Manchurian Paradox

by Stephen S. Roach

04.27.2009

THE CHINESE word for crisis, weiji, includes elements of both danger and opportunity. This symbolic meaning has taken on especially great significance in recent years. The emergence of modern China as a global economic power can, in fact, be dated to the nation’s willingness to seize critical moments of adversity. That was very much the case during the Asian financial crisis of 1997–98, which marked a critical turning point in the ascendance of China as a major economic power. And it could also be the case today.

But there is an important catch: unlike earlier crises, it is not altogether clear that China senses the gravity of the current danger. That leaves it caught in something much closer to denial—making it difficult to seize the opportunity that peril can provide.

The world is in the midst of its most wrenching financial downturn since the 1930s. From subprime to “no-prime,” the once-proud icons of modern finance have all been turned inside out. An asset-dependent and increasingly integrated world has been quick to follow. The global economy is set for its first outright contraction since the end of World War II. Relative to a forty-year trend-growth rate of 3.7 percent in world output, a likely decline on the order of 1.5 percent in the world’s gross domestic product (GDP) in 2009 is all the more stunning. For a $64 trillion global economy, such a shortfall translates into $3.2 trillion of foregone world GDP. Never before has the modern global economy had to come to grips with such a severe and abrupt widening in the so-called global output gap.

The Chinese leadership needs to deepen its appreciation of the global shock that is now unfolding. Only then can Beijing truly comprehend the threat this recession poses to its long-successful outward-facing economic-growth model. And yet there are worrisome signs that China just doesn’t get it—that it is clinging to antiquated policy and economic-growth strategies that presuppose a classic snapback in global demand. That leaves China ill prepared for what could well be the defining feature of the postcrisis world—a U.S.-led shortfall in worldwide consumption. China’s export-led growth model is aimed right at the heart of what could well be the new weak link in the global growth chain.

Notwithstanding these worrisome imbalances, a newly assertive China has stepped up its efforts to shape the global policy debate—warning America of fiscal excesses that could erode the value of China’s investments in U.S. Treasury securities and proposing a radical revamping of the global currency system. China’s views and voice are important and need to be heard. The world has much to gain from a sounder and more stable international financial system. But if China pushes too hard in trying to reshape international policies and institutions without attending to its own imbalances, it could trigger further instability—possibly even a dollar crisis—that would only deepen the world’s malaise. In the construct of weiji, that could tip the balance from opportunity to danger. Therein lies the paradox of Chinese economic power.

RELATIVE TO all the Asian economic-development efforts since the end of World War II, China stands alone in the massive bet it has made on externally led growth. According to calculations made by the research staff of the International Monetary Fund, China’s share of world trade increased eightfold in the twenty-five years following its economic takeoff in the early 1980s. That is more than two-to-three times the gains experienced by other Asian economies over comparable phases of their development journeys. Moreover, China upped the ante on this bet following its accession to the World Trade Organization, taking the export share of its GDP from 20 percent in 2001 to 36 percent in 2007. As the world’s most open large developing economy—with exports and imports, combined, peaking at 65 percent of its GDP in 2007—China could hardly expect to get special dispensation from a global shock.

And it didn’t. On the heels of a precipitous decline in exports, Chinese GDP growth slowed to 6.8 percent on a year-over-year basis in the fourth quarter of 2008, a major deceleration from the 13 percent increase in 2007. Significantly, the gain in the fourth quarter of 2008 turns out to be a number very close to “zero” if it is recalculated relative to activity in the third quarter. Moreover, with export growth turning sharply negative in early 2009—plunging 21 percent on a year-over-year basis during January and February—it is safe to say that the external-demand shock has brought the Chinese economy to a virtual standstill.

Chinese policy makers have been quick to respond to this extraordinary shortfall in economic activity. In November 2008, they adopted an RMB 4 trillion ($585 billion) two-year fiscal-stimulus package dominated by accelerated expenditures on infrastructure projects. Outlays on rural development, rail, highways, airports and the energy grid account for 47 percent of the total stimulus package and Sichuan earthquake-reconstruction efforts make up another 25 percent. This “proactive fiscal stimulus,” as Chinese officials like to call such initiatives, borrows a page from China’s response to two earlier external-demand shocks—the Asian financial crisis of 1997–98 and the mild global recession of 2000–01. In both of those instances, infrastructure-led fiscal support plugged the gap left by a temporary shortfall in external demand. When the global economy snapped back, China’s export-led economy was perfectly positioned to capture the next upturn in global trade. It worked like a charm.

China seems to be betting on a similar outcome this time. In addition to its infrastructure-bolstering policies, Beijing is also providing support to export industries such as textiles, steel, equipment manufacturing, light industries and logistics as part of its recently announced “ten industry” industrial-reinvigoration plan. And it has provided assistance to exporters by increasing their value-added-tax (VAT) rebates. This allows them to further lower their prices and further bolster their competitiveness. The broad thrust of China’s investment- and export-led policy focus is strikingly reminiscent of earlier countercyclical stabilization efforts.

By contrast, the Chinese government is only paying lip service to measures aimed at supporting internal private consumption—long the lagging sector of this rapidly growing economy. Spending vouchers have been distributed to rural households and the government has enacted a relatively modest national-health-insurance scheme—costing just RMB 850 billion (about $125 billion) over the next three years. While there is nothing wrong with these proconsumption initiatives, they are far too small, in my view, to turn around China’s lagging consumption sector, which plunged to a record low of only 36 percent of GDP in 2007. China needs to get far more serious in funding a social safety net—especially social security and pensions—if it is to reduce the excesses of fear-driven precautionary saving and foster a more broadly based consumer culture.

By failing to embark on the heavy lifting of its own rebalancing, China is banking on the same export-led growth model that has worked so well in the past to take it out of the current downturn. In essence, that implies China is placing a big bet, not just on its own proactive infrastructure-led fiscal stimulus, but also on the efficacy of policy actions being taken elsewhere in the world. That latter presumption underscores one of the biggest risks to this strategy. If, as I suspect, the American consumer has only just commenced a multiyear compression in the growth of private consumption, China could end up being very disappointed in the lingering sluggishness of its external-demand conditions. Like the circumstances of 1997–98 and 2000–01, the design of China’s current stimulus strategy is very much dependent on an external-demand-snapback scenario. While that strategy worked well in the past, there is a distinct possibility that it is going to be very different in today’s crisis-torn, postbubble world.

Unfortunately, the Chinese leadership strikes me as being overly complacent in assessing the risks of just such a possibility. By failing to move more aggressively to rebalance its unbalanced macrostructure, China runs the real risk of facing a more pronounced shortfall in economic growth. For a nation long fixated on the perils of social instability, the rising unemployment that would come from such a scenario could be exceedingly problematic. Chinese government officials have already voiced concerns over the mounting joblessness of their export-dependent migrant workforce—admitting that some 20 million unemployed workers have recently returned to the countryside. In the external-demand-snapback scenario, such distress would be relatively short-lived. In a more protracted global slowdown, however, pressures on Chinese workers would only intensify—as would the risks of social instability.

ECONOMIC FORCES, of course, don’t operate in a vacuum. That’s especially the case in financial crises and recessions, when intensifying economic pressures often beget powerful political responses. China is no different from any other nation in that regard. In the depths of this crisis, its political machinery has focused not only on internal problems, such as rising unemployment, but also on external concerns, such as its trade relationship with the United States.

In the context of China’s mounting economic challenges, the geopolitical dimension of its export-led macrostrategy is especially paradoxical. Recently, senior Chinese officials have singled out two key issues for special attention—their lack of confidence in U.S. Treasury securities and the role of the dollar as the world’s major reserve currency. Premier Wen Jiabao has gone public—and loudly so—raising concerns about the safety of China’s massive investments in dollar-denominated assets, some $700 billion in U.S. Treasury securities alone. At the same time, Governor Zhou Xiaochuan of the People’s Bank of China has joined the debate over the reform of the international monetary system—raising concerns about the stability of a dollar-based reserve system in an increasingly globalized and unbalanced world.

These concerns are both perfectly legitimate issues for China to raise. With the Obama administration warning of trillion-dollar U.S. budget deficits for years to come, the rapidly growing overhang of Treasury debt should not be taken lightly by America’s largest foreign creditor. And with a saving-short U.S. economy likely to suffer from a persistent and large current-account deficit, the possibility of a further sharp depreciation of the dollar cannot be minimized. Such an outcome would have a major impact on the value of China’s outsize holdings of dollar-denominated assets.

Yet the Chinese leadership is raising these concerns as if they are disconnected with their own macroimbalances. This is a critical aspect of the China power paradox. As underscored above, China remains heavily dependent on externally supported export-led growth. As in the past, it has set its policy stance with an aim toward catching the wave of the next rebound in global growth. Its currency policy—a “managed float” that still keeps the RMB tightly aligned with the U.S. dollar—is a critical ingredient of this export-led growth dynamic. This currency regime effectively locks China into policies that require an ongoing recycling of its massive accumulation of foreign-exchange reserves into Treasuries. Without such dollar-based recycling of its foreign-exchange reserves, the value of the RMB would skyrocket and China’s products would be far less competitively priced in the global market. That, in turn, means China also has a vested interest in the stability of the U.S. dollar.

The bottom line for China: until, or unless, it rebalances its economy away from export-led growth, Beijing can ill afford to act on the concerns recently voiced by Premier Wen and Governor Zhou. Shifting its currency reserves out of Treasuries or other dollar-denominated assets would undermine Chinese export competitiveness at precisely the time the country’s economy lacks support from internal demand. Consequently, notwithstanding the legitimacy of official China’s concerns over the integrity of its dollar-centric international investment strategy, as an unbalanced export-led economy, it has few alternatives that would work well in its best interest. As such, Beijing’s complaints about U.S. Treasuries and the role of the dollar ring hollow.

BECAUSE CHINA is so heavily dependent on exports, the policies and economic conditions of other nations obviously have an important say in shaping the country’s destiny. The impact of the Washington policy debate cannot be minimized in that regard. America’s penchant for China bashing can hardly be taken lightly in the current climate. Over the 2005–07 period, more than forty-five separate pieces of anti-China trade legislation were introduced in Congress. The good news is that none of the bills passed. In large part, that’s because they were introduced during a period of prosperity and low unemployment. The bad news is that both of those conditions have changed in the United States—prosperity has given way to a deep recession and unemployment is soaring. That means that long-standing pressures on American workers are intensifying—as are the related pressures on their elected representatives to act.

In times of adversity, the dark side of the American body politic tends to fixate on scapegoats. Wall Street is the domestic target du jour and China could well be the foreign focus. Washington’s “reasoning” in going after China is based on three key considerations: that America’s outsize trade deficit is a recipe for job destruction and real-wage pressures; that China accounts for the largest bilateral piece of the overall U.S. trade deficit; and that China manipulates its currency as a conscious element of its mercantilist policy strategy. Never mind that these arguments are all deeply flawed. First, a saving-short U.S. economy doesn’t have a bilateral-trade problem with China, but rather a multilateral-trade problem that has led to deficits with one hundred of its trading partners. Second, the RMB has risen more than 20 percent against the dollar (in real terms) since China abandoned its currency peg over three years ago. And third, the plight of the U.S. workforce may also reflect America’s chronic underinvestment in human capital and education reforms. In times of distress and national angst, it is apparently easier for American politicians to point the finger at China rather than look in the mirror.

This raises the possibility of a most worrisome wild card—that after three years of anti-China rhetoric and saber rattling, the U.S. Congress imposes some form of trade sanctions on China. Unfortunately, such a possibility can no longer be dismissed lightly. After all, the new U.S. treasury secretary, Timothy Geithner, raised the Chinese-currency-manipulation flag in his confirmation hearings. Moreover, Congress opted to insert a “Buy American” clause into its recent stimulus package. And during his election campaign, the new U.S. president repeatedly made the distinction between free trade and fair trade when calling for the renegotiation of NAFTA.

Were the unthinkable to happen and the U.S. body politic to act on its anti-China concerns, then the Chinese response would be very different from the baseline strategy outlined above. In a U.S.-directed China-sanctions scenario, I am reasonably confident that Beijing would instruct its foreign-exchange-currency managers to boycott the next Treasury auction—triggering a full-blown crisis in the dollar and a related spike in real long-term U.S. interest rates that would exact a severe toll on a bruised and battered U.S. economy, to say nothing of the rest of the world. Yes, this would also impose considerable pain and hardship on the Chinese as America’s largest holder of Treasury securities. But China would perceive this action as an all-out economic attack; Chinese national pride would then take precedence over investment considerations. In short, I have little doubt that Beijing would retaliate should Washington choose to vent its frustrations at China.

This wild card is just that—a relatively low-probability outcome. Unfortunately, in a crisis and deepening recession, the probability of such a scenario is not as low as it should be. With the U.S. unemployment rate headed into the 9–10 percent zone over the next year, or sooner, I would place a 25–33 percent probability on the passage of anti-China trade legislation by Congress at some point this year or in early 2010. If such a bill were to pass, it would undoubtedly have broad bipartisan support—moving through both houses of Congress with potentially veto-proof margins in the unlikely event that President Obama chooses to resist a politically expedient groundswell of China bashing.

Wild-card scenarios are generally not worth emphasizing. But in this case, the consequences would be so grave—and so painfully reminiscent of a similar blunder that was made in the early 1930s with the Smoot-Hawley Tariff Act—that they bear special mention.

ON THE surface, China seems to understand the flaws and potential vulnerabilities of its growth model. Two years ago, at the conclusion of the National People’s Congress, Premier Wen warned of a Chinese economy that was “unstable, unbalanced, uncoordinated and unsustainable.” This warning did not come out of thin air. It was issued a year after the enactment of the 11^th five-year plan in early 2006, which was very much framed with an aim toward shifting the mix of Chinese economic growth away from excessive reliance on exports and investment toward a more balanced structure that would draw on private consumption for growth.

Despite its extraordinary successes over the past thirty years, China has failed to execute this key aspect of its own strategic plan. It’s hard to know why, but I suspect the reason may lie in the same mindset that afflicted the rest of the world—the seduction of the great global boom of 2003 through mid-2007. The Chinese economy grew at an astonishing 12 percent pace over the three years ending in 2007, and, despite the perfectly legitimate concerns of Premier Wen, China’s macropolicy makers are apparently not willing to tamper with the formula that has created such extraordinary results. As the current growth slowdown indicates, that is too bad. Export-led China is paying a steep price for failing to heed the premier’s all-too-prescient warning.

Over the past three decades, China has repeatedly opted for reforms and the opening up of a once-closed system. This transformation has paid extraordinary dividends—spearheaded by a 10 percent aggregate GDP growth trend that led to a quadrupling of per capita incomes since the early 1990s. Notwithstanding this spectacular achievement, it was built on a foundation of an increasingly unbalanced Chinese economy. Like all macroimbalances, it is only a matter of time before they work at cross-purposes. Take a look at Japan in the 1990s—and at the United States in 2009.

Today’s unbalanced Chinese economy faces a similar challenge. It is just a question of when—not if—that unbalanced system hits the proverbial wall. As its own premier said two years ago, the model that has served the world’s most populous nation so well for the past thirty years is now in serious need of an overhaul. The same is true of the rest of Asia—an externally dependent region that has increasingly tied its fate to a China-centric export machine. Yet for whatever reason, Beijing seems unwilling—or unable—to embrace a new and more balanced growth model.

Ironically, China is expressing a new assertiveness on the global stage at just the moment when its own imbalances appear increasingly problematic. Its leaders speak with great pride about an economy that can still hit its precrisis 8 percent growth target. They speak about an economy that can be first in leading Asia and the world out of recession. Perceptions of resilience beget a new self-confidence that has also given rise to unusually explicit Chinese views on global currency reform and the lack of U.S. fiscal discipline.

There is nothing wrong with China’s gathering sense of self-confidence and its concomitant contribution to the global debate. In fact, it is to be encouraged. China has earned its place at the table. For a nation steeped in five thousand years of inward-looking experience, China is looking outward as never before. The world can only benefit from this sea change. But that underscores the biggest danger of all—the risk that China takes its newfound external dependence too far and ignores the lasting and serious pitfalls of a postcrisis world. If it fails to rebalance its unbalanced economy, China’s power play could be surprisingly fleeting.