China’s Rise as a Regional and Global Power

David Dollar

CHINA has been growing extremely rapidly for a long time, but animportant shift in its growth pattern occurred at the time of the globalfinancial crisis.

Duringthe six years up to 2007 China’s GDP grew at an average rate of 11 percent,with investment equaling 41.5 percent of GDP. The current account surplus wasrising in this period, reaching over 10 percent of GDP. In the six years sincethe global crisis, the external surplus has fallen sharply into the range oftwo to three percent of GDP, but the shortfall in demand was made up almostcompletely by an increase in investment, which has reached more than 50 percentof GDP in recent years.

China’sgrowth has been impressive compared to the rest of the world, but lost in theadmiration is the fact that the growth rate has slowed down to around sevenpercent—down more than four percentage points from the pre-crisis period. Thus,in the recent period China has been using a lot more investment in order togrow significantly more slowly than in the past.

DavidDollar is Senior Fellow in the John L.Thornton China Center at the Brookings Institution and the U.S. Treasury’sformer economic and financial emissary to China, having previously served asthe World Bank’s Country Director for China and Mongolia.

Thispattern of growth manifests three problems. First, technological advance, asmeasured by Total Factor Productivity (TFP) growth, has slowed down. Second,and closely related, the marginal product of capital is dropping (it takes moreand more investment to produce less and less growth). The real world indicatorsof this falling capital productivity are empty apartment buildings, unusedairports, and serious excess capacity in important manufactur- ing sectors. Thethird manifestation of China’s growth pattern is that consumption is very low,especially household consumption, which is at only one-third of GDP.

China’sresponse to this changing growth dynamic is partly external and partly internal.On the external side, it is no coincidence that this period of excess capacityat home is the moment at which China launched expensive new initiatives, suchas the Asian Infrastructure Investment Bank (AIIB), the BRICS Bank, and the‘One Belt, One Road’ initiative in order to strengthen infrastructure both onthe westward land route from China through Central Asia and on the southerlymaritime routes from China through Southeast Asia and on to South Asia, Africa,and Europe.

Theseinitiatives are largely welcomed by China’s Asian neighbors and this essay’snext section will examine how they can contribute positively to Asianintegration. However, the thinking in China that these initiatives can be amajor solution to China’s excess capacity problems is largely misguided. Thecontributions that these initiatives together make to China’s demand are likelyto be too small to be macroeconomically meaningful.

The domestic response to China’s over-capacity problem is a set of reforms thatemerged from the Third Party Plenum in November 2013. Together, these form acoherent set of measures that would rein in wasteful investment, increaseinnovation and productivity growth, and enhance consumption. A further sectionof this essay reviews the key reform measures, as well as progress to date withregard to reform. Success in this area will enable China to continue to growwell for another decade or more.

 

Inthe recent period China has been using a lot more investment in order to growsignificantly more slowly than in the past.

China’sinitiatives in Asia are seen in many quarters as a setback for the UnitedStates. The U.S. government contributed to this narrative through its effortsto discourage allies from joining the new AIIB. In the end, major Americanallies, such as the United Kingdom, Australia, and South Korea, did join theChinese initiative, and Japan is seriously considering becoming a member.However, this is likely to be a temporary diplomatic setback for the UnitedStates.

America’sown main economic initiative in the Asia-Pacific—namelythe Trans-Pacific Partnership (TPP) —now seems likely to becompleted by the end of 2015. Many major economies in Asia, such as Australia,Singapore, South Korea, and Vietnam want to be part of both Chinese initiatives(the AIIB and the ‘One Belt, One Road’) and the American effort to reduce tradebarriers.  

Iargue in this essay’s third section that these different efforts are in factcomplementary. The kind of infrastructure financed by the Chinese initiativesis the “hardware” of trade and investment, necessary but not sufficient todeepen integration. TPP, on the other hand, represents the “software“ ofintegration, reducing trade barriers, opening up services for trade andinvestment, and harmonizing various regulatory barriers to trade.

Thereis a risk that the competing initiatives of China and the United States willlead to regional blocs and a disintegration of trade, but it is more likelythat Sino-American competition will lead to strengthened institutions and deeperintegration throughout Asia-Pacific.

There is a riskthat the competing initiatives of China and the United States will lead toregional blocs and a disintegration of trade, but it is more likely thatSino-American competition will lead to strengthened institutions and deeperintegration throughout Asia-Pacific.

 

TheBank, the Belt, and the Road

Someof the impetus for China to launch the new Asian Infrastructure Investment Bankwas Beijing’s concern that the governance structure of existing InternationalFinancial Institutions (IFIs) was evolving too slowly. An important agreementto increase the resources of the IMF, and to raise the voting shares offast-growing emerging markets, has been stalled in the U.S. Congress, whereasall other nations have already ratified it. There is a certain irony that oneof China’s frustrations with the Americandominated institutions is that Chinathinks that they need more resources and is willing to contribute, whereas thedifferent parts of the United States government cannot agree to this expansion.

China’sfrustration is not just about the size of the IFIs and China’s weight withinthem. In the case of the World Bank, China has argued for years for more focuson infrastructure and growth. Several years ago, former Mexican PresidentErnesto Zedillo chaired what was called a High-Level Commission onModernization of World Bank Group Governance.

Itis worth looking at its key recommendations, because this was a serious effortby a distinguished international committee that included good representationfrom major developing countries (e.g., Zhou Xiaochuan from China, Arminio Fragafrom Brazil, Montek Ahluwalia from India, and Ernesto Zedillo from Mexico). TheZedillo Report is quite critical of the current World Bank arrangement of aresident board that approves all loans. The resident board represents both alarge financial cost to the bank ($70 million per year) and an extra layer ofmanagement that slows down project preparation and makes the bank lessefficient. Slowness of project preparation is one of the main criticisms ofclients concerning the poor performance of the Multilateral Development Banks(MDBs).

TheChinese officials charged with developing the AIIB are looking at the ZedilloReport for good ideas. The AIIB will have a non-resident board that meetsperiodically both in Beijing and via videoconference. Given its newness, alikely compromise among the countries that have signed up is that its boardwill approve many of the initial projects and eventually delegate moredecisionmaking to management. The Zedillo Report recognizes the importance ofenvironmental and social safeguards, but argues that the World Bank has becomeso risk-averse that the implementation of these policies imposes an unnecessaryburden on borrowing countries. In practice, developing countries have movedaway from using the existing MDBs to finance infrastructure, because theinstitutions are so slow and bureaucratic.

Ithink that the enthusiastic response of developing countries in Asia to theAIIB concept reflects their sympathy with the idea that a new MDB can have goodsafeguards and still be quicker and more efficient than existing ones.

Someof the Western commentary on the AIIB expresses a fear that China will use itfor narrow political or economic ends. Now that a diverse group of nearly 60countries have signed up, it would be difficult for China to use the AIIB tofinance projects in favored countries over the exclusion of other members.

Andthe idea that this would help with China’s over-capacity problems does not makeany sense at all. If the AIIB is very successful, then in five years it mightlend $20 billion per year—that is to say, on a scale with the World Bank’s IBRDlending. But just in steel alone, China would need $60 billion per year ofextra demand to absorb excess capacity. This figure excludes excess capacity incement, construction, and heavy machinery; the point is that the bank is,simply put, much too small to make any dent in China’s excess capacity problem—even if it were the sole supplier for these projects, which it won’t be.

The‘One Belt, One Road’ initiative is larger than the AIIB. It started with theidea that nearby countries in Central Asia—spread along the traditional SilkRoad—could benefit from more transport infrastructure, some of which Chinacould finance bilaterally. However, the economies of Central Asia are not that large,and the potential for investment is limited. Overland transportation willremain expensive, compared to sea-going shipments. For that reason, China addedthe idea of a maritime road—that is, the expansion of infrastructure along theseagoing routes from the Chinese coast through Southeast Asia to the IndianOcean and all the way to Europe. A vast amount of world trade already traversesthis route.

Because‘One Belt, One Road’ will be implemented bilaterally between China anddifferent partners, it may seem that there is more potential for China to usethis initiative to vent some of its surplus. But I still doubt that this willbe on a scale that would make a macroeconomic difference for China.

I think that theenthusiastic response of developing countries in Asia to the AIIB conceptreflects their sympathy with the idea that a new MDB can have good safeguardsand still be quicker and more efficient than existing ones.

Amongthe various developing countries along ‘One Belt, One Road’ routes, there aresome with relatively strong governance— India, Indonesia, and Vietnam, forexample— which will be hard for China to push around. Those countries will notwant to accept large numbers of Chinese workers or take on large amounts ofdebt relative to their GDP. On the other hand, there are weak governancecountries—Cambodia and Pakistan, for instance. It may be more feasible forChina to send some of its surplus production to these countries, but there is areasonable prospect that in the long run, China will not be paid.

TheWest has a long history of debt forgiveness to weakly governed states. It wouldbe smart for China to learn from that history.

 

China’sReform Agenda

Domesticreform is a much more promising road to deal with China’s surplus problem, andto rebalance its economy away from such a heavy reliance on investment. Theresolution that came out of the Third Plenum in November 2013 sketched outdozens, if not hundreds, of reforms. The ones that are likely to have thegreatest effect on rebalancing China’s economy fall into four areas: (1) thehousehold registration system (hukou); (2) inter-governmental fiscal reform: (3) financialliberalization; and (4) opening up China’s service sectors to competition.

UnderChina’s hukou system, 62 percent of thepopulation are registered as rural residents and to date it has been extremelydifficult for them to formally change this designation. The result of thissystem has naturally been a lower rural-urban migration than would otherwise bethe case.

Chinahas one of the highest urbanrural income divides in the world, at more than3:1. Many peasant families would like to move to cities if it were permitted.Despite the restrictions, a lot of the young rural population has come tocities as migrant workers. Even counting the migrants, however, China’surbanization rate of 52 percent is low given its level of development. One keyaspect of the current system is that while migrants can come as workers, theycannot bring families or truly become citizens of the cities.

Reformingthe hukou system would affectrebalancing in several ways. Quite a bit of measured productivity growth at theaggregate level comes from the reallocation of labor from low productivity tohigher productivity activities (often from farming to urban manufacturing andservice employment). Easing up on restrictions on mobility should lead tohigher productivity growth, higher incomes for those now registered as rural,and greater government expenditure on services. In his work report to the NationalPeople’s Congress on March 5th,2015, Premier Li Keqiang set a target of “granting urban residency to around100 million rural people who have moved to cities.”

Oneof the reasons that local governments have resisted hukoureform is that they worry they will lack sufficient fiscalresources to fund the greater social services for migrant families. Chinaoverall has ample fiscal resources, but there is a mismatch in which thecentral government collects most of the revenue, while local governments bearmost of the expenditure responsibilities.

China'sMinistry of Finance has announced general plans for fiscal reform to supportrebalancing. First are measures to bolster local government revenue: this couldinclude a nationwide property tax, which could become a stable source offinance for local governments, and also discourage the hoarding of apartmentsthat is one aspect of excess investment in China.

Second,China is planning to collect more dividends from its state enterprises. If thishappens at both the local and the central level, it would reduce some of thebias towards investment and help ensure resources for government services.

Athird aspect of fiscal reform would be allowing municipalities to issue bondsto fund their infrastructure projects, rather than relying on shorter term bankloans.

Thefinal aspect of fiscal reform may be the hardest: local officials are generallyrewarded on their ability to provide investment and growth. While the systemhas been successful at that, it has been less successful at meeting otherobjectives, such as clean air, food safety, and quality education and healthservices. Changing the incentives of local officials to align with rebalancingis a key institutional reform.

Changing theincentives of local officials to align with rebalancing is a key institutionalreform.

China’srepressed financial system is a third area of reform. Real interest rates thatare close to zero amount to both a tax on household savers and a subsidy toinvestment by firms and local governments able to borrow from the bankingsystem. Almost everywhere in the world has had zero real interest rates inrecent years, but China is unusual in that such rates go back more than adecade. The government has taken some initial steps to raise deposit andlending rates, as well as to allow a shadow banking system to develop withbetter returns to savers and higher-rate loans to riskier clients.

Theproblem with the current arrangement is that most shadowbanking wealth productsare marketed by commercial banks and treated as low-risk by households. Totalshadow banking lending has grown at an explosive rate in recent years and, notsurprisingly, some of the funded investments are starting to go bad. The firstcorporate bond default occurred earlier this year, and that result should helpease the moral hazard that has built up in the system. The announcement of theformal introduction of deposit insurance this year is another important step inthe separation of a cautious commercial banking sector from a risky shadowbanking sector. Central Bank Governor Zhou Xiaochuan recently announced thatinterest rate liberalization would be completed within one to two years. Recentmoves to liberalize the bond and stock markets, so that private firms can moreeasily go to the capital markets, are also in the right direction, as are movesto increase the flexibility of the exchange rate.

TheIMF assesses that China’s exchange rate has gone from “substantialundervaluation” to “fairly valued” in recent years, so it should not be toodifficult for the authorities to reduce their intervention and allow a moremarket-determined rate. Finally, opening up the capital account should be thelast step in this process of reform.

Afinal area of reform is to open up China’s service sectors to competition fromprivate firms and the international market. The modern service sectors are thedomain in which state-owned enterprises continue to be dominant: financialservices, telecom, media, and logistics—to name a few.

Therebalancing from investment towards consumption means that, on the productionside, industry will grow less rapidly than in the past, while the servicesectors expand. China will need more productivity growth in the servicesectors, which is hard to achieve in a protected environment.

Successfulrebalancing will create both challenges and opportunities for other developingcountries. Compared to a business-as-usual scenario, rebalancing is likely tolead to more growth slowdown in the immediate future, as wasteful investment isreined in. Over time, the rebalancing scenario is likely to lead to a modestlyfaster growth rate for China, because it will alleviate the diminishing returnsthat are the problem with the old growth model. Most importantly, thecomposition of China’s growth will be different under rebalancing-with lessinvestment, more productivity growth, and more consumption.

Forother developing countries, China’s rebalancing means that its appetite forminerals and energy will diminish. China’s investment has been an importantdriver of high metals prices for the last decade. Each surge in Chineseinvestment has driven metals prices higher, with a short lag.

Reining-ininvestment in China is already leading to softer commodity prices. The WorldEconomic Outlook base case assumes moderate rebalancing in China and projectsmoderate declines (three to four percentper annum) in energy and materialsprices. While it is notoriously difficult to predict commodity prices, moreaggressive rebalancing in China is likely to have sharper price effects. Thefact that U.S. dollar interest rates are going up (QE tapering) at the sametime that commodity prices are moderating—owing to China’s slowing— will createproblems for developing countries that are commodity exporters, especially onesthat have borrowed imprudently.

Compared to OECDcountries, Chinese outward investment is more targeted towards developingcountries.

WhileChina’s appetite for commodities is likely to moderate, rebalancing should leadto a rise in its demand for manufactures and services from other developing countries.In recent years, China’s wages have been rising at faster than 10 percent perannum—far higher than elsewhere in Asia, where low single digits have been thenorm. Add in the real effective appreciation of China’s exchange rate, and theresult is China becoming a high-wage producer among Asian developing countries.

Hence,it is losing its comparative advantage in labor-intensive activities such asgarments, footwear, and electronic assembly. There is now an opportunity forlower-wage developing countries to step in and take some market share fromChina, either by exporting directly to final markets in the United States andEurope, or by exporting to China as part of a supply chain.

SinceChina still has a large surplus and is moving up the value chain, thisrelinquishing of market share in labor-intensive activities is a healthydevelopment—one that mirrors what occurred earlier in economies like SouthKorea’s and Taiwan’s. This transformation is already taking place; it should bea powerful incentive for nearby developing countries to improve theirinvestment climates and maintain sound macroeconomic policies, so that theygain maximum benefit.

Onthe services side, Asian developing countries are dramatically increasing theirexport of tourist services to China. Last year 100 million Chinese touriststraveled abroad.

In asuccessful rebalancing scenario, China’s external surplus is not likely to growas a share of its GDP, but it is still projected to remain around three percentof a rapidly growing GDP. At the moment, the counterpart to China’s currentaccount surplus is primarily hot money outflow. But one could easily imagine ascenario several years down the road in which China has a current accountsurplus whose counterpart is net outflow of FDI.

Chinais rapidly emerging as a major source of FDI. Initially much of its investmentwas in the energy and mineral sectors, where it is a large importer. But therecent trend is for Chinese outward investment to expand in differentdirections—both sectorally and geographically. Some of the connection toChinese supply chains will certainly come via outward investment by Chinesemanufacturers. Compared to OECD countries, Chinese outward investment is moretargeted towards developing countries. China’s rebalancing creates challengesfor other developing countries, but also major opportunities. A world withoutChinese rebalancing, on the other hand, is likely to be more volatile. In theshort run, commodity prices would likely stay high as China’s investmentcontinues apace. But most commentators think it is unsustainable to invest 50percent of GDP: the diminished returns already evident become more and moreacute. The commercial part of China’s investment has already declined inresponse to poor returns. Government-backed investment faces the problem thatthe government’s overall debt-to-GDP ratio— though not yet alarming—has beenrising rapidly.

Thedownside scenario is that investment drops sharply in China and the growth ratealso slows sharply. Commodity prices would fall more steeply than in arebalancing scenario.

Thisis also a scenario in which a market-driven Chinese exchange rate mightdepreciate: if investment drops sharply without a commensurate rise inconsumption, then the tendency would be for the exchange rate to depreciate andthe trade surplus to widen. China would then hang on to its labor-intensivemanufacturing exports, rather than opening this space up for other countries.China’s successful rebalancing presents a much more attractive scenario for thedeveloping world.

 

Competition& Cooperation

China’s recent economic initiatives appear to be a diplomaticvictory for Beijing and a diplomatic setback for Washington. Certainly, theUnited States handled badly the emergence of the AIIB. The United States made amild effort to dissuade some allies from joining, and was then caughtflatfooted when European and Asian allies chose to join.  

TheUnited States should be pleased that China is shouldering some globalresponsibility. With nearly 60 countries joining the AIIB, it is likely to havegovernance and standards similar to existing MDBs, and may well be able toimprove on their efficiency through competition. Rather than a challenge to theAmerican-led system, the AIIB is likely to be a useful complement to theexisting system.

Moregenerally, the AIIB episode reveals clearly that Asian and European countriesdo not want to choose between China and the United States, and nor is there anyreason why they should have to. The United States made a mistake in itshandling of the AIIB, but we should not exaggerate the importance of thisincident.

Americanow looks well-positioned to complete TPP negotiations. The AIIB will befunding infrastructure that can be thought of as the “hardware” of integration.Equally—if not more—important is the “software,” that is, the rules andregulations that govern international trade and investment. TPP aims to expandtrade into new areas, such as services, whilst laying the foundation fortwenty-firstcentury trade.

Noticethat countries such as Australia, New Zealand, Singapore, South Korea,Malaysia, and Vietnam do not hesitate to participate in both Chinese andAmerican initiatives. This is clearly the smart strategy. For Vietnam, forinstance, a turn to the AIIB should improve infrastructure, whereas using theTPP framework ought to enable Hanoi to integrate with the vast and innovativeU.S. economy.

Thereis a risk that these competing initiatives will result in the development oftrade blocs, but I think it is more likely that the end result will becooperation. China would benefit enormously from joining the TPP, because it isstill extremely closed in many sectors. The United States would benefit fromjoining the AIIB because it is an important new institution in the fastestgrowing region of the world economy.