China and the Global Economic Recovery

January 10, 2005

Unedited transcript prepared from a tape recording

Proceedings:
MR. LACHMAN:  --for the discussion on China and the Global Economy.  I thought [inaudible] that we'd begin with an economic seminar on China and the Global Economy given the importance that China does have for the global economy.  It is well to recall that over the past four years, growth in the Chinese economy has accounted for as much as 20 percent of global growth, and it is no surprise that China has become increasingly open economy, with importance not just for the Asian region, but for the globe as a hole.

By way of introduction, I would just mention that since Deng Xiaoping began to put China on a path of reform some 25 years ago, China has grown at a spectacular 8 percent a year on more or less a consistent basis.  That has made China the sixth-largest economy in the globe.  And on the path that China is, one can only expect China to increase it's importance in the global economy.  By the same token, China, as a trade partner, has really increased its share of international trade.  In 1979, China was responsible for only 1 percent of international trade.  Today, we're looking at something like 6 percent of international trade.

The prospects are good that China will continue to grow at a rapid rate, but I'm sure that many of our speakers this afternoon are going to indicate that for China to grow at the same rate as it did in the past, it's going to have to address serious problems in its banking sector, it's going to have to address problems related to state enterprises, and what it's also going to have to do is it's going to have to reduce its reliance for growth on exports and on investment.

The final point that I'd like to make, before turning to our speakers, is that China will have a fundamental role to play in the international payment adjustment process.  By pegging its currency to the dollar, China has gained a fair degree of international competitiveness and, as a result, today, it's got both a large basic positive balance, a surplus in its basic balance of payments, and it has a very large bilateral balance of trade with the United States, to the tune of something like $150 billion.  If China is to expect the global economy to remain open to it, I would think that flexibility in its exchange rate is something that's going to have to occur.

We are most fortunate this afternoon in having a very highly qualified group of speakers, who have got a great degree of expertise in the Chinese economy.  I'll introduce the panelists as we get to that session.

We're also highly fortunate in having with us today Anne Krueger to provide opening remarks to today's seminar.  Anne Krueger hardly needs introduction to a Washington audience.  She presently is the First Deputy Managing Director at the International Monetary Fund.  And prior to moving to the International Monetary Fund, she spent a career in academia at the University of Minnesota, Duke University, and most recently Stanford, establishing herself truly as one of the world's most renowned international trade economists.  Ms. Krueger, as well, was head of the World Bank's Research Department.

With those brief introductory remarks, it is my pleasure to ask Anne Krueger to make opening remarks.

[Applause.]

MS. KRUEGER:  Thank you, Desmond.  I am pleased to be back here at AEI.

China's role, as Desmond said, is increasingly important in the world economy, and its growing role raises questions for the country itself and for the world.  I'm only sorry that I must leave right after my discussion and can't stay to hear what I'm sure will be a very fruitful and enlightening session after that.

Before discussing one of the brightest aspects of the Asian economies, though, I want to say something about the recent tragic events in Asia.  The scale of the disaster that struck Indonesia, Sri Lanka, India, Thailand and several other countries is difficult, if not impossible, to comprehend.  The number of those who lost their lives is shocking.  Those who survived would have lost loved ones.  Most or all of their possessions and their livelihoods are being counted in the millions.  The extent of the destruction that the tsunami left in its wake is incomprehensible.

The international response has been unprecedented, both at the official level and, in a particularly striking way, at the individual level.  The challenge now is to help those in the countries affected in the first instance by providing humanitarian relief, but they will also require outside assistance as they seek to rebuild their lives.  This will be a long-term effort, and it will be important to maintain the current momentum.

From the first day of the crisis, the IMF has made clear its readiness to assist the affected countries in assessing the macroeconomic impact and in maintaining "macroeconomic balance," and we are already responding to requests for assistance from some countries.

Short- and medium-term relief is vital, of course.  But over the longer term, maintaining the pace of global economic growth will be an important factor in helping the countries worst affected by the tsunami crisis to rebuild what has been destroyed.  In this context, Asia's economic dynamism and resilience will be important, and the Chinese economy is, of course, a key part of that.

The theme of today's seminar is the role of China in the global economy, and I want to start by sketching key aspects of China's changed role in the economy.  I then want to look ahead and suggest some of the issues that I think China will be confronted with and its global economic partners in the next few years, whether China can achieve the much-debated soft landing, the extent to which the Chinese authority should modify current exchange rate policy, China's role in world trade, especially in the wake of the expiration of the multi-fiber agreement and the need for structural economic reforms.

Let me start by putting our discussion in context.  Desmond already did that a little bit.  We are familiar with the rapid pace of Chinese economic growth in recent years.  It's been spectacular.  Real GDP grew by 9.7 percent per year on average between 1990 and 2003 and, as of now, the pace of growth shows little sign of abating.  I will return to the issue of the so-called soft landing later.  And this rapid growth has had a significant impact both within China and around the world.

We're all ware of the extent of the changes that have taken place in recent years, both in China itself and in the Chinese impact on the rest of the world.  It's had a dramatic impact on the lives of millions of Chinese citizens.  Tens of millions of people have escaped poverty in China over the past decade or so.  Yet it's important to remember that this was an economy starting from a very low base.  Per-capita incomes remain relatively low by international standards, even after more than doubling, in nominal terms, and almost doubling in PPP terms in the past decade or so.

The actual numbers, less than a thousand dollars a head on the World Bank World Atlas method and about $4,000 a head on a PPP basis, underline the point that China is still markedly poorer than many of its neighbors and dramatically poorer than Hong Kong.  It is classed by the World Bank as a lower middle-income country.

This is an economy with much catching up to do.  Continued rapid growth will be essential if poverty rates in China are to be reduced further.  The challenge for the Chinese authorities is to ensure that growth rates are sustainable over a long period.  Yet, even now, China's sheer size, coupled with its rapid growth, nevertheless makes it a major player in the global economy.

In nominal terms, China currently accounts for almost 4 percent of world output--not much more than in 2000, by the way--more than 1.5 times bigger than Canada.  Measured on a PPP basis, China's share of global output has risen from close to 11 percent in 2000 to a shade over 13 percent in 2004.  On that basis, it dwarfs Canada, and France, Italy and the U.K, and is almost twice as big as Japan.  Indeed, on the PPP basis, it is the third largest economy if we count the euro area as a single economy.

China's share of world trade has grown even more rapidly.  In 1990, it's share of world exports was 1.9 percent.  That grew to 4 percent in 2000 and 6 percent by 2003--again, numbers Desmond gave us earlier.  China's share of world imports grew from 1.5 percent in 1990 to 5.7 percent in 2003.

Rapid growth in China has clearly been an important factor underpinning the current global economic upturn.  The global recession of 2001 to '02 was relatively modest and short-lived by historical standards and the global recovery has been strong.  The outlook remains relatively benign in spite of continuing geopolitical tensions and a significant rise in oil prices.

Of course, the American economy continues to be an important engine of global growth.  But China's contribution to global and particularly Asian growth in recent years has been increasingly significant, in part, because of the two factors I've already mentioned--the exceptionally strong pace of growth and the growing importance of China in the world economy.

It was also significant, though, because of weaknesses in Europe and Japan.  As an engine of regional growth, it is clear that China has overtaken Japan.  With Japan barely growing in recent years, the buoyancy of the Chinese economy has been crucial for other Asian economies.  Trade between China and the Asian economies has grown rapidly.  It accounts for about one-fifth of Korea's exports now going to China, for example, and Korea accounts for about one-tenth of all Chinese imports.  China is important for Japan, too.  Japanese exports to China have grown much more rapidly than total Japanese exports.

For the ASEAN-5 countries, China has also become an increasingly important market.  In 1995, China accounted for 2.6 percent of ASEAN-5's exports; in 1995, it was 2.6; in 2003, 6.7.  And the share of India's exports going to China has more than quadrupled over the same period from less than 1 percent in 1995 to 4.5 percent in 2003.

And with growth in the euro area continuing to be sluggish at best, the impact of Chinese growth has extended well beyond Asia.  Since 1995, the share of Brazilian exports going to China has more than doubled, from 2.6 to 6.2 percent in 2003; Argentina has seen the share of total exports going to China rise sixfold in the same 8-year period, from 1.4 to 8.4 percent.

China's commodity imports have also grown rapidly, as you know.  In 1990, China was not a soybean importer.  Last year, estimates suggest that its imports represented more than a third of total world imports.  China's imports of cotton represented nearly a quarter of world imports in 2004, compared with about 7 percent in 1990.  Chinese steel imports represented something over 10 percent of world steel imports last year, more than double the share in 1995.

While imports are still relatively small, about 3.4 percent of total world oil imports, but in 1990, China's oil imports were only half of one percent over a lot of commodities.  China's growth is influencing commodity patterns of trade and, of course, prices.

So the contribution Chinese growth has made to global economic recovery, thus far, is clear and positive.  But few think that the current pace of growth is sustainable, and the challenge for China's policymakers is to ensure a smooth adjustment to growth rates that can be sustained over the medium term without fueling inflationary pressures, attaining a soft landing, but avoiding a sharp slowdown.

Last year, as you know, the Chinese authorities took a number of steps intended to moderate the pace of growth and achieve the soft landing, these largely to perform administrative controls, including on-bank lending, but in late October, they also announced a modest rise in interest rates.  So far, though, there have not been clear signs of growth moderating to a level that can be safely viewed as sustainable.  In the third quarter, growth picked up in fixed investment, industrial production and retail sales.   There continue to be bottlenecks, especially in the energy and transport sectors.  It is, therefore, too soon to be confident that the much talked about soft landing, as yet, has been successfully engineered.  The jury is still out.  Experience has taught has that achieving an orderly transition to more moderate and sustainable growth rates is, at best, difficult.  It is a matter of striking the right balance between doing too little and failing to check growth and inflationary pressures and doing too much with the risks that the economy "jutters" almost to a halt.

Chinese policymakers are understandably anxious to avoid too sharp a slowdown.  They are hardly alone.  China's contribution to Asian and global growth has been such that policymakers and exporters fret about an ill-timed falloff in demand from Asia's largest economy.  As I said, I think it's still too soon to be sure the landing will be a soft one, but I also think that fears of a hard landing tend to be overdone for two reasons.

In the first place, the impact of a hard landing on China's neighbors is likely to be less than many have suggested.  In the middle of last year, the Fund conducted a simulation to assess the likely impact on the rest of Asia in the event of a sharp slowdown.  The simulation started by assuming a decline in the rate of growth of investment of 5.5 percentage points of GDP--investment drops by that much.  Investment, as you know, was over 40 percent of GDP when they started on trying to get the slowdown.  And the calculation suggests that that much of a decline would lead over time to a 4-percent fall in GDP from its earlier growth rate and a 10-percent fall in imports relative to what they would otherwise have been.

The Fund's calculations suggest that such  relatively sharp fall in Chinese imports would have a relatively small short-term impact, reducing world GDP of PPP exchange rates by perhaps one-third of a percentage point in the first year, and that figure might rise to three-quarters of a percentage point after several years, with most of the longer-term impact in Asia, and the bulk of that would be in China itself.

The impact for some Asian economies might be significant, but such a shock should be manageable given the fairly robust outlook for the region as a whole.  The United States and the EU are still important export markets for Asian countries.  A substantial drop in the growth of exports to China would still leave countries in the region with relatively robust export growth rates, provided that the growth momentum and industrial markets is sustained in the U.S. and gradually improves in Europe.

Beyond Asia, a hard landing in China would have only a small impact.  In spite of recent rapid growth, trade shares with China are lower for countries outside of Asia.  For example, preliminary estimates for the United States and the euro area point to a decline in GDP of less than one-tenth of 1 percentage point, even over the longer term, given that sharp drop that was posited in investment growth.

The second mitigating factor for the hard-landing scenario is the likely response of the Chinese authorities.  Thus far, they have displayed great caution in trying to bring about the smooth adjustment that we all regard as optimal.  This suggests very strongly that policymakers would respond promptly to any sign of a dramatic slowdown.  It is difficult to imagine that any drop in growth would be sustained for more than a quarter or two without a response from the authorities.  The Fund's analysis takes no account of possible policy responses which would mitigate any initial shock, even of that large magnitude.

So the hard landing really can't be ruled out as yet.  The consequences may be less dramatic, even if it happens, than most commentators have argued.  Far more important, in the longer term, will be the shift away from reliance on administrative controls as an instrument of economic policy.  The more rapidly the authorities are prepared to move toward market mechanisms the greater will be the benefits for the Chinese economy and its future growth prospects.

Letting markets work more freely will make it easier to achieve rapid and sustainable growth in the future and reduce the need for intervention to avoid overheating.  In the longer term, there is no good substitute for price incentives for delivering the appropriate economic signals.

The modest rise in interest rates in October was a welcome move in this direction, suggesting that the authorities are ready to rely increasingly on market signals to achieve a behavioral response.  It was also a welcome sign that the authorities are serious about their commitment to restrain inflationary pressures.

Using monetary policy as a counterinflationary tool, though, is made more difficult by the current exchange rate regime, and there is a large body of opinion that argues for an immediate shift to a floating exchange rate regime.  The continuing reliance on a fixed exchange rate has been the source of some tensions between China and some of its economic partners.  There is no doubt that greater exchange rate flexibility would be desirable and would be in China's own interest.  It will undoubtedly make the pursuit of an independent monetary policy much easier.

The Fund has consistently argued that the Chinese authorities should move gradually toward greater flexibility, and the authorities themselves have accepted this as a broad objective without specifying a time table.  But it is essential that greater flexibility be accompanied by a readiness to tackle difficult structural problems in the banking system.  The problem of nonperforming loans is certainly not one peculiar to Chinese banks.  But in spite of the moves that have been made to reform the banking system, NPLs remain a problem, and the overinvestment that might accompany continued rapid growth in the economy as a whole could create new NPL problems in due course.

Good progress has already been made on bank restructuring and reform, but the momentum needs to be maintained if a smooth adjustment to greater exchange rate flexibility is to be achieved.

Exchange rate policy, of course, is not the only area of potential tension in China's relationship with global economy.  The past year or so has seen a greater deal of speculation about the likely impact of the much-delayed ending of the multi-fiber agreement.  Some exporting countries have been afraid that competition from China would inflict considerable damage on their domestic industries.  There is no doubt that this is an area where China has a competitive edge in many cases.  Removal of textile and clothing quotas and the eventual unrestricted access to this export market are widely expected to bring considerable benefit to Chinese producers.

In the short term, the impact on the Chinese economy is likely to be relatively small, however, and the main benefits for China are likely to accrue over the medium and the longer term.  There are signs that the Chinese authorities favor a gradual transition.

On January 1st, export taxes have been levied on selected categories of textiles and clothing, and many assessments of the consequences of ending the MFA take no account of the dynamic responses that we might expect, such as reforms to improve competitiveness in other exporting countries nor do they assess the impact of changes in exchange rate flexibility.

So let me conclude.  China is an economy undergoing rapid transformation, as we all know.  It's rapid growth has brought about both great opportunities and great challenges, both for China and the rest of the world.  Some producers see Chinese competition as a threat.  They worry about losing market share, about the impact on their markets from highly competitive Chinese exports.  That's as familiar a refrain as it is an understandable one.  But China's growth has brought immense new opportunities for exporters of primary commodities, of manufacturing inputs and of finished goods.

China is contributing to the growth of world trade, not displacing it from elsewhere.  And competition from Chinese exports has benefitted consumers across the world as well.  Let us not forget that competition is one of the great benefits that free trade brings, even when it forces some painful restructuring for those firms unused to it.  But China, too, is undergoing major and sometimes painful restructuring.  It is a large and populace country.  It has a cumbersome and inefficient bureaucracy, especially at the local level and at state-owned enterprises.  Many of its citizens still live in abject poverty, and the gap between the rich and the poor has widened.  It faces enormous demographic challenges as its population ages rapidly over the next few decades.  Its banking system is saddled with debts that will ultimately have to be written off.

Chinese policymakers are seeking to maintain the momentum of economic growth at levels that can have an impact on poverty, while avoiding inflationary pressures that would ultimately hamper growth, and they are often relying on policy instruments that are, at best, unreliable in what is increasingly functioning like a market economy.

The challenges for the Chinese economy are not new, of course.  The transitions we are witnessing today started more than two decades ago. Adjustment is a relatively slow process, even in small, open, simple economies, and China is neither small nor simple.  What has changed is the extent to which all our economic fortunes now are linked with those of China.  Its sheer size and its dynamism make it increasingly important for global economic growth.  With Japan's economy largely stagnant for much of the 1990s, China played a crucial role in sustaining and helping to fuel Asian economic growth.

With European growth still lackluster, the opportunities offered by the Chinese growth are increasingly important for the world outside Asia.  It is in all our interests the Chinese economic miracle be sustained.

Thank you.

[Applause.]

MR. LACHMAN:  Thank you very much, Ms. Krueger, for those remarks.  Ms. Krueger has agreed to take two or three questions, and we have microphones for those who would like to ask questions.

MS. KRUEGER:  I answered all the questions.

[Laughter.]

QUESTIONER:  [Off microphone.]  My name is Susan Tyler, and I wondered, it's been so long since I've studied economics, the export tax that [inaudible] and textiles have, is that [inaudible] more to [inaudible]?  I think usually [inaudible].

MS. KRUEGER:  Well, in a way, what they're trying to do is buffer the transition because, as you know, there was a lot of discussion about what would happen if Chinese exports flooded the world market and all of that, and I think the Chinese move was preemptive in that regard.

An export tax, in China, in a sense, is something that makes it more classically abroad to buy Chinese goods, of course.  So, in that sense, it's kind of, as you say, like a tariff on the importing side, except that what it does is it produces in other countries more of a margin within which to compete.  It's not like an import tariff in other regards, though, so it's slightly different.

QUESTIONER:  [Off microphone.]  [Inaudible] with the Carnegie Endowment.  You mentioned [inaudible] on a Chinese--I'll try to speak loudly--to produce flexibility at some point, but that there's no time table on their side and that it takes preparation.  Does this mean that it really is not something that we're likely to see any time soon for good reason or is it just completely unknown?

MS. KRUEGER:  I think it's completely unknown.  I think they are moving on their banking system, as I said, and I think they have recognized that clearly measures need to be taken on that side if they are to open up in some kind of a smooth way.  So I think that progress is being made.  I take them as being serious in that intention.  I don't think they themselves know a sufficiently precise way in which they will unwind some of these NPLs and get the banks competitive, and functioning and able to withstand foreign competition, and that, of course, is a critical question.

MR. LACHMAN:  This will be the last question.

QUESTIONER:  [Off microphone.]

MS. KRUEGER:  Well, I don't think there is.  I mean, first off, their growth in the 1980s was somewhat above, as I understand on the numbers, above in the 1990s.  So already we've seen a little bit.  We're talking about a 9- or 10-percent rate of growth possibly going forward.

Why won't it be higher?  Well, let me mention that last year, for example, investment was 47 percent of GDP.  That's awfully high, even for the growth rate they were getting, and there are clear bases on which they can make more efficient use of resources, but they were coming to the point where they were pushing so hard for investment that some aspects of getting the high rate of return obviously got overlooked.

So I would argue that we're in a range where probably something on the order of 40 to 45 percent is the most that's desirable and sustainable, but that's a ballpark number, and I wouldn't like to be held to it.  But if you do that, then you're sort of in the range where they're not going to get any more growth and, presumably, as capital accumulates the return on it, even when efficiently allocated, might go down a bit.

There are already some reports on the labor side that there is not quite as much free labor in the sense of willing to migrate and come wherever it's wanted at whatever price is being offered, and there are reports of companies having difficulty attracting workers without raising wages and so on.  And so, once again, it isn't that there aren't opportunities there--there are--and a growth rate of 8 or 9 or 10 percent is already very, very high.

So I don't think that we're talking about a dramatic slowdown to a new range so much as what is sustainable over an intermediate--in any one year, of course, it can be higher or lower, but an average like that would be a very good performance.

MR. LACHMAN:  Thank you, once again.

[Applause.]

MR. LACHMAN:  I'd like now to move to the second item of our program, and that is to get a United States Treasury perspective on the Chinese growth issue.  We're fortunate this afternoon to have Randal Quarles to make that presentation.   Randal Quarles, once again, is rather well known at  the AEI.  Presently, he is the Assistant Secretary for International Affairs at the U.S. Treasury.  And before he took that position, he represented the United States at the IMF at its Executive Board.  Randal Quarles also has been, for a long time, in the private sector at a firm, Davis, Polk and Wardell, where he led the Financial Institutions Group.

With those words, it's my pleasure to welcome Randal Quarles.

[Applause.]

MR. QUARLES:  Thanks, Desmond.  I'm glad to have the opportunity to discuss China and the global economic recovery today, providing the administration perspective, the Treasury perspective, to supplement what I thought was a very good analysis that we just heard from Anne Krueger.

It's something that I've said a number of times here.  It's no surprise to anyone.  The overarching principle of the administration's international economic policy has been to try to increase economic growth around the world.  Rapid growth, at full potential, is the most effective way of creating jobs, raising income, ultimately, the most effective way of raising countries out of poverty.  And in that regard, the rapid growth of the Chinese economy and its increasing integration into the world trading system, the international financial system, has to be viewed as a continuing success and a tremendous opportunity for all of us.

Let me just, again, very briefly, because Desmond did it a little bit at the outset, and Anne did it in much more detail, and I suspect that the panel that follows will also do it in more detail because these are very interesting facts that everyone wants to begin with.  Fortunately, I get to only be the second person, and so, by the time you've heard them four times, you'll probably remember them.

During the 25 years since China decided to move to a market economy, it's been growing, as we all know, at about 9.5 percent a year.  The consequence of that is that, since 1978, the Chinese economy is now 9 or 10 times as large as it was in 1978.  It's the sixth largest economy in the world, roughly.  We've heard the analysis that, on a purchasing power parity basis, it's the second largest economy in the world, third, if you count all of Europe as one.  In a couple years, China will be larger than the U.K. and France.  China will come to be larger than the U.K. and France, thus, putting it only behind probably the U.S., Germany and Japan.

In the course of the last three years, the United States and China together accounted for half of the world's economic growth, and that effect is magnified by China's rapidly expanding participation in that world trading system, as Anne also went through in some detail.

China's trade, in absolute terms over the first few years of this millennium, was growing at about 20 times the rate of U.S. trade, in absolute terms.  And exports to China are a significant element in the Japanese recovery story.  They were an important part of the economic calculations not only of the ASEAN countries, but also increasingly of Latin America.  Again, we heard Anne talk about that, to some extent, whether as an opportunity, say, in the case of Brazil, or as a challenge, as Mexico has viewed China's increasing participation in the trading system.

I think that one question that one might ask about China and economic growth, whether this rate of growth can be sustained, a question that was actually asked earlier, is not really an issue for the longer term.  China has huge labor resources and possibilities for reallocation.  About half of the Chinese population is still involved in agriculture at extremely low rates of productivity, given the actual lack of production of the farmable land in China.

It has a very high savings rate--roughly 40 percent of GDP.  It has a high reception just to new technology.  I think all of those elements come together to say that, again, over the long term, China is going to continue to grow and grow quite significantly, at a very high rate for some time.

China could do more to improve the composition of its growth and improve its total factor productivity, by which I mean, if China were more efficient in the use of savings and investment, it could still achieve strong economic growth, it could increase the share of national income from consumption as it shifts away from its heavy reliance on savings and investment.  That would lead, from the Chinese perspective, beneficial from the Chinese perspective, to greater intergenerational equity.  It would allow the current generation to consume more, instead of saving at such a high rate, for the benefit of what will clearly be a much more well-off generation.

In fact, productivity is going to play a much greater role in sustainable growth in 21st century Asia, generally.  In the past, countries like China have relied upon increases in the number of workers, the quality of the workforce, education of the workforce, for example, and increases in the capital stock due to high investment rates.

But the weaknesses, and the particular interest of the Treasury in this line of thinking, is that the weaknesses of China's financial system in allocating resources to the most productive and profitable uses and making sure that capital input comes at cost are clearly part of China's lagging total factor productivity.  A more efficient financial sector would be better at intermediating savings, and it could lead to growth with less savings and investment and greater consumption.

So that's why China's efforts to modernize its financial system, efforts that we at the Treasury, and others, both in the U.S. Government and around the globe are assisting with, are so important to assuring that China grows as fast as it can over the longer term.  These financial modernization efforts should include, among other things, improving governance of financial institutions, improving the accounting and regulatory systems, addressing deficiencies in the judicial system, bankruptcy laws, enforcement of contracts.

Again, this underscores the need to improve corporate governance, transparency of a bank's clients' financial condition--so not just the financial firms themselves, but the clients with which they are dealing, and as well as those clients' management practices--and, importantly, foreign firms can play a significant role in helping develop China's financial sector by bringing in management expertise, risk management systems, guidance on building modern regulatory systems, all the arguments with which everyone in this room is familiar with, as reasons for encouraging foreign participation in any developing countries, in any industry in any developing country--that certainly is true for the financial sector--and the importance of an increasingly effective financial sector is particularly significant with China.

In addition to these strictly economic reasons for focusing on foreign participation in the financial sector, there is a political reason as well.  China, as it increases its participation in the international trading system, and as it will continue to have a comparative advantage in labor costs, and therefore in labor-intensive manufacturing and other sorts of labor-intensive activity, China has to ensure that its economy is as open as possible to participation of foreign countries in those areas where those foreign countries have a comparative advantage to China.  And that openness can help diffuse some of the protectionist sentiment that can build up as a result of what we see foresee as long-term high Chinese growth and a long-term increasing integration into the international financial and trading system.

In addition, greater protection of intellectual property rights in China will be an important way to improve productivity growth.  China can benefit from the adoption of foreign technologies, but in the knowledge-based economies of this century, it will become increasingly important to increase the confidence of local entrepreneurs and engineers, that their intellectual property will be protected.  This is not simply an issue of the developed countries versus China.  It is an issue from the point of view of China's own internal economy as well as it continues to develop along these lines.

The variability of growth and the tools that China uses to avoid the overheating, inflation and hard landings that have occurred in the past will also have important implications for productivity growth.  China is still an economy in transition from state-owned firms, with soft budget constraints, state-owned banks plagued by a legacy of nonrisk-based lending policies, to a market-based profit-driven economy.

And I think a number of people in this room have commented on the fact that that was one of the most particularly important things about some of the recent measures that China took to attempt to restrain what might have been viewed as overheating its economy; that they were market based rather than administrative based.  Administrative controls are still relied on, still  needed, but they're losing effectiveness.  Increasingly, you need market-oriented, macroeconomic tools to manage the economy.

Financial sector modernization and liberalization will play a critical role, and the most important aspect of the recent decision to raise the policy rate was further deregulation of lending rates, and that will allow banks greater scope to differentiate among firms and among their clients.

Treasury's engagement on all of these issues with the Chinese has been extensive.  We have a number of dimensions to our financial diplomacy with the Chinese.  There is a high-level dialogue.  Senior officials at the Treasury, from Snow on down, Ambassador Speltz is here, who is the Secretary's emissary to the Chinese on financial and economic issues, generally.

When the Chinese were here a couple of months ago for the Bank-Fund meetings, we had a Joint Economic Commission session with them, and those will be repeated in the future.  We have continuing talks on all of these issues at very opportunity with the Chinese, but not only bilaterally.  We engage with the Chinese in a variety of multilateral fora.  The Chinese have been being invited to the G7 meetings at the deputies' level for some time, and most recently at the ministerial level.  We deal with them in the G20.  We deal with them through APEC.  And, increasingly, all of these multilateral fora, as well, are a mechanism for the rest of the world to engage with China on a broad range of issues that are important to all of us as China continues to grow and continues to integrate into the international system.

So we will continue those efforts.  We think that they are important and that they have been bearing fruit.  I have been very--China doesn't care whether I'm pleased or not--but it has been encouraging to see the way, the earnestness with which the Chinese are engaging in all of these fora, and the willingness to discuss various approaches on these issues with the international community, as opposed to what would have been a disappointing, but not unexpected response, to the international community's efforts to address these issues with China had China said, "This is our internal affair.  We're going to proceed in our own way.  We know what we're doing.  Thanks very much, leave us alone."

That has not been the Chinese response.  They have engaged in a serious and professional way in a mature relationship with the rest of the world, and we're looking forward to that continuing.  Again, I'm very glad to have the opportunity to address this group on some of these issues.

Thanks very much.

[Applause.]

MR. LACHMAN:  I'd like to thank Randal Quarles for those remarks, and I'd like to proceed now to our panel, if I could just ask the panelists to take their seats at the table.

As I mentioned, we have five really distinguished panelists who are going to be addressing different aspects of the Chinese economic story.

And the first of our panelists, who is sitting at the far end of the table, is Jeffrey Frankel, who is a highly distinguished international economist.  He currently is a professor at Harvard's Kennedy School of Government, and he also is very much involved with the National Bureau of Economic Research.  In addition to his academic experience, Jeffrey Frankel has had numerous stints in government in various forms, the most recent of which was at the Council of Economic Advisers in 1996.

With that introduction, I'm going to ask Jeffrey Frankel to open the discussion.

MR. FRANKEL:  Thank you very much, and thank you for inviting me to this very interesting seminar.

There are many topics of interest concerning the role of China today.  I am going to focus largely on the question of the currency, which is perhaps the most controversial issue.  Should China allow its currency to appreciate?

Let me, briefly, say what I think is in the U.S.'s interests.  I'm going to spend a lot of my time on what I think is China's interests, and then conclude with some predictions.

First, my analysis is very similar to what I would think is the mainstream analysis today; that the U.S. current account deficit is unsustainable, that the reason for this is low national saving, which is, in turn, due to a high budget deficit, that ideally the U.S. would reduce its budget deficit as a part of a policy adjustment and that the dollar would come down as part of that, so that the improvement in the trade balance would take the place of fiscal stimulus.

The dollar, of course, has already depreciated substantially against G7 currencies.  So that leaves China and other countries in East Asia.  That's the logic that gets us all towards saying that, in the U.S.'s interest, China should allow its currency to appreciate, and it could be part of a coordinated package.  I would not predict that we will have such a coordinated package.  A good coordinated package would consist of the U.S. agreeing to cut its budget deficit and to all the Asian countries together--China, Korea, and the Southeast Asian countries--simultaneously agreeing to appreciate, since each one might be reluctant to do it on its own.

I don't think we'll get such a package.  It would require some leadership from the U.S., and I don't think we're going to get that.  That then raises the question, well, second best.  If you take, given the U.S. budget deficit, is dollar appreciation against the yuan and other currencies second best?  I don't know.  It's a second-order question.  To some extent, it would redistribute the crowding out that the American economy is increasingly going to bear from large U.S. budget deficits.

Currently, the path we're on, that crowding out is going to hit the intrasensitive sector.  If we have a depreciation of the dollar, it will translate some of the crowding out, take some of the pressure off the interest rate-sensitive sector, which I think will otherwise happen in the future, and it will alleviate some of the pressure on the trade sector, rather than the situation over the last four years, which is the dollar-sensitive section has borne more than its share.

Let me talk more about what's in China's interests.  And there's a paper that was in the packet that was distributed that my remarks are based on.  In fact, in the packet, you'll see the long version, the bullet-point version, which is the slides and also an intermediate version.  And the bottom line is simple, that also from China's perspective, I think it's in their interest, as Anne Krueger said, to allow the renminbi or the yuan to appreciate.

Before I give the reasons for that, I want to make four qualifications.

First, I think any discussion about exchange rates should admit that fixed exchange rates have advantages and flexible exchange rates have advantages.  It's useless to just name the advantages on one side and pretend that the others don't exist.

And then, in particular, I think that the de facto peg and, by the way, China's official de juri policy is not a peg, but it has de facto followed a peg, and for the last seven years, that peg has been at the same level.  And I think one has to admit that it has served China well during this period.

Third, I believe that a country has the right to choose a regime that's best-suited to its circumstances.  And this is the one area where I know--

[Tape change: T1-A to T1-B.]

MR. QUARLES:  [Continuing] --talk about illegal currency manipulation is not really appropriate in the way that trade policy we have agreed-upon rules, and we talk about that.

And my final qualification is the fact that I recommend appreciation and that that happens to coincide with a lot of American politicians' statements is pure coincidence.

Let me start with the first of the reasons why I think it makes sense, from the viewpoint of the management of China's economy, for them to move to a more flexible system, in general, and under current circumstances, to allow some appreciation.

A central bank, like the People's Bank of China, in general, has two instruments, and it's not been a market economy in the past, but increasingly this is going to be the right way to think of it in the future, that the two instruments are the exchange rate and the interest rate.

It also has two goals:  One is internal balance, meaning getting the right level of demand for domestic goods, neither a recession on the one hand nor overheating on the on the other hand.  The other goal is external balance, whether your preferred measure is the trade balance or the current account or the overall balance of payments, some measure of equilibrium there.  And it's a general principle.  It's a theorem of macroeconomics that to attain two goals, you need at least two independent policy instruments.  You can't obtain both goals with just one instrument.

For anyone who has taken a course in macroeconomics, the general framework will be pretty familiar.  I don't need to go into it except to say that the two axes here represent the two policy instruments.  I have the instrument on the horizontal axis, sometimes called "expenditure-reducing policies," and I have the exchange rate, the price of foreign exchange, on the vertical axis, sometimes called "expenditure-switching policies."

I know the old principle is, if you want to be on both lines, and you have the internal balance line sloping up and the external balance line sloping down, if you want to have both internal balance and external balance at the same time, then you need both policy instruments to achieve that.

My view is that China, as of a few years ago, was, to the right, that point that says "C-2002."  And sometime in 2003, China crossed over from that excessive supply side or the recession side of the balance line over to the other side, to the overheating side.

So, now, we're at C-2004.  And, yes, if you wanted just to attain external balance, you could do it by reducing the interest rate.  And if you wanted to attain just internal balance, then you could do it by raising the interest rate, and of course they made some steps in that direction.  But the point again is that we have another goal.  We have two goals, and if you want to attain two goals, you can't do it with a fixed exchange rate.  And the reason why I emphasize this is the school of thought, and to name names, I'm thinking of two very eminent economists--Ron McKinnon and Bob Mundell, who are happy with the current exchange rate peg and, to my view, they haven't answered this basic point.  They say that to address external balance, you can use spending, but I don't think they've adequately addressed the point that we need to address both goals.

So the first reason is to reduce overheating as a reason to allow appreciation under current circumstances.

Second, what's wrong with continuing to run a balance of payment surplus as China has?  Well, I think anyone who has watched what happened in the East Asia crises of '97-'98 has to admit that the Asians have a point, that they have a pretty good motivation for holding higher levels of reserves as a shield against future currency crises.  But I think at half-a-trillion dollars they've got enough.  I mean, that's my view about China.  They're holding U.S. Treasury securities, which don't pay a very good rate of return, and it seems to me they could do better with the opportunity costs of those funds.

The other reason why these reserves are, why it's reached a high enough level that if I were them, I wouldn't want to continue, is that it becomes increasingly difficult over time to sterilize the inflow.  In other words, it becomes increasingly difficult to prevent the inflow of reserves from throwing the money supply and leading to inflation, particularly since, like it or not, the degree of capital mobility is rising, which makes it harder and harder to sterilize the inflow.  They can try to do it through financial repression.  They can try to do it through sterilization efforts, and they've had some success so far.

Here is a graph, which I borrowed from UBS.  The green bars represent the balance of payment surplus, the inflow of reserves, and that works to raise the monetary base.  But if you look, the total reserve money growth rate has been relatively constant, and the reason is they've offset it.  You see the blue bars, that's sterilization, that you've had this strong offset sterilization neutralization of reserve inflows.  So, up until now, they have succeeded relatively well in keeping the reserve inflow from increasing the monetary base, but I would predict that that will become increasingly difficult if they don't make some other sort of adjustment.

So my first reason was to avoid overheating.

My second reason was because their level of reserves is getting too high to adjust to the balance of payment surplus.

My third reason is something that I want to do, which is avoid a hard landing, avoid a currency crisis.  One of the questions that Desmond asked us to look at is will there be a hard landing.  And, I don't know, I come out where Anne Krueger is, that maybe there is something to worry about.  I have this sort of crack theory that every time a new country becomes a global economic power that rite of passage is to have a bubble and a crash.  So you think of the Dutch in the 17th century and the British and the French in the 18th century, those two, the South Seas bubble in the 18th century, you think of the U.S. in the 1920s, you think of Japan in the 1990s.  In each case, you have a new global economic power, where their ability to manufacture, and to export, and to trade kind of gets ahead of the financial infrastructure, and they have a bubble and crash.  So that could happen to China at some point.  And the vulnerability is the banking system when you make a bad loan.  The problem is a real problem.

Now, some say that's a reason not to liberalize, not to put increased exchange flexibility and not to liberalize on capital control.  I don't see it that way.  I think if you're pumping more and more air into the tire, yes.  I mean, if you open up, it could precipitate something, but I think it's just going to get more dangerous to do it later on, and I think it's important to let some air out of the tire now rather than run the risk of an even bigger crash in the future.

One qualification, with U.S. interest rates back on the rise, it is possible that the entire situation will reverse itself, carry trade, and the fact that emerging market spreads are so low everywhere in the world, and that all this money is going back into China.  It's possible that this year that that pattern will reverse itself.  And so, number one, I'd want to keep a sharp lookout for that, and if it happened, I would modify my conclusions.  But I don't see it happening yet.

Finally, a fourth argument.  Balassa-Samuelson is an important theory.  It's a modification, a more sophisticated version of purchasing power parity theory.  If you compare prices of goods and services of China to prices in the U.S., they are 23 percent, much lower.  Now, a lot of that is to be expected.  Poor countries, low-wage countries with low capital-labor ratios always have lower prices.  But the Balassa-Samuelson relationship says that the normal place for them to be for their current income level is 36 percent.  So that's still a pretty big gap.  Here's the graph, the horizontal axis's income per capita.  China, yes, it should have low real prices because it's still a relatively poor country, but it's below the regression line, and that gap is 35 percent. So I don't want to be too precise about this, but by this estimate, the renminbi is undervalued in real terms by 35 percent.

Does the Balassa-Samuelson theory have any predictive power to say what will happen in the future?  Well, yes, it does, and to cut to the bottom line, it says, the point estimate is over the next 10 years the yuan should appreciate in real terms by 4 percent per year, getting back partway, halfway towards the average relationship.

Well, 4 percent, that adds up. It's not a lot in one year, but over ten years, that's a lot.  If they were really to keep the exchange rate fixed, they'd have to take it all in the form of inflation, and that's really too much inflation to want to live with.

Well, those are all my reasons for thinking they should allow some real appreciation.  How should that real appreciation be achieved?  Should it take the form of nominal appreciation, which is what I'm arguing, or the form of inflation, which I said a moment ago is the alternative?

For a very small open economy, and Hong Kong has always been our favorite example, the advantages of keeping the exchange rate fixed are quite large, and it's probably worth doing that and taking the adjustment in the form of higher prices instead.  China is not a small, open economy.  For a large economy like China, it makes more sense to adjust via the exchange rate than via prices.

Two more slides.  What will the new regime be?  I don't have as strong a feeling on this.  I don't think there's any need for a pure float.  There's this popular corners hypothesis that became very popular in the late '90s that said that countries today have to choose between a rigid peg on the one hand versus a free float on the other hand.  I've never been a fan of that, and I think China is an excellent example of a country that should be somewhere in the middle, some kind of band or target zone.

What should the anchor be?  I don't know.  I mean, the dollar has an advantage as an anchor.  It's simple and transparent, but, on the other hand, it's not as if all their trade is with the U.S., and we saw the disadvantage, for example, of Argentina linking to the dollar, when not all their trade is with the U.S.

A basket would be better diversified.  The problem really is that Asia lacks a good anchor currency today, so I don't have a good answer to that question.

Last slide.  I was asked to make some predictions.  There is this view, which, I don't know, maybe we don't have it represented on the  panel, but that the exchange rate between the yuan and the dollar can stay fixed forever, that there are good reasons why this is in everybody's interests.  And I'm particularly thinking of Dooley, Folkerts-Landau and Garber, who say that we're in a new Bretton Woods system, analogous to the Bretton Woods system of the '60s only now it's Asia playing the role of buying up unlimited quantities of dollars because they don't like that, but the alternative is worse, namely, allowing their currency to appreciate and losing their exports.  They're doing that today just as Europe did in the '60s.

Well, I think there is some truth to that, but they seem to think that we're at the beginning of the Bretton Woods system, either 1934, when the Bretton Woods meeting happened, or 1958, when convertibility was restored, and they kind of resumed in earnest.  I would say we're closer to the end of the Bretton Woods system.  We're closer to 1971 than we are to 1958.

Capital mobility, of course, is much higher now than it was then.  The U.S. is much closer to the retirement of the baby boom generation and kind of a long-run day of reckoning on the fiscal side.  I think, in the past, we were able to ask other countries on political grounds to keep the system together and to fund the U.S. deficit.  If you think back to Germany offsetting the U.S. troops stationed there in the '60s or the Bank of Japan, after the Louvre Agreement, buying up dollars in the late '80s or you think of Kuwait and Saudi Arabia compensating us for the first Iraq War, they were prepared to offset the effects of our profligacy by bailing us out on balance of payments.  I don't see the world there today.

Having said that, the dollar has already moved quite a bit.  If I were to make a dooms day forecast--no, not dooms day--but if I were to say something exciting that might happen in the next year, it would be that the U.S. bond market I think is ready for a fall, and one of many reasons is that Asian central banks, like the Fed, may reduce the rate at which they are buying Treasury securities.

MR. LACHMAN:  Thank you, Jeff Frankel, for those remarks.  Thank you for addressing a number of the questions, and I'm sure we'll get different points of view across the table.

I'll turn next to Morris Goldstein, who currently is a senior fellow at the Institute for International Economics.  Morris writes extensively on the exchange rate issues, in general, international economics, looking at the emerging markets and has developed an expertise in China.  Before being at the Institute for International Economics, Morris had a highly distinguished career at the International Monetary Fund in their Research Department.  I look forward to hearing what Morris has to say.

MR. GOLDSTEIN:  Thank you, Desmond.  Good afternoon.  It is a great pleasure to be here.  Given the time constraints and the number of panelists, I, too, thought I would concentrate on a particular topic, and I, like Jeff, are going to talk about China's exchange rate policies.  In particular, I am going to take up and answer four key questions reflecting ongoing work with my IIE colleague, Nicholas Lardy.

First, is the RMB currently undervalued?  And, if so, by how much?  Short answer, yes, by 15 to 20 percent.

Second question.  Is China manipulating the value of the RMB, contrary to IMF rules of the game?  Short answer.  Do bears relieve themselves in the woods?  Yes.

Third question.  Would an appreciation of the RMB be in China's own interests as well as in the interest of the international community?  Short answers, yes and yes.

And, fourth, what currency regime would best facilitate an appreciation of the RMB?  Short answer.  A two-stage currency reform that would immediately implement a 15- to 20-percent appreciation of the RMB, but would put off until China's banking system was much stronger both a managed float of the RMB and a significant liberalization of China's capital outflow regime.

So those are the answers.  Let me fill in my remaining time some of the scenery.

How does one figure out the undervaluation, if any, of the RMB?  Well, there are a number of approaches.  Jeff discussed one PPP approach with Balassa-Samuelson flourishes.  Let me talk about two others.

The first approach is called the underlying balance approach, and it defines the equilibrium exchange rate for the RMB as the exchange rate that would produce equilibrium in China's overall balance of payments.  Last year, China ran--excuse me--in 2003, China ran a current account surplus of just over 3.25 percent of GDP.  Adjusted for the overheating of the Chinese economy, which pushes up imports, and for the lagged effects of a depreciating RMB, the underlying current account surplus of 2003 was bout 5 percent of GDP.  Given the surplus that China also typically runs on its capital account, it's about 1.5 percent of GDP, you would have needed, by our calculation, about a 20- to 30-percent appreciation of the RMB to restore equilibrium to China's balance of payments in 2003.

For 2004, China's current account surplus is going to be similar, I think, to 2003.  For the first four months of the year, the trade balance was in deficit.  You heard many people saying China is going to run a current account deficit last year.  Well, that now looks very unlikely.  On the trade balance, they are 5-percent larger in surplus now than they were in 2003.  The IMF's latest forecast is for a current account surplus of about 2.5 percent of GDP.  Doing the same kind of calculations, one would find that the RMB is about 15- to 20-percent undervalued.

The second approach is to look at the role that the RMB might play as part of the global adjustment process, particularly the adjustment of the U.S. current account.  The projected U.S. current account deficit for 2004 is likely to be about $650 billion or 5.5 percent of U.S. GDP.

A sustainable deficit, in the view of most analysts, would be about half as large.  To get that outcome, you need a 30- to 35-percent real depreciation of the dollar from the dollar's peak in February 2002.  You have gotten so far about half of that.  So you have about half to go.  Well, if the dollar is to go down further, other currencies would need to go up, and I would submit that it's hard to find a better candidate for that than China.

The economy is growing at a 9-percent-plus pace.  CPI inflation for last year is going to be a little bit below 4, hit a peak of over 5 and declined some.  Corporate goods inflation was running over 9 last year.  It's now down to about 7.  China has an increase in international reserves of $160 billion in 2003, an incredible 11 percent of GDP.  It probably went up another $150 billion last year.  They have very low external debt.

The classical remedy for a country experiencing both an external surplus and an overheating of the domestic economy is exchange rate appreciation.  So the global payments approach also suggests that the RMB is undervalued by at least 15 to 20 percent.

Now, that all assumes that China doesn't significantly liberalize its capital outflow regime during the next few years.  If China were to do that, well, that could change that conclusion.  After all, there's over 100 percent of GDP in household savings deposits, and if 5 percent of that were put abroad, that would be a significant number.

But there is no indication when that capital outflow regime is going to be substantially liberalized, and if it were to take five to six years, then I'm thinking it's asking too much of the rest of the world to say that we ought to live with a significantly undervalued RMB for that period of time.  So that's how I arrive at the 15- to 20-percent undervaluation issue.

Why do I say China is manipulating the value of its currency?  Under the IMF's rules, you can adopt whatever currency regime you want.  You can fix, you can float, you can do something in the middle.  Countries are also free to intervene from time to time to meet excess volatility in markets.  But what you're not supposed to do is pursue policies that maintain the wrong exchange rate.   And one of the key pointers of the wrong exchange rate is large-scale protracted exchange market intervention in one direction, and that's what we've seen going on in China for over two years.  Maintaining the same exchange rate peg at 8.28 RMB for the dollar for seven or eight years does not mean that you're free of manipulation.  Holding the nominal exchange rate constant, when the real exchange rate is depreciating, and that's still going on in China, and when you have a large balance of payments surplus is thwarting adjustment.  So you can get manipulation just as much from nonmovement of the nominal rate as you can from too much movement.

A problem, of course, is that international codes of conduct for exchange rate policy don't mean much if they are not enforced.  And, regrettably, neither the IMF nor the U.S. Treasury has been willing to speak out about currency manipulation.  In fact, to this date, I think we have not had a statement from either the U.S. Treasury or the IMF that the RMB is undervalued.  They just say they want more flexibility, as if they'd be just as happy if the RMB went lower as if it went higher.  After all, that would make it more flexible.  Clearly, we're not indifferent.

Third question.  Would an RMB appreciation be in China's interests and interests of the rest of the world?  I argue it would be in China's own interest because it would make exchange rate policy the ally of banking reform, of low inflation, of continued market access for China's exports and of a healthy and sustainable rate of economic growth.

A significant undervaluation of the RMB is the enemy of bank reform and low inflation because it attracts a large volume of portfolio capital flows chasing exchange rate appreciation, and these capital inflows, in turn, fuel excessive growth of bank lending and of the broad monetary aggregates.  Then, you get lots of nonperforming loans and rising inflation.  That's what we saw in China in 2003 and the first part of 2004.

By the use of administrative controls on bank lending, project use, land use, they've been able to reduce growth of the monetary aggregates in bank lending from over 20 percent to 13 or 14 percent, but it's  unclear how long those will be effective.

 A hard landing of the Chinese economy is more likely to occur from a forced credit crunch or protectionist measures against Chinese exports than it is from a medium-sized revaluation of the RMB.  What counts for competitiveness in growth is the real exchange rate.  From 1994 to early 2002, the real trade-weighted value of the RMB appreciated by almost 30 percent.  Yet the average growth rate for the Chinese economy was above 8 percent, and in no single year did it fall below 7.5 percent.  So the idea that if China had a medium-size revaluation growth would fall to nothing, does not correspond to history.

RMB revaluation would also be in the interests of the rest of the world.  Here, the short story is you can't correct the U.S. current account deficit at reasonable cost without a further depreciation of the dollar.  You can't get enough depreciation of the dollar without China, Asia and Japan participating, since together they have a 40-percent weight in the index, and you can't get the rest of Asia to appreciate enough without the RMB appreciating.  So the RMB is important as a linchpin for wider Asia currency adjustment.

Last question.  What currency regime would best facilitate an RMB appreciation?  Well, what won't work?  Well, what won't work is making very small changes to the status quo; that is, a series of trade capital account and tax measures intended to substitute for an exchange rate valuation.  These are things like reducing the value-added tax export rebate, promotion of tourist expenditures abroad, et cetera.

If the disequilibrium in the exchange market was 15 or 20 percent, you're not going to get anywhere with 2- or 3-percent appreciation.  That would just make people think there is more to come, and you get a one-way bet.

What also won't work is the U.S. Treasury prescription for opening the capital account and floating the exchange rate.  Given the fragility in China's banking system, if you do that and you get bad news, you get large-scale capital flight and a big depreciation.  The Chinese are not going to do that because it violates what one of my colleagues calls the first law of submarining, which is that you close the hatches before you dive the boat.

[Laughter.]

MR. GOLDSTEIN:  Another option, and the one I would normally prefer, is you keep the controls on capital outflows and float the exchange rate now.  The problem with such a managed float is that in China's case there's likely to be a lot of management and very little float; that is, they'll intervene very heavily, and you may get something that's not very different for the 2 or 3 percent.  That's what led Nick Lardy and I to argue for two-stage currency reform.  In the first stage, you do the 15- or 20-percent revaluation relative to a basket, you widen the bands 5 to 7 percent on each side, then, down the road you float the exchange rate and open the capital account.

The 15-percent revaluation removes the bulk of the disequilibrium.  The band gives you some practice in managing exchange rate flexibility.  When you float, you get the independence of monetary policy you need.

Let me stop there.

MR. LACHMAN:  Thank you very much for those comments, Morris.

I turn now to Pieter Bottelier.  Pieter had a very distinguished career at the World Bank.  Over the past number of years, he's specialized on China.  He was the World Bank's resident representative or head of their resident office in Beijing.  Currently, he is a visiting professor at Johns Hopkins, at the School for Advanced International Studies.

Pieter?

MR. BOTTELIER:  Thank you, Desmond.

I'm afraid I'm going to make it hard for the audience because I'm also going to speak on the exchange rate.  But before I get to that, I'd like to make some remarks on the question of where is China in the current overheating cycle and is the investment boom sustainable.  So I will start with that.

Is the economy overheated?  Yes, in some sense, it still is, but not as badly as a year ago.  It's definitely too early, in my opinion, to relax aggregate demand management.  And I think Anne Krueger and others said that probably there is a need for some further monitoring and fiscal tightening in the year or years ahead.  I don't think this is going to be a hard lending or a soft lending nor no lending, as some people have called it, but more probably a long lending.  It may take some years before they get out of this.

The consumer price index and other indicators of excessive and unbalanced investment growth have improved since the middle of last year, of 2004.  But the important thing is that the underlying fiscal system problems, which are driving these overheating cycles, have not been corrected.

In some sense, the current overheating cycle resembles the previous one of the early '90s--'90 through '96.  And it's, perhaps, interesting to reflect on the differences because there are some important differences.  Two big differences I see:

One, the inflation now in China is much lower than it was during the previous overheating cycle;

And, secondly, the international spillover effects were very minor in the early '90s.  They're pretty significant today because of China's growing weight in the global economy, particularly on the trade front.

The first point on the consumer price index requires a clarification.  It may be a little technical, but it's important to note that this overheating cycle has not been associated with high domestic inflation.  The CPI, the consumer price index, never exceeded 5.5 percent in this cycle.  Right now, it's below 3 percent in a year-to-year basis.  And during the previous cycle, it is actually pushing 30 percent.  So why this big difference?

The big difference is that China is now a much more open economy than it was, and any excess domestic demand can more easily spillover into the import demands at that time.  That's one reason, but there are two other reasons.

One is the CPI that uses a central indicator is, in fact, not a very reliable index in China any more.  It is, in my opinion, significantly understating the degree of inflation, perhaps by as much as half, and that is because the weights that have been assigned in this index to goods and services are out of date, particularly for housing, medical care, education.  These are now much more important expenditure items than they were 10/20 years ago, and the National Bureau hasn't changed the weights.  So the CPI significantly understates actual inflation.

The second factor is that inflation, the price rises, as measured by the CPI, are not driven so much by monetary expansion, just by agricultural factors.  China had bad harvest, grain harvest, for the last five years.  This was the main factor driving up food price indexes in 2002, 2003, and the fact that it came down again in 2004 is more related to good harvest than any other factor.

So what did the government do at this time to cool the overheating economy?  When they became convinced that there was a problem, they calmed down through administrative measures to slow down bank lending and, in particular, investment  projects.  In this way, they fairly quickly corrected the excesses in some sectors, in particular steel, aluminum and cement and some other sectors, but that doesn't mean, in my opinion, that the overheating has been really conquered.

For one, domestic credit expansion picked up again fairly significantly in November, which was unexpected by most.  And I also expect, because of what I said earlier, that the CPI may, in fact, turn up again, partly because of the factors I mentioned, partly because upstream inflation indexes, like the producer goods index, are still way above the CPI.  They're between 7 and 10 percent.  So, at some point, this is going to translate, I think, into higher consumer price index.

Let me say a word or two about what happened to the banking system, the NPL, because that's also important, and Anne Krueger also referred to that.

Most of the increase in lending, there was a veritable orgy of lending in 2003 and the first half of 2004 in China, but the important thing to notice is that most of the increase in lending this time did not come from the four big state banks.  They come from the multitude of smaller banks in China, the city commercial banks, and banks like that.  Most of these are also owned by the government, but not by the central government in Beijing, lower-level government.

The share of the big four that used to be 65 percent in total lending, as recently as three years ago, actually fall to about 50 percent of the [inaudible].  That is very significant because the big banks that are under most pressure for reform are, in fact, reforming.  They have behaved better than in the past.  Two of the four are under active auditor supervision right now.  KPMG and Ernst Young have a team of 100 men each for the first time doing an international audit.  Both banks are preparing for listing in Hong Kong and New York, and both are seeking minority foreign partners, strategic partners, prior to the listing.  So that's very important.  So these are behaving.

That also means that if we get a new wave of NPLs in response to the previous explosion, the most recent explosion, these NPLs are more likely to be concentrated in the smaller banks in China, and that poses new questions because the government has never really had to deal with that in the past.  And the question is whether they will protect the smaller banks as well as they will the big banks.  I don't know.  One important indicator, perhaps, of the concerns they have is that they introduced a formal deposit insurance scheme for all banks in September of last year.

Now the question that others have raised, including Anne Krueger and Morris Goldstein, is the question, and Nick Lardy, is this current investment boom sustainable or not?  Here, I'm afraid, I'll have to be a little technical because the answer to that depends very much on how you measure investment and how you measure the denominator of GDP.  There are problems with both.

In the Chinese statistical system, investment tends to be overestimated.  Some people use an index called gross investment, and that includes, in the Chinese statistics, the price paid for existing fixed assets, such as land and buildings.  That indicator should, therefore, not be used as an indicator of investment.  Many people do that, and they come to excessively high inflation in each index.  The correct index to use is the capital formation in the national accounts on an expenditure basis.  Then, you come to a much lower investment level.  The difference between the two is 8 percent, no less than 8 percent in 2003, the last year for which we have full account.

More importantly, however, the denominated GDP itself is probably significantly underestimated in China for two reasons.  One is, again, the statistical measurement, the database.  The National Bureau of Statistics does not properly account for all sorts of new expenditure items.  They totally underestimate the importance in GDP of private sector transportation, paid-for education, paid-for medical care, and owner-occupied housing.   In addition, they don't account for informal sector value added in trade, in manufacturing, which is increasingly significant.  Many analysts believe that China's GDP may be underestimated by as much as 30 to 40 percent.  I, personally, believe that a correct measurement of GDP in China would probably show you a GDP closer to 2 trillion than the 1.5- that is the official number.

Now, if you're correct for these two, then you come to a very important conclusion.  Then, the official investment, the investment GDP ratio is not 42.3 percent, as per the official statistics, but only about 32 percent, which I believe to be a more meaningful figure, which is far below the peak of the investment ratio of over 43 percent in 1993, which means that even if investment ratio continues to increase, you will not run into a problem for a while.  I think there is no reason to worry right now about the overall investment level.  It will not peak for a while, and even when it peaks, it will probably peak below a previous peak of 46 percent, which may have been overestimated by itself, but to a much lesser degree than at the present time.

So is there nothing to worry about with regard to investments in China?  I think plenty.  I think I'm particularly worried about the housing bubble that seems to be developing.  There are still a lot of ways for investment in the public sector and excess investment in the number of industries.  One example that I want to quote is the automobile capacity.  The expected capacity will be 50 million units local manufacturing capability before the end of this decade.  There is just, in my opinion, no way domestic demand can ever catch up with that production capacity in that time frame.

So what does that mean?  There are many industries, like that, incidently, where the excess capacity is building up.  It means tremendous pressure on margins in certain parts of the manufacturing industry and perhaps export efforts through very low pricing.  That's a problem that we didn't have so much in the past.  Because China's economy is now so big the overinvestment in China will more easily spillover into a cross-border problem than it did in the past.

Now, a few words, if I may, on the exchange rate.  Is the exchange rate undervalued?  Yes, by most standards, it is, but I don't think by as much as Morris indicates.  Some people argue it is not really undervalued because the current account is not very much in surplus.  When I was just in Beijing last month, the people there expected surpluses of no more than 1.5 percent of GDP in terms of where their trade numbers for December will come out, but not a massive surplus.   My preferred way of looking at it is what you called, Morris, the underlying balance approach.  China's surplus basic balance is on the order of $70 billion.  That is the current account plus the FDI, the long-term structural money.  Now, that is an indicator of the problem.  You want to bring that now from 70--or maybe at 75 to, say, around 20 to allow for some further buildup, but that doesn't require a 50-percent revaluation.  In my opinion, 45-percent initial would be more appropriate.

Why haven't they done that?  The Chinese, I think, have, by and large, agreed with the proposition that it is in their interest to change the system.  They've stated so [inaudible], Secretary Snow, in September of 2003.  It's in their interests because they realize, as Jeffrey Frankel pointed out, the fixed rate, as the Asian crisis of '97-'98 pointed out, is potentially very dangerous.

Secondly, it gives you more freedom in monetary policy which, for a large economy, which is structurally very different from the U.S. economy, is a very important thing.

And, also, on a fixed rate, it is much harder to control the real effective rate, which is the really important rate.

Finally, with a more flexible system, you can more easily control or avoid the excess buildup of reserves, which has happened in the last few years, which is not in China's interest.

Does China manipulate the exchange rate?  In a purely technical sense, I agree with Morris, of course, they do.  Like many other countries in East Asia, China prefers to maintain a low exchange rate for export promotion and employment growth, but I have trouble with the use of the word "manipulation," in a legal accusatory sense because, as if China were violating some international law, the choice of a fixed exchange rate system at the present level of 8.28 was  a logical, legitimate and wise choice when it was made in December '97.  It helped stabilize regional currency markets during the Asian financial crisis.  China was, in fact, applauded by the international community for its constructive exchange rate policy at the time.

So, when will China's exchange rate policy become unconstructive or manipulative?  Surely, the transition to unconstructive behavior isn't marked by something that China did.  China allegedly shifted into manipulative behavior in the last few years when the reserves began to build up?  But why is that so?  Two factors.

One, the single most important fact, in my opinion, is the fiscal policy of the United States.  That, more than any other factor, has driven the widening of the U.S. current account and the broadening of the trade balances with China.  The other factor is, of course, the turnaround in international expectations on the value of the RMB.  Whereas, there was net currency flight from China before 2003, the opposite began to happen after 2002.  So I don't believe that it is useful or appropriate to call this manipulative in a sort of legal, accusatory sense.

Now, why they haven't changed their exchange rate if this is so much in their interest?  Well, only, of course, they can answer the question, but I can think of a number of reasons, trying to imagine this complex question from this perspective:

One, is they don't want to reward speculators and, secondly, they don't want to create an environment within which new speculation--and the Chinese are very good at that--will break out.

Secondly, they want, of course, to keep, if possible, a somewhat undervalued rate for employment reasons.  Employment is the biggest problem in China, massive unemployment in the cities already, nonfunctioning or only partially functioning social safety nets, massive migration from the rural areas.  You want to create employment in the urban areas as quick and as fast as you can.

Second, the agenda overload.  Few countries have ever had to cope with as much policy change, institutional change, legal system change as China after they joined WTO.  This country is really in an overdrive type of situation, trying to cope with the very condensed time frame within which they have to make myriad changes in just about everything that determines the function of their society.

Thirdly, a conflicting interest domestically.  This is a very big economy, a very complex.  What is good for manufacturing may not be good for grain-producing areas, where most poverty is concentrated.  This economy is still only half reformed.  There are many structural imbalances.  It's very hard to manage this at the aggregate level, this economy.  It is not a fully reformed market economy.  And it is not surprising that internal opinions in China on the exchange rate question are as divided as international opinion.

Jeffrey mentioned that Bob Mundell and Ron McKinnon have urged the Chinese not to change their exchange rate system.  There is a third international well-known economist, Stephen Roach of Morgan Stanley, with the exact, same position--don't do it.  It's too risky. It's too costly.  You're better off sticking where you are.

So it's not surprising the Chinese I think have some thinking to do.  I think they have done their thinking, and they have announced that they will go--when, I don't know.

Two final small reasons why.  Perhaps they haven't moved.  Derivative markets haven't really developed very much in China, but that can hardly be an excuse because you must remember, when they unified the exchange rate, they [inaudible] exchange rate system on the 1st of January 1994, they did actually move to a flexible exchange rate system.  What they have now is not what they announced in '94.  They didn't begin to peg fully, at a very narrow [inaudible], until December '97, after the Korea crisis broke.  That was the signal for China to actually clamp down on the whole system and go to a fixed-rate system.

But they introduced a flexible system in '94 without having the derivative market.  Now, of course, they say we have to develop the derivative markets first.  They have become wise, but they have been [inaudible].

Finally, convenience, as McKinnon and others have pointed out, much of the trade in East Asia is invoiced in U.S. dollars, and that's, of course, mighty convenient.  Once you go to a flexible system, you have the [inaudible].  You cannot necessarily invoice in dollars any more so easily.  So the convenience factor.

I, personally, think that they will move--when, I don't know.  It's a delicate choice to make for them.

MR. LACHMAN:  Thank you very much, Pieter.  If I understand correctly, you would be agreed, both with Morris and Jeffrey, that, in the long run, China should move to a flexible kind of exchange rate.

MR. BOTTELIER:  Yes, I agree with both points, flexibility, and I think some upward adjustment would be fully justified, but not a big  [inaudible].

MR. LACHMAN:  I think there's a big difference of views, and I don't know whether Morris would like to just comment on this now or at later stage is on the investment issue.  I think that you're making an important point that if, statistically, China isn't having an overinvestment boom, there's no need to worry about the hard lending.  I don't know whether Morris would want to--

MR. GOLDSTEIN:  Well, why don't I come back to that a little bit later and give others a chance.

MR. LACHMAN:  That being the case, we'll move on to John Makin.  John is a colleague of mine here at the American Enterprise Institute.  He is also a partner in Caxton Associates, a New York investment firm.  John has the distinction of not only being involved in markets, but also having been a distinguished academic.

With that, I'd ask John to take the floor.

MR. MAKIN:  Thank you, Desmond.

Certainly, the Chinese economy has been thoroughly examined here by some very competent people, and I'm just going to try to make a contribution on the question of overinvestment and the implications that that may have for the currency regime.

I am quite nervous about a Chinese hard landing, to put my cards on the table, for a very simple reason; that is, China manifests the classic Asian economy syndrome.  It may be the classic boom-bust syndrome of rapidly developing economies that Jeff Frankel alluded to; that is, the economy grows very rapidly, there's tremendous additions to capacity, those additions are very poorly allocated because there's a primitive banking system.  The banking system becomes technically insolvent and so is not longer an effective instrument of monetary policy.

Heavy reliance on rapid growth of investment and capacity to absorb rapid movement of labor into the industrial sector exacerbates the problem, but there is another key element here to describe.  And that is there's a huge amount of saving that is generated by such a rapidly growing economy, and the tendency for countries in this category is to keep the savings at home.  They don't let it go out.

And so the pressure to invest at home is tremendous, and there's a very strong tendency to develop excess capacity, especially in the traded goods sector because that's a way to link up rapid increases in capacity with rapidly growing demand in the rest of the world.  And, of course, over the past year or five years, the primary locus of that rapid growth in demand has been in the United States.  Hence, the exchange rate between the yuan and the dollar is important, and there is a tendency to want to keep that steady in order to try to absorb what otherwise would be a rapid increase in excess capacity in the traded goods sector.

Now, if you think about it, this problem leads to a highly unstable environment.  And I think we're seeing that in China for the last year and a half.  Because when you--

[Tape change: T1-B to T2-A.]

--sector, i.e., an inflation problem, and then, as you try to rein that in, you raise some difficult problems that put more pressure on the excess capacity in the traded sector.  That is, China did implement some administrative controls on demand growth earlier this year--they're not subtle.  And the policy instruments to implement these measures aren't well developed because the banking system isn't well developed, and so you have a rapid slowdown in the domestic economy, and the non-traded sector is especially vulnerable because of the rapid growth of investment, say in residential real estate, which is a very volatile sector if you cut off credit.

So you try to slow the economy down.  The instruments work very well on the domestic sector but not on the traded goods sector, and eventually the pressure from the domestic sector is such that you have to let off on the tightening approach because you get into some crisis situations in the real estate area, especially.

I think we're kind of in that period right now, where the misallocation of investment in China has led to some very difficult policy problems for policymakers.  They can't clamp down too hard on aggregate demand growth, again because of the imbalance between the traded and non-traded sectors.  And I think part of China's reluctance to allow the currency to adjust is related to the heavy reliance that they have to place on the ability to have demand, global demand, play into their traded goods sector.  If the Chinese currency were to appreciate rapidly, not only would there be pressure for the domestic non-traded sector to slow down, but you'd have negative pressure on the traded goods sector, and you could get a very rapid slowdown in the overall economy.

So I think these are some serious problems and constraints facing the Chinese authorities as they face this--or try to manage this very rapidly growing economy, this very dynamic economy.

You know, the banking system with its large stock of non-performing loans is, of course, testimony to the inability of the economy over the past decade effectively to allocate resources among investments.  The bad investments are simply absorbed by the banking system, and now the banking system is insolvent.  And this is a serious problem--not in and of itself; the government can bail out the banking system--but you can't put a modern, workable banking system in China beside an insolvent state banking system.  Why?  Because everybody would take their money out of the state banking system and want to put it into the viable new banks.  It's sort of like the U.S. airline industry, where, you know, Jet Blue is going to crush Delta because they don't have the same cost structure.  You can't leave them next to each other.

So how do you deal with this?  My own suggestion would be, perhaps, twofold.  One, I think the Chinese ought to give some serious consideration to dismantling the controls on capital outflows.  When I was in China, I was struck that, you know, with this as a rapidly developing economy, one of the most difficult problems is to store and allocate wealth in a way that generates an attractive rate of return.  And one of the problems is the money can't go out.  It has to stay inside of China.  And so you see acres and acres of empty apartment buildings that were built because people can't get the money outside of the country, and you see excess capacity in a number of areas, probably including steel, automobiles, and other industries where, again, the pressure goes back onto that traded goods sector to keep the currency from appreciating.

And then the international economy, of course, gets more and more unhappy because the excess capacity in the traded goods sector puts downward pressure on prices in that area, especially within Asia.  So because China is sitting on its currency, because it has excess capacity in its traded goods sector, Japan is very unhappy because the Chinese currency is depreciating relative to their currency.  They have an excess capacity problem.  And so it's the Japanese who come in and accommodate very large U.S. current account deficits along with the Chinese.  Again, all of this is part of the problem of, really, having the Asians exporting the saving through the official sector because they won't let the private sector do it.

As far as the currency regime goes, I just think China needs another policy instrument here.  I don't know how much the currency needs to go up or down.  I say "down," because if you were to reduce the controls on capital outflows or to scale them back, the currency might depreciate.  I would think that the Chinese would want to add to their policy instrument kit along the lines that Jeff suggested.  You need two instruments to achieve two goals.  My own thought, for what it's worth, is that a good model might be the currency basket system that Singapore has employed, partly because it gives you quite a lot of flexibility and it's harder for speculators to take advantage of that type of system because you don't have to announce targets and you can move the weights around and you have some kind of a degree of freedom there.  But I think it's probably time for China to move in that direction, where they essentially appropriate for themselves another policy instrument, and I think the currency basket would be the right way to go.

Failing that--and I'm not sure, I'm kind of doubtful that they will move in that direction because, again, of this excess capacity problem which results from, I think, probably over-investment, but more seriously, this misallocation of investment between the traded and non-traded goods sector.  To say that there's excess capacity in the global traded goods sector I think is probably something that goes through pretty easily, especially if you are producing something like automobiles or steel.  So that creates a lot of the tensions on the trade front that people have referred to here.

So until--when people ask me how do you talk about China to an audience far less sophisticated than this one, I say, well, it's like taking a car with a very powerful engine and not good steering and bad brakes and putting them out on a Formula One course.  All the other drivers don't want to get too close to that vehicle, but it's got a lot of ability to affect the outcome of the race.

So China needs more instruments.  A currency basket would be a step in the right direction.  And failing that, I think we'll see some severe pressures related to the imbalance between its traded and non-traded goods sector that could lead to a hard landing.

[Applause.]

MR. LACHMAN:  Thank you very much, John.

Now, the last speaker is far from the least.  She is Li Shantong, who is visiting us here at the AEI from China.  Shantong is a senior official in the Development Research Center of the State Council, which provides advice for the Chinese government.  She's going to be talking about China's longer-run growth prospects.

MS. LI:  Thank you, Desmond.  It's my honor to be here to share our recent research results with all of you.

China--I remember they already hear about that--China kept a very high growth rate since 1978, it's open to the outside under reform, and also we have a very high investment rate.  At the same time, the economic structure changed very rapidly.  The share of agriculture in GDP has declined and secondary [?] industry is more than half a percent of GDP.  And the service sector has shared the increase, but is still very weak compared with other developing countries.  But I think there is maybe an underestimation of the service sector in GDP because of some statistical issues.  I think maybe--someone estimated, after the economic census for industry and service at the end of last year, the service sector share should be increased a little bit, like 14 [?] percent.  But even that is still very low.

The other feature of the structure change is employment structure.  The share of the labor force in agriculture has declined almost 20 percentage points since 1980.  But there is still 15 percent of the labor force in the agricultural sector.

So we think the very high growth rate is mainly because of the input of capital.  I think from the bottom of the table you can find that more than two-thirds of the contribution is from capital input.  And the TFP also contributed almost 28 percent.  So we think the high investment rate is one important reason for the growth rate, and also the large inflow of foreign capital is very important.

But I think the improvement of productivity is also very important.  The TFP growth was from technology progress, from institutional improvements open to all sides, and reform--and also the improvement of the quality of the labor force through education.  But I think what's very important is the reallocation of labor among the industry sectors from the agriculture sector.  Usually in the agriculture sector, the productivity is very low.  So maybe from a low-productivity sector to a high-productivity sector is a very important contribution to the high growth rate.

But I think we will be facing a lot of challenges now and in the future.  For example, one constraint is natural resources and environmental issues.  For the non-tradable resources, like arable land and water resources, we can see from this table our per capita of fresh water is only one-fourth of the world average, and the arable land is less than half of world average.  Even for tradable resources, I think the per capita is also very low.  From the second-column ratio to the world average, we can see the problem.  Like oil is only 11 percent of the national average.  Even coal is 79 [?] percent of the world average.

The other very serious challenge is the aging problem.  From this table we can see.  Because China's retirement age is 60, we use the people age 60 and above.  We can see that now China has entered the aging society; aging people share the increase very rapidly.  The other [column] is age 15 to 60.  That age people, after 2010 their growth rate is a very big slowdown.

So both the aging problem and the labor force problem also have a lot of influence on the future economic growth.

We also have a lot of pressure on employment.  Every year we have 10 million new labor force, and also we have a lot of labor force transformation from agriculture to non-agriculture.  The industry and service sectors have to provide more job opportunities for this labor force.

And from oth