The Chinese economy, the Renminbi, and Japan-China relations
Toyoo GYOHTEN (President, Institute for International Monetary Affairs)
I. Future of the Chinese economy
The Chinese economy is still booming. The development and the transformation of the Chinese economy during the last decade are truly phenomenal. Humankind has seldom seen the likes of it. In my view, the strength of the Chinese economy can be traced to the following four factors.
First, China has 1.3 billion people in a unified nation state under effective control by the Communist government. There is a broad-based aspiration toward development and ascendancy as a nation. Second, China is ruled by a kind of dexterous developmental dictatorship. The leadership has succeeded in maintaining central control by the Communist party while unleashing dynamic private entrepreneurship. It has contained social discontent to the minimum by providing steady improvement of the living standard and a gradual enlargement of social and political freedom. Third, China is a huge centre of production and consumption. It has a highly qualified labor force and the population has a very strong aspiration for material affluence; and fourth, China is enjoying massive influx of foreign capital, technology, and managerial skill. These factors are not isolated. They have reinforced each other and have generated massive upward momentum.
Of course, the Chinese economy has many weaknesses, none of them insignificant. I will cite four. First, the legacy of the centrally-planned economy is still haunting. The development of the Chinese economy has long been supported by the strong collaboration of state-owned enterprises and state-owned banks. Over time, this collaboration produced inefficient and unproductive management of many bloated state-owned enterprises and deteriorated the balance sheets of state-owned banks. The Chinese leadership, when Zhou Ronji was the Prime Minister, launched an ambitious reform plan.
Progress so far, however, is still far from complete. State-owned enterprises still produce half of the GDP and many of them are losing money. The difficulty of streamlining state-owned enterprises is daunting, because they are providing employment and welfare to tens of million people and playing a pivotal role in many local economies. Four state-owned banks still hold 80% of total bank asset in the country. The ratio of non-performing loans is close to 20% by official accounts, which many experts consider underestimated. The government has already injected about $100 billion to bolster their capital base, but the job has not been completed. The second weakness is in the widening gap between rich and poor in the country. The gap is growing within cities and between cities and rural areas. It is true that the bottom level is rising. However, rapidly increasing inequality in the society does indicate a certain distortion in the system.
It is interesting to recall that in the early days of capitalism in Western Europe there was serious soul searching, trying to establish compatibility between profit-making and ethical conscience. In today's China communism has lost its role as an ideology pursuing egality. A religious sense of social ethic is not familiar to many Chinese people. Rampant corruption and unbridled greed do highlight the weak spot in Chinese society. The third weakness is constraints on high growth. The rapid expansion of the economy is consuming enormous amounts of energy, material and water, the supply of which is limited. China is already the second largest importer of crude oil. Yet, 70% of energy generation still depends on coal, which is the major source of environmental deterioration. The fourth weakness is the possible conflict between economic development and the lack of political and social freedom. When the living standard is rising steadily from a low level people do not feel strongly about lack of freedom.
However, when people become able to think about something else, the lack of social and political freedom will attract public attention. The crucial test is if and when the Chinese people will be allowed to organize an anti-Communist political party. The leadership is clearly planning to proceed on very gradual liberalization. We will see if it is a workable scenario. Also, the serious lack of a social security system and the huge reservoir of 200 million farmers as potential unemployment pose a real challenge.
On top of the medium-term problems I described above there is an immediate and urgent item on the agenda, i.e. how to rein in the current investment bubble. In 2003 capital investment increased by 47% over the previous year. The explosion was prompted largely by the change of political leadership in 2002. The new administration had understandable incentive to boost economic growth. Local governments, state-owned enterprises and banks responded eagerly. While consumption increased by less than 10% there is inevitable accumulation of excess supply capacity, particularly in such sectors as steel, cement, aluminum and automobiles. The price of materials and energy rose while the price of finished products declined. Export drives mounted. The profit margin was squeezed in many corporations. The quality of bank assets deteriorated. In order to reduce the ratio of non-performing loans banks have further stepped up lending.
The situation is still unchanged in 2004. The leadership, particularly the senior technocrats, came to realize the looming danger and recently started to take cooling measures. However, the political need to maintain high growth is still strong. It is yet to be seen if the effort to try to shoot two birds with one stone will succeed. Some good news in this regard is that the fiscal situation in China is still considerably better than in most other developed countries. The current fiscal deficit is around 3% of GDP and total public debt is still about 30% of GDP. Thus, China still has some room left to cover up the imbalance by fiscal instruments. It is obvious, however, that the time left is not unlimited.
The Renminbi has continuously been devalued from 2.8 Rmb. per dollar in the early 1980s until the major devaluation by 33% to 8.7 Rmb. in 1994. Since 1997 it has been pegged to the dollar at 8.28 Rmb. Recently, there is a widespread view that the Rmb is undervalued by around 15-25%. The reasons are, first, Chinese exports are soaring by 30% more than the previous year. Second, although the current account surplus is shrinking, capital inflow is large and as a result foreign exchange reserves are piling up to almost $500 billion. Third, there is a $125 billion trade surplus with the US under the pegged exchange rate.
If the Rmb is undervalued what problems will occur? The immediate problem is naturally trade friction with the US and East Asian countries, which are suffering from China's forceful export drive. Also, the continuous large amount of dollar purchase intervention for the Rmb. is putting constraints on monetary policy, thus fuelling the overheating of the economy.
The more serious medium-term problem probably will be the distortion of industrial structure. When an economy has undervalued currency for too long there ought to be a distorted resource allocation concentrating on high growth sectors. That means over-investment, over-borrowing and over-employment in the export-oriented manufacturing sector creating a condition of over-supply. Indeed, resource allocation as such will generate high economic growth, but the prolonged undervaluation of the currency will eventually undermine the competitiveness of the industry and, when an inevitable adjustment takes place, create a bulk of non-performing loans. In other words, undervaluation needs to be corrected as soon as possible because the delay of correction raises costs.
I believe the Chinese leadership is smart enough to know the problem and they are seriously groping for a way out. However, it is also true that there are constrains that prevent a quick solution. In practice there are four ways to achieve revaluation of the Rmb.
(1) revalue and repeg at the new level. This type of revaluation can be done either in a once-for-all fashion or by the crawling-peg, which means successive revaluations
(2) introduce a limited range of fluctuation
(3) peg Rmb to a basket currency, not to the dollar
(4) let the Rmb float freely
I am afraid that at this moment none of the above is practicable. In introducing a new exchange rate regime China needs to assure that a new stability be established and that a collapse of export and lending banks be avoided. None of the above methods seems to ensure the two objectives because banks are still too weak and the apparatus of exchange control is not effective.
Thus, my hunch is that the leadership will repeat its positive rhetoric on reform pledging a serious study. At the same time, the leadership will make their best effort to complete the preparatory work as soon as possible. However, they will not implement reform until they can feel safe. I guess the timing of reform will, at the earliest, be 2006 when WTO commitment on banking liberalization needs to be carried out.
III. Future of Japan-Chinese relations
For East Asia in the coming decade or two, the most crucial issue is how to establish stable and friendly relations between Japan and China. The continued development and prosperity of the region will very much depend on it.
Indeed, the recent strengthening of the collaborative economic relation between the two countries is truly remarkable. Japan needs production centers and export markets in China. China needs Japanese capital, technology and sophisticated manufactures. The traffic of all kinds of economic components between the two countries is booming.
However, the problem lies in the future. Already in the field of diplomacy and security, China's presence in Asia is much bigger than that of Japan. If -- although it is a big if -- China continues 7% growth for another 20 years, and if Japan settles down to anemic growth and demographic deterioration, China will become the singular leader in Asia with Japan as an important subordinate. If this happens it will be a historic challenge for Japan, and Japan has to adapt itself to the new environment.
Looking back we need to recognize that Japan-China relations is the longest bilateral relation in the history of the world extending to more than one and half millennium. Until the 19th century China was an indispensable teacher for Japan. Japan could create its own original culture only on the basis of absorption and digestion of Chinese culture. Relations have by and large been amicable, except the foiled attempt of the Yuan Dynasty in the 13th century to invade Japan. However, in the latter half of the 19th century, the total corruption and incompetence of the Qing Dynasty and Japan's victory in the Sino-Japanese War changed the Japanese attitude toward China. It turned to one of superiority and arrogance, which culminated in the devastating 15-year war from 1931 to 1945. The defeat of Japan in WWII and the phenomenal development of China since the 1980s have greatly confused the Japanese mentality toward China. Many Japanese today are still trapped in the sense of ambivalence, i.e. a mixture of superiority complex and inferiority complex. A similar kind of ambivalence exists in China as well.
I would argue strongly that Japan has to fundamentally reformulate its mental attitude toward China. It is yet unknown whether China will come to share common values with us, i.e. respect of political democracy and individual human rights. It cannot be denied, though, that China today is in a historic phase of national ascent. Japan needs to deal with China with due respect and clear objectivity. In this regard, it will be useful for both Japan and China to study the essential quality of US-Canada, US-UK, German-Dutch, and German-Franco relations. Obviously these bilateral relations are quite different from Japan-China relations, yet Japan and China must be able to learn many valuable lessons from these experiences.
The future of Asia is uncertain. Totally different scenarios could well be possible, but the importance of Japan-China relations will always be central.