Statement before the

Commission on U.S.-China Economic and Security Review

Hearing on

China’s Industrial, Investment and Exchange Rate Policies:

Impact on the U.S., September 25, 2003

Washington, DC

A persistently weak global economy is now moving into a very dangerous place – the slippery slope of trade frictions and protectionism. As political cycles now enter the macro equation, the blame game has begun. Such sentiment is nearly unanimous in singling out a new scapegoat – a rapidly growing Chinese economy. World opinion has become increasingly becoming united in putting pressure on China to revalue its currency. In my view, that would be a serious mistake for China, the United States, and global economy at large. I think the world has got the China story dead wrong.

The blaming of China goes something like this: With real GDP growth in the industrial world holding on a subpar path for a third year in a row, the ongoing vigor of the Chinese economy obviously sticks out. Industrial output was up an astonishing 17% year-over-year in August, and exports surged by 27%, clear signs that ingChina is capturing market share in an otherwise sluggish world. China’s currency peg is widely believed to be compounding the problem. Many believe the renminbi is undervalued to begin with. Moreover, tied to a now-depreciating US dollar, the RMB appears to have been given a competitive boost against non-dollar currencies. Assumingif I’m right and the dollar has a good deal further to go on the downside – perhaps by as much as another 20% over the next couple of years – then most fear that China’s competitive advantage will become all the more pronounced. Suddenly, China’s image has been transformed from the land of opportunity into a serious threat to the United States and the broader global economy.

If the world economy were thriving, China’s rapid growth would be welcome. Unfortunately, that’s not the case. In a still-sluggish global economy, market share is a very precious commodity. Any threats to competitive positions, compounded by hiring shortfalls, can trigger hostile responses. These pressures are very much in evidence today. China’s huge and growing bilateral trade surplus with the United States is widely seen as a mounting in order source of tension. The culprit, goes the argument, is China’s currency peg. A revaluation of the RMB is now thought to be a necessary antidote. I believe that would be a serious mistake for three major reasons:

First and foremost, there is an enormous confusion over the character of the so-called Chinese export threat. In my opinion, the world has formed an erroneous impressionperception that newly emerging Chinese companies are capturing global market share with reckless abandon. In fact, nothing could be further from the truth. For more than a decade, the real export dynamic in China has come far more from the consciousdeliberate outsourcing strategies of multinational corporations headquartered in the developed world than from the rapid growth of indigenous Chinese companies. overOver the 1994 to mid-2003 interval, China’s exports essentiallybasically tripled from US$121.0 billion to $365.4 billion. It turns out that "foreign-invested enterprises" – Chinese subsidiaries of global multinationals and joint ventures with industrial-world partners – have accounted for fully 65% of the total increase Chinese exports over that period. In other words, China’s increasingly powerful export machine has the stamp of America, Europe, and Japan stampedwritten all over it.

This is hardly an example of China grabbing market share from the rest of the world. Instead, it is more a by-product of the strugglesearch for competitive survival by high-cost producers from the industrial world. Last year, a record US$52.7 billion of foreign direct investment flowed into China, making the country the largest recipient of FDI in the world. This inflow did not occur under coercion – it was entirely voluntary. A high-cost industrial world has made a conscious decision that it needs a Chinese-based outsourcing platform to increase productive efficiencies for its own competitive survival. Dismantling the RMB peg would destabilize the very supply chain that has become so integral to new globalized production models. Ironically, it would be a serious negative for those same economies – Japan, the US, and Europe – that have led the way in the rush to Chinese outsourcing. By putting pressure on China to change its currency regime, the industrial world is working at cross-purposes – runs the risk of , squandering the fruits of its own efforts. Fear of the so-called China export threat completely misses this critical point. The power of the Chinese export machine is more traceable to "us" than it is to "them."

A second argument in support of a stable Chinese currency hinges on the nation’s competitive prowess. Contrary to widespread perception, China does not compete on the basis of an undervalued currency. It competes mainly in terms of labor costs, technology, quality control, infrastructure, and an unwavering and commitment to reform. My guess is honestly if China were to revalue the RMB upward by 10% or even 20% – a change I do not expect nor advise – its exports would suffer minimal loss of market share. A key reason for this is that China’s export prowess is mainly in the role of an assembler – its exports have a high content of materials and products made elsewhere. By contrast, only a small portion of its exports are actually made in China. Stanford Professor Lawrence J. Lau and his colleagues have estimated that for every dollar of Chinese exports, only 30 cents reflects value-added by domestic Chinese production (see C. Xikang, L. Cheng, K.C. Fung, and L.J. Lau, "The Estimation of GDP and Employment Induced by Exports: An Application to Chinese Exports to the United States," Revised December 2001). For Chinese exports going to the United States, the domestic-value added share is even lower – only 20 cents on the dollar. That means even a substantial revaluation of the RMB would not make much of a difference to the price competitiveness of Chinese exports. If, for example, the RMB peg to the dollar were adjusted upward by 20%, this research suggests the price of Chinese exports to the US would go up by only 4% – hardly enough to trigger a major demand shift back into American-made products.

There’s even a more basic element to this argument insofar as the US is concerned: China’s currency is pegged to the dollar – an arrangement that hasn’t changed one iota since 1994. That means there have been no currency-induced shifts in relative prices that can explain the deterioration of the US-China trade deficit from $30 billion in 1994 to $103 billion in 2002. Furthermore, no nation’s competitive threat to the broader world economy should be judged on the basis of bilateral trade imbalances. It’s the overall trade position that matters. In the first eight months of this year, China’s trade surplus amounted to just US$8.9 billion, less than half the pace of a year ago. Consistent with this condition of near balance, our estimates suggest that the trade-weighted value of the RMB is basically in line with average levels prevailing since 1998. It’s hard to conclude on the basis of these trends that the Chinese currency represents a serious competitive threat to the broader global economy.

Third, dismantling the peg could destabilize world financial markets. It is is important to stress that there is littlereally no doubt over the endgame. China has consistently reiterated its long-term commitment to opening its capital account and eventually making its currency fully convertible. At the same time, China knows full well that a good deal of heavy lifting on the reform front has to occur before these objectives can be accomplished. That’s true of both capital- markets reforms and of the need to clean up its banking problems. China has taken great strides extraordinary on theseboth fronts, but a lot more needs to be done. Until there is more progress on on the road tofinancial reforms, I believe it would be entirely entirely premature and very risky for China to float its currency and open its capital account. Such ill-timed actions could lead to heightened instability in Chinese, Asian, and world financial markets that could seriously jeopardize the global economy. This is isa critical lesson of the Asian financial crisis of 1997—98 that an impatient and politically charged world should not lose sight of when putting pressure on China. Nor should we forget the key role China played in tempering that crisis when it resisted the temptation to follow other Asian nations down the road of devaluation.

Several other considerations that also argue against an RMB revaluation: an intensification of imported deflationary pressures on a Chinese economy that is only now climbing back out of deflation; thea possible emergenceoutbreak of bubbles in other Chinese asset markets, especially property; and a signal to market speculators that the RMB would now be "in play." Moreover, there is one of history’s most salient lessons to remember: Poor countries like China will never close the development gap with rich countries if they are repeatedly forced to revalue their currencies. Finally, some observers believe that an open capital account actually would allow Chinese investors the opportunity to diversify their currency holdings into dollar-denominated assets – triggering an asset allocation shift that could backfire and result in a weaker RMB.

I fear there’s a deeper meaning to the pressures now being put on China: Unwilling to accept responsibility for their own economic shortcomings, the wealthy nations of the industrial world are making China a scapegoat for their weak recoveries. That’s especially true of the United States, still mired in a jobless recovery fully 22 months after the last recession hit bottom in November 2001. Frustrated over persistent job losses, America’s politicians have become convinced that China is the culprit. And so Washington is now taking dead aim at the "China problem." Legislation recently has been introduced in the US Senate that threatens to impose 27.5% across-the-board tariffs on Chinese exports into the US if the RMB peg is not abandoned (S 1586). Two of the sponsors of this bill – Senators Schumer and Graham – have presented their views to you this morning. I am strongly opposed to this action, as well as to comparable measures recently introduced in the US House of Representatives (HR 3058). I believe these proposals pose grave risks to the US and world economy.

At present, I would judge the odds of such legislation being enacted as no higher than one in five. Yet those odds will undoubtedly rise as the US political cycle heats up – especially if America remains stuck in a jobless recovery. Perceptions of job and income security have long been the defining issue in US presidential campaigns. It’s hard to believe that it will be any different this time around, especially since America’s current hiring shortfall – some 4.2 million jobs and counting, by my reckoning – is the worst in modern, post-World War II experience. Significantly, this Congressional assault on China is bi-partisan. That underscores the breadth of support for actions proposed against China, an especially worrisome sign of more protectionist initiatives to come. For that reason, alone, it is hard to dismiss the real significance of recent anti-China measures introduced in the US Congress. They are shots across the bow of America’s commitment to globalization.

It is ironic that by pointing the finger at China, the US Congress is avoiding its fair share of responsibility for America’s conundrum. The US has an extremely serious saving problem – a net national saving rate that fell to a record low of 0.7% of GDP in the first half of 2003. In recent years, the biggest swing factor behind this plunge in national saving has been the extraordinary deterioration in the fiscal position of government units – at the federal, state, and local levels. The combined government-sector saving rate has swung from a surplus of about 3% of GNP in 2000 to a deficit of nearly 4% in mid-2003. Moreover, courtesy of Washington’s latest bout of fiscal profligacy, the government shortfall is set to widen by another 1 to 1.5 percentage points over the next 12 months. Unless there is a spontaneous and lasting revival in private-sector saving – highly unlikely, in my view – national saving can only fall further. Hooked on spending, America has no choice other to import surplus saving from abroad in order to finance economic growth. And the only way to get that capital is for the US to run massive current-account and trade deficits.

That’s where China enters the equation. Yes, America’s largest trade deficit is now with China – a $103 billion shortfall in 2002 and on track to exceed that amount in 2003. But keep in mind, a severe domestic saving shortage means the US has to run trade deficits with someone – unless, of course, it is prepared to curtail sharply domestic consumption. If America weren’twasn’t trading with China, those deficits would have to occur with other nations – Canada, Mexico, other Latin economies, Japan, elsewhere in Asia, or possibly even Europe. That poses perhaps the most introspective question of all: Should China be blamed for Washington’s reckless fiscal adventures?

It is dangerous and wrong for the US to point the finger at China as a major cause of its massive and still-widening trade deficit. If the United States wants to reduce its trade gap, it must come to grips with more fundamental problems of its own, namely the rapidly vanishing national saving rate. Until it does so, US trade deficits are likely to be the rule, not the exception, and the low-cost, high-quality option of Chinese trade is in America’s best interest. In fact, this is exactly the way the theory of comparative advantage – one of the mainstays of economics – is supposed to work. By importing from China, American consumers are getting a break in purchasing power. Shifting our trade deficits elsewhere – precisely what would have to occur for a saving-short US economy – would only erode that windfall of purchasing power. Tariffs on China would, in fact, raise the cost of doing business for many American companies. For example, Wal-Mart, America’s largest company in terms of revenues, reportedly sources some $15 billion of product in China. Under S 1586, Wal-Mart would be hit with the functional equivalent of a $4 billion tax hike. American shareholders and consumers would only suffer as a result.

China helps the US economy in other ways. In particular, it plays a very important role in financing America’s current-account deficit. China’s net purchases of long-term US securities hit $60 billion in 2002 and are running well in excess of that pace so far in 2003. With the bulk of that demand concentrated in Treasuries, there can be no mistaking the role that China has played in holding down US interest rates and thereby supporting America’s economic recovery. If the RMB were adjusted upward, Chinese accumulation of currency reserves would slow and its demand for dollar-denominated assets could easily slacken as a result. That, in turn, could lead to a backup in long-term US interest rates that could jeopardize a key source of support for America’s economic recovery.

I am also concerned about the China bashing that has been going on in Japan for well over a year. Senior Japanese officials have blamed China for exporting deflation and for the "hollowing out" of the Japanese labor market. Nothing could be further from the truth. Low-cost, high-quality Chinese imports provide a windfall to the purchasing power of beleaguered Japanese consumers – precisely the same type of benefits that Japan’s export machine provided the world in the 1970s and 1980s. If you want an example of an undervalued currency, study the path of the yen during Japan’s economic renaissance; it averaged close to ¥300 versus the dollar in the 1970s and about ¥220 in the 1980s – dramatically cheaper than its current reading in the ¥110 to ¥115 range. It strikes me asis hypocritical for Japan to criticize China for emulating a strategy that was central to its own development model. Putting pressure on China to revalue its currency is a poor excuse for Japan’s own inability or unwillingness to reform.

Moreover, as I travel through the newly industrialized "special economic incentive zones" in China, I am repeatedly struck by the widespread presence of Chinese subsidiaries of Japan’s most successful companies. In fact, I am hard-pressed to identify any major Japanese producer that does not have a significant presence in China. Corporate Japan is not being forced to shift its production to China. This is the rational response of uncompetitive, high-cost Japanese producers attempting to maintain market share in an increasingly open global economy.

Over the years, I have learned the most about Asia when I hop directly between Beijing and Tokyo – an opportunity recently experienced by US Treasury Secretary John Snow. I can only hope that Secretary Snow has been able to appreciate the extraordinary contrasts between these two economies. A post-bubble Japanese economy has been in a period of relative stagnation for nearly a dozen years – with real GDP growth averaging only 1.1% from 1992 to 2002; over the same period, China’s real GDP growth has averaged about 10%. Yet as the second largest economy in the world, Japan’s per capita national income was still some 40 times that of China at market exchange rates in 2001 (or 6.5 times that of China on a purchasing power parity basis). Notwithstanding this dramatic disparity in living standards, there can be no mistaking the shift in the pendulum of economic power in Asia. China remains unflinching in terms of its commitment to reform and structural change. By contrast, Japan has taken the concept of inertia to a new level. It would be tragic if the political cycle came down hardest on the economy that is playing the greatest role in reshaping the world. Yet that’s precisely the risk as the politics of globalization now come into play.

While China is being charged with maintaining an artificially depressed currency, Japan has long written the book on currency intervention and manipulation. Indeed, in order to prevent a market-induced strengthening of the yen, Japanese authorities have spent well in excess of a record US$80 billion on official currency intervention so far this year. To the extent the US and the rest of the international community condones such massive intervention, the incentive for Japanese reforms may well be diminished. Unlike China, where there is a steadfast commitment to reforms, in Japan there is a very explicit trade-off between reforms and foreign exchange rates. I remember full well the sheer sense of panic that gripped Japan Inc. in the spring of 1995 when the yen/dollar cross rate hit ¥80. The Japanese recognized at the time that radical reforms were the only way to cope with a super-strong currency and were getting ready to implement such measures. But in the end, the world flinched and allowed the yen to depreciate by some 45% versus the dollar over the next three years or so. And Japan never really lifted a finger on reform.

That’s a lesson that should not be lost on US politicians and authorities elsewhere around the world as they overlook Japan’s transgressions and focus on China. Japan’s line of reasoning is that its economy is too weak to tolerate a stronger currency. But to the extent that currency manipulation forestalls long-overdue progress on the Japanese reform front, then there is good reason to question the wisdom of such tactics. Countries that manage foreign exchange rates in order to suit their own purposes are explicitly bringing others into the equation. From the standpoint of the US, that means the Japanese authorities are, in effect, short-circuiting a depreciation of the dollar that would otherwise be the inevitable by-product of a classic current-account adjustment. From the standpoint of Europe, Japanese currency manipulation could well force a disproportionate share of the dollar adjustment onto the euro.

Fortunately, there is reason to believe that the world may now be coming to its senses on bringing Japan into the global rebalancing equation. At the recently concluded G-7 meetings in Dubai, the call for greater flexibility in exchange rates was an unmistakable signal to Japan that the world was losing patience with massive currency intervention by a major developed nation. A firmer economy has given Japanese authorities some leeway to back away from this effort, at least for the time being. As a result, the yen has now strengthened through the ¥115 threshold versus the dollar, and the burden of America’s current-account adjustment now stands a greater chance of being spread more evenly throughout the global economy. This is good news for global rebalancing – provided, of course, Japan stays the course and refrains from returning quickly to its long standing practices of currency intervention. But what applies to Japan – the world’s second-largest economy – does not apply to China, still a very poor country. As I have stressed above, China’s transition to a flexible currency regime must occur on terms that are conducive to its own stability, in economic as well as in financial terms. Japan is rich enough to welcome the verdict of market-clearing exchange rates. China is not – at least, not yet.

There are times when economic weakness and politics make for strange bedfellows. This appears to be one of those times. The political season is starting to heat up in the United States, and all eyes are on the stresses and strains of America’s jobless recovery. This puts the politics of globalization in an entirely different context. Reflecting the often intense interplay between the political and economic cycles, China has now become the tension point du jour in the geopolitical debate.

In tough economic times, politicians always need a scapegoat. That’s what this wave of China bashing is really all about. It has little to do with economics and everything to do with the blame game. Yet this politically-inspired foray is symptomatic of a much deeper macro problem that now confronts an unbalanced world. The world’s sole growth engine – the US – is encumbered with the largest current account deficit in modern history. This reflects not only the inherent pitfalls of a saving-short US economy but also the utter lack of autonomous domestic demand growth elsewhere in the world. As America pulls the world economy along for the ride, it goes deeper and deeper into the quagmire of trade deficits, budget gaps, saving shortfalls, and excess debt accumulation. This is hardly a sustainable outcome for the US or for the rest of the world. It speaks of a worrisome and dangerous build-up of tensions in the global economy.

Like steam in a teapot, ultimately these pressures need to be vented. As I see it, the possible remedies range broadly between two extremes – the economics of a US current-account adjustment and the politics of trade frictions and protectionism. The recent shift in G-7 currency policy is an encouraging sign of an economic resolution to the world’s imbalances. Yet the interplay between America’s jobless recovery and presidential election cycle could well shift the odds from the economic to the political remedy. Right now the odds of a politically driven solution are low. But the risk is that they will rise.

Unfortunately, the saber-rattling over China in the US and Japan is not an isolated example of mounting trade frictions elsewhere in the world. Two other recent examples come to mind that paint a picture of a world veering all too close to protectionism. First is the recent breakdown of talks at the WTO ministerial meetings in Cancun. Tensions between rich and poor countries came out in the open on such long-standing issues as agricultural subsidies, investment and competition rules, and financial market transparency. The failure of this meeting of the World Trade Organization is reminiscent of the fiasco in Seattle in 1999 and raises serious questions about the successful completion of the Doha Round of trade liberalization slated for 2004.

Second, European leaders have joined the fray, aiming to protect their long-sluggish economy. Their fear is that the euro may bear a disproportionate share of the burden of further dollar depreciation. Such concerns are at the root of charges recently leveled at Asian countries whose currency pegs are perceived to insulate them from adjustments in the dollar. This sentiment, which came to a head at a recent gathering of European finance ministers in Stresa, Italy, appears to have spilled over into a more formal protest at the recently-concluded G-7 meetings in Dubai.

In 1930, Senator Reed Smoot and Representative Willis C. Hawley sponsored legislation that significantly raised the level of US tariffs. Courtesy of a recently burst equity bubble, the US economy was in recession and a Republican administration favored the protectionist remedy to provide relief for American workers. President Herbert Hoover signed the Smoot-Hawley Tariff Act into law in June 1930. Global trade retaliation quickly followed, as did a downward spiral in world trade. Many believe that such frictions ultimately set the stage for the Great Depression that followed. These lessons should not be ignored in today’s post-bubble era. No one, including myself, thinks such an outcome is likely today. Yet that’s a risk that can no longer be taken lightly as politics now comes face to face with the dark side of globalization.

I strongly believe that China is the world’s greatest development story of the 21st century. Its emergence will not only benefit not only the 20% of the world that lives in its most populous nation but it will also benefit the 80% of us who do not. But China’s road to prosperity is not without pitfalls and risks. Nor can economic stability be taken for granted in the far richer developed world. Yet in the end, we must all learn to live with the stresses and strains of globalization. Turning inward is not an option for the US. Our commitment to globalization should be unwavering in bad times as well as good. Unfortunately, the combination of a politically charged atmosphere and a tough economic climate often creates scapegoats. China is today’s scapegoat. It’s high time inward-lookingto put an end to this dangerous blame game to an end.