China and the world economy
The world is witnessing a shift in the balance of power, from the West to the East. This shift will take place over decades, and the winners will be:
- Those economies that have financial clout, such as China
- Those economies that have natural resources, whether it be energy, commodities or water, and will include countries, some in the Middle East, some across Africa, Brazil, Australia, Canada and others in temperate climates across, for instance, northern Europe
- And the third set of winners will be countries that have the ability to adapt and change. Even though we are cautious about growth prospects in the U.S. and UK in the coming years, both of these have the ability to adapt and change.
China is at the center of this shift.
The scale and pace of change in China is breathtaking. Against this backdrop of dramatic change, let me look at Chinaâ€™s impact on the global economy, especially in the aftermath of the financial crisis.
It is now clear that the financial crisis was a result of three key factors: an imbalanced global economy; a systematic failure of the financial system in the West; and a failure to heed the many warning signs.
The world needs to move towards a more balanced economy. But that will take years. The imbalanced nature of the world economy led some to point the finger of blame at the savers, such as China. The 1944 Bretton Woods agreement placed no obligation on savers, countries with current account surpluses. The obligation to change was put on those countries with the deficits. This has to change.
Whilst China and other savers may not be the main source of the recent problem, they are part of the solution.
To move to a balanced global economy, the West, or at least countries like the U.S., the UK and Spain, need to spend less, save more. In contrast, regions like the Middle East and Asia need to save less and spend more. It sounds easy. It is not. It requires a fundamental shift in China and in Asiaâ€™s growth model.
At the recent Asian Development Bank (ADB) meeting in Bali, the President called for Asia to rebalance its economy by: expanding the social safety net; providing assistance to small and medium-sized enterprises; and deepening bond markets.
Amongst those present, I detected more enthusiasm for the social safety net than for further financial sector innovation. One of the lessons of the 1997-98 Asian economic crises was the need to open up the financial sector at a speed best suited to domestic needs. One speed does not fit at all. Yet, it is important that if Asia is to see a shift in its growth model it needs to see a reduction in savings and this will be achieved sooner by deepening and broadening its capital markets.
This involves many changes, such as increased personal finance and allowing people to borrow against future income. It requires deep and liquid corporate bond markets, shifting the regionâ€™s culture away from equities, and giving firms alternative sources to bank lending and, in China particularly, reducing corporate savings, possibly through higher dividends.
China will play an important role in this process. It has already helped regional integration, building on the Chiang Mai Initiative, and it has engaged in a number of bilateral swap arrangements with countries around the world.
Another important global impact is the importance of China in helping world trade, investment and financial flows. Over the last decade the three words seen most regularly were â€śMade in Chinaâ€ť. Over the next decade the three most common words might be â€śOwned by Chinaâ€ť. Chinaâ€™s stock of overseas direct investment is one-thirtieth of that of the USA. The stock of foreign direct investment in China far exceeds the total amount China has invested overseas. Last year, Chinaâ€™s investment overseas was $50 billion. Now this is changing. Chinese firms are taking advantage of a strong renminbi and of strategic backing from Beijing to expand overseas purchases.
The impact of China on global commodities is already evident. Chinaâ€™s rapid growth and its strategic needs saw it accumulating increasing amounts of commodities. For instance, it accounts for about one-third of global demand for aluminum and copper, and as much as 38 per cent for zinc. In the first half of this year there has been stockpiling by China of a range of commodities. This stockpiling could be explained by many factors, including the strength of the Chinese yuan and the weakness of commodity prices. In future years one would expect this to continue. And it will not just be metals. Demand for food and soft commodities will be important. As incomes rise, food tastes will change.
Furthermore, 28 per cent of Europeâ€™s land is arable, while this figure is 19 per cent for the U.S., but for China it is only 10 per cent. As a result, China will not only buy commodities, but it will also invest in countries producing commodities. This will reinforce the new corridors of increasing trade and investment flows between China and Africa, Latin America and the Middle East.
Chinaâ€™s purchase of commodities has a direct link into the inflation outlook globally. In previous years, CPI figures around the world could have been renamed China Price Indices, as China exported deflation. In the next few years, if there is an inflation issue it is likely to be through higher commodity prices, with Chinaâ€™s demand exerting a key influence.
China will have a big bearing on the dollar. There is a slow burning fuse under the dollar. Even if the U.S.â€™s economic power were to wane, it is important to stress that the U.S. is still the worldâ€™s major economy. There are no credible alternatives to the dollar. Long after the UK ceased to be the worldâ€™s major economy a century ago, sterling remained the worldâ€™s reserve currency for some time. During this crisis it was noteworthy that, despite much negative sentiment towards the dollar, in the time of trouble the depth and liquidity of U.S. financial markets helped support the dollar as a safe haven.
Furthermore, it would not be a surprise if – as a result of this crisis â€“ more countries learned the lesson of Asian economies after their crisis, and decided to accumulate foreign exchange reserves. During this crisis those countries with high FX reserves were afforded an additional degree of protection. Of course, not all reserves need be in dollars. Even now, countries with large reserve holdings do not actively want to sell the dollar. It is not in their interests to do so. Instead of this active diversification â€“ or outright selling of U.S. assets – there is what I call â€śpassive diversificationâ€ť, whereby a smaller but still sizeable proportion of their net new reserves are allocated to dollars.
For its reserve currency status the dollar needs to retain its status as the medium of exchange and as a store of value. Interestingly, China and Brazil recently agreed to pay each other in their own currencies, not in dollars as is the norm, whilst the pressure China has put on America regarding the dollarâ€™s value highlights the concern some have over its future value.
China still has a huge balance of payments: its surplus reached 9.6 per cent of GDP last year. The authorities have kept the yuan stable versus the dollar, although this has meant it has appreciated on a trade weighted basis. The Chinese are also, it seems, encouraging trade settlement in Chinese yuan. Yet the reality is the Chinese yuan needs to become fully convertible for it to challenge the dollar and that is not going to happen any time soon. In the future I would expect to see more countries manage their exchange rate against the currencies of the countries with which they trade. This, plus the new trade corridors I mentioned earlier, and the likelihood of increased investment flows into emerging economies with higher growth rates, may all suggest downward pressure on the dollar. But this is likely to be a slow process.
On the global stage, Chinaâ€™s rise is also leading to the rise of State Capitalism. A couple of years ago we looked at this in the context of Sovereign Wealth Funds. Add in large foreign exchange reserves, government pension funds and state owned enterprises, and the role of the state has become far more important.
Finally, Chinaâ€™s influence on global policy forum is important. Already this crisis has seen a shift, with the G20 (Group of Twenty) taking a prominent role. The Chinese took a pro-active role ahead of the London Summit, which was welcome, and is perhaps a sign of things to come. One wonders, however, whether it is the G2 of the US and China that might emerge as the real power. Earlier this year President Obama signaled a shift from the Strategic Economic Dialogue, to the Strategic and Economic Dialogue. This extra word â€śandâ€ť signals perhaps a significant change.