Understanding China’s Economy

Ahead of President Hu Jintao’s visit to Washington next week, there are calls in the United States for China to increase the value of its currency, lower barriers to American exports and investments, protect intellectual property rights, and rebalance its economy away from a heavy reliance on exports toward more domestic consumption.

Yukon Huang analyzes China’s economic rise and its impact on the United States and the global economy, and says the trip offers a much-needed opportunity to look for new ways to reduce currency, trade, and broader economic tensions. Huang argues that a major adjustment of China’s currency by itself won’t solve U.S. economic woes, but other approaches—including internationalizing the renminbi—would benefit both sides. 

• What economic issues are on the agenda for President Hu’s visit?
   
• How strong is China’s economy? Will the Chinese economy surpass America’s?
   
• How quickly has China’s currency been appreciating? Is the renminbi undervalued?
   
• Are there trade tensions between the United States and China?
   
• Will China’s economic growth be constrained by inflation and asset bubbles?
   
• Has China been able to rebalance its economy and increase domestic consumption?
   
• Are there any new emerging economic challenges in China?
   
• Will China’s currency start to become an international reserve currency? Is this something that the United States should worry about?
   
• What is China’s policy on the export of rare earth metals? Is this politically motivated?
   
• How can the United States and China work to reduce economic tensions?

What economic issues are on the agenda for President Hu’s visit?

Four topics—trade and currency, technology transfer, the environment, and global governance—will top the agenda during President Hu’s economic discussions with President Obama. Despite a great deal of media attention on China’s exchange rate, both sides will probably agree not to get stuck on the issue, simply because previous talks have been so combative and unproductive.

When trade matters are raised, however, China’s currency will undoubtedly come up—especially with political sensitivities in the United States. But pushing for appreciation has essentially led nowhere. Nevertheless, Beijing is sensitive to international criticism, so it often makes the biggest currency moves ahead of high-profile international events, like Hu’s Washington trip.

To be productive, the discussion needs to move beyond the currency issue and recognize the broader range of policy measures that impact trade outcomes. These include structural factors that influence consumption, investment, government budgets, and the incentives to either encourage or discourage imports and exports. Both sides recognize that trade is not a bilateral issue, but multilateral. The solution to U.S.-China trade imbalances ultimately requires a multilateral approach that involves most of the other East Asian countries that are part of a regional supply chain.

The discussions will also concentrate on the transfer of technology. The reason that technology transfer is so high on the U.S. agenda is because American companies are expressing concerns that they are required to pass on high technology production processes to enter the Chinese market. Understandably, they are reluctant to operate under these restrictions and worry about violations of their intellectual property rights.

China, on the other hand, wants to move away from labor-intensive production and sees the acquisition of high technology from foreign companies as critical to helping the country move up the value chain to become a high-income country. The issue clearly cuts across many economic activities and is becoming increasingly contentious.

The third issue will be the environment—China and the United States are the world’s largest polluters. Over the past year, China moved aggressively to reduce energy intensity and poured a great deal of money into energy-saving technologies. It’s gearing up the production of solar, wind, and other renewable sources of energy—which are high on Beijing’s list of strategic industries.

The United States was startled by the extent that China poured money into these industries and will add to existing complaints that Beijing is subsidizing production costs in ways that go against guidelines set forth by the World Trade Organization. China, on the other hand, believes that renewable energies are not yet commercially viable and therefore the development of new technologies needs help—this is all for the global good.

Finally, the global governance of financial matters and China’s role in international institutions, including the World Bank and International Monetary Fund, and the Group of 20 economic powers is critical. It’s an open question whether economic and financial matters will gradually be handled by the so-called G2 or G20.

The United States wants to know if China will become a responsible global player. China has been reluctant to take a leadership role on international issues, but global realities and the strength of its economy are pushing Beijing into this position.
 

How strong is China’s economy? Will the Chinese economy surpass America’s?

There are two sides of the debate on China’s economy—some believe that an asset bubble will inevitably lead to an economic collapse while others feel that the economy is exceptionally strong and will continue to grow rapidly. The fact that China is trying to moderate domestic demand given concerns about rising inflation suggests that worries about rising prices are more about the sustainability of the process than whether growth will rise or fall in the future.

China’s economy remains basically sound and competitive. But achieving a “soft landing” to growth rates of around 7-8 percent is in China’s interest. It will also be good for the global economy if a more sustainable rate can be established.

China’s economy continues to be extraordinarily competitive because labor productivity is still high compared to other countries, stemming from a decade of high investment rates. Moreover, Beijing’s foreign currency reserves—now over $2.8 trillion—give the country considerable flexibility. Even though its fiscal situation is tight with revenues not increasing as fast as they should be, China still has the resources to expand public expenditures as needed to keep the economy going.  

This flexibility, however, won’t last forever—likely only for another decade. China is going to run out of surplus labor and the returns to investment will eventually decline. When this happens, policy makers will need to adopt a new growth model that relies more on productivity increases based on innovation and technology. During the next ten years China needs to retool to a different growth strategy.

Today, U.S. per capita GDP is still ten times China’s, but when you look at economic comparisons in terms of purchasing power parity the gap is much smaller. China is gaining ground rapidly and will likely surpass America in the aggregate in the next twenty to thirty years, but of course this depends on how fast China continues to grow and whether the United States can retool itself fast enough. A lot can happen during this period.
 

How quickly has China’s currency been appreciating? Is the renminbi undervalued?

The last time China allowed its currency to move was between 2005 and 2008. After that, China basically fixed the renminbi to the U.S. dollar. This changed last summer when it allowed greater flexibility, a move encouraged by the collapse of the euro, which made the renminbi much stronger.

The West has been concerned about its large trade imbalances amid a global financial crisis. Many believe that this will make it difficult to pump up growth enough to bring down intolerably high unemployment rates. With this mindset, there has been a great deal of Western pressure on China to revalue its exchange rate and reduce its trade surplus to make it easier for the West to rebound. 

In reality, the renminbi has only appreciated by around 3 percent since June 2010. And the biggest moves happened shortly before major global events that turned attention toward China’s policies—appreciations are unquestionably politically driven. Aside from when Beijing decides to move the exchange rate upward in light of international political considerations, the renminbi has actually depreciated on balance.

The renminbi is unlikely to appreciate by more than 5 or 6 percent this year. But currency shifts have little significant production impact in the short term. In fact, a major appreciation of the renminbi could have a negative effect on the U.S. trade balance because the cost of imports could rise and the production of many goods would simply shift to other emerging economies—not the United States.

U.S. trade deficits with China are actually an imbalance with Asia overall since the bulk of these goods are a collection of components that are ultimately assembled in China but imported from other countries. Most of the high value parts of U.S. imports from China actually come from other Asian countries. The U.S. trade deficit with China is really a trade deficit with Asia. Recognizing this reality, a change in China’s exchange rate won’t solve the trade problem that so many people worry about in Washington—a real change requires a multilateral solution.  
 

Are there trade tensions between the United States and China?

Trade tensions exist because on paper the U.S. trade deficit is seen as a huge bilateral deficit with China—it’s enormous compared to other countries and seems to captivate Washington. But the trade gap really became a problem between 2005 and 2008, when it was driven to record levels by the booming U.S. fiscal deficits and high spending of American households made possible through borrowing. The mirror image of the U.S. deficits was China’s large trade surplus.

Despite hyped trade tensions, China’s trade surplus has declined over the last few years. China’s trade surplus was around 8 percent of GDP five years ago, but it fell to 3 percent in 2010 and may fall even further this coming year. Beijing points to this slow change as evidence that the problem of imbalances is gradually being resolved and argues that good fiscal and monetary policies on both sides—on the U.S. side to reduce deficits and on the Chinese side to encourage more imports—will help make this possible.

Still, trade tensions aren’t likely to go away. The U.S. political situation remains highly focused on China and the rising power is easy to blame for America’s economic woes. Most experts, however, realize that America’s problems require an American solution, including retooling its economy and changing the nature of its investment patterns.

There will be an increasing focus on technology. The United States argues that China remains unwilling to sufficiently open up its market to high-technology products and the restrictions imposed on American companies operating in China are unfair. Trade frictions can be seen in the Obama administration’s recent decision to file a case with the World Trade Organization on behalf of American steelworkers, alleging that China violated global trade rules by unfairly protecting clean energy technology and production processes. The technology aspect of the trade imbalance will continue to be a contentious issue in the coming years.
 

Will China’s economic growth be constrained by inflation and asset bubbles?

At historically high levels, inflation is a major concern for China’s leaders. China easily tolerates rates of 2-3 percent, but when inflation reaches 6-8 percent—where it is now—and hits a broad range of goods, it gets a lot of attention. 

There is, however, disagreement over how serious inflation really is. Some think that inflation could get out of hand and lead to an economic crisis that will severely cut growth rates—this could ultimately cause an economic collapse. Others feel that while inflation is a concern, it’s not a major risk, as the increase is largely centered on two areas—higher food prices triggered by bad weather and poor harvests, and higher real estate and housing costs—and doesn’t impact the wider range of consumer products and manufactured goods. 

The government is working to tame rising food prices by increasing supplies through more imports and releasing stockpiles. It’s also tightening monetary prices by raising interest rates and placing restrictions on property purchases and development in order to decrease the so-called asset bubble in residential and commercial buildings. If these two measures work, inflation should fall in the coming months.

There is also a third factor at work. If the exchange rate isn’t allowed to appreciate significantly, then the natural consequence is higher-than-normal inflation. And as long as there are large current account surpluses, inflation will continue because it’s the only way for the economy to adjust to trade imbalances. With this in mind, modest inflation will help moderate trade imbalances.

Inflation, however, is politically sensitive in China. If Beijing isn’t able to deal with inflationary pressures through traditional fiscal and monetary mechanisms, it is likely to look for more extreme solutions to tamp down domestic anger and even think more seriously about allowing the renminbi to appreciate. So, inflation will remain a key focus for the government.
 

Has China been able to rebalance its economy and increase domestic consumption?

Many observers believe that China’s unbalanced growth—reflected in its low share of consumption to GDP and high investment rates—is a major reason for global trade imbalances. Beijing is under intense international pressure to reduce its reliance on exports and use stronger consumption to drive future economic growth.

Conceptually, however, a consumption-based growth strategy is not sustainable. This is what got the West in trouble as it relied too much on consumption. Growth is essentially driven by investment, but a country can go overboard if rates get so high that productivity is affected. 

It will also be hard for China to increase consumption any faster. Personal consumption has been going up by 8-9 percent annually for a decade—this is the highest sustained growth rate in the world—and to ask China to boost consumption even more is not credible.  

The problem is investment has been growing even more rapidly than consumption (and GDP). So the real issue is not whether consumption should be increased or decreased, but whether investment levels are excessively high and becoming unproductive. But China is concerned that if it scales back on investments, growth will fall off too quickly.

Chinese investment has been excessive in residential and commercial real estate, and production capacity has expanded more than needed in some cases—and these expenditures need to be curbed. Changes in interest rates can help, but more importantly China should be encouraging investments that improve livelihoods, such as low-cost housing, rapid-rail transport, and improved social services. Investment in social infrastructure offers an attractive option to keep domestic demand high enough so that growth can be sustained at adequate levels to meet China’s current objectives.
 

Are there any new emerging economic challenges in China?

State enterprises are increasingly shaping Chinese policy in ways that might not be helpful to China or the global economy. With virtual monopolies in certain sectors, state enterprises are extraordinarily profitable and don’t pay a great deal of dividends to the government—leaving them with extra funds. The funds are used to increase production capacity and for speculation in commercial and property development that goes beyond the mandate of the corporation. They are also expanding overseas to generate even higher profits.

The major concern is that the government doesn’t quite understand how the profits are used and in some sense may be losing control over a significant portion of its economy. This can hamper China’s ability to reshape its development strategies. It’s an interesting phenomenon and the extent to which it distorts China’s economy is unclear at this stage.
 

Will China’s currency start to become an international reserve currency? Is this something that the United States should worry about?

Only a few years ago, people assumed that it would take decades for China to liberalize its capital account and for the renminbi to become an international currency. It was thought that China would move to a more open financial system and liberalize capital flows only after its financial institutions gained sufficient strength. The global financial crisis changed the game.

China is now worried about the value of the major international reserve currencies—the dollar, euro, and yen—as all have structural weaknesses and therefore the country’s $2.8 trillion in reserves are vulnerable to declines and volatility. China is struggling to preserve the value of its reserves and maintain stability, as the dollar isn’t as reliable as it has been in the past and there are concerns about its long-term strength despite reassurances from Washington.  

So, China is increasingly experimenting with the use of the renminbi as a currency to settle trade balances. There are countries that would like to hold the renminbi in reserve and China has allowed this in a few trial instances, notably Malaysia. And many more countries would jump at the opportunity.

China also realizes that if it allows the renminbi to be more freely used, the movement of capital will need to be liberalized. Chinese households and firms will need the flexibility to move funds overseas more easily and foreigners will be able to bring in resources with fewer restrictions. While Beijing is keen to make the renminbi an international currency, it hasn’t fully accepted the fact that doing so means both changes in its value and movement cannot be controlled as tightly as they have been.

In the long term, however, it’s clear that China now sees that internationalization of the renminbi is in its own interest, as it will give China a greater say in international financial policy and reduce its reliance on the West. There has been a dramatic change in China’s view on this over the past year.

This change should be welcomed by the United States, but Washington may have some reservations. Internationalization of the renminbi could reduce American flexibility to run trade deficits at will and, in the past, negative consequences of monetary and fiscal policies have been shouldered in part by other countries.

The dollar as the world’s dominant reserve currency has been an essential policy for the United States, but Washington should still be keen to encourage the changing role of the renminbi. A smooth and rapid evolution offers a way to get around the concerns about global imbalances, as the renminbi will be forced to become more flexible. Thus both sides have a vested interest in the renminbi becoming an international reserve currency.
 

What is China’s policy on the export of rare earth metals? Is this politically motivated?

The reductions in China’s exports of rare earth metals last year were seemingly tied to politics. Beijing was accused of blocking exports at the same time a standoff with Tokyo was escalating following Japan’s arrest of a Chinese trawler captain in contested waters in the East China Sea. It was seen as political retribution and the curtailment of exports was extended to the West.

China claims otherwise. Beijing made announcements over the past year that the quota of rare earth elements sent abroad would be cut back and therefore less available to the rest of the world. The real problem is that China mines around 95 percent of the world’s rare earth metals, which are integral for products like hybrid cars, batteries, solar panels, wind turbines, and advanced magnets. The metals are increasingly important in high-technology goods in great demand. 

This critical category of minerals is not rare in the sense that they only exist in China, but uncommon because they are not widely produced. The extraction process is difficult and causes significant environmental degradation, including water runoff and radioactive waste. If you look back only a couple of decades, the United States and Australia were producing a large proportion of the metals. But these mines were closed due to tightening environmental standards and the extraction gravitated to China.

China wants to increasingly use its own rare earth minerals as it looks to move to produce higher-end goods. A few years ago China was exporting 75 percent of its metals, but soon the country will be keeping 75 percent for its own local production. China has also clamped down on illegal smuggling of minerals. So as the availability goes down worldwide, the prices are going up in dramatic fashion.

The long-term solution for the United States is obvious. It needs to view rare earth minerals as strategic commodities and support domestic production. A transition will take several years, however, so the problem won’t go away anytime soon and could get worse this year.

How can the United States and China work to reduce economic tensions?

 The economic discussions between Hu and Obama next week will be framed by the political events of the last year. The rocky diplomatic relationship in 2010 had a detrimental impact on the economic front. And the trade imbalance, currency disputes, the sensitive issue of technology transfer, and contention over rare earth metals all escalated economic tensions. The sense in Washington that China is prospering at the expense of the United States is strong and, in the heated American political environment of today, there is a concern that the debates will remain combative and not move toward resolution.

This visit is an opportunity for both sides to step back, lower economic tensions, and find more productive working relationships on several fronts. Beijing and Washington increasingly understand that discussions framed as win-lose situations are unproductive.

Win-win issues build wider trust and will help tackle the tougher matters. For instance, Washington should focus more on increasing China’s imports—something that is clearly in the interest of the Chinese consumer—instead of harping on the need for China to reduce exports. Rather than talking solely about the contentious side of important issues—from trade to technology to corporate governance to the environment—China and the United States should look for ways to foster a productive partnership and find common ground in solutions that benefit both sides.