China and the Global Economy:
Medium-term Issues and Options
A Synthesis Report

Edwin Lim, Michael Spence, and Ricardo Hausmann

CID Working Paper No. 126
June 2006




© Copyright 2006 Edwin Lim, Michael Spence, Ricardo Hausmann and
the President and Fellows of Harvard College


Working Papers
Center for International Development
at Harvard University

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China and the Global Economy: Medium-term Issues and Options - A
Synthesis Report

Edwin Lim, Michael Spence, and Ricardo Hausmann


Abstract
China’s economic and social achievements since the beginning of reform and opening are
unprecedented in global history. Managing the growth process in this continuously changing
environment has required great skill and the use of unconventional economic policy. Now
China has entered a new era in its development process with a set of challenges largely different
from those of the recent past. Some problems - such as growing internal and external structural
imbalances, increasing income and regional inequality – have arisen from, or been exacerbated
by, the very pattern and success of high growth since reforms began. Others are newly posed by
rapid changes in the global economy. These challenges can best be tackled in an integrated and
coordinated fashion. This report, supported by the China Economic Research and Advisory
Programme (CERAP), identifies the primary challenges facing China today and presents options
for meeting them.


Keywords: China, global economy, macro-management, financial imbalances, exchange-rate
regime


JEL codes: 020, 050

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China Economic Research and Advisory Programme













China and the Global Economy:
Medium-term Issues and Options

A synthesis report
















December 2005

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Foreword

This is the second policy study supported by the China Economic Research and
Advisory Programme (CERAP). The main recommendations of the first study on social
security reform were presented to Premier Wen Jiabao in November 2004, as well to a
broader audience at a seminar in Beijing. At the meeting with Premier Wen, it was agreed
that the next study to be conducted by the CERAP should be on medium-term issues
associated with China and the global economy. The counterpart institutions for this study
are the Institute of World Economy and Politics in the Chinese Academy of Social
Sciences, and the Research Institute of the People’s Bank of China.

A number of prominent economists from different parts of the world were invited to write
papers for this study, either on the general topic of China and the global economy or on
more specific issues, depending on personal interests and expertise. A number of papers
were also prepared by the Chinese counterpart institutions.

This synthesis report was prepared by Edwin Lim, Michael Spence and Ricardo
Hausmann on the basis of papers prepared by the following:

A team of economists at the People’s Bank of China, led by Dr Tang Xu, Director of the
Research Department, and a team at the Institute of World Economics and Politics,
Chinese Academy of Social Sciences, led by Professor Yu Yongding and Dr He Fan.

Olivier Blanchard (French), Professor of Economics, Massachusetts Institute of
Technology (MIT), Member of the French Prime Minister’s Economic Advisory Council;
Barry Eichengreen (American), Professor of Economics and Professor of Political
Science, University of California, Berkeley; former Senior Policy Advisor, IMF;
Francesco Giavazzi (Italian), Professor of Economics, Bocconi University in Milan;
visiting Professor at MIT; Member of the Group of Economic Policy Advisers to the
President of the European Commission; Ricardo Hausmann (Venezuelan), Professor of
Economic Development, Kennedy School of Government, Harvard University; former
Venezuelan Minister of Planning and Chief Economist, Inter-American Development
Bank; Takatoshi Ito (Japanese), Professor of Economics, University of Tokyo; former
Deputy Vice Minister for International Affairs, Ministry of Finance, Japan; Senior
Advisor, Research Department, IMF; Michael Lipton (British), Research Professor,
Poverty Research Unit, University of Sussex; Warwick McKibbin (Australian),
Professor of International Economics, Research School of Pacific and Asian Studies;
Director of Centre for Applied Macroeconomic Analysis at the Australian National
University; Maurice Obstfeld (American), Professor of Economics, University of
California, Berkeley; Jean Pisani-Ferry (French), Director, Brussels European and
Global Economic Laboratory (Bruegel); Professor of Economics, University of Paris-
Dauphine; Member of the French Prime Minister’s Economic Advisory Council; Dani
Rodrik (American), Professor of International Political Economy, Kennedy School of
Government, Harvard University; André Sapir (Belgian), Professor of Economics,
Université Libre de Bruxelles and member of the Group of Economic Policy Advisers to

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the President of the European Commission; and Anthony Venables (British), Chief
Economist, UK Department for International Development; Professor of International
Economics, London School of Economics and Political Sciences;

Christopher Allsopp (Reader in Economics, University of Oxford, formerly member of
the Monetary Policy Committee, Bank of England), Professor William Hsiao (School of
Public Health, Harvard University), Dr. Khor Hoe Ee (Assistant Managing Director,
Economics, Monetary Authority of Singapore), Dr Cyril Lin (Managing Director,
Development Initiatives, Ltd, formerly University Lecturer in Economics, University of
Oxford), and Dr Tan Kim Song (Singapore Management University) also provided
inputs to the synthesis paper.

The work of CERAP was guided by the following advisory team, many of whom
reviewed and provided comments on an early draft of this report:

Chinese advisors: Liu Zhongli, Chairman, Economic Committee of Political
Consultative Committee; Xiang Huaicheng, Chairman, National Council for Social
Security Fund; Zhou Xiaochuan, Governor, the People’s Bank of China; Wu Jinglian,
Senior Fellow, the Development and Research Center of the State Council; Li Jiange,
Deputy Chairman, the Development and Research Center of the State Council; Lou
Jiwei, Senior Vice Minister, Ministry of Finance; Guo Shuqing, Chairman, China
Construction Bank; and Yu Yongding, Director General, Institute of World Economy
and Politics, Chinese Academy of Social Sciences.

International advisors: Stanley Fischer (Governor, Bank of Israel, formerly President,
Citigroup International; First Deputy Managing Director, International Monetary Fund,
Chief Economist, World Bank, and Professor of Economics, MIT); Caio Koch-Weser
(Vice Chairman, Deutsche Bank, formerly Deputy Minister of Finance, Germany;
Managing Director, World Bank); Edwin Lim, (formerly Director, World Bank, first
Director of the World Bank office in Beijing and founding CEO of Chinese International
Capital Corporation), Sir James Mirrlees (Nobel Laureate and Professor of Economics,
University of Cambridge); Professor Michael Spence (Nobel Laureate, formerly Dean
of the Graduate School of Business, Stanford University and Dean of the Faculty of Arts
and Sciences, Harvard University); Sir Nicholas Stern (Second Permanent Secretary,
UK Treasury; formerly, Chief Economist, World Bank, and Professor of Economics,
London School of Economics); and Teh Kok-Peng (President, GIC, Special Investment
Pvte, Ltd, Singapore; formerly, Deputy Managing Director, Monetary Authority of
Singapore).

Edwin Lim is responsible for overall management of CERAP.

Core funding for expenses of CERAP is being provided by the East Asian Institute of the
National University of Singapore. Additional funding for the China and Global Economy
study is provided by the United Kingdom’s Department for International Development.

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Contents

Executive Summary
i

Chapter 1 Introduction
1
China’s Economic Achievements in Historical Perspective
1
Challenges to Sustainable Growth
3
Managing China’s Growth and Global Integration
4

Chapter 2 Dealing with Internal and External Imbalances
5
Overview
5
A Graphical Illustration of the Problem and Possible Solutions
6
Increase Consumption
9
A Debt-financed Public Expenditure Program to Increase Domestic Demand
and to Address Social and Regional Problems
13
Appreciation of the Renminbi
14
Dealing with the Capital-account Surplus
16

Chapter 3 Maintaining Growth: Challenges and Opportunities
20
Urbanization 20
Agricultural Productivity and Rural Poverty
22
Maintaining Manufacturing Export Dynamism
23
Service-sector Productivity
24
Efficiency of Investment
24
Internal Trade Integration
26
Investment in Human Capital
27
Energy and Environment
29

Chapter 4 Reforming the Macro-management System and the
Exchange-rate Regime
33
A Dual-track Approach to Macro-management
33
Inflation Targeting
34
The Foreign-exchange Regime and Capital Account
35
Macroeconomic Policy and the Exchange Rate in China
37
Other Reforms and their Sequencing
39

Chapter 5 China’s Role in International and Regional Economic Groupings 41
China’s Role in Informal Global Groupings
42
China’s Links with Regional Groupings
43


Chapter 6 China and the Global Economy in the Next Two Decades
46
Longer-term Trends in the Global Economy
47
Financial Imbalances in the USA
49
China’s Increasing Economic Power and Role in the Global Economy
50

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Executive Summary

Introduction

China’s economic and social achievements since the beginning of reform and opening is
unprecedented in global history. Managing the growth process in this continuously
changing environment has required great skill and the use of unconventional economic
policy. The approach to economic policy has been characterized by pragmatism,
gradualism, innovative experimentation and caution (‘moshi guohe’ or ‘crossing the river
by feeling for stepping stones’), avoiding big-bang solutions and risky outcomes. The
benefits of this growth have been spread widely, with hundreds of million of people lifted
out of poverty.

China, however, has entered a new era in its development process with a set of challenges
largely different from those of the recent past. Some of these challenges – such as the
continued need to reform and modernize the economy, generate employment and raise
living standards – remain outstanding and will always persist in one form or another. But
other challenges – such as growing internal and external structural imbalances, increasing
income and regional inequality – have arisen from, or been exacerbated by the very
pattern and success of high growth since reforms began. And there are still other
challenges newly posed by rapid changes in the global economy. These challenges can
best be tackled in an integrated and coordinated fashion. Some can only be met by being
addressed simultaneously, while responses to others need to be properly sequenced.
This report identifies the major, fundamental challenges facing China today and presents
options for meeting them. Following an introductory chapter, Chapter 2 presents a
comprehensive program to deal with internal and external imbalances, in ways that are
consistent with China’s growth strategy and with the need to address emerging social and
economic problems. Chapter 3 discusses the challenge of maintaining rapid growth while
continuing to reduce disparity and persistent poverty. Chapter 4 proposes a dual-track
approach to building a macro-management system capable of guiding the necessary
process of growth and adjustment in the coming years. Chapter 5 examines how China
may play a more active role and, in some cases, assume a stronger leadership position in
the affairs of regional and international economies. The time frame of these discussions is
medium term, say, over the next 3–5 years. Thus, the final chapter takes a longer-term
perspective, identifying the emerging trends in the global economy over the next two
decades, of which China needs to be conscious now.


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Dealing with Internal and External Balances

The global economy faces serious imbalances today. In this context, attention on China
has focused on its large balance-of-payments surplus and the latter’s implication for the
country’s exchange-rate policy. This is, however, an incomplete and misleading view of
the problem. In our opinion, China should deal with its external and internal imbalances
simultaneously. What is needed is a package of policy measures which would deal with
outstanding issues in a comprehensive and coordinated manner, contribute to the
adjustment necessary in the global economy, as well as help China achieve its own
priorities.

China’s current-account surplus is a reflection of an excess of saving over investment.
This is an unusual and undesirable situation for a low-income country such as China, as it
means that the Chinese are forgoing a substantial amount of consumption for low-return
assets in rich countries. These resources could be better used to address the ‘social debt’
that has been accumulated over the past decades and to create the conditions for future
growth, thus increasing the welfare of the current and future generations of China.

Both saving and investment in China today are very high compared to earlier years or to
other countries. Investment, at about 46% of GDP, has reached a point of very low
returns in some areas. Although more investment is still needed in some key areas, rapid
growth could be maintained through more efficient investment while enabling a reduction
in the overall level of investment.

Eliminating the saving–investment gap, therefore, requires that saving be reduced and
consumption increased. Since 1990, saving has risen rapidly, reaching 50% of GDP in
2004, one of the highest rates in the world. There is therefore ample room for raising
consumption through a reduction in saving. An increase in consumption expenditures that
would help achieve a more balanced development strategy would also increase imports
from the rest of the world and reduce China’s dependence on external demand, thus
achieving a better external balance.

To achieve internal and external balances, consumption in China needs to increase from
the current level of only about 50% of GDP to 55–60% in the coming decade, which
would approach the average level in the world. Thus, the key recommendation of this
report is a comprehensive package of policies with three main elements: (i) reform
measures to promote growth of consumption in the longer term; (ii) a public expenditure
program to stimulate domestic demand in the short and medium term; and (iii) a managed
appreciation of the currency.

Reform Measures to Promote Consumption Growth

Household consumption in China has not risen in line with national income because the
household saving rate, although it seems to have stabilized in recent years, remains at one
of the highest levels in the world, while the share of household disposable income in
national income has fallen. A major cause of the high household saving rate in China is

ii

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the so-called precautionary saving. Although income has risen substantially, the system
of social protection has collapsed to a large extent. This, coupled with the rapid pace of
change, has increased uncertainty.

To remedy the situation, the social security system needs to be strengthened. At the core
is the reform of the pension system. Recommendations to reform the urban-based
pension system, made by an international team organised by this program in 2004,
include reducing the fragmentation of the system and introducing pooling and
administration at the national level; eliminating early retirement abuses; transferring
shares of SOEs still owned by the state to the National Social Security Fund to finance
obligations left by the old SOE system; and strengthening individual accounts by
switching to a Notional Defined Contribution system. In addition, an urgent task is to
provide old-age security for the rural population, strengthen the minimum income
(Dibao) program and improve access to and sharing of risks in health and education.

Financial-sector reforms will also be necessary to provide households with efficient
instruments of saving which at present go mainly into low-return bank deposits.

Over the past few years, another reason for the slow growth of personal consumption has
been the declining share of disposable household income in GDP, which means that
household consumption has grown significantly less than GDP, although household
saving rates seems to have stabilized or declined somewhat (although still at a very high
level). In the last few years, the net income of enterprises has grown sharply. Unlike other
market economies, where a substantial share of the net income of enterprises flows to
households in the form of dividends to finance private consumption, almost all the
income generated by enterprises in China is saved and used for investment, either by the
enterprise itself or within the sector, with limited mobility. More listing of enterprises in
the stock markets and increased allocation of enterprise income to dividends will be
necessary to allow Chinese households to benefit more from growing enterprise income.

Government revenues as a percentage of national income have also increased sharply
over the last few years, largely as a result of improved collection. In addition,
government administrative reforms have led to a decrease in government consumption,
while expenditures on education, health and other public services have not increased
correspondingly. The improvement in fiscal balances has gone mostly into investment.
Much of the increase in investment, especially by local government, has had low returns.
To stimulate consumption in the economy, the government will need to increase the share
of income going to households – through lower taxation of household income and
increased transfers and subsidies – and to increase government consumption itself.



iii

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Special Public Expenditure Program to Stimulate Consumption in the Medium Term

To stimulate domestic demand over the short and medium term and respond to the
macroeconomic objective of increasing consumption by 6–10% of GDP, a special public
expenditure program covering the coming 3–5 years will be needed. The program should
be used to facilitate the transition of the economy to China’s new ‘people-centered’ and
comprehensive, coordinated development strategy by supporting social services and
consumption. A large legacy of ‘debt’ in social development now exists and requires
urgent attention. Such expenditures to support the improvement of health, education and
other social services will by themselves help to stimulate private consumption and reduce
the need for precautionary saving.

The needs are very large and the following are areas that could be considered:

• improvement in health care, including increased government expenditures and
subsidies to poorer regions and population groups;

• increased expenditures in education will be necessary, including the introduction of
compulsory nine-year education in the poorest areas and the strengthening of
technical education;

• in the same way as China has benefited greatly from its integration in the global
economy over the past decade, there are opportunities for efficiency gains and growth
through greater internal integration. Priority should be given to improving the quality
of the transportation and communication infrastructure in the poorer interior regions,
as well as agricultural research and extension, irrigation, rural infrastructure, and
greater access to farm inputs and markets via transport and information. Given the
rapid urbanization that China will be going through in the coming years, investment
in urban infrastructure such as transport, water and sanitation, should also be of high
priority in a public expenditure program.

Conditions exist in China to implement such a public expenditure program. The fiscal
position of the government is strong. Since the growth rate of the economy – at about
9%– is much higher than the average real cost of debt service of about 2.5%, China can
continue to run substantial fiscal deficits over the next few years without having to worry
about the debt burden. The challenge is therefore not financial, but more one of whether a
fiscal adjustment program can be designed that is compatible with macroeconomic, social
and regional objectives, and that also limits the risks imposed by possible government
failures. In addition, the adjustment program should not become a permanent feature of
the fiscal system. With rising budgetary revenues, many of the recurrent elements of the
public expenditure program should be absorbed into the regular budget while still
allowing the government to maintain a balanced current account budget.


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Document Outline

• Dealing with the Capital-account Surplus16
• Executive Summary
  • • • • • Maintaining Export Dynamism
    • Increase the efficiency of investment
• Chapter 1 Introduction
  • • Challenges to Sustainable Growth
    • ÿ
    • Dealing with the Capital-account Surplus
    • Active management of foreign reserves
• Chapter 3 Maintaining Growth: Challenges and Opportunities
  • • Urbanisation
      • Current situation
      • Policy ideas
    • Agricultural Productivity and Rural Poverty
      • Current situation
    • Maintaining Manufacturing Export Dynamism
      • Current situation
      • Policies
    • Service-sector Productivity
      • Current situation
      • Policies
    • Efficiency of Investment
      • Current situation
      • Policies
    • Internal Trade Integration
      • Current situation
      • Policy ideas
    • Investment in Human Capital
      • Current situation
      • Current situation
      • Policy ideas
• Inflation Targeting
• The Foreign-exchange Regime and Capital Account
• • China and East Asia
  • China and the EU
• Chapter 6 China and the Global Economy in the Next Two Decades
  • Figure 6.1
    • Longer-term Trends in the Global Economy
      • The impacts of network-based IT
        • Financial Imbalances in the USA
        • ÿ

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