Transnational China Project Sponsored Commentary:
"Integrating China into the Global Economy"

Dr. Nicholas R. Lardy,
Senior Fellow,
Foreign Policy Studies Program
Brookings Institution

Talk Given at the James A. Baker III Institute for Public Policy
Rice University
Houston, Texas

Co-Sponsored by the Asia Society of Texas and the
Program in Asian Studies and Center for the Study of Culture at
Rice University

April 29, 2002

Steven Lewis:
Good evening. My name is Steven Lewis. I am the director of the Transnational China Project here at the Baker Institute, and I would like to welcome you all to this evening's public lecture.

I want to start by saying that Nicholas Lardy is without a doubt one of America's foremost authorities on the Chinese economy. He is a leader in his field in both policy expertise and scholarship. Dr. Lardy has been Senior Fellow in the Foreign Policy Studies Program at the Brookings Institution since 1995. Before he came to Brookings he taught international studies, economics, and China studies at the University of Washington, where he also headed the China Program in the late 1980s and the Henry M. Jackson School of International Studies in the early 1990s.

He received his Doctorate in Economics from the University of Michigan, and from 1975 to 1983 he was a professor of economics at Yale University. Nicholas Lardy serves on the Board of Directors and Executive Committee of the National Committee on United States-China Relations, and he is a member of the Council on Foreign Relations. He is also a member of the Editorial Boards of The China Quarterly, the Journal of Asian Business, and the China Economic Review.

His current research examines the strategic implications of the deepening ties between Mainland China and Taiwan. And in his 1998 book, entitled China's Unfinished Economic Revolution, he evaluated the reform of China's banking system and measured the economic consequences of deferring reform in the state-owned sector in China.

We have asked him to come here tonight, however, to present the research outlined in his most recent book, Integrating China into the Global Economy, which was published earlier this year. Since China's accession to the WTO in late 2001, people everywhere are wondering just how much China will join the world economy. And so we are happy to have this opportunity to hear this question answered by one of our top policy experts.

Before I conclude I would like to recognize and thank very much our co-sponsors, the Asia Society of Texas, the Asian Studies Program and the Center for the Study of Culture here at Rice University. If you are not familiar with the many excellent programs of the Asia Society, I would urge you to come talk to Nancy Hawes of the Asia Society after the program. I would also like to point out that after the talk we will have a brief question and answer session. Please speak loudly so that we can record it on the microphones and be able to put up a transcript of Dr. Lardy's talk on our website for people to look at. Finally, I would also like to point out that Dr. Lardy will be available to talk more individually after that and also to sign copies of his book, which I highly recommend, and which will be available outside in the commons. So please join me now in welcoming Dr. Lardy.


Nicholas Lardy:
Thank you very much, Steve. I am delighted to have a chance to be here and particularly under the sponsorship of both Rice University and the Texas Asia Society.

I want to address basically two fundamental questions. One, the economic future of China. Is it going to be a global economic power? Or should we look forward, as one recent book title put it, to the coming collapse of China, which is specifically a forecast about an economic collapse leading to a political collapse?

And I would like secondly to look at the question of what is China's likely role going to be now that, as Steve mentioned, it is a member of the World Trade Organization. Is it going to be a successful economic integrator following the rules of the international trading system? Or is it likely to become a flagrant violator of most WTO norms and likely to contribute little, for example, to the new round of trade negotiations that was launched late last year?

I think those are the two key questions one would want to look at since China's entry into the World Trade Organization. There is certainly a range of opinions from various people looking at these questions.

Let me begin by sketching what has happened in the recent past, even before China became a member of the World Trade Organization. China has grown at an unprecedentedly rapid rate. I do not want to bore you with lots of numbers but real GDP last year was about seven times what it was when economic reform began in China a little over twenty years ago.

And China has made substantial progress in recent years in improving some of its long-term problems in the state-owned manufacturing sector. They have laid off about thirty-five million people, a third of the work force. There has been an up-turn in profitability in the state-owned sector for the first time ever in the Reform Period. And China has done extremely well in maintaining reasonably rapid economic growth, even last year in the face of a global economic downturn that left some economies in the region actually in worse shape than they were in the Asian financial crisis of 1997-1998.

So there has been robust performance, at least as measured by gross domestic product. There is also been very robust performance as measured by China's trade growth. Indeed, if you look over this period since reform began in China, from 1977 to 2001 their trade has grown from about fifteen billion dollars to five hundred and ten billion dollars last year. It now ranks as the seventh largest trading country in the world.

No country has increased its role in the international trading system as fast as China did in the last twenty-five years. It is even more rapid than the growth of Japan's role as a trading country, say in the 1960s and 1970s, in the heyday of very, very rapid domestic economic growth, and very rapid expansion into international markets.

Another point to keep in mind is China's success in attracting what is by now a huge amount of foreign direct investment. By the end of last year China had in place, up and running, about four hundred billion US dollars in foreign direct investment. That is not a number you will remember for very long but maybe you will remember that about a third of all foreign direct investment in place in developing countries on a global basis is in China. And most of it came into China in the last ten years; that is, during the 1990s and in the last couple of years.

So, we have an economy that is growing fairly rapidly, has had remarkably rapid trade growth, and has had a very significant inflow of foreign direct investment. And the foreign direct investment, I should emphasize, is really quite different than the patterns we have seen elsewhere in East Asia. If you look at Taiwan, if you look at Japan, if you look at South Korea, foreign direct investment has played a relatively modest role in those economies.

Foreign technology has come into some of them under licensing arrangements and other kinds of arrangements, but these economies in general have not been very open to foreign direct investment, at least during the periods of rapid economic growth. And China has been very, very open to foreign direct investment over the last two and one-half decades, since reform began in the late 1970's.

What are the implications of this combination of rapid growth, rapid trade growth, and large inflows of foreign direct investment? Most importantly, foreign direct investment has become an engine of growth in the domestic economy. If you look at the interaction among these three elements, the transfer of technology, the transfer of managerial know-how, has been a very important part of China's rapid growth over the last fifteen to twenty years. Exports have also become a significant source of economic growth in the domestic economy.

Moreover, if you look regionally, China has become a very important factor in economic growth in the region. I think the best examples are probably China's trade with South Korea and Taiwan.

As little as fifteen years ago these economies had virtually no interaction with their giant neighbor to the west. Now their trade relationships are extraordinarily deep and growing extremely rapidly. It is quite interesting, for example, that since November last year, in every month, Taiwan's most important export market has been the Mainland. The Mainland has replaced the United States as the most important export market for Taiwan. And I think that is likely to continue to be the case as economic relationships between the Mainland and Taiwan expand as they both come into the WTO and bring down trade barriers.

In effect, China is coming to play some of the role that Japan played in the 1970s and 1980s when it led regional economic growth because of its importance in the region. That is a role increasingly that China plays.

A second implication of the three factors that I mentioned at the outset is that foreign firms have now played, are now beginning to play, a really unprecedented role in generating exports from China. Again this is quite different from South Korea, Taiwan and Japan where foreign firms have not been big producers of exports. There has been little foreign investment to begin with and foreign invested exports have been a relatively small factor in the trade performance of these economies.

But in China this has grown steadily since the 1980s, when foreign direct investment first began to trickle in. And by last year, for the first time, over half of all the exports of China sold in international markets, about two hundred seventy-five billion dollars, were produced by firms with foreign investment, either joint ventures or wholly foreign owned companies. Nothing like this has ever occurred in a big continental size economy like China's. This is the kind of thing you would expect to see in Singapore, and in a few places like Hong Kong where foreign firms have played a much larger role and exports have been much more important.

Finally, as a consequence of the interaction of these three factors of rapid growth, rapid trade growth and foreign investment inflow, China has become the world's preeminent low-cost manufacturer, not only of traditional labor-intensive goods like footwear and toys and apparel and sporting goods, but increasingly things like information technology, hardware and electronics. Indeed, in recent years China has become the third largest producer of what is referred to as information technology hardware -- computers, telecommunications equipment and so forth. Interestingly, about half of this output in the Mainland is being produced by Taiwanese companies. So again, it is the openness to foreign direct investment that is driving this process.

What we have seen as a result is that China is increasingly becoming integrated into global production networks. It began in the late 1980s and early 1990s when Taiwanese companies began moving production of very simple computer peripherals to China: power supply units, keyboard, mice, etc. By the mid-1990s Taiwanese companies were beginning to produce PCs in China. By the late 1990s they were beginning to produce laptops in China. These are enormously important developments because Taiwanese companies are producing about sixty percent of the world's laptops and about twenty-five percent of all PCs.

So as this production migrates to China it is having a very important effect. And there is a large flow of parts, components and assemblies going back and forth between Taiwan and the Mainland. As I say, it reflects China's integration into global production networks, particularly those involving firms elsewhere in East Asia, and I think Taiwan is probably the most notable example.

As a result China is becoming a major exporter of information technology hardware to international markets, and new products are moving to China for production all of the time. LCDs are one. Notebooks, starting last year or the year before, are examples of recent products that have been migrating to China and transforming the nature of trade relations in East Asia and, indeed, the nature of trade relations between East Asia and advanced industrial economies as well.

So this economy has been really doing fairly well in terms of growth, trade, and attracting foreign direct investment. It is having a major effect on the region and it reflects, I think, China's increasing integration into global production networks as well.

Well, what is added to this mix once we get China in the WTO? It happened, as Steve mentioned, late last year. What will WTO membership add to the equation?

Now, as I have already indicated, one of the popular hypotheses is that the Chinese economy is going to collapse. The basic argument is fairly straightforward. There will be more international competition. There will be more unemployment domestically. There will be increasing worker unrest, and the cost of restructuring socially-politically will be overwhelming. The economy will go into collapse and the rule of the Chinese Communist Party is likely to end. So in a sense, the argument is that the WTO will be the straw that breaks the camel's back and brings down the whole political/economic system on the Mainland.

I tend to be a little bit skeptical about this argument simply because I think it underestimates how much international competition has already increased in China over the past two decades, particularly over the last five to ten years. Economists are fond of looking at things like tariffs and non-tariff barriers, and I will give you some of the indicators.

Tariffs, by the time China came into the World Trade Organization, on average were about fifteen percent. They have been reduced by about three-quarters from the peak level in the 1980's. Fifteen percent is relatively low. Indian tariffs are about thirty-five percent. It is about half the level of tariffs that exist, for example, in Mexico and Brazil. So the tariff levels are fairly low.

More importantly, China is committed to going to about nine percent by the year 2005. They already went to about thirteen percent at the beginning of this year. So they have gone from something like sixty percent down to fifteen percent, now they are down to thirteen percent, and they have to reduce it by a further four percent over the next five years. So competition has already increased dramatically as a result of this reduction in tariffs over the past decade and a half. It will increase more. There will be additional adjustment costs. But a lot of the adjustment has already occurred because tariffs have been reduced.

Similarly for non-tariff barriers, quotas and licenses are the most important form of non-tariff barrier in China. At their peak they restricted about forty-five percent of all imported goods coming into China in the late 1980s. By the time China came into the World Trade Organization last year these restrictions only applied to about four percent of all import lines in their tariff schedule. And again, over the next five years all of those will be phased out. They are on a glide path. They have already reduced the quotas and licensing requirements on most products. They have a few more to get rid of over the next five years.

Another very important indicator of competition that I think is frequently overlooked is the role of competition that is introduced into the system by foreign goods produced in China. I have already indicated there is a lot of foreign direct investment in China, but in effect these foreign firms in China have hugely increased competitive pressures on domestic firms. About three-quarters of all this foreign investment is in manufacturing. There is a little bit in real estate and a few other smaller sectors, but the vast majority of it is actually in manufacturing.

Two years ago, for the first time, the share of manufactured goods output produced in foreign-invested firms, as we call them, actually exceeded the output being produced in firms that were wholly owned by the state. So there is a great deal of additional competitive pressure being introduced into the economy by goods produced by foreign firms in China.

And those goods have many of the attributes or have many of the advantages as goods produced in North America, Japan, or Europe. They have the advantage of access to advanced technology, which they can bring into China on a duty-free basis. They have foreign management if they think it is going to improve their productivity. And so forth.

So this is a very important source of competition that quite frankly does not apply in very many economies, and I think it is frequently overlooked. But I think in the Chinese case one has to recognize that in addition to the reduction of tariff and non-tariff barriers you have a lot of foreign goods competing against domestic goods; and the foreign goods are being produced in China itself.

So the theme to take away from all of this, quite frankly, is that basically China has a running start on meeting its WTO obligations. It is not at a standstill and is going to try to catch up with all the vast obligations that it has undertaken. It has restructured very substantially over the last decade and a half and particularly over the last five years.

If I can switch the analogy. The coming collapse story is that China is going to be nudged into having more competition and the economy is going to fall off a cliff. And I think it is basically more a glide path, which I mentioned earlier. They have been adjusting to a big increase in competition over the last fifteen years. Their WTO commitments will increase that somewhat, but not as much as the collapse theory suggests.

So I am a little bit more optimistic than the collapse theory suggests. But why do I think that the WTO is going to add to the equation after they have already gotten rid of all of these trade barriers and have a lot of competition? Where's the beef, so to speak, in terms of the WTO obligations?

I think the real market opening in China that is going to occur as a result of its membership in the WTO is going to be additional investment liberalization and investment in sectors that have been relatively closed, and these are all in the services sector. Investment in telecommunications, financial services and distribution will be the most important liberalizations that occur.

As I mentioned, manufacturing, with a few exceptions, has been pretty open to foreign investment for a long time. But telecommunications, by contrast, has been completely closed to foreign investment. You can sell equipment to them if you are Lucent or one of the other telecom equipment producers. But you have not been able if you are a service-provider; you have not been able to enter the market to provide services, whether wired or wireless, and so forth.

It is an extremely attractive market in certain respects. China is now the world's largest wireless phone market, starting from the year 2000. China Mobile is likely to overtake Vodafone as the world's single largest mobile phone operator. The market is growing very rapidly and the penetration rates are still relatively low, so obviously there is a substantial future for additional expansion of the market.

Under China's WTO obligations, it is going to allow foreign service-providers into the wired market, the wireless markets, the value-added areas such as Internet service-providers and so forth. Foreign firms will be able to enter into all of these markets in the form of joint ventures. China is not completely throwing open the doors. There will be requirements to come in as a joint venture with some restrictions on ownership, and the Chinese, in most cases, will maintain a majority ownership of these joint-venture service-providers. But the market, nonetheless, is opening up.

A second area is financial services, which includes banking, insurance, securities, and asset management. This is a very important area for the economy. The domestic financial services sector is large. Financial assets in the system are already over twice gross domestic product, which is very high for an economy with a relatively low level of per capita income. But these resources, for the most part, have been allocated relatively inefficiently, and I think there are substantial opportunities for improving the efficiency of the financial system through a greater role for foreign banks and foreign insurance companies, securities companies, and asset management.

Just to take the asset management area for example. China is trying to shift away from pay-as-you-go pension system to a funded system in which people will have a compulsory IRA. That will put them ahead of the United States and a lot of Western countries that run entirely on a pay-as-you-go basis. They want to have a blended system that has a pay-as-you-go system, similar to our Social Security in certain respects, but then adds a mandatory IRA and a voluntary 401K-type program. And obviously once that gets up and running and expanded over the market, there is going to be a very large business in asset management, which does not now exist. Foreign asset management companies are going to be able to participate in that market.

So in summary I think that is where the challenges are for China - the opening up these services sectors. There are big gains for China in this as I indicated. There is the provision of additional services in telecommunications, which are still under-provided. Foreign capital will help in increasing the penetration rates.

The opening of distribution services is extremely important for many joint venture companies that want to expand their presence in the market.

I had a very interesting, or at least to me interesting or illuminating, discussion with somebody from General Electric a few weeks ago. Among the many businesses General Electric has is medical equipment. They sell their medical equipment to hospitals, and the biggest barrier to getting a bigger market share for their equipment is after-sales service, which is covered by distribution.

Now that China is in the WTO, they will be able to set up their own servicing network, which they could not do before. They will be able set up repair centers around the country. They will be able to guarantee to Chinese hospitals that if they buy their equipment, and something goes wrong with it, GE will have somebody there to fix it within twenty-four hours. And they will be able to dramatically expand their marketing of the equipment

So distribution sounds kind of boring, but for many businesses it is quite important and will allow them to be more successful in their manufacturing and sales activities in China. It is another area that is going to be quite important, I think, going forward, for many, many firms.

So I think there are gains to China and there will be new opportunities for Western firms in these areas as well.

Well, let me turn next to the question of the challenges for China once it is in the WTO. As I have indicated, I am not a subscriber to the coming collapse theory, but yet I certainly do not want to underestimate the challenges that China faces in coming into full compliance with its WTO applications. I think there will be a huge challenge of maintaining political stability and moving forward on political reform. Already, as I have indicated, increased competition has led to a dramatic reduction in employment in the state sector.

As many as thirty-five million people have lost jobs over the last four years in state-owned enterprises. There has been a fraying of the social safety net. The pay-as-you-go pension system is bankrupt. They do not have a social security system like the United States where in twenty years payouts are going to be greater than inflows. They are already in a situation in which they are beginning to make social security payments from general tax revenues because the contributions coming into the system cannot cover the benefits, even though the contribution rate is already roughly twice what it is in the United States. It is in the twenty-two, twenty-three percent range, between employer and employee, which is roughly twice the US rate.

And so we read of increasing labor unrest and demonstrations, particularly in the Rust Belt provinces of the Northeast which have traditionally concentrated on heavy industry and which are most impacted because China has the lowest comparative advantage in those sectors. And so we see widespread unrest in which the government is facing enormous challenges.

Another thing that is worth highlighting is growing inequality in China. In this period, in which China has grown very rapidly and done all of these other things which are fairly positive, inequality has increased at an unprecedented rate. In fact I do not think one can find a society, perhaps with the exception of wars or natural disasters, which has had such a rapid deterioration in income distribution in a twenty-year period.

China has gone from being one of the most equal income distributions in the developing world to one of the worst. China now has an income distribution by most measures that is much more unequal, for example, than India, whereas twenty years ago India was much more unequal than China. This too, I think, poses significant challenges for the government as they manage this transition in meeting their WTO obligations. Obviously what this underlines is the need for maintaining fairly robust economic growth in order to generate jobs to replace those that are being lost in the state sector.

And generating fairly rapid economic growth is also very important, I believe, in making inequality more manageable. One of the reasons inequality has been manageable to date is that even the poorest members of Chinese society have much higher incomes today than they did twenty years ago. Relatively speaking they have fallen further behind. But in absolute terms they have done, with very few exceptions, extremely well. Their absolute living standard has gone up enormously.

So it has been a combination that I think has made increased inequality more politically sustainable, if you will. But if economic growth were to slow down, that whole equation would change dramatically. Then you might have a situation in which as inequality gets worse, the people at the bottom of the income distribution might be experiencing an actual decline in their real living standards, rather than an increase. And I think that would be much, much more difficult for the regime to manage. So I think maintaining a robust economic growth and delivering rising living standards is a precondition for maintaining political stability.

I also think the regime will have to move ahead a little bit more rapidly on political reform. I do think there is a tendency to characterize China as having a lot of economic reform and no political reform. I think that is inaccurate in certain respects. I think there has been a lot of political reform in China. They began more than two decades ago the process of electing officials at the village level. This is a process not very different from the process that began in Taiwan in the early 1950s when elections started at the village levels and then gradually moved up the administrative hierarchy over time and led to the democratic transition that we have witnessed in Taiwan in the last decade.

So China has begun the process, but has not moved up the hierarchy very far. And I think they will have to start moving up these elections higher than the village level, and they have to start introducing them in the urban areas as well as the rural areas.

There are other things that have been done to increase government accountability. Local people's congresses in China now sometimes hold hearings on controversial issues to solicit public opinion, something that would have been unheard of in the Maoist days of the 1950s, 1960s, or 1970s. And they have passed an administrative law which allows citizens to sue the government, again something that would have been unheard of in the pre-reform era.

Many, many cases exist in which citizens have sued the government and actually collected damages for failure, for example, of the government to enforce anti-pollution laws. Down-steam communities have sued the government for failure to close factories that are in violation upstream, and so forth.

So there is an increase in accountability and an increase in the responsiveness of the government to the needs of the populace, but it is only the beginning of a political reform process and I think it will have to go further. Otherwise the disparity between the relatively advanced economic reforms on the one hand and the less advanced political reforms will be increasingly a challenge for the regime.

I have already indicated that Taiwan might be something of a model for China to emulate in its gradual transition, as Taiwan has a multi-party system. And that is certainly much more attractive than some of the alternatives that come to mind. But, of course, China is much more complex because of its size. Its living standards are much lower than those in Taiwan and so the political transition in China could be much more protracted than it was even in Taiwan's case which, of course, took several decades.

Finally I would mention specifically corruption. I think the regime is well aware of how corrosive corruption is. And we have seen some dramatic examples in recent months of corruption in the financial system, where high-level officials have absconded with huge amounts of depositors' money. And in some cases this threatens the very foundations of the financial system. So there are at least four challenges that China has to deal with going forward: maintaining political stability, maintaining economic growth, accelerating the pace of political reform, and dealing more effectively than they have in the past with corruption.

I would identify a couple more challenges that I think are important. One in particular is the development of a modern commercially-oriented financial system. China, as I mentioned, is committed to allowing foreign financial service providers to come into the market, but domestic financial institutions have a long way to go before they will be competitive, and in the transition period they need to accelerate the process of developing a domestic capital market.

They have had a stock market now for almost ten years but insignificant amounts of funds are raised through that market. And the regulation of the stock market remains weak with widespread market manipulation, insider trading, non-compliance with disclosure standards, and other shortcomings that have led domestic critics of these markets to characterize them as casinos rather than as a mechanism for providing funding for new kinds of economic activities.

Banks also need to develop a commercial credit culture rather than acting as cashiers for the government, as they have historically. There is some progress on this front in recent years, but there is a very, very long way to go. And China now only has five years to get ready for full-fledged competition with foreign banks because foreign banks are going to be able to do business in China with very, very few restrictions five years from China's entry into the WTO in December of 2001. The door is opening up very, very slightly before them, but in five years the door really completely opens up for foreign banking services.

I have talked a lot about the challenges for China. Let me close with something on the challenges for the United States and the challenges for the West more generally.

The focus in the United States in particular, and especially in the business community that lobbies on these issues is, of course, concern that China fully complies with its obligations. And they anticipate selling a great deal more product in China.

Those are the exporting industries, but as an economist can tell you fairly quickly, China is going to have to export a lot more into international markets if it is going to be able to buy more goods from abroad. I think we will see now, as China has joined the WTO, a potentially even more rapid rise in Chinese exports than we have seen in the last fifteen years. This is particularly true of products like apparel, which have been highly constrained by a quota system that governs trade and apparel through the WTO, but which is going to be phased out in only two years.

China has an opportunity when those restrictions phase out to dramatically increase its production of apparel and its export of apparel. The reason is that the quota system in effect now basically provides protected market shares for higher cost producers. So when the quota system is eliminated we are going to have a much more market-driven system.

China is a much lower cost producer of many kinds of apparel than those countries that have market share today. And so what will happen is there will be a displacement and a displacement of production and of market share of some of these countries. I am thinking in particular that countries in Southeast Asia like the Philippines, Thailand and Malaysia will probably lose market share as China gains market share. Even Mexico is likely to lose market share to China. Mexico has gained market share since the advent of NAFTA, which has given them a preferred position in the US market, for example, but it will be closer to a level playing field once the quotas are phased out.

So the challenge for the West is preparing to accept substantially higher levels of Chinese goods. We already have a record trade deficit with China. Last year, for the first time, the deficit with China was greater than our deficit with Japan. Japan had been number one for quite a long time, more than a decade. China is now firmly number one and is likely to continue to be our largest deficit-trading partner because of this displacement effect.

We are going to buy lots of additional things from China that we used to buy from other countries. We have already been through this in footwear and toys, now it is going to come in apparel, consumer electronics, and, not very far down the road, computers and other kinds of information technology hardware as well.

There are also adjustment costs in terms of foreign direct investment in other countries, particularly those in Southeast Asia. They probably will get a little bit less foreign direct investment inflow as those inflows are increasingly concentrated in China. For inflows of foreign direct investment into East Asia and Southeast Asia, outside of Japan, at the beginning of the 1990s, eighty percent or so were going to Southeast Asian countries, with only twenty percent going into China.

Now it is eighty percent going into China and a much, much smaller percentage going into Southeast Asian countries. So China's liberalization of telecoms and some of the other sectors that I mentioned probably will reinforce that trend so that other countries in the region will have to accelerate their reforms or figure out how to do with smaller inflows of foreign direct investment.

As I have indicated, even the most advanced economies, the United States, for example, and Japan, will face the challenge of adjusting to rapidly increasingly imbalances in their trade with China because of the displacement effect that I have already mentioned. Now unfortunately, from my point of view as an economist who believes very much in free trade, the terms of China's coming into the World Trade Organization included several clauses that are potentially highly protectionist.

A safeguard clause makes it very easy for the United States and other WTO members to restrict the inflows of Chinese goods if they begin to grow too rapidly. We have already seen Japan putting restrictions last year on Shiitaki mushrooms, green onions and the rushes that they use to make tatami mats. They put sixty-three percent tariffs on those products as their market share had gone up quite a bit.

If those kinds of protective responses are fairly widespread it will reduce the hope that China will be able to adjust to increased openness, because China is going to have to reduce its output in many non-competitive sectors which tend to be capital intensive. They need to expand production and exports of more labor-intensive products, including the apparel that I have mentioned.

Also, there are vegetables and other crops which are more suited to China's agricultural endowments, than are grains, which they are going to import more of. So they need to expand production and exports of labor-intensive manufactured goods, which will be extremely difficult if the rest of the world is relatively protectionist.

Finally, another challenge for the United States in particular is to seek an alignment of our trade interests between China and the United States. It is possible that China could become a significant positive force in multilateral trade liberalization. One of the reasons is that I do not think China is going to necessarily line up with developing countries on all issues.

China frequently talks about how it is a developing country, but in fact in some areas their interests are more similar to those of an advanced industrial economy. The fact that they have already lowered their tariffs so much more than most other developing countries is going to give them a stronger stake, I hope, in supporting multi-lateral trade liberalization in the Doha Round of trade negotiations. And there could thus, with a little skill from diplomacy, be an alignment of interest between the United States and China on some issues.

Now unfortunately this is not likely to be achieved if the United States continues to use non-tariff barriers to restrict access to our markets, especially anti-dumping procedures, and safeguard protectionism that we have seen increasing in recent months and of which China, of course, has been the chief victim, if you will. China has been the subject of more anti-dumping cases than any other economy on the globe, and the numbers are growing rapidly even as China has come into the WTO.

So I think the challenges are there not just for China but also for the West in terms of maintaining open markets and being prepared to accept large trade imbalances with China, not because we are going to lose a lot of jobs in the United States but because there is a displacement effect somewhere else and we should try to work for an alignment of our trade interest with those of China.

In summary, China is on track to have a continued rise as a global economic and trading power, but there are significant risks. There are risks to the financial system, there are some risks to political stability. But if these risks can be overcome, I think China is likely to emerge within ten years as the largest producer in the world of information technology hardware and to emerge as the second largest trading country in the world.

They have already gone from about number thirty-seven in the late 1970s to number seven today. Within four to five years they could move up to number four and then in the next five years they could overtake both Germany and Japan to become the second largest trading country in the world, after only the United States.

That would be a very dramatic transformation in a relatively short period of time, but I think it is within their reach if they can manage the kinds of risks that I have talked about and maintain this openness to foreign direct investment which, as I have said, is really unprecedented for a large continental-sized economy.

The second point in summary is that WTO accession will provide substantial new opportunities for foreign firms, including US firms, particularly in the sectors that are being liberalized for foreign direct investment: telecommunications, distribution, and financial services. China is going to gain substantially in the medium and long run from its membership in the World Trade Organization, but it will face substantial challenges in maintaining political stability in the face of rising transitory unemployment, particularly in the early years when it takes a while to move people out of uncompetitive sectors into new sectors.

There is that transitory unemployment and also there is the challenge of developing a modern, commercially-oriented financial system, which is also essential to supporting this kind of restructuring that will be required.

And I would just close by saying that the whole adjustment process would be in jeopardy if countries like the United States and Japan and other advanced industrial countries made widespread use of these potentially protectionist measures that are a feature of China's accession to the World Trade Organization. If those were invoked it would substantially reduce the opportunities China has to expand employment in labor-intensive industries as unemployment falls in response to increased foreign competition in agriculture and certain heavy industries.

So it would threaten the whole internal adjustment process within China and make it more likely that China would fall badly out of compliance with its commitments to the World Trade Organization. I think it would give an unfavorable outcome to the question that I posed at the beginning about China's likely role in the World Trade Organization.

Frequently people focus on whether or not China is going to comply with its commitments, and they think of it as something that is entirely up to the Chinese. At one level it is. But at a more fundamental level, unless the international community remains open and willing to accept increased quantities of Chinese goods it will be very unlikely that China will be able to absorb or substantially increase quantities of imports and to undertake the domestic restructuring that those increased levels of imports would require.

Well, I would be happy to try to answer questions as time permits.

Audience Member:
Rapid economic growth is necessary to allow the least advantaged sector of populations to continue to improve its living standards. What is the minimum level of economic growth necessary to do that, in your judgment? And second, how vulnerable is economic growth to the worldwide economic slump?

Well, the Chinese are very fond of saying that they have to have a seven or eight percent growth rate to generate new jobs at a sufficiently rapid rate. I tend to be a little less dogmatic. I think a lot depends on the structure of the growth. If they can move rapidly to more labor-intensive manufacturing they could probably generate more new jobs with a five or six percent growth than seven or eight percent at less restructuring.

So I think they have a focus on the headline growth rate, which I think is a mistake. I think what they should really be focusing on is restructuring, because if they restructure fast enough and get more people employed in labor-intensive industries, like apparel, and if the world market will accommodate it, they will generate a lot more new jobs than a higher headline growth rate with a different structure.

How vulnerable are they to a downturn? Well, as I mentioned at the outset, they did extremely well last year when world trade growth basically collapsed.
To have that kind of export performance and trade performance in general in the face of a weakening global market was pretty strong. Part of it is that they are less vulnerable than, for example, Taiwan. Taiwan has a very highly concentrated export structure with a very significant dependence on electronics. And as business investment in IT declined, and as IT product markets were collapsing, Taiwan found itself in the worst recession since 1949.

That is really quite amazing because Taiwan came through the Asian Financial Crisis among the strongest of all the economies in the region, and never had a recession at all. Now a slight slowdown in the US, and to some extent in Europe, has put their economy in a recession. And it is a function of the fact that they are very export-dependent and their exports are very highly concentrated.

So it is nothing they did wrong from a policy point of view, but that is the structure of what they have. China has much more diversified exports and, as I mentioned, they are exporting a lot of footwear, toys, and sporting goods. All of these products Taiwan got out of decades ago, largely by moving them to China. China is sometimes at the low end of the quality spectrum, so when income growth slows down elsewhere the mass marketers who are buying more goods from China are doing relatively well.

You know, they are not buying some Italian fancy shoes, they are buying something slightly less expensive and that is more likely to be something coming from China than from Italy. So they had some insulation. They are not as vulnerable as several other economies in the region. But they certainly are far more vulnerable than they were twenty years ago when their trade was negligible.

Audience Member:
If you would, talk about the currency in terms of the prospect of devaluation over the next three or four years and convertibility issues.

I think the currency is not likely to devalue or depreciate in the short term, the next one to three years. They have unprecedentedly large foreign exchange reserves. They still have a slight trade surplus that has come down in the last two to three years, but they are in a very, very strong position, and foreign direct investment inflows look like they will continue to grow somewhat in the years ahead.

So I think the confluence of all of those things means that there will not be any significant downward pressure on the currency. Of course, the yen has weakened in recent months. Will this bring more pressure on the Chinese currency? Certainly the Chinese talk about that. But it is more of a game in which they are scoring points against the Japanese than a real concern. Because the concern, of course, is not with the direct competition between Japanese goods and Chinese goods in third country markets, but it is a fact that as the Japanese currency weakens the currencies in Southeast Asia, which are now mostly floating rates, tend to weaken. And Chinese goods, and Southeast Asian goods to a much greater extent, are competitive in third country markets. So there will be consequences for China if the Japanese currency declines, but I do not think it is going to lead to currency depreciation.

Now, on the question of convertibility, of course China has had convertibility on what is referred to as current account transactions now for almost five years. If you are a Chinese company and you want to import something, unless it is a restricted good that has an import licensing requirement or something like that, you can get currency to import those goods.

So the currency is referred to as what is convertible on current account transactions. Or if you are a foreign company, a foreign-invested company, and you have profits and the Board of Directors of your joint venture declares a dividend, you can repatriate those. You can take those earnings and convert them into foreign currency and repatriate them to the United States, the EU or wherever your headquarters is located.

The tougher question is convertibility on a capital account, which the Chinese continue to say is their long-term goal but they have been steadfastly -- particularly since the Asian financial crises -- unwilling to say anything about the time table for that. I think that is a very sensible approach and I look at it primarily in the following way.

I do not think it makes any sense for the Chinese to have convertibility on capital account transactions when their domestic banking system is so weak. The reason I say that is that the domestic banks are extremely weak. They probably have negative net worth. That is, they are insolvent in some of those larger institutions. And if depositors could take their money out of the bank and convert it into dollars and send it to Citibank in New York or Hong Kong Shanghai Bank or something like that, there is a fundamental risk to the financial system.

So I think until they have restored the strength and viability of their own domestic banks that they should not allow capital account convertibility which would allow Chinese citizens to take their savings, which are denominated in domestic currency, and convert them into Swiss francs or Euros or whatever.

Because deposits in the banking system are predominantly from households, deposits in the banking system amount to about three-quarters of GDP. If households decided to take some of that money out of the bank, or a substantial portion out of the bank, the banks would not just be insolvent, they would be illiquid and there would be a potentially major problem.

So I think the answer to when they will have convertibility on capital account transactions is when the strength of their own domestic banks has been restored and they are operating on a fairly sound commercial basis. Hopefully they will be there in five years because that is when they are going to face the full brunt of foreign competition. But it might be longer.

Audience Member:
How reliable are Chinese statistics? In the US a year ago the Department of Commerce was recording a five percent gross for 2000 and then they revised it to four. Could a similar situation exist in China?

Well the safest thing to be said about China's statistics is that the quality is variable. Some of the data are almost certainly close to worthless. And in some cases competing agencies and entities put out different data. Look at their income distribution data, which I did talk about but you will notice I did not quote you any number. They publish different numbers about income distribution, and I do not think there is any question that income distribution has become a great deal more unequal, but exactly how much more unequal it is I am not sure.

The GDP numbers are the things that most people are asking questions about and there has been quite a debate among specialist in the last few months about whether or not the economy might be growing at a much slower rate than the government claims. Some people have suggested that if you take the last four years, of which if you add up the official claims, the GDP has expanded by about a third. Some of the critics are saying no it could not possibly be that large. It might be something between zero and ten percent. That is over a four-year period.

Now I am very skeptical and I will just give you one piece of information. Chinese imports have grown over this four-year period by seventy percent. And imports are: (A) easy to measure, and (B) there is no incentive for the Chinese customs authorities to overstate the imports because as they bring in imports they are also supposed to be collecting import duties. So if they exaggerate imports then they have to come up with the money to hand over to the treasury.

So I do not see any incentive for overstating. And it is pretty easy to measure imports. There are a limited number of ports, etc. And we can also check China's reported import data by looking at the export duties of export partners.

Well, there is no economy in the world that has ever had a seventy -- actually a seventy-two -- percent increase in imports over a four year period where GDO has only grown between zero and ten percent. It is impossible.

Yes, the currency has appreciated in real terms a little bit over this period because the yen has gone down so that the trade-weighted currency has appreciated a little bit. That could account for some of the growth of imports even if there was not much growth in the underlying economy. But imports everywhere are predominantly or overwhelmingly determined by the change in income. And so I am a skeptic of this theory that the economy has had a dramatic slowdown in the last two to three years because I think it would be reflected in the import data.

So I am not defending the official data on GDP for the last tenth of a percentage point. There are lots of problems in measuring GDP, as you point out, even in the United States. We have to revise the numbers occasionally. The preliminary numbers get significantly revised.

More importantly, you may remember a few years ago there was this Boston Commission that recalibrated what kind of a price deflator we use because the argument was we were not taking enough into account for quality improvements. So we were over-deflating and understating our rate of growth.

Now that has been at least partially corrected but there are a lot of technical issues on how to measure GDP. So it is not just a matter of exaggeration or fabrication, but some real economic issues about how to handle issues, particularly related to prices. So I do not want to defend the Chinese figures on GDP growth to the last tenth of a percentage point, but I think the idea that the economy has grown very, very slowly since the Asian Financial Crisis is wrong.

First of all I have been there about fifteen times over this period. I do not like to rely on that kind of eyeball evidence, but you do not see much of an evidence of a slowdown. And you certainly do not see it in the imports.

Audience Member:
Given the fact that China has a growing manufacturing base and given the fact, or assumption, that it is still a majority coal-based economy, do you think China will shift to a cleaner technology or cleaner way of producing energy? Is that something that is part of its WTO obligation?

Well, there is nothing in the WTO that would affect the mix of types of energy that they use. And you are absolutely right, they have relied predominantly on coal for many years because they have very large coal reserves and their alternative sources of energy are fairly limited. Because of the major environmental problems that have emerged as a consequence of rapid growth and a very heavy dependence on coal several of the major cities are the worst -- as measured by particulate matter and other indicators -- or if not the world's worst, among the world's worst in air pollution.

And so they have encouraged the use of natural gas for domestic cooking and heating. Starting about ten or fifteen years ago, in a few cities you saw people carrying these tanks of propane on the back of bicycles because they had switched over to propane type heat. Now in more cities it is being piped in.

There is at least one major LNG project that is apparently now, after years of negotiation with a foreign firm, coming to completion and that will bring in LNG. There is another big proposal, for a gas pipeline from Xinjiang to Shanghai and that would even give foreigners the right to be involved in the distribution on the downstream end.

But even after all those things are done, this is an economy that is going to be heavily coal-oriented probably for several more decades. Gradually its preponderance -- something like seventy percent of all energy is coming from coal -- will go down, but it is going to remain a pretty coal-dominated economy for quite some time.

Audience Member:
To what extent would you compare China's demographic profile to Europe's? Is it an Asian population? And, for example, over the next decade, what we might expect in terms of the burden on the Chinese economy of pensions expenditures and retirement schemes? And to what extent do rising social aspirations seem real despite the inequality of income? There is a rising prosperity. How could these mutually affect one another in terms of the available capital accumulation for reinvestment?

Well, the demographics are fairly unfavorable over the long run, but they are not quite as bad as some of the most extreme cases of advanced industrial economies. The dependency rate is going up. Fewer and fewer people are supporting more and more retired people. And we are now in the period where the one-child policy has now been in effect for several decades. So there is a very sharp decline in the birth rates starting twenty years ago, and the dependency rate is going up quite significantly.

I will give you one indicator. The World Bank did a very comprehensive study of China's pension program a few years ago. As I mentioned, already at that time and still today the contribution rate for pensions is twenty-two percent. They said that to continue to provide the same level of benefits, and if you did not change anything else, like the retirement age or the percentage of the wage that was replaced, etc., that the contribution rate would have to go to something around forty-five percent in order to keep the system from having a huge deficit.

Now, of course there are alternatives. The system only covers a relatively small portion of the population, so for a while they can finesse this problem by bringing more people in. The system now covers primarily the urban population, the modern sector, and it entirely excludes people in the rural sector. But they put into effect a very generous system, with very low retirement ages and a very high rate of replacement. It is much higher than the most advanced industrial economies, and it did not much matter for the first few decades when the number of people retired was small.

But now the system is extremely expensive and, as I indicated, for the last two years now the Chinese have been using general tax revenues to make the pension contributions; not to make the pension contributions, but to make the payments to people already retired.

Now as for the broader picture in terms of savings and investment, the great strength of this economy has always been that it is a very high savings rate economy and it has had a very high rate of investment throughout the reform period. And savings increasingly have come from the household sector. The rate of investment in many years approaches forty percent. So in all finance with domestic savings there is a bit of a paradox and it is frequently not well understood.

When you think of all this foreign direct investment coming into China it must be financing a lot of investment, and it is, but there has been no net absorption of foreign savings. Or to put it another way, the inflow of foreign direct investment has been fully offset by huge increases in foreign exchange reserves and capital outflows. China has become a significant capital outflow country.

I mentioned four hundred billion dollars in foreign direct investment, which is huge, but their foreign exchange reserves have gone from nothing up to now about two hundred forty billion US dollars. And there has been significant off-shore investment by Chinese companies, some of it approved and some of it a result of the leaks in their controls on capital outflows.

So they have a very high savings rate and the challenge of the system has always been, in my view, to utilize the savings more efficiently and have a banking system that would really evaluate projects or borrowers on the basis of their likely ability to repay rather than seeing who their backer is and always lending to the same old company. The challenge is how to use those resources more efficiently.

They have got the highest savings rate of any country in the world with the exception, as far as I know, of Singapore. And Singapore, a very substantial portion of savings is forced through mandatory contributions to the provident fund.

Audience Member:
How do you see the role of the Communist Party ten years from now?

First of all, along the lines of what I said earlier, the role of the Party has declined substantially over the past two decades. And I would think that it would continue to shrink. Twenty years ago the Party controlled everything. They controlled housing, the rationing of grain, and virtually every aspect of people's lives. Everyone was assigned a job whenever they left school, whether it was at grade school, middle school, upper middle school or college. Now you have a complete market for labor. So I think in most respects the role of the party has been dramatically reduced. Certainly in most major cities today housing has been almost entirely privatized, as in Shanghai. There may be a few places where it is not so advanced, but basically we are beginning to have a significant private housing market in China. It is no longer controlled by work units.

Remember the work unit was the key feature of the system in the late 1970s. You worked there, you got your housing from them, you got your health care, and you got your retirement from them: everything. And all these elements have come unglued. The housing has now been privatized and it is a real job market. There is more labor turnover. People do not have lifetime employment. As I mentioned, thirty-five million people in the state sector are losing their jobs. Of course, grain rationing is gone.

The controls on where people live are still to some extent in effect, but they have been watered down quite a bit and you have the huge emergence of a very large mobile population, predominantly of young men from the countryside, who are looking for work and frequently they do find jobs in construction and other kinds of seasonal employment. I think some people wring their hands and say, "Oh, this is very bad." But it really shows there is a labor market now and people have opportunities that were not available two decades ago.

Audience Member:
To what degree is the Chinese government's influence on foreign direct investment an issue, and how is that going to be resolved?

What do you mean by influence?

Audience Member:
Say a foreign company wants to invest. How does the government limit the amount of money they can invest and then limit the projects they can do?

Well, the general picture that I gave you before is based on these aggregate numbers. It seems like a very liberal environment with four hundred billion in foreign direct investment. It was forty-six billion last year alone. Just by comparison India got about four or five billion in all of 2001. China's getting ten times more per year than India.

But if you start going to the firm level and you start focusing on something other than the aggregate numbers, there are still enormous restrictions. There is a whole process of approval and licensing and of getting a partner, particularly in sectors where you cannot have a wholly foreign-owned company. So the government still has substantial powers in those areas.

Telecom is a good example, as I mentioned. The market is being opened up, but you are going to have to have a domestic partner and at every step it is city by city. With licensed insurance it is the same thing. You want to sell insurance, but you have to get a license in every city.

They just promulgated new regulations on banks. It is going to be the same way there. Their WTO commitment says that it is going to be completely open and there is a long list of cities where you can open a bank. But then they promulgated new regulations in February which say after you have applied for a new branch license -- all the foreign banks that operate in China are operating as branches rather than subsidiaries -- you cannot submit another license application for one year.

So even though there is this huge long list of cities being opened up, if you are the Hong Kong and Shanghai Bank or Citibank and you want to get into the retail market, you are not going to be able to apply to all forty cities on the list. It would take you forty years to get a branch in every city. And apparently it is not inconsistent with WTO obligations because they have said all of these cities are open and you can apply to be there, but there is nothing in their commitments that says you can apply to every open city on day one.

So there are administrative regulations and licensing requirements and a substantial degree of control, particularly in sensitive sectors like insurance and banking.

Audience Member:
So it is not truly resolved?

It is not. I would say there is slow progress and it is reflected in the aggregate numbers. If there were not slow progress, you would not have something close to fifty billion dollars a year coming in.

Audience Member:
To what extent have the Western provinces benefited from all this economic growth?

Well, many of the Western provinces, but not all, are actually growing in percentage terms more rapidly than the Shanghais, the Guangdongs and places that have done extremely well. The problem, of course, is that you start out at a differential between the places that is about ten to one.

You have Shanghai at the top and you have Gansu or Guizhou or someplace like that at the bottom. And if the guy at the bottom grosses fifteen percent and the guy at the top grosses ten percent, the absolute difference keeps getting bigger and bigger even though the growth rate in poor places is more rapid.

And that basically has been China's story over the past twenty years. It is not that the poor places are stagnating and experiencing no growth. They are actually having fairly rapid economic growth, in many cases above the national average. That is what the government increasingly is trying to address in the last couple of years as they have launched this new campaign, the so-called "Go West Campaign", to try to encourage even more rapid development in Western regions.

It gets back to the classic question that people always face in income and distribution questions, whether you are talking about provincial units or individuals. What is it that really matters? Is it the absolute gap or is it the relative gap between the two?

I think the decision, the political decision recently, has been that the widening absolute gap is something they want to whittle away. But given the gap, in per capita terms, between the richest and the poorest, I am not predicting any success in the short or median term in reducing the absolute gap. In order to do so you would have to bring Shanghai's growth or Guangdong's growth practically to zero to be able to actually reduce these absolute gaps.

Audience Member:
How about the media market in China? Is it an obligation under WTO to open the market?

I do not think there is anything specifically in the WTO that requires China to allow foreign investment in media, whether in print or broadcast. This has been a very contentious area for a long time. Murdoch has tried to get his TV channel and satellite system in and he has had his ups and downs. He is doing pretty well now after a low point a few years ago. But I do not recall anything specifically in China's WTO obligations that is going to allow foreigners to invest in media.

It has become a much more competitive sector. State subsidies for major political party-run newspapers have been diminishing. There is the growth of investigative reporting. There are all kinds of new journals in the economic area emerging within China that are actually quite interesting. But I do not think any of these involve any foreign participation. Party controls on what is published have eroded dramatically. And I think that will continue with economic growth. But I do not think the WTO per se is going to accelerate that very much.