January 2005

China and the Global Economic Recovery

Anne Krueger
International Monetary Fund

Gross domestic product (GDP) growth in China has been spectacular in the last decade. Real GDP grew by an annual average of 9.7 percent between 1990 and 2003. Although this growth has improved the lives of millions of Chinese citizens, the country was starting from such a low level, and living standards are still low by international standards. The World Bank World Atlas method puts per-capita income at $1,000.

China’s share of the world economy has also grown by several measures. It is currently 4 percent of world output in nominal terms and 13 percent in purchasing power parity (PPP) terms in 2004. Using the PPP statistic China is the third biggest economy when counting the euro as a single economy. China’s share of world trade has also grown. Its exports have increased from 1.9 percent in 1990 to 6 percent in 2003. Imports grew from a 1.5 percent share in 1990 to a 5.7 percent share of all world imports. China’s growth has helped to support the current period of economic growth in the world and has been especially important to the Asian market. Trade growth between China and other Asian economies has steadily increased.

Although the impressive growth of the Chinese economy has been important for its citizens and the entire world, it is unlikely that the current growth rates are sustainable over the medium term. It is up to the government to develop policies that reduce growth slowly and avoid sharp increases in inflation. Although a few minor policies have been implemented in an effort to curb growth, meaningful policies necessary to bring growth down to a sustainable level have not been enacted.

There is a lot of concern that without the proper growth curbing policies in place, the Chinese economy may encounter a hard landing. I believe these concerns are misguided for two reasons. The IMF ran a simulation to determine the effect of a sharp turndown in the Chinese economy, assuming a decline in the growth rate of investment of 5.5 percentage points of GDP. This slowdown would result in a 4-percent fall in GDP and a 10-percent fall in imports. This would cause a drop in world GDP of about one-third of 1 percent in the short term and could rise to three-fourths of 1 percent after several years. Most of the impact would be felt in Asia; the rest of the world would feel minor effects.

The second factor that makes a hard landing unlikely is the likely response of Chinese authorities. The Chinese government would respond quickly to any severe slowdown, and any significant effects would probably be felt for no more the a few quarters. An important long-term effect of a slowdown would be the possible decline in government control of the economy and an increase to more free market policies.

The Chinese need to move away from a fixed exchange rate, to reform the banking industry, and to eventually end the multi-fiber agreement which would eliminate a number of textile quotas.

In conclusion, the growth China has experienced has had numerous positive effects for the rest of the world. Rather then taking away market share from other countries, it has increased growth throughout the world. In addition, while the country has seen important benefits from the substantial growth, it still has problems to tackle: the country’s banking system has numerous debts that will have to be written off; most of the country still lives in poverty; the gap between rich and poor is still increasing; and the bureaucracy is large and often inefficient.

Randal Quarles
U.S. Treasury

A goal for the administration is to increase economic growth throughout the world. Rapid economic growth creates job, increases income, and reduces poverty.

Since 1978 China has been growing at about 9.5 percent a year; this growth rate has made the economy nine or ten times bigger then it was in 1978. Today it is roughly the sixth largest economy in the world. During the last three years the United States and China have accounted for half the world’s economic growth. Chinese growth has contributed to Japan’s recovery, as well as growth in other Asian countries and in Latin America.

Sustainable growth in the long term does not seem to be an issue for China. It has huge amounts of resources and unused labor and is very receptive to new technology. It also has a very high saving rate, nearly 40 percent of GDP; if the country was more efficient in its use of savings and investment, it could continue to have strong economic growth. In order to assist with this task the Treasury is helping to update and stabilize China’s financial system, as China moves to improve governance of institutions, refine its accounting and regulatory systems, and address issues in the judiciary system. The government needs to shift from administration-based policies towards market-based policies. While the Treasury’s involvement in these changes has been extensive, the Chinese government has welcomed the advice and participated in numerous economic forums.

Jeffrey Frankel
Harvard University

The main topic of my discussion about China will concern issues of currency, namely whether China should allow its currency to appreciate. There are several reasons why allowing it to appreciate are in the interest of the United States and China.

First I will deal with why it is in the U.S. interest. The U.S. current account deficit is unsustainable, largely due to a low national savings, which results in a high budget deficit. If the dollar was allowed to come down further, this would improve the trade balance, thereby improving the current account balance. These actions would take the place of any necessary fiscal stimulus by the U.S. government. Ideally, the United States would like a coordinated package of a reduction in its budget deficit coupled with all the Asian countries allowing their currencies to appreciate. This situation is unlikely to happen.

There are several reasons that movement towards a more flexible system is in China’s interest. All central banks have two goals: internal and external balance. Domestic demand must be kept under check, and there must be some amount of equilibrium in the balance of payments. In order to achieve both of these goals you cannot have a fixed exchange rate. There are four reasons eliminating the fixed rate helps the Chinese economy. It reduces overheating as a reason to allow appreciation under current circumstances. When the balance of payments surplus becomes too large it is difficult to prevent the inflow of reserves from throwing the money supply and contributing to inflation. It is necessary to prevent a hard landing and possibly a currency crisis. And finally by allowing its currency to float prices will be able to adjust to their correct level. Currently they are 23 percent lower then the United States, but the Balassa-Samuelson prediction estimates their normal level to be at 36 percent.

There is some talk that we are in a Bretton Woods-like system with Asia. While this may be true, I believe we are near the end of this simulated agreement. Also I believe Asian banks may cut the rate at which they are purchasing Treasury securities, which may lead to a crash in the U.S. bond market

Morris Goldstein
Institute for International Economics

I will also be discussing China’s exchange rate policies. In particular, I will be discussing four key questions. First is the question of whether or not China’s currency is undervalued, and the answer is yes, by about 20–30 percent. We arrived at this number by looking at the necessary adjustment to the exchange rate to bring equilibrium to China’s balance of payments and also by looking at what role the currency might play in the adjustment of other countries’ accounts.

The second question is whether Chinese manipulation violates the rules of the IMF, and again the answer is yes. Under IMF rules, countries can adopt what exchange rate policy they want and can even intervene from time to time, but they cannot purse policy that keeps the exchange rate at the wrong level. This is precisely what China is doing; they maintain the current exchange level even though the real rate has been depreciating.

The third question is whether or not an appreciation of China’s currency would help the rest of the world, as well as China. The answer is yes on both accounts. It would help China by helping to bring along banking reform, keep inflation low, allow for continued access to markets for Chinese exports, and to sustain healthy growth.

The last question is what currency regime would best facilitate an appreciation of the Chinese currency? My preferred method would be to conduct a 15–20 percent revaluation based on a basket of currencies and after a time when the banking industry is more stable, to allow for a currency float and open the capital account.

Pieter Bottelier
Johns Hopkins University School of Advanced International Studies

I will also be discussing the exchange rate, but first I want to address the issue of where China is in the overheating cycle and whether the investment boom is sustainable. In my opinion the economy is overheating, but not as badly as it was a year ago. There is continued need for aggregate demand management and some fiscal tightening in the years ahead. Although indicators of unbalanced investment growth have improved over the last year, the underlying fiscal problems have not been corrected. There is some evidence that this overheating cycle is not as severe as the one that occurred during the early 1990s. This is because the government has slowed down the economy by restricting bank lending, particularly on investment projects.

In reference to the question of whether the current investment boom is sustainable, I believe that the current investment statistics tend to be overestimated. I believe the actual investment GDP ration is not 42.3 percent but only 32 percent. By this measure it is clear that investment has not peaked and may not peak for a while. I do have a couple of concerns with regard to investment, namely a growing housing bubble and excess capacity in a number of industries.

In regards to the exchange rate, I do not believe it is as undervalued as Morris indicates. I believe that a 50-percent revaluation in unnecessary, an initial revaluation of 45 percent would be appropriate.

Although I do not like the term “manipulation,” China has maintained a low exchange rate in order to promote exports and spur employment growth. An important question is why haven’t they changed their system if it is in their interest to get rid of the fixed rate? Although only the government knows the real reasons, I can make a few guesses. First, they do not want to reward speculators and create a favorable speculation environment. Second, the fixed rate has greatly increased employment growth; unemployment is a massive problem in China and anything that detracts from growth should be discouraged. Next, there is a bevy of policy changes the government is dealing with, and they may have not been able to tackle the exchange problem just yet. Fourth, the economy is a divided market between rural and urban-based industries; this can lead to a stark difference in opinions over which system is best.

John H. Makin
AEI

I am very concerned about a hard landing for the Chinese economy. The country appears to be suffering from the same problems that have plagued other Asian economies, over-inventment coupled with a poor banking system. There is increased saving due to the rapidly growing economy, which encourages more investement domestically. Right now the misallocation of investment rather then over-investment is an important problem for policymakers. An imbalance between the traded and non-traded sectors presents a problem in attempting to slow growth. This may be a reason for the reluctance to allow the currency to appreciate; it could create downward pressure on both of these sectors, which would cause a rapid slowdown across the economy.

An important problem is the insolvency of the banking system in China. Too many banks have bad investments that will have to be absorbed by the system. It is impossible to install a more stable system next to the unstable one, yet something must be done. I recommend dismantling the controls on capital inflows and changing the currency regime, preferably to a currency basket similar to the one currently in Singapore.

Li Shantong
China Development Research Center

From our data, we believe China’s high growth rate can be attributed to several different factors. I believe the inflow can account for two-thirds of the growth. Improved productivity is also an important factor. Related to this is the reallocation of labor from agriculture to different industry sectors. Moving from a low-productivity sector to a high-productivity sector can contribute to economic growth.

There are several problems facing China both in the present and future. With regard to natural resources, both our tradable and non-tradable resources are well below world averages. Another serious issue is the aging problem. The over-sixty percentage of our population is increasing rapidly. We also have a shortage of job opportunities. Every year we have 10 million new citizens entering the labor force, and industries must provide jobs for them.

Income distribution is another serious problem. Rural household income growth has stalled while urban income growth has increased, thereby widening the income gap. Regional income disparities have also increased throughout the country.

Three sectors are likely to influence economic growth in the future: The Baseline supports policies that promote a more open economy and continued transfers away from the agriculture sector. The Balanced Policy Scenario involves promoting the service sectors and improving efficiency of natural resources. The Sectors in Areas of Risk involve banking reform and the popularization of basic education and the improvement of the labor force.

We believe it is possible for China to sustain its growth rate in the next fifteen years, but there are several challenges to face in the future. The period from 2005 to 2010 will be a crucial period for reform in China.

AEI intern Michael Wilson prepared this summary.