How Sustainable Is China's Economic Growth?

April 21, 2005

Unedited transcript prepared from a tape recording.

Proceedings:
MR. BARFIELD:  Welcome to the American Enterprise Institute and with my co-moderator and cohost, Ellen Frost, I'd like to welcome you to the second of a series of China in Asia seminars that the American Enterprise Institute is jointly sponsoring with the National Defense University.

As you can see from your program, and I think we announced before, the title of this particular program is How Sustainable Is China's Economic Growth?  We have a packed agenda this morning with two speakers, one on the general question and the other on questions related to China's energy drive and energy needs.

As I picked up the papers this morning, I'm sure some of you have, all the papers are full of the quarterly reports from China on the economy.  The Financial Times headline is "Soaring Exports and Strong Consumer Spending Drive China to 9.5 Percent Growth."

In the article, they also point out that there have been a soaring--this has not been historically true but a soaring increase in trade surplus in China, and that led me to a second headline in the New York Times, which is not quite fair, because I think this is bipartisan, but the Times said, "Democrats Try New Tack on Overtrade with China," and the point of the piece is the push by some Democrats to hold up the confirmation of the U.S. trade representative in order to get agreement to pass a bill to make it easier to go against Chinese exports or alleged subsidies, and they also mention, to the administration's astonishment, the refusal of the Senate to kill a bill by almost two to one that would institute 27.5 percent tariffs against China, if they don't change, revalue their currency.

 So this is a very timely discussion, both in terms of what's happening in China itself, and also already the reaction in the United States.

I'm going to turn to Ellen to introduce our speakers.

MS. FROST:  Thank you, Claude.  I'm Ellen Frost, a visiting fellow at the Institute for International Economics.  I'm an adjunct fellow at the Institute for National Strategic Studies at the National Defense University, and on behalf of the National Defense University, I'd like to welcome all of you to the second in this series.

I want to remind you of the central challenge facing all of us.  Something becomes a policy issue when there are legitimately differing  perspectives brought to bear on a given issue or trend.  A perfect example if the rise of China and its impact in Asia.

It was our experience, and mine, personally, in 30-plus years in this town, that governments tend to have a bureaucratic and conceptual gap between people who work on political economic issues and people who work on political military issues.

So we were very happy to team up with AEI to try to get a group of people together to bring both of these perspectives to bear on this very timely topic.

The biographic information in your folders will tell you just a little bit of the distinguished career of our two speakers and I'm only going to introduce them in the briefest possible way.

The first speaker, known to most you, I'm sure, Nick Lardy, is a senior fellow at the International for International Economics.  Every time you read a newspaper article about the Chinese economy, you're likely to find a quote from Nick.  He is literally one of the world's most respected economists looking at China.

Mike Herberg was, for 20 years, the director for global energy and economic at ARCO and in that capacity gained a tremendously practical knowledge of international energy issues, and brings that background to his current position which is director of the Asian Energy Security Program at the National Bureau of Asian Research.

So we will have first, a presentation from Nick Lardy, followed by a presentation from Mike Herberg, and then we will open it up for discussion.

Nick.

MR. LARDY:  Thank you, Ellen.  I'm going to take less than my half hour, so we'll have more time for discussion, and essentially I will lay out the reasons I think China's long-term growth is sustainable.

But I want to begin by talking about--or maybe not talking about but perhaps to stir up some controversy or something, to dismiss what I would refer to as "the laundry list" approach to looking at the Chinese economy, and by that I mean when you start talking about the Chinese economy there are a huge number of major challenges.

The environment, the water shortage, the rising inequality, the challenge of securing adequate energy resources, and everybody's got their list.

You can easily come up with seven, eight or nine, or ten items.  And people sometimes draw the conclusion that one or more of these obstacles or these obstacles combined are going to sink the Chinese economy.

I essentially don't agree with that approach.  I think if you look over the last 25 years at every point in time, you could have come up with a list of major challenges and I think the record speaks for itself.  I think the Chinese have addressed some challenges, although some of them have been largely deferred.  But I basically take the view that many of these things are manageable and I'm not an expert about water or the environment or energy, so I won't give you my relatively uninformed opinions about those.

What I will do is try to lay out what I think are three or four major explanatory factors that underlie China's spectacular economic growth over the last 25 years and then just quickly comment on whether or not those underlying factors are going to continue to have a major influence on the growth pattern, going forward.

Let me just lay out what those factors are.

I think number one is what I call the rise of the market, and I mean, in particular, the rise of market-determined prices for products and for labor.

I think it's easy to lose sight of the fact that if you go back 25 years ago, all retail sales were at state-fixed prices, all prices for producer goods, machinery, equipment, all the investment goods in the economy were fixed by the state, and even 95 percent of all agricultural products that entered the market were sold to the state at state-fixed prices through the procurement system.

There was a state price commission that fixed these prices and the price that prevailed in many, if not most cases, bore no relationship to underlying scarcity.  Supply and demand simply wasn't a factor.

It was a bureaucratically-determined price system.  Now why is that important?  It's very important because in the early years of economic reform, there was no connection between underlying efficiency and profitability in the economy.

If you were a firm that had the advantage of underpriced inputs, and I am thinking in particular of food processing, textiles and apparel, tobacco, it was a license to print money.  The rates of return in these sectors are extraordinary high.

On the other hand, if you had the misfortune to be producing a product that the state thought should be underpriced, it wouldn't matter how efficient you were from an economic point of view.  You were never going to make any money.

So there was no connection between efficiency, on the one hand, and profitability on the other.

That situation dramatically changed over the course of the '80s and '90s as virtually all prices were gradually determined by the market.  I don't think we need here to go into the details of how they accomplished that, but by the mid '90s, and particularly by the late '90s, about 85 to 95 percent of all transactions for all three of the categories that I mentioned, were carried out at market-determined prices, and by and large the markets were pretty competitive.

If you look at the industrial structure in China, there are no--well, I shouldn't say that.  It's hard to think of very many sectors or industries in which a few firms have a very large market share.  It's more typically the case that there are dozens of firms in most industries.  So there's a lot of competition that's enhanced by the external sector, which I'll come to in a moment.

This is very important.  I, among others, have written a lot about the weakness of the financial system, the banking system, in particular, and that of course would be on anyone's list of the things that might derail this economy.

But partially offsetting that is the fact today, and particularly in the last five to ten years, reinvested profits is the most important source of investment in China.  It's far more important than the increase in loans outstanding through the banking system.  It's more important than the financing that comes through the budget.  It's more important than the funds that come from foreigners in the form of foreign direct investment.

And what that means is since prices now reflect supply and demand, and profitability now has a connection with efficiency, the firms that are more efficient and therefore more profitable, are able to expand more easily, and firms that are less efficient are less profitable and are less likely to be able to expand.

Some of them of course go to the state and still get special deals, et cetera, et cetera, but, on average, those firms are becoming relatively smaller and in many cases they're going out of business.

So the overall kind of resource flow has improved very dramatically.  I think the same thing is true in the labor market.  We also see the rise of the market in labor and I'm particularly thinking of the modern sector, either services or manufacturing.  Go back 25 years ago, when you left school, whether it was primary, secondary or tertiary education, you were assigned a job by the state, and most people never changed jobs.

If you went to work for the ABC company, you continued to work for the ABC company and they provided your housing and your health care and schooling for your children, and everything else, and there was no labor turnover and I think labor was very inefficiently allocated.  There was no opportunity for people to move to where their skills might earn a higher return.

You had a entirely state-fixed wage structure.  If you were in the xyz industry and, you know, you had a BA in engineering and you'd worked for 10 years, you could turn to a book and point to the exact column on the grid and you'd know exactly how much money you were going to be making.  And the next year you'd be getting a little more.  It was a very rigid system.

Today, of course, that's entirely "out the window."  People compete for jobs.  When they finish school, there is no guarantee of a job.  There's a lot of labor turnover.  People leave jobs in the modern sector, go to work where they can earn more, where presumably they're more productive.  So, again, the rise of the market in the labor market.

Now the one market that falls very short of course is the capital market and we could talk about that.  But anyway, the number one factor I think underlying China's success over the last 25 years is the rise of the market.

The second I'll take less time on because I think it's well-known.  China has a very high savings rate and that allows them to have a very high rate of investment.  Even as reform was getting underway, the savings rate was above 30 percent.  By the time you got to the late '80s, it was about 35 percent.  By the time you get to the '90s it's approaching 40 percent, and today it's over 40 percent.

This is the highest rate of savings of any economy in the world, with the single exception of Singapore because of its mandatory provident program that requires people to make gigantic outsize contributions to the pension scheme, has a savings rate of over 50 percent.

But China is the highest savings rate economy in the world.  It's higher--Ellen can correct me if I'm wrong, since she knows a lot about Japan--but I think today it's much higher than Japan ever was, or any other country in Asia which we generally tend to think of being high savings type economies.

Now the savings rates I'm talking about are national savings rates, so I'm talking about the combined savings of households, corporates, and the government.

So China has the ability to finance a very high rate of investment.  Obviously, as I've already alluded to, some of this is not necessarily the most efficient.  There are more than a few "white elephants" that get financed.  But a very high rate of investment does allow massive additions to capital stock which is a very important source of growth, particularly in the early stages of economic development.

The third factor is what I call the intersectoral transformation of the labor force.  We are moving from an economy that is predominantly agrarian to one that has most of its employment, or will have most of its employment in what I call the modern sector, that is, either services or manufacturing.

When reform began 25 years ago, 70 percent of the workforce was in agriculture.  Today, it's 50 percent, and it will go much lower.

Productivity on average, that is, output per worker in the farm sector is extremely low.  Obviously because of the shortage of arable land, the very labor-intensive production techniques in agriculture result in very high yields per unit of land but very low yields per unit of labor.

So as you move people from this low labor productivity sector into modern activities, either in services or in manufacturing, output per worker goes up dramatically.

So as you transform your labor force from predominantly agrarian to predominantly modern sector, it's a very powerful force adding to the growth of the economy.

And the fourth factor is one that ties back in with the rise of the market and competition and that is China's openness to foreign trade and investment, and it has dramatically increased competition in the domestic market and has forced firms to become much more efficient and has resulted in a dramatic shrinkage of the state sector, particularly in manufacturing, and that openness leads to more competition which leads to more productivity which fuels economic growth.

Just a few numbers.  Tariffs in China are extremely low by the standards of developing countries.  We're talking about applied tariff rates of under 10 percent.  We're talking about actual tariff rates, that is, collections as a share of imports, that is under 3 percent.

Compare China with India, for example.  India's applied tariffs are roughly three times those of China.

It's no mystery why India has been a laggard in terms of trade performance.  If there are any imported components in a product, India is automatically not competitive because the firms have to pay high tariffs on the inputs.  That makes the price, even if they're very efficient and their labor costs are very low, it makes their output prices higher and so the products generally tend not to be competitive on the global market.

China has low tariffs, in fact zero tariffs for their entire export processing regime, so firms can operate at global prices and not be penalized by the tariff structure.

Import quotas and licenses have now been entirely eliminated with the exception of one product and that will be eliminated next year.  So those kinds of barriers don't exist.

What difference does this make?  Gigantic.  China's openness.  If you look at, you know, imports to GDP, it's roughly doubled over the last decade.  China's now at something, last year close to--imports were roughly 35 percent of GDP, I think it was 33 or 34 percent.  I don't remember exactly.  I think one-third.  Japan is 9 percent.  Okay.  So China, on this metric, is three times, maybe four times more open than Japan.  I can't remember the most recent number for the U.S., but my memory is even though we're running this gigantic trade deficit and our imports are almost twice as big as our exports, but despite that, I think imports are about 17, 18 percent?  Fourteen?  14, 15 percent of GDP.  So China's twice as high as the U.S., even though the U.S. is running--you know, even though we're consuming more imports than we probably can afford, at least in the long term.

So the openness is extremely important and the other dimension of course is the foreign direct investment, which is cumulatively now, at least the way they value it, something over $500 billion.

But the more important thing is that about 25 percent of all manufactured goods in China are made by foreign firms.  That is a very high number.  The U.S. figure is in the high teens.  The average in the EU is in the low twenties.

In Japan, the last number I saw was one percent.  There is some more investment now in Japan in the financial sector but in the manufacturing sector, it's still, I don't want to say almost nonexistent, but maybe to simplify things we could just call it nonexistent.

Now why does this matter?  Everybody thinks foreign firms are using China as an export platform, but about half of everything produced by foreign firms in China is sold in China.

And this adds further to competition.  So if you're a domestic producer in China, you not only have to worry about competition from imports because tariffs are low.  You also have to worry about all those foreign firms, you know, next door or across the street, or in the next province, that are producing goods.

 And they can bring to bear whatever, you know, modern technology, modern management, modern financing, modern distribution--you know, whatever advantages foreign firms have in a particular sector can be brought to bear, and it doesn't, I don't think from the point of view of the competitive effect, I don't think it really much matters whether the goods are produced in Japan or North America or Europe, or they're produced somewhere domestically.

Just to put a number on it, domestic sales, I don't have a final number--but domestic sales of foreign firms in China were approaching 400 billion U.S. dollars last year.  Imports, order of magnitude, were something on the order of about 600 billion or slightly less.

So that's my fourth factor, openness as reflected in low tariffs, no licenses or quotas on imports, high import to GDP ration, high end rising import to GDP ratio, and a very large role for foreign firms in the manufacturing sector.

And this is very important because of all--you know, manufacturing is about half of GDP, roughly.  So getting things right in this sector makes a huge difference to overall economic performance.

Now I said I would say briefly what's the story going forward.  Well, the market is there, it's not going to disappear for goods and for labor.  The challenge China faces is getting a market for capital, getting a decent banking system, getting an equity market that works, read The Wall Street Journal this morning, getting a bond market that works and that can provide an alternative source of funding for the corporate sector.

In that area, they have nowhere to go but up.  So I look for that as a possible additional factor that would contribute to economic growth, if they can improve the allocation of resources through a more efficient banking system and through a more significant and more efficient capital market.

The savings rate.  Let me take the sectoral transformation of labor force.  As I've already indicated, I think it has a long way to go.  We've gone from 70 percent to 50 percent over 25 years.  I don't know what the end point will be but there's at least 100 or 200 million people that can be taken out of the agricultural sector and moved into the modern sector with a very positive effect on the growth of the economy.

I don't know how soon we'll get down to, you know, 20 or 10 percent of the population in agriculture but we don't even need to get to 10 percent.  The point is this is a story that has a decade or two to go.

On the openness, the goods market is already very open, even before China came into the WTO, and the increased openness I think we will see, and are beginning to see, is in the services sector, because China's really revolutionary commitments in the WTO were in services, financial services, distribution, telecommunications and so forth.

Those are sectors where the foreign presence is still quite modest but there are very dramatic openings coming in 06 and 07.  So I think the openness story will continue in the goods sector and will be enhanced by the increased openness in the services sector.

So there are three factors basically where I think the story continues to be positive, that is, the rise of the market, the sectoral transformation of labor force, and the openness.

The one potential negative factor is the savings rate.  Many people believe, and I tend to share this belief, that because of the very quick demographic transformation that China will undergo, particularly starting in the next decade, that the savings rate could come down significantly.

That is, households are a major contributor to this high savings rate.  Even if households at every age have the same savings behavior as they've had in the past, the share of households that will be retired and the dissaving cohorts will go up, and those cohorts that are still in the working age population will get relatively smaller.

And so the household contribution to savings could come down as this demographic transition occurs.

I think the year for the peak ratio of workers to dependents is about 10 or 12 years from now.  So the possibility is after 10 or 12 years, the kind of demographic bonus that China has had disappears and turns negative.

That of course could be offset by a more efficient allocation of resources through a more competitive banking system or better capital market.  So I don't think that's fatal.

So I think the long-term prospects are that this economy will continue to do very well.  That is, it will have, I don't know whether it'll be 8 percent or 9 percent, or what the specific number will be, but China can easily continue to grow in the high single digits, on average, and I emphasize on average, for another decade, and perhaps somewhat longer.

Now the second question we're asked to address is, you know, what's the chance for a significant slowdown, and there I'm a little bit--I have to say I think there is a chance for a significant slowdown in the short and medium term, that is, over the next two to three years.

And I know many of you have read what I've written on this, so I will just be fairly telegraphic and say we have had four consecutive years now where growth has been higher than the year before.  We have had basically an investment boom that has generated increasingly rapid economic growth.  The investment boom has been fed by a very substantial credit boom, particularly in 03 and the beginning of 04.

Credit growth now has begun to slow down a little bit, fixed-asset investment growth has begun to slow down a little bit, and since the investment share of GDP is at an all-time high and higher than it has ever been in any other country in Asia, as fixed-asset investment growth continues to moderate, that will have a dampening effect on economic growth, and it could be quite significant.

It depends on how much the investment share of GDP comes down.  But the key thing to keep in mind is that the long-term performance of the Chinese economy, on average, is very good, but it is highly cyclical and there are very marked business cycles, if you want to call them that, and we are near the peak of GDP growth in the cycle.

We were at a peak of growth of fixed-asset investment in 03.  It's come down a little bit.  I think it'll come down more.

Offsetting that is what Claude mentioned, and that is this now tremendous growth of exports and the tremendous increase in the trade surplus.

This is exactly what happened in the last cycle.  The peak of the last cycle was 1993 and over the next four years, net exports as a share of GDP, or net exports as a contributor to GDP improve by 6 percentage points of GDP.  So it was a big, big addition to GDP growth in that period, when also investment growth was slowing down and the investment share of GDP was starting to decline.

The big difference this time compared to last time is that in 1993 China had a significant current account and trade deficit.  From a GDP accounting point of view, net exports were minus 2 percent of GDP.  We don't have the precise accounting but the current account surplus, which you might take as a proxy for net exports, although it's not perfect, last year China's current account surplus was over 4 percent of GDP, and if you think things are bad now, think of what it's going to be like two or three years from now if China's current account surplus goes to, you know, 10 percent of GDP.

A percent of GDP is about 160 billion U.S. dollars, if you want to translate it into something that you can relate to.

So I do think the likelihood is that the economy will slow down, if they are successful in--and it should slow down, they need to slow down, the investment rate is too high, there are risks accumulating in the financial sector.

I don't think they can allocate 45 percent of GDP to investment efficiently, and I think the leadership recognizes that.  Wen Jiabao at the NPC last month said we need to fix that.  You know, they had a target for fixed asset investment growth this year of only 16 percent.  In 03, it was 26 percent.  Last year, in nominal terms, it was about 24 percent.  So they're looking for a slower rate of growth of fixed asset investment.

So that'll pull things down.  The offset is the trade side and the real question there is how much is the rest of the world prepared to accept in terms of a growing China's current account surplus?

I will tell you that all of the numbers that have been in print on this subject are incorrect.  Incorrect.  Even the Financial Times, which usually has the story correct, said that China's current account surplus last year was 32 billion.  The official Chinese number for the preliminary estimate for current account surplus last year was 70 billion U.S. dollars.

It's not large but as a percentage of GDP it was 4.2 percent.

Last year was the first time ever, ever, that China's current account surplus went ahead of Japan's as a percentage of GDP.  Japan's was, I believe, 3.7 percent.  China's at 4.2.  So the time series on China actually, for the current account surplus as a share of GDP, for four years, starting in 01, was 1.9 percent, 2.5 percent, 3.3. percent, 4.2 percent.  And it's going to be at least 5 percent this year and I don't think people have really gotten the point and there's still people going around saying the Chinese currency's not undervalued.

So my question is, How high does a current account have to get as a percentage of GDP before you think a country's currency is undervalued?

I've already talked too long.  I'll stop there.

MS. FROST:  Nick--

MR. BARFIELD:  [audio blip] was all the Congress wanted to hear anyway.

MS. FROST:  That was very stimulating.  Before we turn to Mike, let me ask you just one clarifying question, and that is you said in your verbal remarks that the slowdown in the investment boom could slow down economic growth.

In your longer IIE paper you said that the decline in investment growth isn't necessarily going to slow down investment growth because--excuse me.  The slowdown in investment doesn't necessarily mean that economic growth also has to decline.  Can you just explain what else could keep--since growth is such a source of China's prestige and influence, can you explain how the growth could be maintained despite the slowdown.

MR. LARDY:  Right.  So fixed asset investment slows down.  That means the contribution of that contribution to GDP would decline.  It's about 45 percent of GDP, so that puts a big damper on growth.

The second biggest contributor to economic growth is consumption, and one of the--you know, the article this morning in the FT talks about rapid consumption growth.

The problem is it's very difficult to sustain rising growth of consumption in a period when fixed asset investment growth is slowing down.

If you go back and look at the Chinese data over the last 25 years, growth of consumption and growth of investment are positively correlated and significantly correlated.

And the reason is fairly straightforward I think.  That is, when investment growth is slowing down it shows up first in construction.  When construction growth is slowing down--I don't mean shrinking.  I mean slowing down.  I mean growing at 10 percent instead of 25 percent.

When construction growth slows down, job creation slows down, there are fewer workers in the construction sector.  There's a very close linkage between growth, construction, growth of labor force in construction, and also in periods when investment growth is slowing down you tend to have slower growth of wages.

So think of it kind of from a macro point of view, whether you're talking about the United States or any other country.  It's pretty hard to think of the policy instruments you use to stimulate consumption growth in a period when employment growth is slowing down and wage growth is slowing down.

In other words, you've got pretty strong headwinds.  I'm not saying it couldn't be done.  You know, the Koreans did it over the last few years, up to 03, through a huge increase in credit card debt.  It didn't work out too well.  But it's pretty hard to do that.

Government expenditures, increased government expenditures.  But if you kind take noninvestment government expenditures in China, they're about 10 percent of GDP.  So investment is 45 percent of GDP.  Government expenditures are 10, 11, 12 percent.  So you need a pretty massive increase in government expenditures to offset the decline in fixed asset investment.

They're already worried about the quantity of government bonds that are out there and the rising kind of long-term fiscal problems, so that they've been pretty cautious about increased budget deficit on current expenditures.

The fourth of course is net exports and net exports can be a big offset, and it happen naturally, it doesn't require a government policy.  It happens because when the economy slows down, the demand for imports slows much more rapidly than export growth.  I mean, export growth in the first instance, at least it seems to me, is a function of growth elsewhere in the world, so you see exactly what we're seeing now.

You know, the last two years, export growth has been over 30 percent, and in 03 and 04 import growth was also over 30 percent.

Now in the first quarter of this year, export growth is still 30 percent but import growth has fallen to 10 percent.  That's why we have a massive surplus.  The swing in the trade account, this Q1 compared to last year, is well in excess of 20 billion U.S. dollars.  They are heading for a current account surplus this year of easily in the neighborhood of 100 billion U.S. dollars, in other words, about 50 percent more than last year.

So trade could be an offset but consumption is, over a period of two to three years, is not likely to be an offset.

MS. FROST:  Thank you for that clarifying answer.  We'll turn next to Mike Herberg.  Mike.

MR. HERBERG:  Well, thank you.  First, I want to thank the National Defense University and AEI for inviting me to speak to this group, I appreciate that, especially the chance to be on a panel with Nick Lardy.

Back when I was with ARCO, '93, '94, we brought Nick in a couple of times to help us understand the Chinese economy.  ARCO had probably the strongest position of Western oil companies in China.  We were involved in kind of every aspect, or trying to get involved in every aspect of China's energy development.

And that was when you were at the University of Washington, and his career has been straight up ever since then.  So I think I can take a lot of the credit for that meteoric career that Nick's had since that point.

What I'll do is talk--you know, when you talk about Chinese energy, it's a "800 pound gorilla," and you don't know quite where to start and where to stop.  There's a lot of different things that you can talk about.

What I'll try to do is just talk briefly about some broad characteristics of China's energy demand, and outlook across fuels, and different issues, and then I'll narrow down the focus more specifically to oil, which is the issue that's the most acute and the most significant geopolitically for China.

 And I'll throw in a few tidbits.  I think it's important to keep in mind the overall Asian energy picture as well, because in some sense, China is getting a lot of the blame for today's high crude prices.  A lot of that goes to the rest of Asia as well, which is this giant oil-consuming machine also, and I'll show you some numbers which are truly stunning, and if we're remotely correct about our long-term forecast, Asia's oil demand is the big issue, not just China's oil demand.

So with that little preview, let me just go through a few just "up front" statements here.

It's clear China will become one of the largest petroleum importers over the next ten to twenty years.  There's no way virtually, particularly on the oil side, that it can avoid that.  There's no silver bullet that they can use for that.

Its efforts at controlling supplies in the region is already beginning to affect regional geopolitical relationships, and I'm sure an audience like this doesn't need much elaboration.

It's also going to send China out to become a major player and already is becoming one in places like the Persian Gulf or Arabian Gulf, or I'll just say The Gulf, depending on which side of the gulf you're sitting on.

In Central Asia as well as trying to become a player vis-a-vis Russia as well.  So it will be a major player in energy geopolitics.  I think you can almost say Asia, but, in particular, China is literally changing the face of global energy geopolitics that we've known since the 1973 oil crisis.

I think it's that significant, or at least Asia is, and I'll make a few comments about what the geopolitical implications of China's growing impact on markets and regional geopolitics through energy.

Just a few quick things.  I'm going to go through very quickly in the interest of time.  But this I think shows you a long-term forecast from a Japanese forecast and just gives you an idea of how outsized Asia's impact on the future market, total energy consumption is.  I mean, it's just absolutely overwhelming the other regions of the world in terms of that growth in energy demand, and that's developing Asia.  It's not Japan, it's not South Korea.  It's developing Asia, and particularly China.  But it's across the board of developing Asia.

Okay.  China.  This gives you, from the same source, a history as well as a outlook to 2020 based on different fuel types for China.

And you can see it's headed for a very black, dark part of the energy spectrum, expansion of energy consumption.

40 percent of the increase is going to be coal, 30 percent of that's oil.  That's the dirt end of the energy spectrum and obviously that has tremendous implications.  You know, a 60 to 70 percent increase in coal consumption, which is, you know, truly frightening from an environment standpoint.  But that all stems back to the very steep increase in electricity demand that China's experiencing, particularly in the last several years, and with electricity demand increasing so fast, China's scrambling for fuels to generate electricity.

You can only grow gas so quickly, and if you look at natural gas, that blue wedge up there, it's almost nonexistent in the China energy mix today.

It's going to grow extremely rapidly because of deliberate policy efforts and a lot of availability of gas in the Asia Pacific region over the next 15-20 years, but even at the end of that timeframe, a fivefold increase in gas consumption in China, it's barely going to make a dent in the overall energy mix.

About half of that gas will go into power generation but a lot of it will go in residential use and other kinds of uses.

You can see from those bar charts relative shares or increments of demand which are coming from each of those fuels.

If you look over at the other potential electricity sources, you've got outside of coal, gas, you do have some oil-fired power generation but that's something that's in decline and it's a complicated story, I'd rather not start, unless you really want to.

But if you look at nuclear and hydro as the other alternatives, tremendous expansion of nuclear capacity expected, tremendous expansion of hydro expected.  But you can see, compare that to the coal that's going to be required to fire that power generation.

It's just overwhelmed.  In China, in energy as in many things, it's a scale problem.  These numbers are so large, that it's difficult to change the trajectory very quickly, and in the energy sector 15 years is quickly.  Thirty years is medium term.

So coal will remain king in the Chinese energy mix for the foreseeable future, and if you go out to 2030 with other forecasts, the picture's largely the same, no matter which forecast you look at.  Roughly the same outcome.

The other key part there of course is oil, growing relatively rapidly, and I'll show you some reasons for that.  Transportation is the reason.  But I think as you look at the dilemma that China faces broadly in energy, this is the story that you need to keep in mind.

How do you generate electricity without the huge coal consumption?  Given the starting point for natural gas, it's literally almost impossible to grow it any faster than we show it here, and barely making a dent.

To give you another simple example, China's going to build something like two nuclear plants a year for the next 15 or 20 years.  At the end of that period, nuclear will account for three or four percent of all electricity demand.

In those Three Gorges at 19 gigawatts, when it's fully operational, only will account for 2 percent of China's electricity demand.  The scale of this thing is just enormous.

So it points you back to something that I won't talk too much about because I'll kind of take these assumptions and then go with them.

And that's how do you bring the demand curve down?  The biggest uncertainty and the most important question for China isn't so much how they go out and secure supplies abroad, which is what they're doing very quickly, or trying very hard.  The real acid test is whether they can reform domestic policy and pricing for energy, particularly electricity, to bring that demand curve down, because as long as that demand curve continues at the current pace, the pressure is on to go out and lock up resources, to invest tens of billions in coal development to meet that demand.

So internal price reform for electricity, for example, is extremely important or China, and it's something they put, continue to put off in a big way, and it needs to be addressed as quickly as possible.  Otherwise, it will be difficult for China to generate the energy it needs to keep the economy growing at the kind of rates that Nick's talking about.

And this is what scares the leadership, is that energy will become a bottleneck to economic growth, which is a bottleneck to job creation, which is a bottleneck for social stability and political control.  That's the linkage, that energy very quickly comes back to some very critical issues for the leadership.

This show you just a quick, in an Asian perspective--the red bars there total, the left bar, the left stack is total energy, total primary energy supply, and what that says is China's going to make up over 50 percent of total energy consumption growth in Asia.  66.  Two-thirds of coal consumption growth.  Nearly half of oil consumption growth and more than a third of gas consumption growth.

On a world scale, China's going to account for 20 percent of the total global increase in energy consumption.  Roughly half of the world's coal consumption increase.  About a third--or about 20 percent of the world's oil consumption increase, but a very much smaller portion of gas because they're starting from such a small spot, small level in gas.

But this is literally a behemoth in the world energy markets.

Now let me switch, and I'll be glad to take questions on the broader energy issues as we go through it.  I'm going to switch to the issue of oil here.

This show you how important Asia, as a whole, has been in the oil demand picture over the last 13, 14 years, and in particular, China.  Roughly a third of demand growth coming from China alone and 75 percent of the total world's demand growth the last, since 1990 has come from Asia.

So it's not just China.  Look at the numbers for Asia, and that's developing Asia, are just huge, and as you go out you're getting similar forecasts for the future.

MS. FROST:  Mike, is Japan not on this chart, then, if it's developing Asia and China?

MR. HERBERG:  What I mean is the increase is largely driven by developing Asia but Japan is in those numbers for Asia.

Japan's actually mostly been in decline since '96 in terms of both energy demand, oil demand, just slightly--economic issues being the obvious cause.

QUESTION:  [inaudible].

MR. HERBERG:  Those are million barrels a day.  I guess I don't have--I transferred it over from something else.  I guess it didn't transfer.  Millions of barrels a day and that's incremental growth each year in terms of million barrels a day.

And you can see some years, world demand declined, even though Asian demand was increasing.  So had Asian demand been flat, for example, 1993, world demand would have dropped by a million barrels a day.

So it's accounted for literally more than a 100 percent of the increase in many years, technically speaking.

This shows you a historical vision of Asia's growing oil demand and production in that big huge wedge of import growth.  10 million barrels a day since the mid 1980's, again, spread across developing Asia.

This is a future vision which is even more extreme.  This is the IEA forecast.  The blue bars are the Asian oil demand forecasts from 2002 out to 2030.  The red bars are the regional production of oil.  So the difference is the import wedge that's going to come from outside the region and you can see that's literally 21-plus million barrel a day incremental growth, which per perspective equals roughly what the entire production of today's Persian Gulf is.

Saudi Arabia, the whole group.  Entire production, and including their internal consumption, not just their exports.  So this is a big number.  About 8 to 10 million of that forecast is China.  But the rest is the rest of Asia.  So the story really--and that's why we have an Asian energy security program at NBR and not just a China energy security, because Asia is the story as well as China.

Now we'll switch to China a little bit.  This shows you a shorter-term view of recent developments and you can see that rapid increase from 2001 up to 2005, and the blue bars in demand, and the pink bars or red bars are the imports, lockstep with the demand increase because production's relatively flat and likely to remain that way.

You see a real jump in 2003 and 04 and that was related to power generation needs, shortages of coal, and a surge in electricity demand means that there's a lot of oil getting sucked up into power generation on a temporary basis and a lot of diesel units being used by businesses and others as backup supply, things like that.  So there's been a real surge, the last couple years, which explains some of that short-term rise.

But last year, a 800,000 barrel a day increase in Chinese oil demand, 13 or 14 percent.  These kind of things are unprecedented.  Even Korea, in its heyday of the late '80s and early '90s, didn't grow quite at these rates of oil demand.

This is the punch line for China and the leadership.   This is the IEA's long-term forecast for oil.  Production is the red bars, oil demand is the yellow bars, and that blue line is the relative import dependence as a percentage of total consumption.

We're at about 40 percent today, headed for 80 percent, 75-80 percent of total demand out there in the outyears, and this may turn out to be quite conservative as a forecast for demand.

Merrill Lynch just put out a reasonably good report which suggests there'll be a 10 million barrels a day in demand by 2010, which is probably 3 million barrels ahead of this 2010 number.

You know, forecasts are forecasts, but every [inaudible] essentially the same conclusion--

[Start side 1B.]

MR. HERBERG:  [continuing] whole series of things but most importantly, motorization, vehicle expansion.  This gives you a historical picture and a long-term view.  As oil comes out of power generation, it's going to go into transportation.

I don't have another vehicle slide there, but vehicle use is around 30 million today.  That's expected to head for 140 million by 2020.  So that is a critical dimension of China's efficiency policies and domestic energy policy, is fuel choices, engine choices, transportation technology, mileage standards, which they're beginning to move on, but the scale of the issue again here shows you that it's just a huge issue for them to tackle in the kind of capital cycle that you're in in this kind of industry.

Where is that all going to come from?  It's going to come from the Middle East.  The Gulf.  And this shows you a current picture of how much of the Middle East oil exports already go to Asia, roughly two-thirds, and that's just going to expand over time.  And this gives you a vision of why this nexus between Asia and the Gulf and Middle East is getting strong and is going to be even stronger in the future, diplomatically, geopolitically, economically, militarily, in a whole series of ways which raises lots of issues.

I think I'll skip through this, but just a picture of where China's oil imports are coming from today in 2003.  Longer term, you can see on the bottom that yellow wedge is the Persian Gulf share of, out to 2009, expected, really is going to dominate China's oil import picture.

And the other side of that equation is this is Japanese forecasts for the increase from 2001 to 2020 in terms of total Persian Gulf or Middle East oil exports, rising from about 16 million to about 25 million.

Of that 9 million barrel a day increase, it's expected that seven and a half, roughly, will go to Asia.  So that mutual nexus of ties that energy is generating between Asia and the Middle East is going to get even stronger as time goes on.

What that means is another set of questions, but that's a fundamental thing that's going to happen.  We just don't know what the implications are going to be.

Natural gas shows a very similar long-term picture, although not nearly as acute as the oil picture.

You would expect 30 or 40 percent of China's natural gas to be imported out around 2030.  But the key issue there is that most of that gas is going to have to come from the same places as the oil comes from.  Russia, the Persian Gulf and Central Asia possibly, to some extent.

So it brings to bear the same geopolitical  questions as oil does.

I'll just briefly skip through this, but there's a deep angst in the leadership about future oil supplies for just the set of reasons I've been sketching out here, and here's like a laundry list of the fears that go into that.

I won't go through every one of them.  One I think is crucial is $50 oil prices creates a lot of uncertainty, angst, and a sense of scarcity in Asia's global energy picture today.  Globally as well but particularly in the case of China.

So this sense of scarcity, this debate about whether oil supplies are going to peak in 2010 or 2015, which by the way I think is nonsense, but it's a very real perception of many people out there, and the last time I was in Japan and China, people said, well, that's a fact, and I said, well, I'm not sure it's a fact.

But a lot of people are operating on that assumption and that sense of scarcity, that the supply's limited out there and we've got to make sure we've got our gas station in country X, Y or Z.

A whole series of things to highlight the U.S. issue.  The energy picture reinforces China's sense of encirclement by the U.S., strategically, and I'll be glad to elaborate on that.

The transit bottlenecks through the Molacca Straits.  11 million barrels a day goes through there today.  22 million barrels a day will be going through there in the next 10 or 15 years.  A big chunk of that Chinese oil.  So you have Wen Jiabao pounding on the table with the three company heads about do your realize we need that oil? and that's driving a lot of activity by the national oil companies out there.

But a whole series of reasons, including capricious Russian policies.  I said that recently in a meeting and the Russian delegate got very angry with me.  He reacted very nationalistically to me about my assertion that it was a nationalistic oil policy.  I didn't say it but I thought of saying, well, you just proved my point for me.

But what that has meant is that energy, and particularly oil, is now high, not just on the policy agenda but the national security agenda for the Chinese leadership.

The way I put it is is it's too important to be left to the markets, and they need to leave it to the markets.  That's the best way and the most effective and least costly way of doing it.  But the leadership is viewing this through a prism, a very mercantilist kind of antique 19th Century view, that we have to lock up our particular barrels as much as we can for our energy security.

So the sense of zero sum, a way of viewing their future oil concern, is a very powerful element of today's policy mix.

And here's, you know, just a laundry list of the things that are happening, mainly through the national oil companies, CNPC, Sinopec and CNOC [ph], and I won't elaborate too much, and they're converging on all these places that you would expect them to converge on where the resources are, from the Persian Gulf to West Africa to North Africa, Central Asia and Russia, and even now in Venezuela and Canada.

I was on the Hill this morning, talking with some people, and you're beginning to get some resonance, concern about China's going after "our oil" in the Western hemisphere, and, you know, that's lurking in the background right now, and I think we're going to hear more about that as China gets more active, which they definitely will.

Now I'll go through three sets of potential concerns or issues.  One is what China's impact on the global oil market and prices is likely to be.  It depends on market conditions.  Today's very tight conditions means that that incremental growth in China's demand has a real significant price impact at the margin, and that's where the price is set.

But it's important to know that it's a big piece of that but not the only factor.  U.S. oil demand has grown almost as much as Chinese oil demand over the last three or four years but you don't hear Americans talking about those "damn Americans" consuming more oil, driving prices up.

But, in fact, in absolute numbers of barrels, the U.S. has almost matched China in terms of the growth in demand, and I won't get into that story.  We all know the basis of that.

OPEC's inability to increase production capacity over the last ten years means that this demand surge has bounced up against global capacity, and so that's a big part of the story. Probably the biggest part of the story is the lack of investment in new production capacity globally to meet this rise in demand.  There's plenty of oil reserves known, ready to produce globally.  The problem is it's in places that won't allow the investment to do that.

And so you have a flat capacity picture combined with this rising demand curve and you're bouncing off it.  That lack of spare capacity is probably the biggest factor in today's $50 oil prices.

China's imports will rise enormously but, again, Asia is an even bigger piece of that.  I think from China and Asia's perspective, it's this risk of a zero-sum scramble for supply.  In some ways, Asia is where the industrial countries were in 1973 at the outbreak of the first oil crisis, when everybody went scrambling to hoard their oil supplies.  We didn't have the IEA, we didn't have a sharing mechanism, the Arab countries were able to split the Western countries diplomatically over the issue of Middle East, and it took seven or eight years before the industrial countries got together, created the IEA sharing mechanisms to say hey, scrambling for supplies is counterproductive.

It just simply spiked prices much higher than they needed to be.

Asia's, in effect, still back there in terms of their approach to this.  We can hope that they go up that learning curve as well, that the industrial countries have gone up.  A number of other issues I'll be glad to talk about.  I think those are the key ones.

Second, what's the impact regionally within Asia?  First and foremost is simply how does Asia handle the rise of China in a broad sense?

If the rise of China in Asia is peaceful and handled reasonably calmly, amicably, or however you want to term that, energy should not become a serious bone of contention in Asian affairs.  On the other hand, if Asian relations and the rise of China are bumpy, nasty, contentious and competitive, the kind of thing we see now between China and Japan, for example, energy will become a serious source of friction, and we're seeing that, absolutely concrete case of that in the Japan-China shoving match over the East China [inaudible] over the north, East Siberian oil pipeline from Russia.   So a lot depends on the overall tenor of relations in Asia as to how important energy is as an issue.

But it certainly obviously has the potential to aggravate existing rivalries in the region, and amongst really all the major players, and then you add a potentially kind of pernicious influence from Russia in this.  It gets very interesting.

APEC has been trying, and the other regional institutions have been trying to carve out a cooperative process, role, but it's just going very slow.  We're pushing on a string on that policy.  There is some potential of northeast Asia gas pipeline cooperation, other things, but it's moving slowly, and each of these items tends to get deeply politicized by the overlaying mistrust and geopolitical problems.

Let me just skip to the U.S.-China relations, and then close.

Here, again, Is energy going to be a bone of contention between the U.S. and China?  The first and foremost is what's the tenor of that relationship in the future, first.  Tell me that and then I can tell you more about whether energy's going to be an issue for the two.

But China is very concerned about what they view as U.S. control over the Persian Gulf, increasingly ensconced in Central Asia, control of the sea lanes all the way from the Persian Gulf and Straits of Hormuz through the Straits of Molacca, through the South China Sea.  The U.S.-Japan alliance.  In many ways, they are very worried about the U.S. ability to cut off their oil flows and if you think that's an idle fear, just think of a Taiwan crisis.  This is something that's very much a concern for strategic planners as oil supplies in the case of a Taiwan crisis with the U.S.  So it's a very real issue for the Chinese leadership.

But I think in the future, China will have the ability, in many places, through its energy diplomacy, energy ties, alliances--it's literally reshaping its strategic architecture to fit its energy needs--will give it, in many places, the ability to impact U.S. interests.

The most obvious example is in Iran, Sudan, right now, and the inability to get them to the Security Council for sanctions, for example.

But I can think of many other issues in the future, where the U.S. and China could be at odds, in the Middle East and other places.

That nexus with the Middle East will grow.  Central Asia.  I think there's prospects for a more collaborative process because I think our interests are less naturally antagonistic and much closer aligned, potentially.

Venezuela.  It'll be interesting to see the political reaction to their involvement here in the Western Hemisphere.  And environmental concerns.  Mercury from Chinese coal burning is already landing in Seattle, and if you believe the coal forecast that I showed you earlier, a lot more mercury and soot and other stuff's going to be heading that way.  Acid rain in northeast Asia issues.  Just a whole range of things that are environment issues coming out of this, but will begin to have broader geopolitical impacts, I'm afraid.

So I think just with that I'll close, and open it up.

MR. BARFIELD:  Thank you very much.  Well, I said we had a packed agenda.  I think we could have spent a session on each of the speakers, and a session on pieces of what the speakers had to say.  I'm going to turn, now, to the audience, but I'd like to open with one question to Nick, and it ties back to my particular interest in trade policy and to a point I made about legislation on the Hill.

There's a debate among nations, and some nations are going one way, some the other, about whether or not it is time to, in WTO terms, and in terms of national trade legislation, to declare China a market economy as opposed to being a nonmarket economy.  This designation has [inaudible] and the audience probably know, has major implications for trade policy, particularly in anti-dumping and subsidies legislation.

From what I take from your own analysis--I'm not trying to put words in your mouth--you would have no problem I would guess--but this is a question--saying that we should move to the, as other nations have done, to say that China, in WTO terms, is a market economy.  Or am I incorrect in that?

MR. LARDY:  Well, I think the short answer is I think from an economic point of view, they're a market economy.  I mean, there have been plenty of economies around the world at various times that have had good products in labor markets and have had crummy banks and crummy capital markets.  So I don't think we can wait until those things are all fixed, to say they're a market economy.

On the other hand, I only dimly understand them.  On the other hand, there is a whole list of other criteria that are specified in U.S. law about what hoops you have to jump through to be in the market economy category, and I didn't say anything about most of those.  I think it would still be tough--I think the criteria don't make any sense, so I think it'd probably still be a stretch to say China's a market economy from the point of view of the current regulations.

But, on the other hand, lots of countries have been waved through, you know, Russia, Poland, years ago, when they didn't really meet the criteria.  So, at the end of the day, although we have got a bunch of criteria in the law that governs this, and the regulations that govern this, at the end of the day it seems to me it's largely a political decision.  But I think the economic case is there.  This is a market economy in terms of free market prices, supply and demand, competitive markets.  Obviously, you can point to exceptions and there's murkiness around some of the edges, but I would argue that it is predominantly a market economy today.

MR. BARFIELD:  Thank you.  For those of you who are not [inaudible], the WTO rules give very little--they don't give much guidance and so each nation has its own, either explicit, as we do, or just opaque, as other nations do, and this basically is decided arbitrarily.  I think it's based on politics as Nick said.

All right.  Let's turn to the audience and please raise your hands, and identify yourself, please.

QUESTION:  Nancy Roman from the Council on Foreign Relations.  Just sort of staying with the trade issue for a minute, given your sense, Nick, that China continues to rise for ten years, which I think most people agree on, even if they disagree about when and where the bumps come, and your observation that things are heating up on Capitol Hill, and suddenly--and I sense this also--people are starting to see competition for energy as, you know, something to be worried about.

I mean, how do you see all this trade stuff playing out?  I mean, could we end up, you know, in a trade war with China?  I think the conventional wisdom last year was it was all sort of show because of the manufacturing pockets and how the issue was playing in political districts.

But it seems now to be deeper.  So I'd be interested in your perspective on just what's happening and how you think the Chinese are reading what's going on politically on Capitol Hill.

MR. LARDY:  There are probably a number of people in the room that would be able to better answer the question than I am.   I certainly talk to people on the Hill and try to follow what's going on there, but, you know, how this will all play out seems to me still highly uncertain.

If we were to wake up tomorrow morning and read in the newspaper that the Chinese had revalued their currency by, you know, x percent, and x was not two or three, you know, it was some bigger number, my impression is that a lot of the push for legislation would disappear, and if China, you know, announced they were moving towards a more flexible rate, and it was going up 6-7 percent to start with, and there would be future adjustments, you know, going forward, that would be exactly what the critics have been asking for.  So I don't see how they could then turn around and try to impose the WTO and consistent 27.5 percent across-the-board tariff.  That's certainly what a lot of the associations have been asking for.  So a lot depends on what the Chinese do.

You also asked, you know, how did the Chinese, how are the Chinese reading it.  I have not talked to anybody on that subject.  So I can't really answer.  I think it does critically depend--and again, there's been very little commentary on this--a huge difference in the Schumer bill this year compared to the Schumer bill last year.  In the Schumer bill last year there was no waiver provision.  Once it was passed, if the Chinese didn't do something in 180 days, you had to have 27.5 percent tariffs.

This time, there's a waiver provision and the president can declare that the Chinese are moving in the right direction or are about to do something, or whatever other excuse he wants to "pull out of his hat" and postpone putting the tariffs into effect.  And I don't know what the Chinese view is about the likelihood that the president would exercise that waiver provision.  But I haven't seen much analysis of it.  So this bill, this year, is quite different.  There was no discretion in the bill that was introduced last year.  The bill this year has a lot more discretion.  That's one of the reasons it's gotten a lot more co-sponsors and it's probably one of the reasons that people are more likely to vote for it, because instead of setting off the atomic bomb, you know, 27.5 percent, you're saying to the Chinese we might do this but you're then ultimately passing the responsibility for whether a bomb's going to go off to the president.

So the Chinese might feel that they have nothing to fear.  I don't know.

MS. FROST:  Is there anyone in the audience who would like to add to Nick's answer to Nancy Roman's question, given this group of people?  No?

MR. LARDY:  You know, the energy side is getting interesting and I've been up on the Hill a little bit, the last couple days, talking to people about it, and I guess I'd characterize it right now as a kind of vague discomfort amongst a lot of people, that China's buying all this oil and we're competing for the oil and driving prices up, and then they start talking about coal and pollution and other issues.  Why are they burning so much dirty coal and why can't they change that?

It's just kind of a vague sense of discomfort about a series of issues, headline issues that you see here and there.  I think right now people there, they want more information, they're asking, you know, we don't understand why this coal situation looks the way it does.  Can  you tell us.  Or the oil situation.

So I think right now it's still at the stage of vagueness, not very focused, but I think as time goes on my fear is that it's another potential "China bashing" instrument, for not very good reasons, but on the surface, intuitively, it might become a useful political tool, if the overall tenor of U.S.-China relations, you know, depending on currency issues and other issues, gets nastier.

MR. BARFIELD:  Sylvia, I know you and everybody else here knows you but tell the rest--

QUESTION:  I'm from Canada, the University of Toronto.

MR. BARFIELD:  A former Canadian trade negotiator.

QUESTION:  Why should you read the concern about the role of China and Asia in dealing with a key commodity as sort of "China bashing"?  If you go back to the commodity power arguments of the '70s, and that the role of Henry Kissinger was that the IEA had to be formed because this was a political issue of enormous dimension.  It turned out to be wrong.  [inaudible] really quite good.  But the French blocked the IEA because they liked their relationship [inaudible].

But you were able to form the IEA because you could ignore the French.

What is your view of how you would deal with this as a global issue [audio fades out.]

What are you proposing [inaudible]?

In Canada, there hasn't been an adequate debate on this, and it's not simply that they're buying up, they want to buy up the Alberta tar sands and they want to invest in the, whatever you call it [inaudible], and so on.

They clearly are going beyond that and they intend to buy, as they have done in Brazil, as much in the way of Canadian natural resources as they can.

The Alberta tar sands have an awful lot of gas underneath them.  Is that a global issue, or is it an American issue? talk about "our oil"?  I don't know if it's "their oil."  But there is the NAFTA [inaudible] and the question of a North American [inaudible].  I sort of go out--I'm just saying that the situation is intensely political, there's been a shift in the balance of power, and the likelihood of getting a global solution to something like the IEA seems to me to be very [inaudible].

MR. LARDY:  I wouldn't argue with most of what you said.  You know, this issue of "China bashing" I think reflects the poor quality of the American debate about these issues, frankly.  But be that as it may, it's a concern, and I think, you know, the trade debate is similarly dislocated.

So I think it's something that's lurking potentially out there but I don't see any real basis for it.  But it's political.  You're right.

As to what the solution or how do we move forward, politically, more broadly, something like the IEA model or the European energy charter, or something like that has to be put in place somehow in Asia or to bring China, India as well, into an IEA type of arrangement.

The institutional mechanisms don't fit very well for that as you know.  You have to be a member of OECD to be a member of the IEA.  So that's a problem; it's right there.

But what I'm worried about is you're not even getting a serious discussion about this.  One of the places to start would be a regional strategic petroleum reserve, and there are a number of really creative proposals around.  The U.S. finances it, or something like that.  The Russians and Saudis fill it.  You locate it in Southeast Asia.  You have a regional mechanism to release it, when necessary. It's collaborative, cooperative.  Right now, China's building their own.  India's going to build their own.  ASEAN's talking about building their own.  Tremendously ineffective.

And so the problem is that it's not even really seriously being discussed, and so this thing has to be raised politically to very high levels.  I think you're exactly right.

MR. BARFIELD:  Okay.  Right here.

QUESTION:  Thank you.  I'm Margaret Ryan.  I'm with Platz [ph].  I wondered, Mr. Herberg, if you could give us a little more detail.  What do you think the possibilities are for any kind of internal reform that would allow more market mechanisms to come to bear in the energy field.

Mr. Lardy spoke about the openness in many other fields, but in energy, the one we're focusing on here, there really isn't, or the internal market is very skewed because of the all the allocations to state-owned enterprises and the artificially low tariffs for political reasons.

MR. HERBERG:  You know, I guess it's odd, or maybe not odd, but I think the energy sector is way behind the rest of the economy in terms of reform, and it has to do with the perception of it as a strategic pillar industry.  It's so important to the prosperity and economic growth, that the leadership doesn't want to let it out of its grip until it absolutely has to.

It sees low energy prices as a job-generating kind of thing.  So there's a whole lot of reasons why reform in the energy sector is difficult in China.

They've been talking about raising fuel taxes, for example, but politically, they don't feel like they can do that.  There's resistant publicly, but probably more important, from various vested industries, state industries.

I think they're beginning to start figuring that out and I think, in the long run, they have to be on the same learning curve as they were on trade.  You know, they went from managed, state-driven, bilateralist kind of trade in the '70s and '80s to, you know, WTO now.  It was a learning curve, and I think they have to go through that learning curve as well on the energy reform.

But they are beginning to do some things on fuel standards, efficiency standards, environmental standards for engines, things like that.  They are debating fuel taxes, which are vital to bring that demand curve down, and they are talking about electricity price reform.  They tried to raise electricity prices recently, because all the power companies were getting eaten alive by rising coal costs, and capped power prices.

Got tremendous reaction from industry and consumers, had to back away from a lot of the increase.  But they got some of it.

So I think they're beginning to work on it but they really have a long way to go, and you worry that they're not moving fast enough.

MR. LARDY:  Just to elaborate a little bit on the pricing side, I think the Chinese move very strongly in favor of market-determined prices on energy in the late '90s.  That was the time at which they decided to price all petroleum based on the Singapore price, and then later, they adjusted it to some weighted average of the Singapore price and a Rotterdam price.

And so that was an example of a price that was still fixed by the state.  It was adjusted monthly, based on the prices in the international market.  So the historic underpricing of oil, in particular, was largely eliminated in the late '90s.  So there was a period of several years where they did these monthly price adjustments, most of them fed through to the retail level.

The problem has been, at least as I see it, is in the last couple of years, in the huge run-up in global prices, the Chinese, shall we say, "fell off the wagon."  They decided it was too tough to implement all these price increases, so they suspended the monthly price adjustments, and now, you know, I think the original rationale was oh, this is a short spoke, this isn't going to last, you know, this'll go away, we don't need to make this adjustment.

So now they're way behind and, you know, the retail pump prices of gas, even though they were raised quite a bit just a few weeks ago, are now substantially less than the U.S. and, you know, we're near the bottom of the world, at least among oil-importing countries.

So what I'm saying is they did make substantial progress, they had embraced the idea, and they had actually implemented, you know, international prices affecting the domestic price for oil, but in the last couple of years, and the spike, the volatility and the much higher levels on average, they have not been willing to pass through those prices, and this is highly political.

This is the best example of the difficulty China has in dealing with, you know, various interest groups.  The national legislation to implement a fuel tax went to the National People's Congress.  I can't remember the first time; it was some time in the late '90s.  It was defeated.   You know, this rubber stamp legislative body which has never voted no on anything, defeated the fuel tax, even though the government was making a big pitch for it.

They brought it back the next year and it was defeated again; unheard of.  The third year it was passed and it has yet to be implemented.  There's so much opposition.  The government has got this fuel tax on the book and they have been, they're getting lobbied, you know, everybody from the taxi drivers to the, you know, the truck company, the farmers that don't want to pay higher fuel prices, and the government, you know, maybe one of these days will take a deep breath and actually impose a tax.  But I'm not expecting it any time soon because they won't even do the pass-through, the international price increase.  Why are they going to add a new tax layer on top of it?

So it's intensely political.  So I just want to underline what you said.

MR. HERBERG:  If I can just add one thing.  It's [inaudible] thing.  They've largely decontrolled coal prices and so coal prices have skyrocketed.  This is one of the issues on the electricity side.  Coal prices have really jumped with the increase in demand and tight world supply.

But the most egregious problem in pricing is on the electricity side because that's the "big gorilla," that's the driver for coal and these other issues, and until they really start tackling the electricity price increases they need--and I think on the oil side, they need the fuel taxes in a big way.

And so those are the places I think are really egregious.

MR. BARFIELD:  I'll take one or two more questions over here.

QUESTION:  Phil Sodgers [ph], NDU.  That kind a points out a couple things, in particular the role of the state in influencing the policies that Chinese energy companies follow, and you kind of have it squeeze both ways, with the prices to Chinese consumers and companies artificially low, especially on electricity and also oil, but at the same time the international behavior of these companies, where they're making foreign investments and finding long-term yields, what I'm told by people who follow it more closely than I do is that they are paying above market prices that don't really reflect the risks involved in developing some of this.

So there's kind of an increasing wedge where you have these energy companies selling into China at below market prices, buying internationally at above market prices.  How can a company do that and survive?  And does that imply that the Chinese government is subsidizing this in various ways?

MR. LARDY:  It's a good question.  One of the reasons they feel so much pressure to go out and do these deals and throw money at them and overpay, which is a serious problem, and they're literally skewing the entire market for exploration rights globally today.

MR.     :  [inaudible].

MR. LARDY:  Yeah, threatening to buy Unical but didn't quite do it.

MR.       :  [inaudible].

MR. LARDY:  Well, I'm not convinced but I think there's more to that but I don't have any evidence of that.  But you're right, they're out throwing money at deals abroad, and this incredible pressure they feel to go get, you know, resources abroad, is a reflection of the failure of domestic energy reform.  You know, the two sides of the same coin.

And so that if they really do being to move more quickly on energy reform and bring down that demand curve, the pressure comes off to a great extent on the external side.  There's no way they're not going to have to import massive amounts of oil.  That's irreversible.  But some of that sense of panic can come off, and I think right now, there's almost a sense of panic about the supply, and there is a question whether they're going to overpay for these things, oil prices are not $50 forever necessarily, prices go back to twenty, a lot of these investments are going to look really dumb.

Just like the oil companies in the '70s and '80s did.  Spent a lot of money, and the U.S. Government, in oil shale; everybody did.  So, you know, I think if oil prices change, their key driver for this, money's flowing over the transom because of high oil prices, cheap government loans.  There's a whole series of things that allow them to overpay like this right now.  Oil prices come down, a lot of things will change.

MR. BARFIELD:  I want to take [inaudible].  Sir, over here, you've been waiting patiently.  I'll take a couple questions and we'll wrap it up.  Here on the side and then right here.  Please.

QUESTION:  Thanks very much.  Bob Sutter with Georgetown University.  The picture that's painted here is of a China that has a lot of money.  There's a lot of surplus, a current account surplus, and of course we hear about China's very large foreign exchange reserve.

The question I have, and getting on the focus of our effort dealing with China and Asia, what are they doing with this money in Asia?  What are they investing in in overseas?  What are they giving in foreign aid?  What are they doing in U.N. dues, or things like that?

When the Japanese had a large account, they spent a lot of effort putting the money overseas.  Is any of this money going overseas?

The reason I ask this is that some of the figures I see about China's foreign direct investment overseas, it's very small.  These numbers are very small and I wonder if those numbers are incorrect, given the fact that China has all this money at home.

MR. BARFIELD:  Nick?

MR. LARDY:  Well, this is a murky area.  I would begin by saying that I don't think it's the case that any of the foreign exchange reserves are being used to finance foreign aid or foreign purchases or foreign direct investment.

I think, you know, as of the end of Q2, we were talking about $659 billion in foreign exchange reserves, went up by about 30 billion in the first--no.  It went up by about 50 billion in the first quarter.  But I think, you know, that's under the administration of foreign exchange.  They buy the usual kinds of Treasury and government issues, and I don't think too much of that money leaks over into other areas.

I don't know how--obviously China's spending a lot more in Africa, places like Angola, they're putting out big aid programs.  I think most of that is being financed through the state budget but we don't have a disaggregated number that identifies that.

And then there is a lot of lending activity.  A lot of the infrastructure projects that China is funding abroad, in Africa, to some extent in Latin America, I believe, but I can't prove it, I think is probably being financed by, you know, loans from Chinese state-owned banks.

And you're absolutely right.  The numbers the Chinese put out on their foreign direct investment abroad are laughably low.  I mean, we read by the month, you know, a billion here, a billion there, and then you look, the official number for outward foreign direct investment last year is under 4 billion.

 You know, they've got gas fields in Indonesia and Australia that are worth that.  The problem is, at least my perception is, and you can probably expand on this, these headline numbers that we frequently read about like, you know, the Australians claim the deal on natural gas is the biggest inward foreign direct investment in all their history.

I think these are complicated deals that involve some equity investment, some long-term supply contracts, and maybe some other things, and it's all melted into one number and they say, you know, it's a $10 billion deal.  Well, I don't know.  Unless you have the contract in front of you and you can see what the equity investment is versus what the long-term supply contract is, and exactly what the pricing formula is and how that works out, it's hard to know how these things are valued.

Similarly, a lot of the foreign aid projects China's doing are you read they're building infrastructure in various African countries.

Some of its aid, some of its subsidized loans, which would be a form of aid, some of it is outright commercial, and probably very little of that is foreign direct investment in the sense of Chinese entities taking equity stakes in various infrastructure projects.

But I don't know of anybody who's worked through all these details, and I do agree with you that it's a murky area, and the official Chinese numbers on outward foreign direct investment may be accurate but they don't begin to capture what's going on, and as I say, I think most of that is because there are lots of other channels through which the funds are flowing.

MR. HERBERG:  Nick's exactly right about the, at least the energy side.  A good example is the Australian deal.  You know, it was a $25 billion deal.  Well, what that was was their equity investment and a 25-year cumulative stream of natural gas, all totaled up, so it's a 25-year bill all brought back to the present in nominal dollars.

You know, annual cost of L&D [?] shipments on that scale, when you add it all up, it's $25 billion.  Now what was the actual equity investment in that?  The Chinese put, I believe, about a 25 percent equity stake in one train of five Australian northwest shelf L&D trains, which gave it around 10 percent of the whole consortium.

That was, if I recall the numbers correctly--David Platz may know this better--it's about $500 million equity investment by CNOC [ph].

So that's the actual investment.  It may be less than $500 million.  That's the actual equity outflow by Chinese investment standards.  The $25 billion is really an illusion in terms of--it's not investment, it's a long-term contract cumulatively.

MR. BARFIELD:  We'll take one more question.  There.

QUESTION:  Steve Beckman [ph] with the UAW.  Since energy policy intersects with transportation policy, I have a sort of parochial question about what you see happening in the transportation sector in China.

it is one that is not a market-based industry in China.  It is directed by the government as a pillar of industrial policy and a tremendous amount of foreign investment has gone in.

How do you see the development of energy policy in China affecting the development of the auto industry and how much of the increase in net exports by China over the next five or ten years do you think might be attributable to net exports in the auto sector, if all the investments that have been planned take place and the market maybe doesn't grow so fast in China because of energy policies that are undertaken?

MR. LARDY:  I certainly think there's a reasonable prospect that there will be auto exports from China.  I don't think it's going to happen in the near term.  Remember, the one big tariff they have remaining, even after all their WTO obligations are phased in, is that they have a 25 percent tariff on automobiles and I think it's fair to say that their production costs are above those--there is no world production cost--but I don't think you could export their output from China at current production levels.  Their costs are too high.

On the other hand, Honda has made an explicit commitment to export--you know, someone says they're going to be bringing the Cherry [ph] automobile to the United States starting next year, maybe even late this year.  But I think for the next two to three years, it's likely to be modest if production costs are still very high.

But, on the other hand, as the domestic industry grows and you get more economies of scale, and you maybe get some consolidation in the industry, so a few firms have a much larger share of the total, production costs will come down.  The domestic supplier network is growing, so, you know, presumably, the cost of components and parts is coming down as that industry develops.

So I would think over, you know, over a 3- to 5-year period, they probably are going to be able to export.

QUESTION:  Because the Chinese had adopted the automobile industry, generally the policy of the electronics or subsectors of having low tariffs on components and import of parts, so you can come in and have a production platform, or are they doing this sort of from an indigenous--

MR. LARDY:  Well, they've not wanted to do that because they're worried about too many--you know--knock-down kits coming in and get assembled, and then getting sold.

So they don't want to have the low tariffs on the parts and components.  It's a little bit--so they have those up pretty high as well because they don't want that to be a loophole around--you know--we won't import the vehicles but we'll bring in the chassis and the engine and all this stuff and put it together.

MR. BARFIELD:  Okay.  Well, thank you very much and please join me in a round of applause for a very fact-filled, content overload--

[Applause.]