2007) also reached the same conclusion. 9. Based on the International Financial Statistics, International Monetary Fund, various issues. 10. The source of these statistical data is the website of the US International Trade Commission, Washington DC. It can be accessed at http://dataweb.usitc.gov/ classification_systems.asp. 11. See box 1.3, p. 24, WEO (2006). 12. Ibid. 13. In November 2007, the euro touched an all-time high peak of 1.48 dollars. 14. It is attributed to Larry H. Summers (2004), who used it for the first time. 15. These statistics come from different volumes of the Direction of Trade Statistics, International Monetary Fund. 16. Boeing Corporation projected that China will be the largest market for commercial aircrafts and travel outside the US for the next two decades. Based on the current expansion rate of the traffic and air travel industry in China, Boeing has forecasted that China will need 2,300 more commercial aircrafts by 2023. 17. The source of these statistical data is the World Development Indicators 2007. 18. This section draws on Lardy (2006). 19. See, for instance, Eichengree (2004); Roubini and Setser (2005); Roubini (2006); Chinn and Ito (2007); WB (2005). 20. See Krugman (2007) for a detailed discussion on the need for a dollar depreciation. 21. Krugman (2006) irreverently referrers to it as “the alleged emergence of a Bretton Woods-II system.” 22. See, for instance, Eichengreen (2004); and Goldstein and Lardy (2005). 23. Various analytical accounts of the Plaza Accord are available, for instance, Das, 1992; Funabashi, 1989. 24. The other participants in this IMF-led Multilateral Consultation on Global Imbalances were Euro Area, Japan and Saudi Arabia. 25. Over the years, the G-20 emerged as a valuable piece of global architecture. It was formally created at the September 25, 1999, meeting of the G-7 Ministers. It was launched with fanfare in December 1999 in Berlin, where the first meeting of the G-20 took place. Representatives of the EU, the International Monetary Fund (IMF) and the World Bank were made a part of G-20. The French and Italian governments were opposed to the concept of this G-20. The reason they gave was that it would undermine the authority of the IMF. Instead, they supported the new International Monetary and Financial Committee (IMFC) of the IMF. The US and Japan were very much in favor of the new body. Britain, while supportive, was somewhat reserved, for fear that the G-20 might undercut in practice the prominence of the new IFMC, which Britain’s erstwhile finance minister Gordon Brown was chosen to initially chair. Canada threw its weight in favor of the G-20. It was largely because it wished to see a broader consultative structure that was more formalized, linked to other supranational institutions and less controlled by the US. The G-20 was chaired for its first two years by Canadian Finance Minister Paul Martin, who declared that the mandate of the G-20 was to “promote discussion and study and review policy issues among industrialized

Notes 241 countries and emerging markets with a view to promoting international financial stability.” Its initial 18 member countries consisted, in addition to the G-7, of Argentina, Australia, Brazil, China, India, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey. Canada hosted the second meeting in 2000. It was decided that the chair would rotate among participants with two-year terms, and with the initial chairs being chosen from among the G-7 countries. 26. McKinnon and Schnable (2006) disagree with the line of logic suggested by William Cline.

5

The Chinese Renaissance and Its Currency Conundrum

1. In Mandarin renminbi means people’s currency and yuan means a round coin. 2. See, for instance, Fernald et al. (1999). 3. The abbreviation ASEAN stands for the Association for Southeast Asian Nations. The ASEAN-Plus-Three (APT) grouping comprises the ten members of ASEAN, and the three Northeast Asian economies, namely, China, Japan and Korea. 4. The broad index is computed and published by the Board of Governor, Federal Reserve System, and is available on the Internet at http://www.federalreserve. gov/releases/h10/Summary/indexb_m.txt. 5. Only Morgan Stanley believed that the RMB yuan-dollar peg might continue until late 2005 (Baker and Jen, 2004). 6. China’s unemployment problem has been far more serious than indicated by the statistics. Although an increase was reported in total employment created for 31 million between 1998 and 2002, the number of registered urban unemployment increased from 3 percent to 4 percent—or from 6.7 million to 10 million—over the same period. Urban employment during this period increased from 224 million to 248 million. These statistics reveal only a fractional picture of unemployment in China and conceal the reality. Research by the RAND Corporation indicated that when proper allowance is made for “disguised” rural unemployment as well as “unregistered” urban unemployment, China’s actual unemployment rate soared to an estimated 23 percent of the total labor force. The term “disguised” unemployment refers to labor that is reported as nominally and gainfully employed, but in fact does not contribute to output. In the US labor market, “featherbedding” is an equivalent term. The strains and stresses that were caused by the persistent masses of China’s unemployed and underemployed labor force were difficult to assess but hard to overestimate. China’s employment problems have been a deeper, more long-term, and potentially more serious challenge to economic and social stability than is known outside China (Wolf, 2004). 7. Published on Bloomberg.com on November 30, 2004. See “China Tells Currency Speculators to Get Lost” by W. Pesek. Accessed on December 15, 2004. Available on the Internet at http://quote.bloomberg.com/apps/ news?pid=10000039&refer=columnist_pesek&sid=aDaFXG_.Fn08. 8. Chinese Premier Wen Jiabao repeatedly remarked in the financial press that China shall not relax the dollar parity under pressure from other countries. During the ASEAN summit held in Vientiane, Laos, during November 29–30,

242

9.

10.

11. 12. 13. 14.

15. 16. 17. 18. 19.

20. 21.

Notes 2004, he went a step further, issuing a warning of sorts to currency speculators. He stated, “To be frank, it’s not possible to launch changes to the renminbi yuan when speculation is so rife.” He added, “rampant speculative activities on the renminbi yuan” would render the introduction of any measures “impossible.” He meant that currency traders who were testing China’s resolve were only delaying a change in its currency regime. The implications were that the more the market expectations and speculative activity regarding revaluation of the RMB yuan the longer the process was likely to play out. The Japanese policy makers responded to the US pressure and ill-concealed threats of trade sanctions by applying “voluntary” constraints on products of large exports to the US. Also, the yen was appreciated from 360 to the dollar in 1971 to 110 in the mid-1980s (Das, 1992). A steep currency appreciation caused a long-lasting deflationary slump in Japan. The economy was rendered fragile; this fragility persisted until late during the 2000s. Senator Charles Schumer of New York introduced a legislation to impose punitive tariffs of 27.5 percent tariffs on all imports from China and senior Bush-administration officials agreed on greater flexibility of exchange rate of the RMB yuan. As this would have been an egregious violation of the World Trade Organization (WTO) regulations, in September 2007, Lindsey Graham and Charles Schumer crafted a bill for imposing sanctions on China, which was consistent with the WTO regulations. The new bill would require the US to warn China with threats of imposing anti-dumping duties because of its fundamentally misaligned currency. See, for instance, Bergsten (2007). See Chapter 4. The source of these statistical data is the World Development Indicators 2007. China was invited to the Group-of-Seven (G-7) meeting which took place in London on February 5, 2005. Chinese central bank deputy governor Li Ruogu told reporters after the meeting, “We are determined to move towards a flexible exchange rate,” although a timeframe of future events was not available at that point. For a detailed discussion of the BBC regime, see Williamson (2001). Ogawa and Sakane (2006) supported this inference. These citations from Frankel and Wei (2007) have been made after taking their permission, which was received on September 20, 2007. This section draws on McKinnon (2007). “Processed goods” is a term used by Chinese customs for export products that are manufactured with the help of imported parts, components and subassemblies. For detailed analyses, see Thorbecke (2006a); and Gaulier et al. (2005). Joint ventures are often, although not always, between foreign corporations and domestic Chinese firms.

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Index A administrative failure, 63–64 Agreement on Textiles and Clothing, 42 agricultural reforms, 9–10 ASEAN-Plus-Three, 118–119 Asian crisis, 108–109, 163 B Balassa-Samuelson hypothesis, 202–204 BEER, 204–206 Big Mac index, 202 Bretton Woods regime, 162, 184 Bretton Woods II, 182 C China and ASEAN, 51 and Asian economy, 91–94, 102–104 century, 32 syndrome, 25 China Investment Corporation Cobb-Douglas production function, 17 competitiveness, 145–147 competitive threat, 100–101 coping strategy, 114–116 coping with China’s growth, 151–154 corruption, 64 Cultural Revolution, 3 currency appreciation, 223–224 basket, 215–216 current account deficit, 156–170 surplus, 163–165 D Deng doctrine, 5 Deng Xiaoping, 7, 8 demographic bonus, 14–16 development model, 5–7

dollar peg, 200–201, 210 dual economy, 53–54 E economic ascent, 20–25 catch-up process, 7 liberalization, 7–11, 199 reform program, 6–7 reform strategy, 8–9 turn-around, 1–5 eleventh Five Year Plan, 27, 50, 219 Emperor Qian Long, 2 Emperor Yung Ho, 2 environmental degradation, 65–66 European Central Bank, 161 export expansion, 39–43 of advance technology products, 45–46 of consumer products, 45–46 processed, 97 resource based, 100–101 shoddy products, 63–64 exchange rate, 167–169 misalignment, 202–205 regime, 198–202 F FEER, 204–206 financial imbalances, 178–180 markets, 74–75 flying-geese paradigm, 91–93 foreign direct investment, 18–20, 28, 46–48, 92 geographical concentration, 48–51 growth, 51–53 lumpy, 112 multinationals, 54–57, 108–109 outward, 147–149 foreign exchange reserves, 57–60, 213 foreign-invested enterprises, 9–10, 28, 42, 46–48, 53, 109–111, 176–177 Free Trade Area, 117–118 261

262

Index

G Gini coefficient, 4, 72–73 globalization, 4–5 global acceptance, 32–33 citizen, 32 growth, 137–140 impact, 29–32 integration, 25–27, 149–151 place in, 76–77 repositioning, 125–129 gravity model, 107 Great Leap Forward, 3 Great Wall, 1 growth assessment, 129–130 catch-up, 131–132 path, 72–76 performance, 126–129 strategic shift, 54–56 trajectory, 66–70 transition, 73–74 I industrial economies, 90 inflation discount, 26 intra-regional trade, 95–96 investment performance, 11–14 ITeS, 147 L labor productivity, 19–20 large-trading economy, 33–37 M macroeconomic imbalances, 160–163, 181–185 reforms, 4–5, 105 Manchu Dynasty, 2 manufactured products, 93 Mao Zedong, 3 MFA quota, 108 MFN status, 110 multinational corporations, 54–57 N National Reform and Development Commission, 50 non-performing loans, 69–72, 208–209

O one-child per couple, 14–15 open-door policy, 5–6 outlier, 101–102 P peaceful ascendancy, 132–134 PEER, 204–206 Plaza Accord, 188 Plaza Accord II, 186 positive supply-side shock, 128–129 precautionary saving, 12–13 production network, 96–99 Q Qin Dynasty, 1 Qualified Domestic Investor Initiative, 61 quality-ladder, 102 R reforms, 105 regional for a, 90–91 integration, 116–118 RMB appreciation, 209–12 dichotomy of perspectives, 216–19 reforms, 215–216 revaluation, 213–215 sub-prime crisis, 224–225 and trade, 219–221 rural-urban gap, 12–13, 72–73 S SAFTA, 118 saving performance, 11–14 soft power, 22 sovereign-wealth funds, 62–63 special economic zones, 176 Starbucks index, 202 State administration for Foreign Exchange, 60 state-owned banks, 70–71 state-owned enterprises, 7–10

Index 263 T technology base, 94–95 total factor productivity, 16–20, 54, 68–69, 200 Town and Village Enterprises, 6 Toxic shroud, 66 trade configuration, 99–101 structure, 173–175 surplus, 170–173 transnational corporations, 109, 176–177 U urban-rural divide, 6–7

V value-added chain, 104 vertical specialization, 95–96, 99 W Water pollution, 65–66 World Trade Organization, 92, 130, 136 accession, 37–39, 144–145 Z zero-sum game, 113–114 Zhao Ziyang, 5

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