Arthur Kroeber expands upon a recent paper, answering questions about China's monetary policy on the valuation of the renminbi and the political issues this raises.

1. The Chinese currency, or renminbi (RMB) has been a contentious issue for the past several years. What is the root of the conflict for the United States and other countries?

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund, the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25% against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the U.S. and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

2. What impact does exchange rate control have on the economy?

According to foreign observers, consistent intervention by China to keep its exchange rate substantially below the level the market would set is a price distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus, it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly. However, Chinese policy makers do not agree with this view, and believe the managed exchange rate is broadly beneficial for economic development.

3. What is the Chinese view of their policies toward exchange rate control?

Chinese officials see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus, they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy in order to meet development objectives such as the creation of basic industries and infrastructure.

Since they perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China is an independent geopolitical power, it is fully able to resist international pressure to change its exchange rate policy.

4. What are some misconceptions about China’s large-scale reserve holdings and investments in U.S. Treasury Bonds, specifically the idea that China is “America’s banker?”

Because China’s central bank is the single biggest foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. China is not in any practical sense “America’s banker.” China holds just 8% of outstanding US Treasury debt; American individuals and institutions hold 69%. China holds just 1% of all US financial assets (including corporate bonds and equities); US investors hold 87%. Chinese commercial banks lend almost nothing to American firms and consumers – the large majority of that finance comes from American banks. America’s banker is America, not China.
It is more apt to think of China as a depositor at the “Bank of the United States:” its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere (no other bank in the world is big enough).

5. What are the implications for U.S. policy and how should policymakers react?

China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Also, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy generating large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency.

In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage which can be plausibly brought to bear. U.S. policy should therefore de-emphasize the exchange rate, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.

Event Information

In recent years, China has increasingly confronted new challenges in economic policy, including rising labor costs, low household consumption, rapid urbanization and inefficient domestic investment. While it is now widely acknowledged in Beijing that major structural adjustments are needed to address these issues, implementing serious reforms pose major challenges for the newly installed leadership.

On April 16, the John L. Thornton China Center at Brookings and China’s Caixin Media Group hosted a conference to examine the daunting challenges confronting China’s new leaders. The morning panels featured a discussion of the financial sector as well as the relationship between the domestic agenda for financial reform and China’s evolving strategy for outbound investment. The afternoon panels took a close look at the political obstacles to implementing major economic reform in areas such as tax policy, the household registration system and land transfers, as well as explore the impact of environmental and natural resource constraints on China’s economic growth.

Audio

• Part 1 - The Road Ahead for China’s Economy
• Part 2 - The Road Ahead for China’s Economy

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20130416_china_economy

The recent gyrations in the Chinese interbank market underscore that the chief risk to global growth now comes from China. Make no mistake: credit policy will tighten substantially in the coming months, as the government tries to push loan growth from its current rate of 20% down to something much closer to the rate of nominal GDP growth, which is about half that. Moreover, in the last few months of the year the new government will likely start concrete action on some long-deferred structural reforms. These reforms will bolster China’s medium-term growth prospects, but the short-term impact will be tough for the economy and for markets.

The combination of tighter credit and structural reforms means that with the best of luck China could post GDP growth in 2014 of a bit over 6%, its weakest showing in 15 years and well below most current forecasts. A policy mistake such as excessive monetary tightening could easily push growth below the 6% mark. Banks and corporations appear finally to be getting the message that the new government, unlike its predecessor, will not support growth at some arbitrary level through investment stimulus.

The dire performance of China’s stock markets in the past two weeks reflects this growing realization among domestic investors, although we suspect stocks have further to fall before weaker growth is fully discounted.

Slower growth… but no Armageddon

But the China risk is mainly of a negative growth shock, not financial Armageddon as some gloomier commentary suggests. Financial crisis risk remains relatively low because the system is closed and the usual triggers are unavailable. Emerging market financial crises usually erupt for one of two reasons: a sudden departure of foreign creditors or a drying-up of domestic funding sources for banks. China has little net exposure to foreign creditors and runs a large current account surplus, so there is no foreign trigger. And until now, banks have funded themselves mainly from deposits at a loan-to-deposit ratio (LDR) of under 70%, although the increased use of quasi-deposit wealth management products means the true LDR may be a bit higher, especially for smaller banks. The danger arises when banks push up their LDRs and increasingly fund themselves from the wholesale market. So a domestic funding trigger does not exist—yet.

The People’s Bank of China clearly understands the systemic risk of letting banks run up lending based on fickle wholesale funding. This is why it put its foot down last week and initially refused to pump money into the straitened interbank market. Interbank and repo rates have dropped back from their elevated levels, but remain significantly above the historical average. The message to banks is clear: lend within your means. This stance raises confidence that Beijing will not let the credit bubble get out of control. But it also raises the odds that both credit and economic growth will slow sharply in the coming 6-12 months.

If the economy slows and local stock markets continue to tumble, doesn’t this mean the renminbi will also weaken sharply? Not necessarily. Beijing has a long-term policy interest in increasing the international use of the renminbi, which can only occur if the currency earns a reputation as a reliable store of value in good times and bad. Allowing a sharp devaluation now runs against this interest, and also would be a sharp break from a long-established policy of not resorting to devaluation to stimulate growth, even at moments of severe stress (as in 1997-98 and 2008-09). So while our call on China growth has been marked down, our call on the renminbi has not.

Short-term pain is better than long-term stagnation

From a broader perspective, the biggest China risk is not that the country suffers a year or two of sharply below-trend growth. If that slowdown reflects more rational credit allocation and the early, painful stages of productivity-enhancing reforms, it will be healthy medicine. And even a much slower China will still be growing faster than all developed markets and most emerging ones.

The real risk is rather that the new government will show a lack of nerve or muscle and fail to push through financial sector liberalization, deregulation of markets to favor private firms, and fiscal reforms to curtail local governments’ ability to prop up failing firms, overspend on infrastructure, and inflate property bubbles. The old government wasted the last three years of its term doing none of these things despite the obvious need. The new leaders are talking a better game, but they have a year at most to articulate a clear reform program, begin implementation (liberalizing interest rates and freeing electricity prices would be a good start), and ruthlessly removing senior officials who stand in the way. If they fail to deliver, then the short-term slowdown could become a long and dismal decline.

Event Information

China’s outbound investment is expected to increase by leaps and bounds in the next decade. Chinese companies are poised to become a major economic force in the global economy. Outbound direct investment by Chinese companies presents unprecedented opportunities for both Chinese companies and their global partners.

The relatively brief history of Chinese companies’ outbound investment indicates, however, that Chinese outbound FDI faces many hurdles both at home and in the destination countries. How can we assess the regulatory, financial, labor, environmental and political risks faced by Chinese multinational companies? What remedies can mitigate such risks for the Chinese firms, for the host countries of Chinese investment and for the Chinese government and people?

The Brookings-Tsinghua Center for Public Policy co-hosted with the 21st Century China Program at UC San Diego, and in collaboration with the Enterprise Research Institute and Tsinghua’s School of Public Policy and Management, a two-day conference at Tsinghua University in Beijing, China, on September 23 and 24, 2013. The conference gathered leading experts, policy makers and corporate leaders to examine the latest research on trends and patterns of Chinese outbound direct investments; the regulatory framework and policy environment in China and destination countries (particularly, but not only in the U.S.); and the implications of Chinese outbound direct investment for China’s economic growth and the global economy. Keynote speakers of each day were Jin Liqun, chairman of China International Capital Corporation, and Gary Locke, U.S. ambassador to China. Mr. Jin suggested that China’s foreign direct investment companies should cooperate with local firms and be willing to talk to the local governments about their problems. Ambassador Locke, on the other hand, introduced the advantages of the U.S. as an investment destination country. He also agreed that investors were supposed to get local help to achieve success.

The audiences included major Chinese companies, service providers in the area of overseas direct investment, policy makers and scholars.

Read more about the speakers and the conference agenda »

Video

• Overview of China's Overseas Investments: Trends, Patterns and Comparison
• Chinese ODI: Motivation and Policy Environment
• Risk Management in Chinese ODI
• China's Outbound Direct Investment - Gary Locke Keynote Address
• Regulatory Environments in Destination Countries (Non-U.S.)
• Regulatory Environments in Destination Countries (Focusing on the U.S.)
• Labor, Environment, and Community Relations in Destination Countries

Transcript

• Keynote speech of U.S. Ambassador to China Gary Locke (.pdf)

Event Materials

• Remarks of Ambassador Locke
• Brian Beglin slides
• Daniel Levine slides
• Jiang Heng slides
• LIU Qian
• Matt Ferchen slides
• Steve Olson slides
• Tang Xiaoyang slides
• Thilo Hanemann slides
• Weiyi Shi slides
• Kang Rongping slides
• Duan Zhirong slides

The much anticipated Third Plenum of the Chinese Communist Party’s 18^th Congress closed its four-day session last Tuesday. A relatively bland initial communiqué was followed today by a detailed decision document spelling out major initiatives including a relaxation of the one-child policy, the elimination of the repressive “re-education through labor” camps, and a host of reforms to the taxation and state-owned enterprise systems. Today’s blizzard of specific reform pledges allays earlier concerns that the new government led by party chief Xi Jinping and premier Li Keqiang would fail to set major policy goals. But is this enough to answer the three biggest questions analysts have had since Xi and  Li ascended a year ago?

Those questions are, first, do Xi and his six colleagues on the Politburo standing committee have an accurate diagnosis of China’s structural economic and social ailments? Second, do they have sensible plans for addressing these problems? And third, do they have the political muscle to push reforms past entrenched resistance by big state owned enterprises (SOEs), tycoons, local government officials and other interest groups whose comfortable positions would be threatened by change? Until today, the consensus answers to the first two questions were “we’re not really sure,” and to the third, “quite possibly not.”

These concerns are misplaced. It is clear that the full 60-point “Decision on Several Major Questions About Deepening Reform”[1] encompasses an ambitious agenda to restructure the roles of the government and the market. Combined with other actions from Xi’s first year in office – notably a surprisingly bold anti-corruption campaign – the reform program reveals Xi Jinping as a leader far more powerful and visionary than his predecessor Hu Jintao. He aims to redefine the basic functions of market and government, and in so doing establish himself as China’s most significant leader since Deng Xiaoping. Moreover, he is moving swiftly to establish the bureaucratic machinery that will enable him to overcome resistance and achieve his aims. It remains to be seen whether Xi can deliver on these grand ambitions, and whether his prescription will really prove the cure for China’s mounting social and economic ills. But one thing is for sure: Xi cannot be faulted for thinking too small.

Main objective: get the government out of resource allocation

The four main sources we have so far on Xi’s reform strategy are the Plenum’s Decision, the summary communiqué issued right after the plenum’s close,[2] an explanatory note on the decision by Xi,[3] and a presumably authoritative interview with the vice office director of the Party’s Financial Leading Small Group, Yang Weimin, published in the People’s Daily on November 15, which adds much useful interpretive detail.[4] Together they make clear that the crucial parts of the Decision are as follows:

• China is still at a stage where economic development is the main objective.
• The core principle of economic reform is the “decisive” (决定性) role of market forces in allocating resources (previous Party decisions gave the market a “basic” (基础）role in resource allocation.
• By implication, the government must retreat from its current powerful role in allocating resources. Instead, it will be redirected to five basic functions: macroeconomic management, market regulation, public service delivery, supervision of society (社会管理), and environmental protection.

In his interview, Yang Weimin draws a direct comparison between this agenda and the sweeping market reforms that emerged after Deng Xiaoping’s southern tour in 1992, claiming that the current reform design is a leap forward comparable to Deng’s, and far more significant than the reform programs of Jiang Zemin and Hu Jintao.

This a very bold and possibly exaggerated claim. But the basic reform idea – giving the market a “decisive” role in resource allocation – is potentially very significant, and should not be dismissed as mere semantics. Over the last 20 years China has deregulated most of its product markets, and the competition in these markets has generated enormous economic gains. But the allocation of key inputs – notably capital, energy, and land – has not been fully deregulated, and government at all levels has kept a gigantic role in deciding who should get those inputs and at what price. The result is that too many of these inputs have gone to well-connected state-owned actors at too low a price. The well-known distortions of China’s economy – excessive reliance on infrastructure spending, and wasteful investment in excessive industrial capacity – stem largely from the distortions in input prices.

Xi’s program essentially calls for the government to retreat from its role in allocating these basic resources. If achieved, this would be a big deal: it would substantially boost economic efficiency, but at the cost of depriving the central government of an important tool of macro-economic management, and local governments of treasured channels of patronage. As a counterpart to this retreat from direct market interference, the Decision spells out the positive roles of government that must be strengthened: macro management and regulation, public service delivery, management of social stability, and environmental protection. In short, the vision seems to be to move China much further toward an economy where the government plays a regulatory, rather than a directly interventionist role.

Keep the SOEs, but make them more efficient

Before we get too excited about a “neo-liberal” Xi administration, though, it’s necessary to take account of the massive state-owned enterprise (SOE) complex. While Xi proposes that the government retreat from its role in manipulating the prices of key inputs, it is quite clear that the government’s large role as the direct owner of key economic assets will remain. While the Decision contains a number of specific SOE reform proposals (such as raising their dividend payout ratio from the current 10-15% to 30%, and an encouragement of private participation in state-sector investment projects), it retains a commitment to a very large SOE role in economic development. The apparent lack of a more aggressive state-sector reform or privatization program has distressed many economists, who agree that China’s declining productivity growth and exploding debt are both substantially due to the bloated SOEs, which gobble up a disproportionate share of bank credit and other resources but deliver ever lower returns on investment.

The communiqué and the Decision both make clear that state ownership must still play a “leading role” in the economy, and it is a very safe bet that when he retires in 2022, Xi will leave behind the world’s biggest collection of state-owned enterprises. But while privatization is off the table, subjecting SOEs to much more intense competition and tighter regulation appears to be a big part of Xi’s agenda. In his interview, Yang Weimin stresses that the Plenum decision recognizes the equal importance of both state and non-state ownership – a shift from previous formulations which always gave primacy to the state sector. Moreover, other reports suggest that the mandate of the State-owned Assets Supervision and Administration Commission (Sasac), which oversees the 100 or so big centrally-controlled SOE groups, will shift from managing state assets to managing state capital.[5] This shift of emphasis is significant: in recent years SOEs have fortified their baronies by building up huge mountains of assets, with little regard to the financial return on those assets (which appears to be deteriorating rapidly). Forcing SOEs to pay attention to their capital rather than their assets implies a much stronger emphasis on efficiency.

This approach is consistent with a long and generally successful tradition in China’s gradual march away from a planned economy. The key insight of economic reformers including Xi is that the bedrock of a successful modern economy is not private ownership, as many Western free-market economists believe, but effective competition. If the competitive environment for private enterprises is improved – by increasing their access to capital, land and energy, and by eliminating regulatory and local-protectionist barriers to investment – marginal SOEs

must either improve their efficiency or disappear (often by absorption into a larger, more profitable SOE, rather than through outright bankruptcy). As a result, over time the economic role of SOEs is eroded and overall economic efficiency improves, without the need to fight epic and costly political battles over privatization.

Can Xi deliver?

Even if we accept this view of Xi as an ambitious, efficiency-minded economic reformer, it’s fair to be skeptical that he can deliver on his grand design. These reforms are certain to be opposed by powerful forces: SOEs, local governments, tycoons, and other beneficiaries of the old system. All these interest groups are far more powerful than in the late 1990s, when Zhu Rongji launched his dramatic reforms to the state enterprise system. What are the odds that Xi can overcome this resistance?

Actually, better than even. The Plenum approved the formation of two high-level Party bodies: a “leading small group” to coordinate reform, and a State Security Commission to oversee the nation’s pervasive security apparatus. At first glance this seems a classic bureaucratic shuffle – appoint new committees, instead of actually doing something. But in the Chinese context, these bodies are potentially quite significant.

In the last years of the Hu Jintao era, reforms were stymied by two entrenched problems: turf battles between different ministries, and interference by security forces under a powerful and conservative boss, Zhou Yongkang. Neither Hu nor his premier Wen Jiabao was strong enough to ride herd on the squabbling ministers, or to quash the suffocating might of the security faction. By establishing these two high-level groups (presumably led by himself or a close ally), Xi is making clear that he will be the arbiter of all disputes, and that security issues will be taken seriously but not allowed to obstruct crucial economic or governance reforms.

The costs of crossing Xi have also been made clear by a determined anti-corruption campaign which over the last six months has felled a bevy of senior executives at the biggest SOE (China National Petroleum Corporation), the head of the SOE administrative agency, and a mayor of Nanjing infamous for his build-at-all-costs development strategy. Many of the arrested people were closely aligned with Zhou Yongkang. The message is obvious: Xi is large and in charge, and if you get on the wrong side of him or his policies you will not be saved by the patronage of another senior leader or a big state company. Xi’s promptness in dispatching his foes is impressive: both of his predecessors waited until their third full year in office to take out crucial enemies on corruption charges.

In short, there is plenty of evidence that Xi has an ambitious agenda for reforming China’s economic and governance structures, and the will and political craft to achieve many of his aims. His program may not satisfy market fundamentalists, and he certainly offers no hope for those who would like to see China become more democratic. But it is likely to be effective in sustaining the nation’s economic growth, and enabling the Communist Party to keep a comfortable grip on power.

Editor's Note: Arthur Kroeber is the Beijing-based managing director of Gavekal Dragonomics, a global macroeconomic research firm, and a non-resident fellow of the Brookings-Tsinghua Center. A different version of this article appears on www.foreignpolicy.com.

A year after he and his colleagues took control of China’s government, Xi Jinping has emerged as an extraordinarily powerful leader, with a clear and ambitious agenda for remaking the Chinese governance system. Economic, social and foreign policy are now on a far more clear and decisive course than they were during the drifting and unfocused last years under president Hu Jintao and premier Wen Jiabao.

Xi arguably wields more personal authority than any Chinese leader since Mao: he has subdued the fragmented fiefdoms that arose under Hu; has arrogated all key decisions to himself, unlike Jiang Zemin who delegated much economic policy power to his premier Zhu Rongji; and does not have to deal with the cabal of conservative patriarchs that often hemmed in Deng Xiaoping.

Perhaps the biggest surprise of Xi’s first year was the speed with which he consolidated his power and signaled his policy intentions. He achieved this through two big house-cleaning drives. First was an anti-corruption campaign that neutralized a powerful political enemy (former security boss Zhou Yongkang), brought to heel a powerful vested interest (state oil giant China National Petroleum Corporation, much of whose senior management was arrested) and signaled the costs of opposing his reform agenda by sweeping up 20,000 officials at all levels of government. The other was the so-called “mass line” campaign that involved party, government and military officials engaging in “self-criticism” sessions and getting marching orders from party central.

So there is no question that Xi has power. What does he intend to do with it? The Decision document that emerged last November from the Communist Party plenum made clear that his aim is comprehensive governance reform. This does not mean eroding the party’s monopoly on power; quite the reverse. The intention is to strengthen the party’s grip by improving the administrative system, clarifying the roles of the market and the state (resulting in a more market-driven economy but also in a more powerful and effective state), and permitting a wider role for citizen-led non-governmental organizations—so long as those NGOs effectively act as social-service contractors for the state and do not engage in advocacy or political mobilization.

And at the recent National People’s Congress (NPC) we got additional detail on Xi’s economic program, which is the most comprehensive structural reform agenda since the late 1990s. (Xi’s propagandists make the bolder claim that it is the most sweeping reform program since Deng’s original “reform and opening” drive of the late 1970s.) Much commentary has focused on the Plenum Decision’s emphasis on giving the market a “decisive role,” and this shift is indeed important. But Xi is not some Chinese version of Ronald Reagan or Margaret Thatcher: for him and his colleagues, the market is a tool, not an end in itself. The respective roles of state and market need to be clarified, but the state role will remain very large. Xi’s economic agenda is not just about deregulation and improving the environment for private enterprise; it is also about fixing the state-enterprise and fiscal systems so that they become more effective instruments for achieving state aims.

If Xi succeeds, the result will be a China with a more efficient economy, a better run and somewhat more transparent government—and a Communist Party with enhanced legitimacy and tighter control of all the crucial levers of power. But there are also two less rosy potential outcomes. One is that his reforms fail, and China is left with a debt ridden, slow-growing economy with an overbearing state sector and an increasingly dissatisfied population. Another is that he succeeds—but either becomes a permanent dictator himself, or establishes the belief that China only be ruled by a strongman, thereby retarding the development of a more open and participatory political system.

It’s the economy, and we’re not stupid

On the immediate economic policy questions, a gulf has opened between foreign and many non-official domestic analysts on the one hand, and the apparent stance of the government on the other. According to the prevalent outside view, China’s biggest problem is the huge increase in leverage since the 2008 global financial crisis: total non-financial credit rose from 138 percent of GDP in 2008 to 205 percent last year. Unless this spiraling leverage is brought under control, the argument goes, China risks some sort of financial crisis. To stabilize the credit/GDP ratio, annual credit growth must fall from its current rate of around 17 percent to the trend rate of nominal GDP growth, which now appears to be around 10 percent. But such a dramatic fall in credit growth must almost certainly cause a drop in real GDP growth, at least in the short run. The conclusion is therefore that if Beijing is serious about controlling leverage, it must accept significantly lower growth for at least a couple of years. If on the other hand the leaders insist on keeping economic growth at its current pace, this means they cannot be serious about controlling leverage and imposing structural reform, and a train wreck is more likely.

As far as we can tell from the agenda laid out at the Plenum and the NPC, Xi and his colleagues do not agree with this analysis. Their priorities are to restructure the state-owned enterprises (SOEs) and the fiscal system, and maintain real GDP growth at approximately its current rate of 7.5 percent. The leverage problem, by implication, can be sorted out over several years.

The argument in favor of this approach is that SOE and fiscal reform strike at the root causes of the debt build-up. Local governments have borrowed because their expenditure responsibilities exceed their assigned revenues, they have an implicit mandate to build huge amounts of urban infrastructure, and they face no accountability for the return on their investments. SOEs have borrowed because their return on capital has deteriorated sharply. Improving SOEs’ return on capital and cleaning up local government finance, should greatly reduce the demand for unproductive debt, and hence bring credit and economic growth back into alignment—eventually. In the meantime credit will flow at whatever rate permits real GDP to keep humming at 7 percent or more, meaning that leverage will continue to rise.

In other words, the government thinks the debt build-up is merely a symptom, and it intends to attack the underlying disease while letting the symptoms take care of themselves. One can feel comfortable with approach this on two conditions: first, that the government is right that the debt buildup does not itself pose an immediate threat to economic health; and second that the government is serious about tackling the structural problems.

Debt – what, me worry?

The safety of the current debt trajectory is a judgment call. On the plus side, the last several months have seen a steep decline in year-on-year credit growth, with very little apparent impact on economic activity. Growth in broad credit (including activity in the “shadow” financing sector) peaked at 23.5 percent in April 2013 and declined continuously to 17 percent in February, while GDP growth remained basically steady in both real and nominal terms. If this pattern holds, it suggests that leverage will continue to increase, but at a slower rate than in the past two years, so the runaway-train risk is reduced.

The government’s own case for the safety of the present debt situation implicitly rests on a report by the National Audit Office (NAO) in late December, which found the debt position of local governments to be poor but manageable. Total liabilities of local governments as of 30 June 2013 were found to be Rmb18 trn (US$3 trn), or approximately 31 percent of GDP; of these liabilities 40 percent were guarantees and contingencies (and thereby not an imminent risk to local finances). NAO’s estimate of consolidated public debt, including the central government, came in at about 53 percent of GDP, well below the levels of public borrowing in most OECD countries.

Another basis for the sanguine view on debt was an extensive national balance-sheet analysis published in December by the Chinese Academy of Social Sciences (CASS), the party’s main think-tank. CASS’s calculation methods differ from NAO’s, so the two sets of figures are not directly comparable. CASS found that total government debt was 73 percent of GDP in 2011, and that broad public-sector liabilities (including the debt of SOEs and policy banks) were 151 percent of GDP. This sounds scary until you inspect the asset side of the balance sheet, which comes in at a more cheerful 350 percent. This figure is almost certainly too rosy: nearly three-quarters of it represents the land holdings of local governments and SOE assets, whose reported values are probably well above their true market values. But even discounting these values substantially, it is still possible to conclude that the public sector’s assets comfortably cover its liabilities.

Whether one agrees with these estimates or not, it is clear that policy makers accept the central conclusion that the nation’s debt problem is serious but manageable, and that direct efforts to deleverage immediately are not warranted. The important question then becomes whether Beijing’s efforts to tackle the underlying structural problems are bearing fruit.

Rolling back the SOE tide

So what are those efforts? The agenda on SOE reform is now clear. SOEs will be compelled to focus on improving their return on capital, rather than expanding their assets; private capital will be permitted to enter previously restricted sectors; direct private investment in SOEs and in state-led investment projects will be encouraged; and most likely (although government officials have been coy on this point), a swathe of underperforming locally-controlled SOEs in non-strategic sectors will be privatized or forced into bankruptcy.

In essence, this revives the zhuada fangxiao (grasp the big, release the small) SOE reform strategy of the late 1990s. The idea was that the state would retain control, and try to improve the operational efficiency, of a relatively small number of very large enterprises in strategic sectors such as railways, aviation, telecoms, power and petrochemicals, while privatizing most activity in competitive consumer goods and services sectors. This strategy was successful: in the decade ending in 2008, the number of SOEs fell from 260,000 to 110,000, the private sector’s share of national fixed investment rose from less than a quarter to 58 percent, the profitability and return on assets of state firms rose dramatically and came close to matching the returns in private firms, and the proportion of SOE assets in “strategic” sectors rose to an all-time high of 62 percent.

Thanks to the Hu/Wen leadership’s lack of enthusiasm for state sector reform, and their mandate that state firms support the massive 2009 economic stimulus, some of these gains have been reversed. Crucially, the return on assets in SOEs plummeted to less than half the private-sector average, and state firms began to re-colonize sectors from which they had previously retreated: by 2011, half of SOE assets were in these non-strategic sectors.

Now the reformers are back in charge and aim to complete the zhuada fangxiao objective. This does not mean eliminating the state sector, or privatizing the core centrally-owned firms on the economy’s commanding heights. But it does mean a determined push to shed non-core SOEs and assets, abandon consumer-facing sectors in favor of private firms, and improve the operational efficiency of the remaining SOES. The headline efforts in this direction so far have been an announcement by the Guangdong provincial government that it aims to move 80 percent of provincial SOEs to a mixed-ownership structure, with no predetermined minimum state shareholding; and an announcement by petrochemicals giant Sinopec that it will seek private investment for an up to 30 percent share of its downstream gasoline and diesel distribution operations.

Funding the unfunded mandates

SOE reform was a surprisingly strong component of the Third Plenum decision; fiscal reform took center stage in the recent NPC session. China’s central fiscal problem is unfunded mandates for local governments. Localities control less than half of revenues but are responsible for 85 percent of government expenditure. In theory, the gap is supposed to be bridged by transfers from the central government, but in practice the transfers often do not match up well with localities’ actual needs. Not surprisingly, they respond to this structural deficit by resorting to a variety of off-budget funding schemes, a lot of which involve grabbing land and selling it to developers at a big markup.

A mismatch between local expenditure and revenue was a deliberate feature of the landmark 1994 tax reform (in whose design finance minister Lou Jiwei was involved as a junior official). But until the early 2000s, localities’ expenditure share was roughly stable at around two-thirds of the total; unfunded mandates and chronic deficits have grown dramatically in the past decade.

The centerpiece of Lou’s fiscal reform strategy is a recentralization of expenditure responsibility and a more flexible transfer system, reducing incentives for local-government rapacity. But in his budget speech he outlined a host of other detailed reforms, whose combined effect would be curb over-investment in real estate and heavy industry, permit fiscal policy to become more countercyclical and increase budget accountability. The main items include:

• Revenue estimates “are now seen as projections instead of tasks to accomplish.” This aims to discourage the current practice of trying to increase tax collections during economic downturns.
• Adoption of a three-year budget cycle and accrual accounting.
• Increase local government borrowing authority (from a small base), via provincial and municipal bonds.
• Make budgets at both the central and local level more open and transparent.
• Clean up the maze of local government tax breaks.
• Impose the long-delayed tax on property values, establish an environmental protection tax and hike the resource tax on coal.

Good diagnosis, but will the cure cause more harm?

All in all the reform agenda is a strong one: its diagnosis of China’s economic ills is compelling, and the proposed cures seems sensible. There are three concerns. First, there is the worry that the government has underestimated the financial risks of the burgeoning debt burden and a rapidly-changing financial system. The only clear promise of stronger financial regulation so far is Lou’s statement that a deposit insurance system will be launched later this year. This would reduce moral hazard by clarifying for investors which financial assets are guaranteed and which are risky. But more action to cut debt and restrain the “shadow banking” sector may be needed.

Second, it is possible that reforms may be thwarted by powerful bureaucratic and business interests: some reforms (like the property tax) have been proposed in the past but gone nowhere. On the whole, Xi’s success at whipping officialdom into line by the anti-corruption and mass line campaigns suggests he will be more effective than his predecessor, but there is no guarantee. Finally, there is the worry that Xi’s program succeeds, and validates highly centralized and authoritarian style of governance that could harm China’s long-term prospects for development into a more open and liberal society.

Event Information

While countless factors have contributed to China’s dramatic economic transformation, the groundbreaking economic reforms instituted by Premier Zhu Rongji from 1998 to 2003 were critical in setting the stage for China to become one of the world’s dominant economic powers. From combatting corruption and inefficient state-owned enterprises at home to engineering China’s ascension to the World Trade Organization, Zhu left behind a legacy on which successive administrations have sought to build. What similarities, differences or parallels can be drawn between Zhu’s time and today? And what lessons can China’s current leaders learn from Zhu’s reforms?

On January 9, the John L. Thornton China Center at the Brookings Institution launched the second English volume of Zhu Rongji: On The Record (Brookings Press, 2015), which covers the critical period during which Zhu served as premier between 1998-2003. In addition to highlighting Zhu’s legacy, this event also featured public panel discussions outlining the past, present and future of Chinese economic reform and its impact domestically and internationally.

Audio

• Chinese Economic Reform: Past, Present and Future - Part 1
• Chinese Economic Reform: Past, Present and Future - Part 2

Transcript

• Transcript (.pdf)

Event Materials

• 20150109_china_economic_reform_transcript

The rapid development of China’s shadow banking sector since 2010 has attracted a great amount of commentary both inside and outside the country. Haunted by the severe crisis in the US financial system in 2008, which was caused in part by the previously unsuspected fragility of a large network of non-bank financial activities, many analysts wonder if China might be headed for a similar meltdown. The concern is especially acute given China’s very rapid rate of credit creation since 2010 and the lack of transparency in much off balance sheet or non-bank activity.

This paper will address the following questions:

1. What is shadow banking?
2. Why does the sector matter?
3. What was the Chinese credit system like before shadow banking?
4. What is the nature of shadow banking in China now?
5. How big is shadow banking in China?
6. Why has Chinese shadow banking grown so fast?
7. How does Chinese shadow banking relate to the formal banking sector?
8. Why has the Chinese sector developed as it has?
9. How does the size and structure of shadow banking in China compare to other countries?
10. Will there be a major shadow banking crisis in China?
11. How do Chinese authorities intend to reform shadow banking?

Downloads

• Download the full paper

Just how much economic trouble is China in? To judge by global markets, a lot. In the first few weeks of the year, stock markets around the world plummeted, largely thanks to fears about China. The panic was triggered by an 11 percent plunge on the Shanghai stock exchange and by a small devaluation in the renminbi. Global investors—already skittish following the collapse of a Chinese equity-market bubble and a surprise currency devaluation last summer—took these latest moves as confirmation that the world’s second-biggest economy was far weaker than its relatively rosy headline growth numbers suggested.

In one sense, markets overreacted. China’s economy grew by 6.9 percent in 2015; financial media headlines bewailed this as “the lowest growth rate in a quarter century,” but neglected to mention that this is still by a good margin the fastest growth of any major economy except for India. Even at its new, slower pace, China continues to grow more than twice as fast as developed economies. Some doubt the reliability of China’s economic statistics, of course, but most credible alternative estimates (based on hard-to-fake indicators of physical output) still suggest that China is growing at around 6 percent, and that if anything there was a slight pickup in activity in late 2015.

It’s true that construction and heavy industry, which drove China’s growth from 2000 to 2013, are now nearing recession levels. But services—which now account for over half of China’s economy—and consumer spending remain strong, underpinned by solid employment and wage gains. The latest Nielsen survey of consumer confidence ranked China eighth of 61 countries in consumer optimism, and confidence actually increased in the last quarter of 2015. All in all, another year of 6 percent-plus growth should be achievable in 2016.

Markets also exaggerate the risk of financial crisis, with their breathless talk of capital fleeing the country. Most of this so-called “capital flight” is simply a matter of companies prudently paying down foreign-currency debts, or hedging against the possibility of a weaker renminbi by shifting their bank deposits into dollars. In the main, these deposits remain in the mainland branches of Chinese banks. Domestic bank deposits grew by a healthy 19 percent in 2015 and now stand at $21 trillion—double the country’s GDP and seven times the level of foreign exchange reserves. The continued fast rise in credit is an issue that policymakers will need to address eventually. But they have time, because lending to households and companies is backed one-for-one by bank deposits. By contrast, the United States on the eve of its crisis in 2008 had nearly four dollars of loans for every dollar of bank deposits. As long as China’s financial system stays so securely funded, the chance of a crisis is low.

Yet while we should not worry about an imminent economic “hard landing” or financial crisis, there are reasons to be seriously concerned about the country’s economic direction. The core issue is whether China can successfully execute its difficult transition from an industry- and investment-intensive economy to one focused on services and consumption, and how much disruption it causes to the rest of the world along the way. History teaches us that such transitions are never smooth. And indeed, China’s transition so far has been much rougher than the gradual slowdown in its headline GDP numbers suggests.

Remember that when China reports its GDP growth, this tells you how much its spending grew in inflation-adjusted renminbi terms. But to measure China’s impact on the rest of the world in a given year, it is better to look at its nominal growth—that is, not adjusted for inflation—in terms of the international currency: the U.S. dollar. This is because nominal U.S.-dollar figures better show how much demand China is pumping into the global economy, both in volume terms (buying more stuff) and in price terms (pushing up the prices of the stuff it buys).

When we look at things this way, China’s slowdown has been precipitous and scary. At its post-crisis peak in mid-2011, China’s nominal U.S.-dollar GDP grew at an astonishing 25 percent annual rate. During the four-year period from 2010 to 2013, the average growth rate was around 15 percent. By the last quarter of 2015, though, it had slowed to a tortoise-like 2 percent (see chart). In short, while investors are wrong to complain that China distorts its GDP data, they are right to observe that, for the rest of the world, China’s slowdown feels far worse than official GDP numbers imply.

This dramatic fall in the growth of China’s effective international demand has already hit the global economy hard, through commodity prices. In the past 18 months, the prices of iron ore, coal and oil, and other commodities have all fallen by about two-thirds, thanks in part to the slowdown in Chinese demand and in part to the glut of supply built up by mining companies that hoped China’s hunger for raw materials would keep growing forever. This has badly hurt emerging economies that depend on resource exports: Brazil, for instance, is now mired in its worst downturn since the Great Depression. The slowdown also hurts manufacturers in rich countries like the United States and Japan, which rely on sales of equipment to the mining and construction industries.

This helps explain why markets react so fearfully at every hint the renminbi might fall further in value: A weaker currency reduces the dollar value of the goods China can buy on international markets, creating more risk of a further slowdown in an already languid world economy.

There is a silver lining: The flattening of its commodity demand shows China has turned its back on an unsustainable growth model based on ever-rising investment. The question now is whether it can succeed in building a new growth model based mainly on services and consumer spending. As we noted above, growth in services and consumer spending is solid. But it is still not strong enough to carry the whole burden of driving the economy. For that to happen, much more reform is needed. And the pace of those reforms has been disappointing.

The crucial reforms all relate to increasing the role of markets, and decreasing the role of the state in economic activity. China has an unusually large state sector: OECD researchers have estimated that the value of state-owned enterprise assets is around 145 percent of GDP, more than double the figure for the next most state-dominated economy, India.[1] This large state sector functioned well for most of the last two decades, since the main tasks were to mobilize as many resources as possible and build the infrastructure of a modern economy—tasks for which state firms, which are not bound by short-term profit constraints, are well suited.

Now, however, the infrastructure is mostly built and the main task is to make the most efficient use of resources, maximize productivity, and satisfy ever-shifting consumer demand. For this job, markets must take a leading role, and the government must wean itself off the habit of using state-owned firms to achieve its economic ends. And the big worry is that, despite the promises in the November 2013 Third Plenum reform agenda, Beijing does not seem all that willing to let markets have their way.

The concerns stem from the government’s recent interventions in the equity and currency markets. Last June, when a short-lived stock market bubble popped, the authorities forced various state-controlled firms and agencies to buy up shares to stop the rout. This stabilized the market for a while, but left people wondering what would happen when these agencies started selling down the shares they had been forced to buy. To enable these holdings to be sold without disrupting the market, the authorities instituted a “circuit breaker” which automatically suspended stock-exchange trading when prices fell by 5 percent in one day. Instead of calming the market, this induced panic selling, as traders rushed to dump their shares before the circuit breaker shut off trading. The government canceled the circuit breaker, and the market remains haunted by the risk of state-controlled shareholders dumping their shares en masse.

Similarly, Beijing got into trouble in August when it announced a new exchange-rate mechanism that would make the value of the renminbi more market determined. But because it paired this move with a small, unexpected devaluation, many traders assumed the real goal was to devalue the renminbi, and started pushing the currency down. So the People’s Bank of China (PBOC) intervened massively in the foreign exchange markets, spending down its foreign-currency reserves to prop up the value of the renminbi. This stabilized the currency, but brought into question the government’s commitment to a truly market-driven exchange rate. 

Then, in December, PBOC made another change, by starting to manage the renminbi against a trade-weighted basket of 13 currencies, rather than against the dollar as in the past. Because the dollar has been strong lately, this in effect meant that PBOC was letting the renminbi devalue against the dollar. Again, PBOC argued that its intention was not to devalue, but simply to establish a more flexible exchange rate. And again, it undermined the credibility of this intention by intervening to prevent the currency from falling against the dollar.

One could argue that these episodes were merely potholes on the road to a greater reliance on markets. This may be so, but investors both inside and outside China are not convinced. The heavy-handed management of the equity and currency markets gives the impression that Beijing is not willing to tolerate market outcomes that conflict with the government’s idea of what prices should be. This runs against the government’s stated commitment in the Third Plenum decision to let market forces “play a decisive role in resource allocation.”

Another source of unease is the slow progress on state enterprise reform.  Momentum seemed strong in 2014, when provinces were encouraged to publish “mixed ownership” plans to diversify the shareholding of their firms. This raised hopes that private investors would be brought in to improve the management of inefficient state companies. Yet to date only a handful of mixed-ownership deals have been completed, and many of them involve the transfer of shares to state-owned investment companies, with no private-sector participation. Plans to subject the big centrally controlled state enterprises to greater financial discipline by putting them under holding companies modeled on Singapore’s Temasek have been incessantly discussed, but not put into action. Meanwhile the number of state firms continues to grow, rising from a low of 110,000 in 2008 to around 160,000 in 2014.

So long as Beijing continues to intervene in markets to guide prices, and fails to deliver on the key structural reforms needed to create a sustainable consumer-led economy, markets both inside and outside China will continue to be nervous about the sustainability of growth, and we will see more “China scares” like the one we endured in January. A clearer sense of direction is required, as is better communication.

For three decades, China sustained fast economic growth by steadily increasing the scope of markets, even as it preserved a large role for the state. Because investors were confident in the general trend towards more markets and more space for private firms, they were happy to invest in growth. Today neither private entrepreneurs in China, nor traders on global financial markets, are confident in such a trend. By the end of 2015 growth in investment by non-state firms had slowed to only about two-thirds the rate posted by state-owned firms, ending nearly two decades of private-sector outperformance.

Doubts are amplified by the government’s failure to communicate its intentions. During the last several months of confusion on foreign exchange markets, no senior official came forth to explain the goals of the new currency policy. No other country would have executed such a fundamental shift in a key economic policy without clear and detailed statements by a top policymaker. As China prepares for its presidency of the G-20, the government owes it both to its own people and to the global community of which it is now such an important member to more clearly articulate its commitment to market-oriented reforms and sustainable growth.

[1] P. Kowalski et al., “State-owned Enterprises: Trade Effects and Policy Implications,” OECD Trade Policy Papers No. 147 (2013). http://dx.doi.org/10.1787/5k4869ckqk7l-en

Editors' Note: Hammering out the political deal that has now brought Trans-Pacific Partnership (TPP) negotiations to a successful conclusion was a landmark achievement, but as Mireya Solis argues, there are still battles to be fought. This post originally appeared in Nikkei Asian Review.

The Trans-Pacific Partnership (TPP) deal that the United States and 11 other Pacific Rim countries struck in Atlanta today was five years in the making. More than once we heard that the end game had come, only to see deadlines pass us by as the negotiations continued to move at a frustratingly slow pace. The grueling work required to cinch this mega trade deal should not come as a surprise, however, given the sheer complexity of the negotiation agenda and the wide differences in the makeup of the participating countries.

Hammering out the essential political deal that has brought TPP negotiations to a successful conclusion is a landmark achievement. But we should not lose sight of the fact that more battles will need to be won before the TPP morphs from an agreement in principle to an agreement in reality. Success at the Atlanta ministerial, however, delivers immediate and portentous benefits. 

U.S. leadership: A balance between strength and flexibility 

Central to American grand strategy has been updating the international economic architecture to match the realities of 21st-century economy and consolidating the critical role of the United States as a Pacific power as envisioned by the Asian rebalance policy. The TPP has long emerged as a litmus test of the American will and resolve to rise to these challenges in a world of fluid geopolitics. With success at the TPP negotiating table, the convening power of the United States—as demonstrated by its ability to steward the most ambitious blueprint for trade integration—has received an enormous boost. 

But equally important is that in the final TPP deal, the United States has displayed another key trait of international leadership: flexibility. Critics of American trade strategy have frequently complained that the U.S. rigidly pushes for its own free-trade agreement (FTA) template without incorporating the preferences of its counterparts: that de facto, the United States does not “negotiate” in trade negotiations. But the set of final compromises that enabled the TPP deal to be struck at Atlanta shows a different picture, one that in fact makes U.S. leadership more attractive and the TPP project more compelling. 

The TPP project is still a promise, not a reality.

In endorsing the principle that TPP countries can opt out of investor-state dispute settlement in their public regulation of tobacco products, and in adopting a hybrid approach that will give up to eight years of data protection for biologic drugs, the United States has shown the strength to compromise without surrendering high standards. In turn, these negotiated compromises cast a favorable light on the TPP as a collective endeavor with a commonality of purpose among founding members: to ensure that protection of foreign direct investment does not hinder public health regulations; and to both promote innovation and access to medicines.

Reviving trade policy 

The trade regime has not had a success of this magnitude for the past two decades. Rather, the list of failures and missed opportunities is long, and the prospects of the Doha Round are dim at best. 

In powerful ways, the TPP revives a stagnant trade regime. It shows that mega trade agreements can offer a platform to devise updated rules on trade and investment that cover sizable share of the world economy. And it creates an incentive structure for concurrent trade agreements to aim higher if they want to remain competitive. 

A genuine re-launch of Abenomics 

After a bruising political battle to secure passage of the security legislation, Prime Minister Shinzo Abe announced that the economy would be his utmost priority. In so doing, he disclosed three fresh arrows: a strong economy, raising the fertility rate, and boosting social security to care for the elderly. 

Abenomics 2.0, however, has fallen flat, as it lacks specifics on how to achieve the target of 600 trillion yen GDP, and because subsidies for young families and the expansion of nursing homes, while desirable and politically popular, do not make for a strategy of economic revitalization. Instead, the TPP deal boosts Abenomics 1.0 where its true transformative power lies: structural reform.

An informed debate on TPP 

After legal scrubbing, the TPP text will be released. This will offer the much-needed opportunity to debate the merits and demerits of the agreement with facts, and not speculation. Full disclosure of the agreement, close public scrutiny, and a spirited discussion on where the agreement has lived up to expectations and where it has fallen short will be essential in shoring up public support.

The TPP project is still a promise, not a reality. Another set of milestones will be required (twelve, to be exact). Each participating country has its own domestic procedures for ratification, and some definitely face an uphill battle: Malaysia is gripped by a major political crisis as Prime Minister Najib Razak fights charges of corruption; and it is anyone’s guess what the electoral results in a couple of weeks will mean for Canada’s place in the TPP. 

For the United States too, the quest for TPP ratification could not come at a more complicated time with a full-blown presidential election race. In wrapping up the TPP negotiations, the United States has demonstrated its leadership in convening a significant and diverse group of countries and in stewarding with success the negotiation of an ambitious blueprint for economic governance. But this will mean little if TPP is voted down in Congress or stays frozen in ratification limbo. Without the power to deliver a TPP in force, past accomplishments will rightfully be brushed aside. 

As part of his economic revitalization plan, Japan’s Prime Minister Shinzo Abe has been touting “womenomics,” a plan to increase the number of women in the labor force. One way for women to enter the workforce but bypass the conventional corporate structure is through entrepreneurship.

Four questions for three female entrepreneurs

At a recent Center for East Asia Policy Studies event on womenomics and female entrepreneurship in Japan, we brought together three successful female entrepreneurs to discuss their experiences both in the United States and Japan. Prior to their panel discussion, we asked each of the speakers four questions about their careers.

1. What was the trigger that made you decide to start your own business?
2. What was the biggest hurdle in starting and/or running your business?
3. How or when was being a woman an asset to you as an entrepreneur and/or running your business?
4. How has the climate for female entrepreneurs changed compared to when you started your business?

Despite the differing environments for entrepreneurs and working women in the two countries, the speakers raised many of the same issues and offered similar advice. Access to funding or financing was an issue in both countries, as was the necessity to overcome fears about running a business or being in male-dominated fields. All of the speakers noted the positive changes in the business environment for female entrepreneurs since they had started their own businesses, as well as the impact this has had in creating more opportunities for women.

Donna Fujimoto Cole

Donna Fujimoto Cole is the president and CEO of Cole Chemical and Distributing Inc. in Houston, Texas. She started her company in 1980 at the urging of her clients. Today Cole Chemical is ranked 131 among chemical distributors globally by ICIS (Independent Chemical Information Service) and its customers include Bayer Material Scientific, BP America, Chevron, ExxonMobil, Lockheed Martin, Procter & Gamble, Shell, Spectra Energy, and Toyota. Cole is also an active member of her community and serves on the boards of a variety of national and regional organizations.

Fujiyo Ishiguro

A founding member for the Netyear Group, Fujiyo Ishiguro is now the president and CEO of the Netyear Group Corporation based in Tokyo, Japan. The firm, which was established in 1999, devises comprehensive digital marketing solutions for corporate clients. The Netyear Group was listed on the Mothers section of the Tokyo Stock Exchange in 2008. Recently, Ishiguro has served on a number of Japanese government committees including the Cabinet Office’s “The Future to Choose” Committee and the Ministry of Economy, Trade and Industry’s “Internet of Things” Committee. 

Sachiko Kuno

Sachiko Kuno is the co-founder, president, and CEO of the S&R Foundation in Washington, D.C., a non-profit organization that supports talented individuals in the fields of science, art, and social entrepreneurship. A biochemist by training, Kuno and her research partner and husband Ryuji Ueno have established a number pharmaceutical companies and philanthropic foundations including R-Tech Ueno in Japan and Sucampo Pharmaceuticals in Bethesda, Maryland. Together, Kuno and Ueno hold over 900 patents. Kuno is active in the greater Washington community and serves on the boards of numerous regional organizations.

Full video of the event featuring these speakers can be found here.

Video

• The importance of mentors for female entrepreneurs
• Female entrepreneurs: Different options and different styles
• Female leadership creates opportunities

Event Information

Earlier this month, the Trans-Pacific Partnership Agreement was signed by its 12 member states in New Zealand, bringing the trade deal one step closer to fruition. The member states must now work on resolving their respective domestic issues tied to TPP. For Japan, one of the major issue areas involving TPP is agriculture.

On February 24, the Center for East Asia Policy Studies hosted Kazuhito Yamashita for a presentation in which he discussed the impact of Japan’s market access commitment on agriculture, the TPP countermeasures that the Japanese government announced for agriculture, and the types of agricultural policy reform that are being considered in Japan.

Transcript

• Transcript of Kazuhito Yamashita Presentation (.pdf)

Event Materials

• Yamashita Brookings presentation for website 022416
• Transcript Kazuhito Yamashita Presentation

What makes the Trans-Pacific Partnership (TPP) consequential?

Since the onset of the 21st century, countries from every corner of the world have vigorously negotiated free trade agreements (FTAs) based on the principle of preferential market access (as opposed to the most-favored nation obligation of the WTO). This has resulted in a veritable avalanche of such trade deals, with close to 400 FTAs notified to the WTO in the past 20 years. If the negotiation of preferential trade agreements is now the dominant trend in the trading regime, and almost no country has escaped contagion from the FTA syndrome, why does one agreement in particular—the TPP—remain the focal point of policy debates on trade?

Chart 1. Multilateral trade regimes and FTA proliferation

The TPP generates most attention because it has spurred the emergence of mega trade agreements (as compared to the mostly small bilateral trade deals that had characterized the FTA wave), and has offered a new platform to advance the trade agenda as negotiations on the Doha Round continue gridlocked. The TPP has come a long way from its humble beginnings as a trade grouping of four small open economies (Brunei, New Zealand, Chile, and Singapore). Today, it comprises 12 nations, covers 26 percent of world trade, and is expected to generate global income gains in the neighborhood of $492 billion by 2030.

Chart 2. From humble beginnings to mega trade deal

But the significance of the TPP is not to be grasped by numbers alone. Consider the following defining traits of this trade agreement:

1. Its high level of ambition for tariff liberalization vowing to disallow sectoral carve-outs. While it is true that sensitive sectors asserted their political weight by deferring or limiting tariff elimination (e.g., autos for the United States and five agricultural commodities for Japan), the commitment of TPP countries to eventually eliminate 99-100 percent of tariff rates is indeed impressive. Japan does stand out for a lower level of committed tariff elimination (95 percent); but again this is the highest level of liberalization that Japan has ever committed to in any trade negotiation.
2. Its comprehensive set of rules to target non-tariff barriers by introducing disciplines on issues such as regulatory coherence, state-owned enterprises, competitiveness, supply chains, etc. With 30 chapters and over 5,000 pages of text, grasping the reach of TPP rules will certainly take time. However, a quick glance does reveal novel, and needed, disciplines in important areas of the economy. For example, the e-commerce chapter establishes a binding obligation for governments to allow free data flows, disallows forced localization of data servers (except for the financial sector), and mandates that all countries must provide a legal framework to protect personal information. Another important innovation is the TPP provision that governments cannot require the transfer of source code from private companies operating in their market.
3. Its expansive vision as an Asia-Pacific platform with aspirations to set global standards. Its open architecture with a docking mechanism to encourage further member expansion and its explicit aim to establish a trans-regional platform that bridges Asia and North and South America are strong selling points for the TPP. It undercuts the oft-mentioned fear of using preferential trade agreements to create closed-off regions, and it gives its rules and standards the opportunity to disseminate far and wide.
4. Last but not least, the TPP has emerged as a central policy priority for both the U.S. and Japan to hone their international economic competitiveness and achieve broader foreign policy goals. In the area of foreign economic policy, the TPP is one of the most compelling frameworks to encourage China to deepen its market reforms and sign on to more ambitious liberalization commitments. The TPP, therefore, has emerged as a central arena for the interaction of the three giants of the world economy.

The United States as a Pacific power

The U.S. expects to reap important economic benefits from the TPP. It is a trade agreement that taps into the areas of competitive strength of the American economy: agricultural exports, trade in services, the digital economy, to name a few. Econometric studies put the expected income gains of the TPP for the U.S. in the order of $131 billion per year, and to the extent that the TPP becomes a global standard, these gains will grow. Indeed, the TPP is the centerpiece of the American trade agenda. Its success is required for continued momentum in the on-going trans-Atlantic trade negotiations, but it could also influence other important trade initiatives. For example, TPP disciplines on services and state-owned enterprises are expected to influence deliberations on the Trade in Services Agreement, a plurilateral trade negotiation carried out under the aegis of the WTO.

From the point of view of global governance, the TPP is a litmus test of the U.S. ability to provide leadership at a time of great complexity in the world economic order: one where supply chains have emerged as a main driver of production and trade, where emerging economies are increasingly vocal in the management of the global economy, and where the test of updating Bretton Woods institutions looms large. Through the TPP, the U.S. can display its convening power to negotiate novel trade rules, to devise new institutional forms that complement and spur on the multilateral regime, and to be proactive and not just reactive to initiatives from rising economic powers.

But the TPP is also a pillar of U.S. Asia policy, one that solidifies the U.S. commitment to remain an engaged Pacific power. This trade agreement increases the appeal of the rebalancing policy by defining it not just as a reorientation of military resources toward a region undergoing a significant power transition; but also as the pursuit of a common endeavor: furthering economic interdependence with rules that match the realities of the 21st century economy, and potentially establishing a bridge toward China with the prospect of TPP membership.

Japan is an essential partner for the U.S. to achieve these important goals. Japan came late to the TPP negotiations (in the summer of 2013), but it transformed the economic and political significance of this deal. Japan’s participation allowed the TPP to qualify as a mega trade agreement. For the U.S. alone, the projected economic gains with Japan on board tripled. This is not surprising given the size of the Japanese market and the fact that the U.S. and Japan do not have a bilateral trade agreement; nor has Japan ever accepted these levels of liberalization. Moreover, prior to Japan joining the TPP there were doubts as to whether this could indeed become an Asia-Pacific platform of economic integration since no major Asian economy was participating. Japan’s entry put those objections to rest.

Japan as a reviving power

For Japan as well, the TPP negotiations have had salutary effects on its trade diplomacy and on the pursuit of central domestic and foreign policy priorities. Prior to joining the TPP, Japan’s trade strategy had achieved modest results: it lagged behind its peer competitors in negotiating an FTA network that covered a substantial share of its trade, it had faced difficulty in persuading Southeast Asian countries to adopt many WTO+ rules, it had received the cold shoulder from the U.S. and Europe as it proposed the negotiation of trade agreements, and remained deadlocked with China over the membership configuration of an East Asian trade grouping. The TPP altered the parameters of Japanese trade policy. It allowed the country to negotiate preferential access to main markets of destination, to disseminate next frontier trade rules, and to undertake concurrent mega trade negotiations. As a reaction to Japan’s courting of TPP membership, China recalibrated its trade policy to speed up the launch of trilateral trade negotiations in Northeast Asia and was now amenable to a 16-member trade grouping upholding the principle of ASEAN centrality (Regional Comprehensive Economic Partnership or RCEP), and the Europeans also came to the negotiation table.

As a full participant in the mega FTA movement, Japan can aim high in order to pursue signature objectives such as:

• Negotiate deep integration FTAs that enhance the international competitiveness of Japanese global supply chains. An assessment of Japan’s core competencies in the 21st century should start with the recognition that a significant share of industrial capacity has been relocated overseas. On-shoring of manufacturing operations is not a viable goal given projected demographic trends. Rather, the aim should be to sustain and strengthen Japan’s role in global supply chains (the leading force of international production and trade today). Japan’s international diplomacy has a role to play here by negotiating deep FTAs that meet the needs of fragmented production chains. Additionally, deep FTA commitments will also help Japan address its own domestic inefficiencies such as the modest liberalization of the services sector.
• Lock-in structural reforms. One of the main benefits of linking the domestic structural reform agenda to international trade commitments is that it will be harder to roll back the reforms if and when political circumstances change (this is indeed a major lesson of the failure to institutionalize Prime Minister Junichiro Koizumi’s reforms). Importantly, the TPP negotiations do not conform to the old-style gaiatsu pattern where a reluctant Japan would deflect U.S. pressure for it to change its ways. This time Japan has eagerly sought to be at the TPP table and has—of its own accord—identified the synergies between the new trade commitments and its own efforts to reform the domestic economy.
• Manage the transition from “regime-taker” to “regime-maker.” With the stagnation of the WTO, we have moved to a system of decentralized competition whereby different clusters of countries seek to define the standards for economic integration. The costs of a passive trade policy are much higher today than in a most favored nation (MFN) world where preferential trade agreements were the exception and not the rule. The expectation of steady liberalization benefits through successive multilateral trade rounds has been sharply revised. Therefore, countries that want to avoid the discriminatory effects of existing preferential trade deals and to improve access to important markets through additional elimination of tariffs and the adoption of rules that address behind-the-border barriers have resorted to an active FTA diplomacy. More broadly, Japan has much to win from displaying leadership in international economic governance, in a manner that resonates with the goals of the Abe administration to play a proactive role in world affairs.

For all the shared interests between the U.S. and Japan in the TPP project, negotiations over long divisive market access terms proved difficult and frustratingly long. Of course, a host of other issues also kept the larger TPP membership apart. Biologics especially was the last topic to close in the final TPP ministerial held in Atlanta in October 2015, and negotiations went to the wire. Despite all these difficulties, the ability to strike a TPP deal last fall represents a big win for the trade regime which has not seen a success of this magnitude in two decades. Since its creation, the WTO has not updated the rules of international trade and investment, and the Doha Round lingers on life support. Many were skeptical that a major trade negotiation tackling front and center the complex and unwieldy behind-the-border agenda could succeed. This is the most powerful message coming from Atlanta: it can be done.

With a TPP deal in hand there is greater hope that we can manage the tectonic changes in international trade governance. The transformation of the trade agenda (increasingly about regulatory matters) and the limitations of the WTO as a negotiation forum, have called into question the pure multilateral ideal—one set of binding rules for 150+ countries. Instead, the center of action is now on what we call “variable geometry” arrangements where subsets of countries negotiate next-frontier rules: the plurilaterals in the WTO and the preferentials through mega trade agreements. The emerging system for trade governance is not risk-free, and much effort will be required to forestall potential dangers: fragmentation (if TPP-like standards do not disseminate widely) and exclusion (if less developed countries are bypassed by the FTA wave).

Moreover, the TPP deal opens a new and promising chapter in U.S.-Japan relations. It is certainly more than a U.S.-Japan trade agreement—it represents the ability of 12 countries at varying levels of development and with very different regulatory regimes to agree on the most substantive trade liberalization to date. But it is also true that at the core of the TPP, the U.S. and Japan as the largest and most developed economies have acted as an engine of negotiations. The TPP marks a milestone in U.S.-Japan relations, as an effective instance of cooperation to upgrade the international economic architecture. In the TPP, the U.S. and Japan are on close alignment on the rules area of the talks and were able to reach an agreement on market access issues that in the past had proven intractable.

Ratification, reform, and reach

None of these effects will be long lasting nor will they reach their full potential, if TPP countries (and the U.S. and Japan in particular) do not double down on the next crucial steps. For simplicity sake, these can be dubbed the three “Rs” of ratification, reform, and reach.

Ratification

Ratification rules in the TPP require that six countries representing 85 percent of combined GDP approve the agreement before it enters into force. Therefore, to meet this numerical requirement both the U.S. and Japan must ratify. However, for the U.S., TPP ratification will represent a steep political battle in the midst of an American presidential election year. Despite public opinion polls showing that most Americans see in international trade an opportunity, the politics of trade agreements are fractious. Long-standing opposition by environmental groups and unions to trade agreements has resulted in their active mobilization against the TPP. And the debate on the merits of trade agreements has only become more heated as critics suggest that trade globalization is to be blamed for growing income inequality and the erosion of state regulatory powers.

For both national parties, the TPP is a divisive issue. While President Barack Obama has made TPP negotiation and ratification a central priority of his administration, Democrats in Congress have not backed his trade initiative in large numbers, in part due to the opposition of the party’s traditional base, labor unions. The internal dynamics of the Republican Party have shifted dramatically, complicating the odds for the TPP. The Republican Party has become less cohesive with the emergence of the Tea Party wing determined to deny Obama a legacy-making trade agreement. The support of key Republican figures in the Senate has also waned due to dissatisfaction over the tobacco carve-out from investor-state dispute settlement and the exclusivity period for biologics. And the business community has also criticized these provisions, offering only qualified support for the TPP deal.

The U.S. has yet to fail in ratifying a negotiated trade agreement. And a vote down on the TPP would be singularly costly for the credibility of U.S. foreign policy and the evolution of the international trade regime.

Reform

One of the most powerful benefits of trade agreements is the ability of governments to use them as commitment devices to implement needed economic changes. Reform is in fact the crucial issue for Japan as it tries to leave behind stagnant growth. Economic revitalization certainly goes beyond agricultural reform, to encompass the host of productivity-enhancing measures across all areas of the economy, the internationalization of services, the promotion of inward direct investment, and the further upgrading of regional and trans-regional production networks.

Yet, farming countermeasures adopted in the wake of the TPP deal have raised doubts about the government’s resolve to transform its agricultural sector. Japan’s TPP market access commitments do include a 56,000-ton import rice quota (to grow eventually to 78,400 tons). But the government promptly announced an increase in stockpiling purchases to match the TPP quota, effectively preventing a drop in the price of rice and market adjustment. This artificial support preempts the modernization of the agricultural sector since it enables part-time farmers to continue operating in tiny plots, hindering the emergence of commercial farming. The government also submitted a generous 2016 supplementary budget with 312 billion yen earmarked for agricultural TPP countermeasures. But informed experts question its impact in boosting farming competitiveness since public works allocations still loom large (30 percent of outlays will go to land reclamation projects).

Just as the electoral cycle has not facilitated TPP ratification in the U.S., the looming Japanese Upper House election in July is not conducive to moving past prior trade compensation practices.

Reach

The release of the TPP text has clarified a very important point: membership can be extended not only to APEC economies but also to other countries that are willing to meet TPP disciplines. Enlargement will be critical to avoid the above-mentioned risks of fragmentation and exclusion by helping disseminate TPP standards. In the short and medium term, the conclusion of the TPP talks is expected to have two main effects: increase the list of potential applicants, and encourage a higher level of ambition among on-going trade negotiations.

The number of economies expressing an interest in joining the TPP has grown to include South Korea, Taiwan, Indonesia, Thailand, the Philippines, Colombia, and Costa Rica, among others. Regarding the second wave of accession the key issue will be readiness to undertake the ambitious liberalization commitments of the TPP, and the list of prospective applicants shows wide variation on this score. The conclusion of TPP talks also creates an incentive for the updating of existing FTAs and/or scaling up the level of ambition in ongoing trade negotiations, as countries outside the TPP want to secure export markets, attract foreign direct investment, and embed their companies in global supply chains.

In the long run, the key challenge will be to devise an effective strategy to engage emerging economies, such as China, India, and Brazil. This is still the gaping hole in the U.S. plans to develop trans-Pacific and trans-Atlantic trade groupings. Certainly, putting in place the TPP and the Transatlantic Trade and Investment Partnership is the first step in such strategy since it changes the incentive structure for these countries to entertain further market liberalization. But at the end of the day, these emerging economies must reach the determination that it is in their national interest to abide by these economic standards, and find the political will to tackle vested interests. This is a tall order indeed.

The most pressing question may well be how China will position itself vis-à-vis the TPP. Can we expect it to act on past precedent and seek TPP accession just as in the past it used WTO membership to advance economic reforms? Or will it choose instead to champion the negotiation of a Free Trade Area of the Asia-Pacific (FTAAP) after both the TPP and RCEP materialize, in order to play a more proactive role in the international economic architecture—more in conformance with the recent launch of the Asian Infrastructure Investment Bank?

The recently struck TPP agreement underscores the potential of furthering U.S.-Japan cooperation to supply needed international economic governance. However, the overview of remaining challenges also shows that clinching a TPP deal is just the first step.

This article originally appeared in the March/April 2016 issue of Economy, Culture & History Japan SPOTLIGHT Bimonthly.

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• The high stakes of TPP ratification: Implications for Asia-Pacific and beyond

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In an era of fluid geopolitics and geoeconomics, challenges to the global order abound: from ever-changing terrorism, to massive refugee flows, a stubbornly sluggish world economy, and the specter of global pandemics. Against this backdrop, the question of whether leader summitry—either the G-7 or G-20 incarnations—can supply needed international governance is all the more relevant. This question is particularly significant for East Asia this year as Japan and China, two economic giants that are sometimes perceived as political rivals, respectively host the G-7 and G-20 summits. 

On April 18, the Center for East Asia Policy Studies and the Project on International Order and Strategy co-hosted a discussion on the continued relevancy and efficacy of the leader summit framework, Japan’s and China’s priorities as summit hosts, and whether these East Asian neighbors will hold parallel but completely separate summits or utilize these summits as an opportunity to cooperate on issues of mutual, and global, interest.

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• Japan’s G-7 and China’s G-20 chairmanships: Bridges or stovepipes in leader summitry?

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• 20160418_g7g20_transcript

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For decades Chinese companies focused their international investment on unearthing natural resources in Africa, Asia, and Latin America. In recent years, Chinese money has spread across the globe into diverse sectors including the real estate, energy, hospitality, and transportation industries. So far in 2016, Chinese investment in offshore mergers and acquisitions has already reached $101 billion, on track to surpass its $109 billion total for all of 2015. What do these investments reveal about China’s intentions in the West? How is China’s image being shaped by its muscular international investments? Should the West respond to this new wave, and if so, how?

On April 25, 2016, the Center on the United States and Europe and the John L. Thornton China Center at Brookings hosted the launch of "China’s Offensive in Europe" (Brookings Institution Press, 2016), the newly-published, revised book co-authored by Visiting Fellow Philippe Le Corre (with Alain Sepulchre). During the event, Le Corre offered an assessment of the trends, sectors, and target countries of Chinese investments on the Continent. Following the presentation, Senior Fellow Mireya Solis moderated a discussion with Le Corre and Senior Fellows Constanze Stelzenmüller and David Dollar.

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• China’s overseas investments in Europe and beyond

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