Wednesday 1 April 2009

Actions Speak Louder Than Words

To gain a bigger voice in the global economy, China must build ups its domestic economy.

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Guanyu said...

Actions Speak Louder Than Words

To gain a bigger voice in the global economy, China must build ups its domestic economy.

Shen Minggao, Caijing
1 April 2009

China now marshals hefty economic clout. According to the International Monetary Fund, China replaced Germany as the third largest economy in 2008, if calculated with nominal exchange rates, and is very likely to surpass Japan to take the number-two spot next year. The IMF also forecasts that China’s incremental GDP between 2009 and 2013 – perhaps a better measure for the significance of an economy within a given period of time – will equal that of the U.S.

Yet it is still too early to claim China has a decisive influence on international policy. A bigger voice does not guarantee compliance. The key question to ask is, What can China do to encourage other countries to comply with its economic wishes, and what can it do about those countries that don’t?

While condemning the U.S. government for increasing the risk of global inflation by “printing money,” China is meanwhile stockpiling U.S. Treasury bonds, which reduces its critical voice to an ineffectual grumble. As long as China’s foreign exchange reserves continue to grow, it has few if any alternatives to the ‘safe haven’ of U.S. Treasuries, thus binding it to the risks of dollar depreciation and inflation.

China also lacks the solid footing needed to denounce trade protectionism, as it is still counting on exports to maintain rapid growth. Unless China can safely rely on its domestic demand, other countries may use trade barriers as a bargaining chip, aware that in the off chance of retaliation, it would hurt China worse.

The dangers of protectionism come not only from industrial countries but also emerging markets. China’s growth was benefitting emerging economies until last year, when trade deficits emerged between China and most of the emerging economies in Asia, Africa and Latin America. As China’s trade surpluses with advanced economies shrink, it has been exporting more to these developing countries. But the dividend these countries reap from China’s growth is diminishing, and China seems more like a rival rather than a partner.

Moreover, the common prescription for the crisis, enhanced financial regulation, would also require further opening of markets to compensate for the rising costs. Under these circumstances, China will be pushed harder to widen access to its markets.

With pressure coming from all sides, how can China attain a bigger say in the global economy? The key lies in a sincere turnaround, moving the nation from an export-oriented economy to one driven by domestic demand. Although one cannot expect the transition to be completed overnight, the beginning of such a process would be enough to affect how other countries view China. And for this transition to get underway there might not be any better time than right now during this crisis.

China’s change is crucial. First off, the financial crisis again proved that the imbalance of savings and trade is unstable. Although it would be unfair to attribute the entire crisis to China, it must change its growth model in order to eliminate the disparities.

The market environment that governments, companies and consumers got accustomed to is gone, probably forever, and the only way to survive is to adapt to the new system. Market players will have to go through a painful course with contracting fiscal revenues, business failures and rising unemployment. But if China is able to manage this leap, it would enjoy better quality growth that would be more sustainable.

China could broadcast a credible commitment to the global economy by starting the necessary transformation, a move consistent with its ultimate interests. China must reduce savings and boost consumption. The magnitude of such measures will determine China’s ability to smooth out its growth and to recover ahead of other economies.

A credible commitment could lend credence to China’s demands and wishes. Should China’s growth rely primarily on domestic demand, especially consumption, few obstacles would remain for reforming the exchange rate mechanism and the pricing of inputs such as interest rates and commodities. Further appreciation of the yuan would be very likely, which could help enhance China’s purchasing power. In this scenario, the yuan would naturally become a candidate for an international reserve currency.

What’s more, if domestic demand could gradually replace external demand, China would be better prepared to accept a narrowing trade surplus. The current 2 trillion dollar reserve might have already hit a ceiling. If China’s foreign coffers shrink, ot would have more options than just holding the U.S. Treasuries – this would really constrain the U.S. government’s inflationary policies. The resulting increase in financing costs, although not desirable in the short term, would accelerate deleveraging in the direction of a more balanced global economy.

China could also increase its power to object to protectionism if its imports were more comparable to its exports. By developing more independence, China’s rise would provide more opportunities for other economies instead of posing threats. Combining the advantages of low labour costs, the scale of its economy and a vast consumer market, China would be able to secure a central position in global manufacturing for a long time to come.

But a growth model driven by domestic demand cannot be achieved without opening domestic markets, in particular the service market. Also essential is financial innovation to support multi-layer capital markets, among them a fixed-income product market for yuan-holders to invest in. With this, the yuan could internationalize. By adopting sound regulatory rules learned from the current crisis, China should aim at a highly efficient international financial center to compliment its significance in manufacturing.