What Else Can China do?

As if we needed a reminder, the present crisis has made it abundantly clear that China has become a vitally important and integral part of the global economy. The bilateral US-China economic relationship is even stronger than the EU-China links, especially in the financial arena. Larry Summers, former US Treasury Secretary and former President of Harvard University, described the US-China economic relationship as a balance of mutually assured economic destruction (MAED). Although this sounds rather negative, it is clear that China and the US need each other. China needs the US for exports, employment and knowledge; the US needs China to help finance its massive current account and fiscal deficits. The EU has become China’s largest trading partner, but does not need financing from China like the US does. Although the EU’s trade deficit with China is also very large (and growing), the EU’s overall current account with the rest of the world is almost balanced.

 

China holds over $2 trillion on foreign exchange reserves, mostly in US dollar-denominated financial instruments. The Chinese government is the largest external creditor of the US federal government, Fannie May and Freddie Mac. China is the third largest client for US exports and the most rapidly growing one. Many thousands of US enterprises have production facilities and/or sales operations in China. A sizeable proportion of US corporate profits, perhaps 10 percent, is derived from China-related commercial operations.  Uncomfortable as it may sound to some in the US and in China, the two countries have developed a symbiotic or mutually dependent economic relationship.

 

During the past 30 years China has learned much from the US and from European countries. It has been able to leapfrog technologies and to develop institutions thanks to it openness to foreign investment, trade and foreign advice. Its legal system, still a work in progress, is based on a pragmatic mixture of American and European law and practices. China has also benefitted from studying the mistakes of under countries. It has a rich trophy of lessons to learn from the debacle of the American subprime crisis and subsequent developments.

 

If the US-China bilateral relationship had been mature and relaxed at the political level, it might have been possible to negotiate large-scale bilateral debt-equity swaps to recapitalize US financial enterprises.  That burden now falls mostly on the US Treasury and the Federal Reserve.

 

There is no doubt that China has benefited enormously from WTO membership and from globalization in general, perhaps more than any other developing country.  There is no doubt either that the entry of China into the global economy under the international rule system has been highly beneficial to the US and the Europe as well.

 

Looking forward, we first have to deal with the immediate pressures of the current crisis. But, in doing so, we have to keep the longer term in mind.

 

Dealing with the current crisis

 

To counter its domestic economic slowdown and in the interest of the global economy, China must expand domestic demand as rapidly as possible through fiscal expansion and monetary relaxation. It is one of the few credit-worthy, large developing countries than can safely do so. There is significant room for a more rapid expansion of consumption; China’s household consumption-to-GDP ratio (35.4 percent in 2007) is one of the lowest in the world, the country’s fiscal situation is strong and the economy is only lightly leveraged. It has already announced that it will implement a significant fiscal stimulus program.  If there is any doubt regarding its appropriate size, China should err on the liberal side, provided the program is well-targeted and efficiently implemented.  Fortunately, China had considerable and relatively recent experience with fiscal stimulus programs focused on infrastructure. It has little experience with fiscal stimulus focused on social programs, where most of the top priorities for development and economic rebalancing lie. But an institutional infrastructure major new social programs (such as the dibao program and rural and urban basic health insurance programs), supplementing the social security reforms of the late 1990s, has been created in recent years. Once economic confidence returns, the effects of re-leveraging (borrowing by) Chinese corporations and households can contribute significantly to growth.

 

As President Hu Jintao himself stated at the recent G-20 meeting in Washington DC, the biggest contribution China can make to the global economy at this stage is to stay healthy and to grow fast.

 

But China can make further contributions by relaxing import controls and by making its exchange rate more flexible.  Such measures should not been seen as concessions to the US or the EU, but as measures that are also in China’s own long-term interest.

 

By all reasonable standards, China’s currency remains undervalued, in spite of the nearly 20 percent nominal appreciation against the US dollar since July 2005 (when China shifted from a fixed dollar peg to a basket of currencies peg.) It would be a mistake in my opinion if China were to abandon its policy of gradual appreciation and widening the trading band so as to achieve greater exchange rate flexibility. It is not in China’s long-term interest to have an undervalued exchange rate. It would retard economic rebalancing and slow employment and output in non-tradable goods and services.

 

Looking beyond the immediate crisis

 

In the interest of its own long-term development and financial stability, China should continue to modernize its financial system, strengthen its regulatory framework, and open the capital account step by step until full convertibility is within reach. In the long-term (10-20 years) if all goes well, the RMB Yuan could become an international reserve currency.  Intermediate steps in that direction include the promotion of Panda bonds and the facilitation of RMB transactions in Hong Kong and other major Asian cities.

 

From their side, the US, EU and other rich countries should make more serious efforts to integrate China more fully in multilateral organizations and international consultative groups. The G-7 has already outlived its usefulness; the G-8 without China is clearly incomplete and the new G-20 seems too large and unwieldy. We need new global governance structures to reflect the realities and answer the needs of today’s world.

 

Whatever new arrangements are made in this regard, the bilateral US-China relationship should be recognized as uniquely important, not only for the two countries, but also for the rest of the world. For example, without a full participation by China and the US, it will be very difficult to make real progress in climate control, which is going to be perhaps the greatest long-term challenge facing us.