Saudi Arabians woke up over the weekend to a once-in-a-decade cabinet reshuffle. Octogenarian oil minister Ali al-Naimi, who has been in charge of the Kingdom’s energy policy since 1995, was replaced by Khaled al-Falih, who is to head the newly created Energy, Industry, and Natural Resources Ministry. Majed al-Qusaibi was named head of the newly created Commerce and Investment Ministry. Finally, Ahmed al-Kholifey was made governor of the Saudi Arabia’s Central Bank (SAMA). It may come as a surprise to many Saudis that the origin of this reshuffle—and indeed the Kingdom’s new economic direction—finds its impetus in a report by the global management consulting firm McKinsey & Company.

A man with a plan

Saudi Arabia has been struggling to deal with the impact of lower oil prices. After years of recording budget surpluses, the government has seen its budgetary deficit grow to 15 percent of GDP. Lower oil prices—coupled with tensions with regional rival Iran over Yemen, Syria, and Lebanon—have put the Kingdom’s finances under pressure. Since oil prices began to plummet, Saudi Arabia’s ever-ambitious Deputy Crown Prince Mohammed bin Salman has been spearheading an ambitious reform initiative that seeks to diversify the Kingdom’s economy away from oil. 

Dubbed “Saudi Arabia’s Vision 2030,” the prince says that the new economic blueprint will increase the role of the private sector from 40 percent to 60 percent, reduce unemployment from 11 percent to 7.6 percent, and grow non-oil income exponentially. This is to be financed by the partial privatization of the Kingdom’s oil behemoth, Aramco. 

The 2030 document outlines a number of significant reforms that seek to change not only the Saudi economy, but state-society relations more broadly, in a way that has been done since the Kingdom’s founding.

The 2030 document outlines a number of significant reforms that seek to change not only the Saudi economy, but state-society relations more broadly, in a way that hasn't been done since the Kingdom’s founding. The prince’s vision seems to have been inspired by a report issued by the McKinsey Global Institute in December 2015 titled “Moving Saudi Arabia’s Economy Beyond Oil.” The vision and the report have similar policy prescriptions for diversifying the Kingdom’s economy away from oil. 

Such similarities highlight the influence of consultancies on policymaking in the Kingdom. Indeed, Bloomberg news reported that consultancies are set to earn 12 percent more in commissions in Saudi Arabia this year, the fastest growth amongst the world’s advisory markets. In a wide-ranging interview with The Economist in January, Prince Mohammed himself said that “McKinsey participates with us in many studies.” According to the Financial Times, Saudi businessmen have sarcastically dubbed the Ministry of Planning as the “McKinsey Ministry.”

McKinsey’s key report, full with glossy illustrations, contains consultant buzzwords (“transformation,” “efficiency,” and “synergies”) that would make Marty Kaan in Showtimes’s House of Lies proud. It’s by no means novel for consultants to advise governments in the region and across the world, and indeed the report does outline an ambitious blueprint for the Kingdom’s economic transformation and diversification away from oil. 

Will the public buy it?

But in a glaring omission, the report does not adequately explain how the Saudi government will be able to change the mindset of everyday Saudi Arabia citizens, who have long been accustomed to state largesse that included fuel subsidies, loans, free land, and public sector jobs. 

This is the key issue. The reform plans sound promising, and will indeed make headway in weaning the Kingdom off its oil “addiction” (as the prince himself put it). But how will everyday citizens react to the reforms? The Saudi government will be asking more of its citizens—will the citizens in turn ask for more accountability and representation? Since January, the prices of gasoline, electricity, and water have gone up. There was a public outcry against higher utility prices, which lead King Salman to fire the water minister to absorb the public’s anger. 

Such discontent is the harbinger of things to come. The coming months and years will show how Saudi leadership implements much needed economic reforms without alienating its population. While the outcome is uncertain, one thing is: consultants will continue to flock to Saudi Arabia to work on the “mother of all transformation projects.”

Editors' Note: This post was corrected on May 12, 2016 to clarify that the report “Moving Saudi Arabia’s Economy Beyond Oil” was issued by the McKinsey Global Institute, the research arm of McKinsey & Company. MGI’s work is independent and wholly funded by McKinsey Partners. The MGI report was not commissioned by the government of Saudi Arabia and has no formal role in government decision-making.

On Friday, June 3, S&P Global Ratings announced that it would not downgrade South Africa’s credit rating to junk, letting South Africa breathe a sigh of relief. The outlook, however, remained negative. While some experts were confident that the rating would not be cut, most continued to warn that future economic or political turmoil could spark a downgrade later this year. The South African Treasury agreed, but remained positive releasing a statement saying:

Government is aware that the next six months are critical and there is a need to step up the implementation [of measures to boost the economy] … The benefit of this decision is that South Africa is given more time to demonstrate further concrete implementation of reforms that are underway.

South Africa, whose current rating stands at BBB- (one level above junk), has been facing weak economic growth—at 1 percent—over past months. The International Monetary Fund has given a 2016 growth forecast of 0.6 percent. Many feared that a downgrade could have pushed the country into a recession. Borrowing by the government would have also become more expensive, especially as it tackles a 3.2 percent of GDP budget deficit for the 2016-2017 fiscal year.

Other credit ratings agencies also are concerned with South Africa’s economic performance. Last month, Moody’s Investors Service ranked the country two levels above junk but on review for a potential downgrade, while Fitch Ratings is reviewing its current stable outlook and BBB- rating.

For South African Finance Minister Pravin Gordhan’s thoughts on the South African economy, see the April 14 Africa Growth Initiative event, “Building social cohesion and an inclusive economy: A conversation with South African Finance Minister Pravin Gordhan.”

This week, the Extraordinary African Chambers—located in Dakar and established in collaboration with the African Union—sentenced former Chadian President Hissène Habré to life in prison. Habré seized power in 1982, overthrowing then President Goukouni Oueddei. He fled to Senegal in 1990 after being ousted by current Chadian President Idriss Deby. After he fled to Senegal, the African Union called on Senegal to prosecute Habré. In 2013, the Extraordinary African Chamber was created with the sole aim to prosecute Habré. The Habré trial is the first trial of a former African head of state in another African country.

Habré faced a long list of charges including crimes against humanity, rape, sexual slavery, and ordering killings while in power. According to Chad’s Truth Commission,  Habré’s government murdered 40,000 people during his eight-year reign. At the trial, 102 witnesses, victims, and experts testified to the horrifying nature of Habré’s rule. His reign of terror was largely enabled by Western countries, notably France and the United States. In fact, on Sunday, U.S. Secretary of State John Kerry admitted to his country’s involvement in enabling of Habré’s crimes. He was provided with weapons and money in order to assist in the fight against former Libyan leader Moammar Gadhafi. Said resources were then used against Chadian citizens.

Also this week, Simone Gbagbo, former Ivorian first lady, is being tried in Côte d’Ivoire’s highest court— la Cour d’Assises—for crimes against humanity. She also faces similar charges at the International Criminal Court though the Ivoirian authorities have not reacted to the arrest warrant issued in 2012. In March 2015, Simone Gbabgo was sentenced to 20 years in jail for undermining state security as she was found guilty of distributing arms to pro-Laurent Gbagbo militia during the 2010 post-electoral violence that left 3000 dead. Her husband is currently on trial in The Hague for the atrocities committed in the 2010 post-election period.

On Monday, May 30, South African chemical and energy company Sasol Ltd announced that Mozambique’s ongoing debt crisis and continuing low global gas prices would not slow down its Mozambican gas project. The company expressed confidence in a $1.4 billion processing facility upgrade stating that the costs will be made up through future gas revenues. In explaining Sasol’s decision to increase the capacity of its facility by 8 percent, John Sichinga, senior vice president of Sasol’s exploration and production unit, stated, “There is no shortage of demand … There’s a power pool and all the countries of the region are short of power.” In addition, last week, Sasol began drilling the first of 12 new planned wells in the country.

On the other hand, on Monday The Wall Street Journal published an article examining how these low gas prices are stagnating much-hoped-for growth in East African countries like Tanzania and Mozambique as low prices prevent oil companies from truly getting started. Now, firms that flocked to promising areas of growth around these industries are downsizing or moving out, rents are dropping, and layoffs are frequent. Sasol’s Sichinga remains positive, though, emphasizing, "We are in Mozambique for the long haul. We will ride the waves, the downturns, and the upturns."

While falling off the "fiscal cliff" (of automatic spending cuts and tax increases if Congress fails to act) could hurt the economy, expert William Gale says the actual result, if coupled with a temporary economic stimulus, would be greater incentives to make a better long-term budget deal.

Video

• William Gale: Combine Going Over the Fiscal Cliff with a Stimulus

Editor’s Note: The National Perspectives on Global Leadership (NPGL) project reports on public perceptions of national leaders’ performance at important international events. This fifth installation of the NPGL Soundings provides insight on the issues facing leaders at the Seoul G-20 Summit and the coverage they received in their respective national media. Read the other commentary »

The week before the Seoul G-20 Summit was one in which the main newspapers read in Washington (The New York Times, The Washington Post and Financial Times) all focused their primary attention on the “currency war,” global imbalances, the debate on quantitative easing (QE 2), the struggle over whether there would be numerate current account targets or only words, and the US-China relationship. As early as Wednesday, November 10, The Washington Post front-page headline read: “Fed move at home trails U.S. to Seoul; Backlash from Europe; Obstacles emerge for key goals at G-20 economic summit.” By Thursday, November 11, things had gotten worse. “Deep fractures hit hopes of breakthrough; governments are unlikely to agree on a strategy to tackle economic imbalances” read the Financial Times headline on Alan Beattie’s article from Seoul. Friday, November 12, The New York Times front-page headline declared: “Obama’s Economic View is Rejected on World Stage; China, Britain and Germany Challenge U.S.; Trade Talks with Seoul Fail, Too.” By Saturday, the Financial Times concluded in its lead editorial: “G-20 show how not to run the world.”

From these reports, headlines and editorials it is clear that conflicts over policy once again dwarfed the progress on other issues and the geopolitical jockeying over the currency and imbalances issues took centre stage, weakening G-20 summits rather than strengthening them. Obama was painted as losing ground, supposedly reflecting lessening U.S. influence and failing to deliver concrete results. China, Germany and Brazil were seen to beat back the U.S. initiative to quantify targets on external imbalances. Given the effort that Korean leaders had put into achieving positive results and “consolidating” G-20 summits, it was, from this optical vantage point, disappointing, to say the least.

How was the Rebalancing Issue Dealt With?

At lower levels of visibility and intensity, however, things looked a bit different and more positive. Howard Schneider and Scott Wilson in Saturday’s edition of The Washington Post (November 13) gave a more balanced view of the outcomes. Their headline read: “G-20 nations agree to agree; Pledge to heed common rules; but economic standards have yet to be set.” They discerned progress toward new terrain that went beyond the agreement among G-20 finance ministers in October at Gyeongju, which other writers missed.

“By agreeing to set economic standards, the G-20 leaders moved into uncharted waters,” they wrote. “The deal rests on the premise that countries will take steps, possibly against their own short-term interests, if their economic policies are at odds with the wider well-being of the world economy. And leaders are committing to take such steps even before there’s an agreement on what criteria would be used to evaluate their policies.”

They continued: “In most general of terms, the statement adopted by the G-20 countries says that if the eventual guidelines identify a problem, this would ‘warrant an assessment of their nature and the root causes’ and should push countries to ‘preventive and corrective actions.’”

The Schneider-Wilson rendering went beyond the words of the communiqué to an understanding of what was going on in official channels over time to push this agenda forward in real policy, rather than declarative terms. As the Saturday, November 13, Financial Times’ editorial put it, “below the headline issues, however, the G-20 grouping is not completely impotent,” listing a number of other issues on which progress was made including International Monetary Fund (IMF) reform which the Financial Times thought might actually feed back into a stronger capacity to deal with “managing the global macroeconomy.”

The Role of President Barack Obama

Without doubt, the easy, simple, big-picture message coming out of Seoul was that Obama and the United States took a drubbing. And this did not help the G-20 either. The seeming inability of the U.S. to lead the other G-20 leaders toward an agreement in Seoul on global imbalances, the criticism of U.S. monetary easing and then, on top of it all, the inability to consummate a US-Korea trade deal, made it seem as if Obama went down swinging.

But again, below the surface of the simple, one got a different picture. Obama himself did not seem shaken or isolated at the Seoul summit by the swirl of forces around him. At his press conference, he spoke clearly and convincingly of the complexity of the task of policy coordination and the time it would take to work out the policies and the politics of adjustment.

“Naturally there’s an instinct to focus on the disagreements, otherwise these summits might not be very exciting,” he said. “In each of these successive summits we’ve made real progress,” he concluded. Tom Gjeltin, from NPR news, on the Gwen Ifyl Weekly News Roundup commented Saturday evening that the G-20 summits are different and that there is a “new pattern of leadership” emerging that is not quite there yet. Obama seems more aware of that and the time it takes for new leadership and new patterns of mutual adjustment to emerge. He may have taken a short-run hit, but he seems to have the vision it takes to connect this moment to the long-run trajectory.

Reflections on the Role of South Korea

From a U.S. vantage point, Seoul was one more stop in Asia as the president moved from India to Indonesia to Korea to Japan. It stood out, perhaps, in higher profile more as the locus of the most downbeat moments in the Asia tour, because of the combination of the apparent lack of decisive progress at the G-20 along with the needless circumstance of two presidents failing to find a path forward on something they both wanted.

From a Korean vantage point, the summit itself was an event of immense importance for Korea’s emergence on the world stage as an industrial democracy that had engineered a massive social and economic transformation in the last 50 years, culminating in being the first non-G8 country to chair the G-20 summit. No one can fault Korea’s efforts to reach significant results. However, the fact is that the Seoul Summit’s achievements, which even in the rebalancing arena were more significant than they appeared to most (see Schneider and Wilson), but included substantial progress on financial regulatory reform, international institutional reform (specifically on the IMF), on development and on global financial safety nets, were seen to be less than hoped for. This was not the legacy the Koreans were looking for, unfortunately.

Conflicts among the major players on what came to be seen as the major issue all but wiped out the serious workmanlike progress in policy channels. The leaders level interactions at G-20 summits has yet to catch up to the highly significant degree of systemic institutionalization of the policy process of the G-20 among ministers of finance, presidents of central banks, G-20 deputies and Sherpas, where the policy work really goes on. On its watch, Korea moved the agenda in the policy track forward in a myriad of significant ways. It will be left to the French and French President Nicolas Sarkozy to see if they can bring the leaders into the positive-sum game arrangements that are going on in the policy channels and raise the game level of leaders to that of G-20 senior officials.

The biggest news at the end of the Brisbane G-20 on Sunday will be to confirm for the first time in an official G-20 communique that China will indeed chair the G-20 Summit in 2016. 

Coming on the heals of a momentous week of great power realignments and breakthroughs at the APEC Summit in Beijing and other one-on-one meetings of heads of state, the timing of China’s presidency of the G-20 Summit in 2016 could not be a better follow-up to this week’s accomplishments. It puts China in play as a global leader at a critical moment in geopolitical relations and in terms of several global agendas that will culminate in the next two years. It also provides an unusual opportunity for the U.S. and China to collaborate on a broader set of societal issues affecting everyone everywhere building on their agreements this week.

One of the reasons why the G-20 Summits have yet to realize their full potential is that the leaders-level summits have been captured by the finance ministers’ agendas and discourse. Leaders at G-20 Summits have individually and collectively failed to connect with their publics; ordinary citizens do not see their urgent issues being dealt with. Exchange rates, current account balances, reserve ratios for banks, and the role of the IMF do not resonate with public anxieties over their lives and livelihoods.

Three streams of global issues will culminate in 2015:  the forging of a “post-2015 agenda” on sustainable development with a new set of global goals to succeed the Millennium Development Goals (MDGs); the agreement on  “financing for development” (FFD) arrangements and mechanisms to support the new post-2015 Sustainable Development Goals (SDGs) to be realized in 2030; and the achievement of a United Nations Framework Convention on Climate Change (UNFCCC) by the end of 2015, which looks more promising now than it did a week ago.

What has been learned from previous global goal setting processes is that building on the momentum for the goal-setting process in 2015 and carrying it directly into the mobilization of national political commitment, resources and policies for implementation is vital. China as a member of the G-20 troika in 2015 through 2017 will be in crucial position of bridging the goal-setting and implementation phases of the new SDGs for 2030 to be adopted at the United Nations in September of next year.

China, as one of the five permanent members of the U.N. Security Council, will be in a pivotal position to create complementarities between the G-20 forum for the major economies and the U.N. as a forum for all countries for this critical period of setting the global sustainability agenda for the next fifteen years.  

The post-2015 agenda for social, economic and environmental sustainability is of high interest to the United States, and the new China-U.S. climate change agreement in Beijing this week augurs well for collaboration between the two countries on the broader agenda. White House Chief of Staff John Podesta was on the high-level panel for the post-2015 development agenda last year, which signals high U.S. policy involvement. The Shanghai Institute for International Studies has argued in a recent paper for the U.N. Development Program that “the G-20 and the U.N. could have certain complementary roles. The development issue could become the one linking the major work of both the U.N. and the G-20.”  

The world should welcome the unique role that China can now play in bringing the international community and the global system of international institutions together in charting a common path forward building on the progress made in the various summits this week. 

“The Earth in the coming decades could cease to be a ‘safe operating space’ for human beings,” concludes a paper by 18 researchers “trying to gauge the breaking points in the natural world,” published in Science in January 2015. That our planetary environment seems to be approaching “breaking points” is but one of several systemic threats looming on the horizon or lurking under the surface.

Since the economic crisis in 2008, the world has learned that financial instability is a global threat to sustainable livelihoods and economic progress. The underlying dynamics of technological change seem to be more labor displacing than labor absorbing, creating increasing anxiety that employment and career trajectories are permanently threatened. These two challenges undermine public confidence in the market economy, in institutions, and in political leaders. They constitute systemic threats to the credibility of markets and democracy to generate socially and politically sustainable outcomes for societies.

The fact that one billion people still live in extreme poverty, that there are scores of countries that are considered to be “failed states,” and that genocide, virulent violence, and terrorism are fed by this human condition of extreme deprivation together constitute a social systemic threat, global in scope. These challenges together merge with a growing public awareness of global inequality between nations and of increasing inequality within nations. The power of money in public life, whether in the form of overt corruption or covert influence, disenfranchises ordinary people and feeds anger and distrust of the current economic system. 

These challenges are global in reach, systemic in scale, and urgent. They require deliberate decisions to abandon “business-as-usual” approaches, to rethink current practices and engage in actions to transform the underlying fundamentals in order to avoid the collapse and catastrophe of systems that average people depend upon for normal life.  

Systemic risks are real. Generating new pathways to systemic sustainability are the new imperatives. Holistic approaches are essential, since the economic, social, environmental, and political elements of systemic risk are interrelated.  “Sustainable development,” once the label for environmentally sensitive development paths for developing countries, is now the new imperative for systemic sustainability for the global community as a whole.

2015 is a pivotal year for global transformation. Three major work streams among all nations are going forward this year under the auspices of the United Nations to develop goals, financing, and frameworks for the “post-2015 Sustainable Development Agenda.”  First, in New York in September—after two years of wide-ranging consultation—the U.N. General Assembly will endorse a new set of global development goals to be achieved by 2030, to build upon and replace the Millennium Development Goals (MDGs) that culminate this year. Second, to support this effort, a Financing for Development (FFD) conference took place in July in Addis Ababa, Ethiopia, to identify innovative ways to mobilize private and public resources for the massive investments necessary to achieve the new goals. And third, in Paris in December, the final negotiating session will complete work on a global climate change framework.  

These three landmark summits will, with luck, provide the broad strategic vision, the specific goals, and the financing for addressing the full range of systemic threats.  Most of all, these events, along with the G-20 summit of leaders of the major economies in November in Antalya, Turkey, will mobilize the relevant stakeholders and actors crucial for implementing the post-2015 agenda—governments, international organizations, business, finance, civil society, and parliaments—into a concerted effort to achieve transformational outcomes. Achieving systemic sustainability is a comprehensive, inclusive effort requiring all actors and all countries to be engaged. [3]

Four major elements need to be in place for this process to become a real instrument for achieving systemic sustainability across the board. 

First, because everyone everywhere faces systemic threats, the response needs to be universal. The post-2015 agenda must be seen as involving advanced industrial countries, emerging market economies, and developing nations. Systemic sustainability is not a development agenda limited to developing countries, nor just a project to eradicate poverty, nor just an agenda for development cooperation and foreign aid. It is a high policy agenda for all countries that goes to the core of economics, governance, and society, addressing fundamental dynamics in finance, energy, employment, equity, growth, governance, and institutions.

Second, systemic threats are generated because of spillover effects from activities that used to be considered self-contained and circumscribed in their impact. The world of silos and vertical self-sufficiency has given way to an integrated world in which horizontal linkages are as important as vertical specialization. The result of these interlinkages is that synergies can be realized by taking comprehensive integrated approaches to major issues. In this new context, positive-sum benefits are potentially more easily realized, but integrated strategies are necessary for doing so. 

This new context of spillovers and synergies has two implications. The domestic dimension is that whole-of-government approaches are necessary for addressing systemic sustainability. Cross-sectoral, inter-ministerial approaches are essential.  Since markets alone are not able to realize optimal outcomes in the widespread presence of externalities, the only way to realize the positive sum potential of synergies is through coordination among related actors. On the international dimension, this new context also requires more cooperation and coordination than competition to realize synergistic, positive-sum outcomes.

Third, domestic political pressures are primary. This may be a variant of the old saying that “all politics is local.”  However, the aftermath of the 2008 global financial crisis has been a world of hurt in which impacted publics are feeling anger and alienation from an economic system that has threatened their jobs, incomes, pensions, homes, and livelihoods. The task of leaders is not to pander to these plights but to lead their people to understand the vital linkage between domestic conditions and external forces and the degree to which the global context inevitably impacts on domestic conditions. Leaders need to be able to explain to their people that systemic threats have inextricable global–domestic linkages that need to be managed, not ignored.

Fourth, given all this, it is absolutely necessary that the global system of international institutions be “on the same page,” share the same vision, strategy, and goals, rather than each taking its primary mandate as a writ for independence from the common agenda. 

The major challenges for global governance in this pivotal turn from goal-setting in 2015 to the beginning of implementation in 2016 are to ensure (i) that all countries adapt and adopt the post-2015 agenda in ways that are congruent with their national culture and context while at the same time committing to reporting on all aspects of the agenda; (ii) that whole-of-government institutional mechanisms and processes are put in place domestically to realize the synergies that can accrue only from comprehensive, integrated approaches and that international cooperation mechanisms gain greater traction to reap the positive-sum outcomes from global consultation, coordination, and cooperation;  (iii) that national political leaders learn new modes of domestic and international leadership that are capable of articulating the new context and new systemic risks that need to be managed both internally and globally; and (iv) that each international institution realizes the need to be part of a system-wide global effort to achieve systemic sustainability through concerted efforts of all relevant actors working together on behalf of a common global agenda. [2]

Currently under discussion are 17 Sustainable Development Goals (SDGs) and 169 indicators for 2030 to extend and replace the eight MDGs for 2015, which had 21 targets and a variety of indicators, which in turn extended and replaced seven International Development Goals (IDGs) agreed to in 1995 by development cooperation ministers from OECD countries. There is much chatter now about whether the SDGs and indicators are too many, too ambitious, and too widespread.  The Economist asserts that the SDGs “would be worse than useless,” dubbing them “stupid development goals”. And Charles Kenney at the Center for Global Development in a thoughtful piece argues that “we lost the plot.” 

It may be true that there is too much detail. Two previous efforts, one by the Centre for International Governance Innovation (CIGI) and the Korean Development Institute (KDI) had 10 goals, and the other, the U.N. High Level Panel of Eminent Persons report in 2013 had 12 goals.[iii] This quibble alone does not prevent the use of political imagination to conjure a storyline that connects the 17 proposed SDGs with the vision of the post-2015 Sustainable Development Agenda as addressing systemic threats and having comprehensive integrated strategies for addressing them. 

Fourteen of the 17 SDGs can be clustered into four overarching strategic components: poverty (2); access (6); sustainability (5); and partnership (1). The other three goals have to do with growth and governance (institutions), which were underpinnings for both the IDGs and the MDGs though not embodied in the sets of goals themselves. The four SDG components seamlessly continue the storyline of the IDGs and the MDGs, both of which included poverty as the first goal, gender equality- education-and-health as issues of access, an environmental sustainability goal, and (in the MDGs) a partnership goal. The two underpinning components of growth and governance remain crucial and, if anything, are still more important today than 20 years ago when the global goal-setting process began. 

Continuity of strategic direction in transformational change is an asset, ensuring persistence and staying power until the goal is fulfilled.

The SDGs now convey a sense of the scale and scope of systemic threats. The sustainability goals (goals 11 through 15) highlight the environmental threats from urbanization, over-consumption/production, climate change, destruction of ocean life, to ecosystems, forests, deserts, land, and biodiversity. No knowledgeable person would leave out any of these issues when considering threats to environmental sustainability. 

The fact that goal 10, to “reduce inequality within and among countries,” is on the list of SDGs signals a new fact of political life that inequality is now front-and-center on the political agenda globally and nationally in many countries, advanced, emerging, and developing. This goal is really the “chapeaux” for goals 3 through 7, which deal with health, education, gender, water and sanitation, and energy for all—the access goals that must be met to “reduce inequality within and among countries.” It is inconceivable that a group of global goals for a sustainable future in the 21st century would leave out any of these goals crucial for achieving social sustainability, and undoubtedly political sustainability as well. 

Reducing inequality is not an end in itself but a means of providing skills and livelihoods for people in a knowledge-based global economy and hence the social and political sustainability required for stable growth. Growth is both a means and an end.

The two poverty goals are now more ambitious and inclusive than earlier. “Ending poverty” is different from reducing it, as in the IDGs and MDGs. And “ending hunger” through food security, nutrition, and sustainable agriculture are means to the end of eliminating poverty. For the Economist, eliminating extreme poverty should be the most important goal, stating that “it would have a much better chance of being achieved if it stood at the head of a very short list.”

This observation would apply if the SDGs are again intended to be, as the IDGs and MDGs were previously, development goals for developing countries. But development for developing countries is not the primary thrust and drive of the post-2015 agenda taken as a whole.  

The world is now facing systemic risks that threaten unacceptable collapse in social, political, economic, and environmental systems. A global community under threat from systemic risks needs a strategic vision and a pathway forward with specific guideposts, benchmarks, and means of implementation. 

The SDGs, the FFD documents and the U.N. Framework Convention on Climate Change accords will not be perfect. But, the three U.N. processes in 2015 capture the main elements, attempt to get specific in terms of priority actions and accountability, and together will provide a vision for the future for achieving systemic sustainability in its multiple, interconnected dimensions.

To think that simplifying the wording is going to simplify the problems is illusory. To narrow the vision to poor countries and poor people is to misunderstand the systemic nature of the threats and the scope and scale of them. 

This is a global agenda for all. Partnership now means we are all in the same boat, no longer acting on a global North-South axis of donor and recipient. Without the participation of all nations, all stakeholders, and all the international institutions, actual transformation will fall short of necessary transformation, and the world will reach breaking points that will inflict pain, suffering, and high costs on everyone in the future. The post-2015 Sustainable Development Agenda for 2030 brings an awareness of the future into the present and makes us understand that the time for action is now. 

Endnotes:

[1] For an example of a recent multistakeholder interactive conference on this set of issues, review the related report on the Brookings-Finland private meeting on March 30, 2015 on “implementing the post 2015 sustainable development agenda.

[2] See “Action Implications of Focusing Now on the Implementation of the post-2015 Agenda,” which outlines in more detail the key elements of implementation that need to be set in motion during 2015 and 2016, emphasizing especially roles for the Turkey G-20 summit in 2015 and the China G-20 summit in 2016.  

From 2006 to 2011, Qatar was highly active as a conflict mediator within the greater Middle East, seeking political consensus in Lebanon as well as securing a key peace agreement regarding the Darfur conflict. What were the drivers of Qatari mediation during this time, and how successful were Qatari negotiators in their efforts? How has Qatar’s foreign policy during the Arab Spring affected its ability to act as a mediator? How might Qatar expand its mediation capacity in the future?

In an Analysis Paper, Sultan Barakat weighs the prospects for renewed Qatari mediation efforts in a changing regional landscape. He holds that Qatar’s turn towards a more interventionist foreign policy during the Arab Spring shifted the country’s focus away from mediation, while backlash against the country’s positions has limited its ability to engage with the region’s conflicts.

Drawing on interviews with government officials, Barakat concludes that Qatar’s efforts were much aided by financial resources and wide-ranging political ties which helped drive initial mediation efforts, yet were hampered by a lack of institutional capacity to support and monitor such mediation.

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Over the past few years, higher education has been a frequent casualty of the violent conflicts sweeping the Middle East. Campuses have been bombed in Syria, Gaza and now Yemen; occupied or closed in Libya and Iraq; and been the subject of severe police crackdowns across the region. What institutional measures can both regional entities and international bodies take to protect institutions of higher learning in the Arab world? Beyond this, how can strategies of protection be incorporated into programs of reconstruction and development for this much-maligned sector?

Read "Houses of wisdom matter: The responsibility to protect and rebuild higher education in the Arab world"

Sultan Barakat and Sansom Milton, in a new Brookings Doha Center Policy Briefing, contend that higher education is often an unrecognized casualty of these conflicts, with priority given to more pressing humanitarian needs. They assert that the protection and rebuilding of such institutions across the Middle East forms a crucial response to present concerns, helping to shelter and develop strategically vital youth populations. Crucially, they hold that an action plan for higher education in the Arab world cannot end at rebuilding shattered classrooms or rescuing individual scholars.

Ultimately, Barakat and Milton argue for a regional approach to defending and advancing higher education, as a key tool to combat violent extremism, address economic challenges, and encourage social stability. A strategy of “building back better” would allow higher education to serve as an engine for regional revitalization, living up to the historical example set by the region’s centuries-old institutions of higher learning.

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Ron Haskins and Isabel Sawhill were just awarded the 2016 Daniel Patrick Moynihan Prize by the American Academy of Political and Social Science. The honor is presented to “a leading policymaker, social scientist, or public intellectual whose career demonstrates the value of using social science evidence to advance the public good.” In this case, however, for the first time the award was awarded jointly.

Here at Brookings, Belle and Ron have forged a powerful and unique intellectual partnership, founding and elevating the Center on Children and Families and producing world-class work on families, poverty, opportunity, evidence, parenting, work and education, and much more besides.

The Association highlighted Belle and Ron’s bipartisanship. This was appropriate, given that the two have different political backgrounds, and work with people across the political spectrum. The skills and attributes they display in order to work in this way are:

1. Deep respect for the views of others regardless of their politics.
2. Reverence for the evidence and for the facts.
3. A willingness to adapt their views to the facts, rather than (as so often in this town), the other way around. This has been true even when it has made their life more difficult with people on “their” side of the political spectrum.
4. A desire to work hard to bring ideas to bear on public policy. The point is to do good work, but also to have real impact.
5. An insatiable intellectual curiosity to find out more, push new boundaries, and to keep learning. (Both of them have new books out, of course.)

These attributes, when you think about it, are those every decent scholar should aspire to. Belle and Ron have shown us that the skills for bipartisanship turn out to be essentially the same skills as those required for good scholarship.

In his remarks at the Prize lecture, Ron focused on the rise, importance, and prospects for evidence-based policy. Ron has tackled this subject at book length in Show Me the Evidence. Here is part of what Ron had to say:

“Perhaps the most important social function of social science is to find and test programs that will reduce the nation’s social problems. The exploding movement of evidence-based policy and the many roots the movement is now planting, offer the best chance of fulfilling this vital mission of social science, of achieving, in other words, exactly the outcomes Moynihan had hoped for. Today, evidence-based policy rests on the mighty oak of program evaluation in general and the random assignment study in particular.”

Ron highlighted the growth of Pay for Success programs, the Obama administration’s emphasis on evidence-based initiatives, and the creation of the Ryan/Murray Commission on Evidence-Based Policy.

Ron argued that it was right to be skeptical about the likely impact of any particular intervention. But this is not to say that policy doesn’t work—just that some policies work, others don’t, and it good to know the difference. In his slides, Ron lists some programs that have been shown to have demonstrable, sustainable impact—what he described as “his entry in the evidence-based policy sweepstakes.”

But there are plenty of challenges ahead, including the need to improve our understanding of implementation; and the following critical question: “When a program fails, what’s next?” Ron argued that the answer should not be to simply pull the funding, but to work on improving performance.

Belle highlighted the work captured in her latest book, Generation Unbound, on how to reduce the damaging rise of unintended pregnancies and births in the U.S. Over 40 percent of children are born outside of marriage, and 60 percent of births to single women under age 30 are unplanned. In the spirit of being faithful to the facts, and focused on what works, Belle showed the costs of unintended pregnancies for poverty, family stability, and opportunity. Child poverty rates have increased, Belle estimates, by about 25 percent since 1970 because of changes in family structure.

So what are the solutions? In the spirit of following the evidence, Belle argued that the goal must be to help people plan for rather than drift into pregnancy, by broadening access to and use of long-acting reversible contraception. The best example is the intrauterine device, or IUD. The risks of pregnancy for women using this method of contraception are very much lower than for condoms or the pill: 

A fact-based analysis of a problem, followed by an evidence-based approach to solutions: Belle’s work on contraception (sometimes alongside Ron) is a perfect example of bipartisanship, impact-oriented scholarship and a commitment to evidence.

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As a rhetorical ideal, greater opportunity is hard to beat. Just about all candidates for high elected office declare their commitments to promoting opportunity – who, after all, could be against it? But opportunity is, to borrow a term from the philosopher and political theorist Isaiah Berlin, a "protean" word, with different meanings for different people at different times.

Typically, opportunity is closely entwined with an idea of upward mobility, especially between generations. The American Dream is couched in terms of a daughter or son of bartenders or farm workers becoming a lawyer, or perhaps even a U.S. senator. But even here, there are competing definitions of upward mobility.

It might mean being better off than your parents were at a similar age. This is what researchers call "absolute mobility," and largely relies on economic growth – the proverbial rising tide that raises most boats.

Or it could mean moving to a higher rung of the ladder within society, and so ending up in a better relative position than one's parents.

Scholars label this movement "relative mobility." And while there are many ways to think about status or standard of living – education, wealth, health, occupation – the most common yardstick is household income at or near middle age (which, somewhat depressingly, tends to be defined as 40).

As a basic principle, we ought to care about both kinds of mobility as proxies for opportunity. We want children to have the chance to do absolutely and relatively well in comparison to their parents.

On the One Hand…

So how are we doing? The good news is that economic standards of living have improved over time. Most children are therefore better off than their parents. Among children born in the 1970s and 1980s, 84 percent had higher incomes (even after adjusting for inflation) than their parents did at a similar age, according to a Pew study. Absolute upward income mobility, then, has been strong, and has helped children from every income class, especially those nearer the bottom of the ladder. More than 9 in 10 of those born into families in the bottom fifth of the income distribution have been upwardly mobile in this absolute sense.

There's a catch, though. Strong absolute mobility goes hand in hand with strong economic growth. So it is quite likely that these rates of generational progress will slow, since the potential growth rate of the economy has probably diminished. This risk is heightened by an increasingly unequal division of the proceeds of growth in recent years. Today's parents are certainly worried. Surveys show that they are far less certain than earlier cohorts that their children will be better off than they are.

If the story on absolute mobility may be about to turn for the worse, the picture for relative mobility is already pretty bad. The basic message here: pick your parents carefully. If you are born to parents in the poorest fifth of the income distribution, your chance of remaining stuck in that income group is around 35 to 40 percent. If you manage to be born into a higher-income family, the chances are similarly good that you will remain there in adulthood.

It would be wrong, however, to say that class positions are fixed. There is still a fair amount of fluidity or social mobility in America – just not as much as most people seem to believe or want. Relative mobility is especially sticky in the tails at the high and low end of the distribution. Mobility is also considerably lower for blacks than for whites, with blacks much less likely to escape from the bottom rungs of the ladder. Equally ominously, they are much more likely to fall down from the middle quintile.

Relative mobility rates in the United States are lower than the rhetoric about equal opportunity might suggest and lower than people believe. But are they getting worse? Current evidence suggests not. In fact, the trend line for relative mobility has been quite flat for the past few decades, according to work by Raj Chetty of Stanford and his co-researchers. It is simply not the case that the amount of intergenerational relative mobility has declined over time.

Whether this will remain the case as the generations of children exposed to growing income inequality mature is not yet clear, though. As one of us (Sawhill) has noted, when the rungs on the ladder of opportunity grow further apart, it becomes more difficult to climb the ladder. To the same point, in his latest book, Our Kids – The American Dream in Crisis, Robert Putnam of Harvard argues that the growing gaps not just in income but also in neighborhood conditions, family structure, parenting styles and educational opportunities will almost inevitably lead to less social mobility in the future. Indeed, these multiple disadvantages or advantages are increasingly clustered, making it harder for children growing up in disadvantaged circumstances to achieve the dream of becoming middle class.

The Geography of Opportunity

Another way to assess the amount of mobility in the United States is to compare it to that found in other high-income nations. Mobility rates are highest in Scandinavia and lowest in the United States, Britain and Italy, with Australia, Western Europe and Canada lying somewhere in between, according to analyses by Jo Blanden, of the University of Surrey and Miles Corak of the University of Ottawa. Interestingly, the most recent research suggests that the United States stands out most for its lack of downward mobility from the top. Or, to paraphrase Billie Holiday, God blesses the child that's got his own.

Any differences among countries, while notable, are more than matched by differences within Pioneering work (again by Raj Chetty and his colleagues) shows that some cities have much higher rates of upward mobility than others. From a mobility perspective, it is better to grow up in San Francisco, Seattle or Boston than in Atlanta, Baltimore or Detroit. Families that move to these high-mobility communities when their children are still relatively young enhance the chances that the children will have more education and higher incomes in early adulthood. Greater mobility can be found in places with better schools, fewer single parents, greater social capital, lower income inequality and less residential segregation. However, the extent to which these factors are causes rather than simply correlates of higher or lower mobility is not yet known. Scholarly efforts to establish why it is that some children move up the ladder and others don't are still in their infancy.

Models of Mobility

What is it about their families, their communities and their own characteristics that determine why they do or do not achieve some measure of success later in life?

To help get at this vital question, the Brookings Institution has created a life-cycle model of children's trajectories, using data from the National Longitudinal Survey of Youth on about 5,000 children from birth to age 40. (The resulting Social Genome Model is now a partnership among three institutions: Brookings, the Urban Institute and Child Trends). Our model tracks children's progress through multiple life stages with a corresponding set of success measures at the end of each. For example, children are considered successful at the end of elementary school if they have mastered basic reading and math skills and have acquired the behavioral or non-cognitive competencies that have been shown to predict later success. At the end of adolescence, success is measured by whether the young person has completed high school with a GPA average of 2.5 or better and has not been convicted of a crime or had a baby as a teenager.

These metrics capture common-sense intuition about what drives success. But they are also aligned with the empirical evidence on life trajectories. Educational achievement, for example, has a strong effect on later earnings and income, and this well-known linkage is reflected in the model. We have worked hard to adjust for confounding variables but cannot be sure that all such effects are truly causal. We do know that the model does a good job of predicting or projecting later outcomes.

Three findings from the model stand out. First, it's clear that success is a cumulative process. According to our measures, a child who is ready for school at age 5 is almost twice as likely to be successful at the end of elementary school as one who is not.

This doesn't mean that a life course is set in stone this early, however.

Children who get off track at an early age frequently get back on track at a later age; it's just that their chances are not nearly as good. So this is a powerful argument for intervening early in life. But it is not an argument for giving up on older youth.

Second, the chances of clearing our last hurdle – being middle class by middle age (specifically, having an income of around $68,000 for a family of four by age 40) – vary quite significantly. A little over half of all children born in the 1980s and 1990s achieved this goal. But those who are black or born into low-income families were very much less likely than others to achieve this benchmark.

Third, the effect of a child's circumstances at birth is strong. We use a multidimensional measure here, including not just the family's income but also the mother's education, the marital status of the parents and the birth weight of the child. Together, these factors have substantial effects on a child's subsequent success. Maternal education seems especially important.

The Social Genome Model, then, is a useful tool for looking under the hood at why some children succeed and others don't. But it can also be used to assess the likely impact of a variety of interventions designed to improve upward mobility. For one illustrative simulation, we hand-picked a battery of programs shown to be effective at different life stages – a parenting program, a high-quality early-edcation program, a reading and socio-emotional learning program in elementary school, a comprehensive high school reform model – and assessed the possible impact for low-income children benefiting from each of them, or all of them.

No single program does very much to close the gap between children from lower- and higher-income families. But the combined effects of multiple programs – that is, from intervening early and often in a child's life – has a surprisingly big impact. The gap of almost 20 percentage points in the chances of low-income and high-income children reaching the middle class shrinks to six percentage points. In other words, we are able to close about two-thirds of the initial gap in the life chances of these two groups of children. The black-white gap narrows, too.

Looking at the cumulative impact on adult incomes over a working life (all appropriately discounted with time) and comparing these lifetime income benefits to the costs of the programs, we believe that such investments would pass a cost-benefit test from the perspective of society as a whole and even from the narrower prospective of the taxpayers who fund the programs.

What Now?

Understanding the processes that lie beneath the patterns of social mobility is critical. It is not enough to know how good the odds of escaping are for a child born into poverty. We want to know why. We can never eliminate the effects of family background on an individual's life chances. But the wide variation among countries and among cities in the U.S. suggests that we could do better – and that public policy may have an important role to play. Models like the Social Genome are intended to assist in that endeavor, in part by allowing policymakers to bench- test competing initiatives based on the statistical evidence.

America's presumed exceptionalism is rooted in part on a belief that class-based distinctions are less important than in Western Europe. From this perspective, it is distressing to learn that American children do not have exceptional opportunities to get ahead – and that the consequences of gaps in children's initial circumstances might embed themselves in the social fabric over time, leading to even less social mobility in the future.

But there is also some cause for optimism. Programs that compensate at least to some degree for disadvantages earlier in life really can close opportunity gaps and increase rates of social mobility. Moreover, by most any reasonable reckoning, the return on the public investment is high.

Editor's note: This piece originally appeared in the Milken Institute Review.

The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia and Panama. While not going that far, the Senate Majority Leader, Harry Reid, and Senator Charles Schumer have promised a vote on the issue some time this year.

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. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011—fueling efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.

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 (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy as part of a broader program of “rebalancing” the Chinese economy away from its traditional reliance on exports and investment, and towards a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a 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.

Chinese officials take a very different view. They 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 to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea and Taiwan since World War II, or by Britain, the United States and Germany in the 19th century. Since the Chinese leaders 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—unlike Japan in the 1970s and 1980s—is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.

A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 which has contributed about three-quarters of the nearly US$3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. treasury debt. Some fear that China has become the United States’ banker, and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All of these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense “America’s banker;” it is more a depositor than a lender, and its economic leverage over the United States is very modest.

And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.

China’s Currency Policies

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms being tools to that end rather than ends in themselves; and second, China’s geopolitical position.

The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particular, the catch-up growth strategies of its east Asian neighbors Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting the colonies from exporting manufactures back to Britain, were important components of that nation’s rise as the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the “American system,” which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership and the need for protection waned for Britain, this occurred in the mid-19th century; for the United States, the mid-20th.

After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of post-war economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand—so-called “import substitution industrialization,” or ISI, which usually involved an overvalued exchange rate—in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the Communist bloc, experienced severe financial crisis and fell into long periods of stagnation.

As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997, and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar, to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the Asian financial crisis of 1997-1998, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.

Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred in many oil-rich Persian Gulf countries in 2005-2007, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the nation’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia and Bangladesh.

In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the nation’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macro-economic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.

International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact. The basic reason is that other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the Plaza Accord of 1985, which resulted in a doubling of the value of the yen over the next two years. China, being, geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other nations such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.

Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the dramatic appreciation of the yen in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the global financial crisis of 2008, which in China thoroughly discredited the idea—already held in deep suspicion by Chinese leaders—that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the nation’s strategy of a managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.

The Internationalization of the RMB

Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: a serious deterioration of the US economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: when United States credit markets seized up in late 2008, trade finance evaporated and exporting nations such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policy makers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.

Before considering the significance of RMB internationalization, it is worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. treasury bonds. Because China’s central bank is the biggest single 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. First of all, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting nation, China would be among the biggest victims of such chaos. Second, if China sells U.S. treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about US$400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China “dumping dollars,” China actually doubled its holdings of U.S. Treasury securities, to US$1.3 trillion.

The other crucial point is that China is not in any meaningful sense “America’s banker,” and its economic leverage is modest. China owns just 8% of the total outstanding stock of US Treasury debt; 69% of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker—not China. And China’s holdings of all US financial assets – equities, federal, municipal and corporate debt, and so on – is a trivial 1%. Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks, and secondarily from European ones. 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.

It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the “Bank of the United States.” But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.

The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in under 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB, since they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB – just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.

Since China is already the world’s leading exporter, and is likely to surpass the United States as the world’s leading importer within three or four years, it is quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro—let alone replacing the dollar as the world’s dominant reserve currency—is remote. The reason for this is simple: to be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly-created RMB bond market in Hong Kong (the so-called “Dim Sum” bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.

Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all of its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally-available safe RMB assets to make the RMB a substantial international reserve currency.

In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today: it had surpassed Germany to become the world’s second biggest economy, and it was accumulating trade surpluses and foreign-exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power, and the yen a dominant currency. Yet this never occurred. The yen internationalized – nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated “Samurai bonds” on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets, and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared to 69 percent percent for US Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.

Implications for U.S. Policy

The above analysis suggests two broad conclusions of relevance to United States policymakers. First, 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. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates 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. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control, and gradually forcing an upgrade of China’s industrial structure.

Generally speaking, these trends are quite benign from a U.S. perspective. 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 that can be plausibly brought to bear. While the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. United States policy should therefore de-emphasize the exchange rate, where the potential for success is limited, 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.

This paper is part of a series of in-depth policy papers, Shaping the Emerging Global Order, in collaboration with ForeignPolicy.com. Visit ForeignPolicy.com's Deep Dive section for discussion on this paper.

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.

In the last two months China has executed a decisive change in its policy for managing its currency, the renminbi. Ending an eight-year period of slow but relentless appreciation against the U.S. dollar, the People’s Bank of China (PBOC) engineered a swift devaluation of about 3 percent, and doubled the size of the currency’s daily trading band. These moves took financial markets by surprise and sowed confusion. Was Beijing simply trying to re-ignite export growth by making its currency cheaper? Or was it making a more fundamental shift?

The answer is straightforward. China has taken a huge step towards making its exchange rate more flexible and market determined. In doing so, the authorities have clearly signaled their intention to switch from a monetary policy that mainly targets the exchange rate, to one that mainly targets domestic interest rates. The change in renminbi policy is thus part of a broad and ambitious financial reform strategy, reflecting the agenda laid out last November in the “Decision” published following the Third Plenum of the 18th Party Congress. It is all about improving China’s macroeconomic management, and has little or nothing to do with boosting exports.

Four Phases of China’s Exchange Rate Management

To understand the significance of the new renminbi policy, some background is helpful. The history of China’s exchange rate management can be divided into four phases. In the first, from 1979 to 1994, there was a steady depreciation in order to wean the country off the artificially overvalued exchange rate inherited from the previous period of Communist autarky. During this period Beijing maintained a dual exchange rate system. This consisted of an official rate, still overvalued, but gradually converging toward reality, which essentially applied to the capital account; and a more market based “swap rate” which was available to exporters. The purpose of this arrangement was to enable a competitive (though rudimentary) export economy to develop while still keeping the local price of imported capital goods relatively low, and avoiding the collapse in living standards that a full-on depreciation would have caused.

The second phase was a brief transition period in 1994-1995 when the two exchange rates were combined and the currency was allowed to float more or less freely in order for fair value to be established. In late 1995 the value of the renminbi was fixed at a rate of 8.3 against the U.S. dollar, initiating the third phase—a hard peg against the U.S. dollar—which lasted until July 2005.

It’s important to recall that the first test of this regime was the refusal to devalue in 1998 in the wake of the Asian financial crisis, when the currencies of the countries with whom China was then competing for export orders all fell dramatically. Rather than devaluing to help out exporters, Beijing hardened its peg. This was costly: China’s exports flatlined in 1998, and arguably the relatively strong currency played a role in the deflation that China suffered for the next four years. One reason the government hardened the peg, rather than devaluing, was to establish that China was a dependable player in the world system and that its currency could be relied on as a store of value. The short-term hit to exports was more than offset by the strategic gain in China’s reputation as “responsible stakeholder” and a safe place for foreign direct investment.

The hard peg against a declining U.S. dollar led eventually to a depreciation of the trade-weighted, inflation-adjusted exchange rate (known as the real effective exchange rate, or REER) that contributed to the exploding exports and ballooning trade surpluses of the early 2000s. This in turn prompted the fourth phase of Chinese currency policy: a crawling peg against the U.S. dollar, starting in July 2005. Each day, the PBOC fixed a reference rate for the renminbi against the dollar, and permitted the currency’s value to fluctuate within a narrow band around the reference. The daily trading band was initially set at 0.3 percent (in either direction), and subsequently widened to 0.5 percent in 2007 and 1 percent in April 2012. Over eight years, the crawling-peg system delivered a 35 percent appreciation against the U.S. dollar and a 40 percent appreciation of the REER.

In light of the vociferous criticism China endured for its undervalued exchange rate, it is striking in retrospect how swift Beijing was to change its currency regime once a serious external imbalance appeared. As late as 2004, China’s merchandise trade balance was around 2.5 percent of GDP, just slightly above the 15-year average. In 2005 it jumped to 5.5 percent, and the decision to let the currency rise was immediate. At first the rise was too timid, and the trade and current account balances continued to expand. But by mid-2007 the appreciation pace picked up to 5 percent a year. The ultimate result of the crawling-peg regime was a reduction in the current account surplus from its peak of 10 percent of GDP in 2007 to the measly 0.8 percent recorded in the first quarter of 2014.

As the above account makes clear, mercantilist motives historically played a secondary role in China’s exchange rate policies—and after 2007 China pursued an anti-mercantilist policy of deliberately shrinking its trade surplus. Beijing’s bigger concerns were the exchange rate’s role in facilitating a broad shift from administered to market prices (1978-1995), as an anchor for monetary policy (1995-2013) and as instrument for correcting an external imbalance and promoting a shift in favor of domestic demand (2007-2013). Lying in the background was the idea that a relatively stable exchange rate was strategically beneficial. After the Asian crisis, foreign investors were reassured that China was a safe place for direct investment; and after the 2008 global crisis the case for the renminbi as an international trade-settlement and portfolio investment currency was strengthened.

Given this history, we can safely rule out the theory that this year’s devaluation is a tactic to boost exports at a time of flagging domestic demand. An explanation that better fits both the recent facts and the historical context is that, in line with the Third Plenum Decision, Beijing wanted to make the exchange rate more flexible and market-determined. But it faced a problem: for almost 18 months from September 2012, the daily market rate of the renminbi was at or near the top of the 1 percent trading band, because investors assumed (rightly) that the Chinese currency would always go up: it was a “one-way bet.” The one-way bet caused large-scale capital inflows that were routinely much larger than the monthly trade surplus. Under these conditions, if the central bank had simply widened the daily trading band, traders would quickly have pushed the value of the currency to the top of the new band, and even more capital would have flowed in. To prevent this outcome, the PBOC in late February starting pushing down its daily fixing, and ordered Chinese state-owned banks to sell renminbi and buy dollars. In mid-March, when the “one-way bet” psychology had been chased out of the market, PBOC doubled the daily trading band to 2 percent.

Welcome to the Managed Float

It is clear that China has entered a new phase of currency management, and the rulebook that has worked well since 2005 must be heavily revised. Two observations inform this judgment. First, the main aims of the strong renminbi policy have been achieved. The current account surplus has been virtually eliminated, and at least one serious technical study of the currency (by Martin Kessler and Arvind Subramaniam of the Peterson Institute for International Economics), the structural undervaluation of the renminbi has been eliminated.

Second, the adoption of a 2 percent daily trading band means that, on a day-to-day basis, the renminbi rate can now be determined mainly by the market most of the time (since only at times of extreme stress do currencies move more than 2 percent in a day). This newfound capacity seems consistent with the broad aim articulated in the Communist Party’s reform agenda last November, of having market forces play a “decisive role” in resource allocation. A willingness to let the currency float more freely is also consistent with the apparent agenda to liberalize deposit interest rates within in the next two years, which implies shifting from a monetary policy that mainly targets the exchange rate to one that mainly targets a domestic money-market interest rate.

It is also clear, however, that the renminbi will not simply be left to its own devices: the float will be a heavily managed one. Mechanically, it will likely operate much like the Singapore dollar “basket, band and crawl,” or BBC system, with an undisclosed trade-weighted index target, a 2 percent daily trading band puts a limit on extreme movements and a periodic readjustment of the slope of the policy band to prevent a major misalignment of the currency emerging (as it did at the end of China’s hard-peg era).

Strategically, the two most important aims of Beijing’s exchange rate regime will be maintaining stability of both the current and capital accounts, and providing support for the emergence of the renminbi as a serious international currency. (For an analysis of the renminbi-internationalization drive, see China’s Global Currency: Lever For Financial Reform.)

The first factor basically means that when capital flows (in or out) threaten to become destabilizing, the PBOC will use the exchange rate to reverse those flows; the same applies to extreme movements in the current account. In effect, Beijing will try to keep both parts of the balance of payments in roughly neutral position, while it undertakes deep reforms of the domestic economy.

The second aim means that sustained depreciation is unlikely to be tolerated, since as the new kid on the block the renminbi still must convince global investors that it is a reliable store of value over the medium to long term. Yet intolerance for sustained depreciation is perfectly compatible with significant short-term depreciations lasting several months or more, to correct current or capital account imbalances. The days of the one-way bet are over.

The bottom line is that Beijing has made a decisive commitment to a much more flexible and far more market-driven exchange rate—exactly what the U.S. Treasury Department and the International Monetary Fund have been suggesting for years. This commitment means that the exchange rate will cease to be a major point of friction between China and its trading partners. The interesting question now is how quickly China will follow up with the even bigger task of liberalizing its domestic financial system.