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Rebalancing the U.S.-China Economic Relationship [Rush Transcript; Federal News Service]

Speaker: David H. McCormick, Undersecretary for International Affairs, U.S. Department of the Treasury
Presider: Paul Calello, Chief Executive Officer, Investment Bank, Credit Suisse
January 30, 2008
Council on Foreign Relations

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PAUL CALELLO: Okay, good morning. Good morning, everyone, and welcome. My name is Paul Calello. I'm chief executive of the Investment Bank at Credit Suisse, and I'm delighted to be able to preside over this morning's meeting hosted by the Council on Foreign Relations.

I'm particularly pleased to have the opportunity to be able to preside over today's session, having lived and worked in Asia-Pacific for over a decade, the last five years as the CEO for Credit Suisse in the Asia-Pacific region. And during that time I had the opportunity to work with many government officials and industry leaders throughout China and really witness the phenomenal story of China's emergence - quite remarkable.

So I can't think of many as important or interesting topics as the one today on engaging China, the importance of the relationship between our two countries. I can think of few topics as important, with regards to both economic growth and political stability, than engaging China. And I can think of actually few speakers as empowered as our speaker today to make a difference with regards to engaging China.

At this point if I can ask everyone to please remember to turn off your cell phones, turn off the ringers - I always forget, myself - to hold your questions until towards the end of the session when we'll make sure we entertain as many questions as we can, and remind everyone that today's session is, in fact, on the record. It's being filmed and I see many of my friends from the press here as well.

Today's speaker is extremely thoughtful on this sometimes delicate and always complex issue. As undersecretary for international affairs, Dr. David McCormick, a senior figure in the Treasury Department and the principal advisor to Secretary Paulson on international economic issues. He oversees policy in the area of international finance, trade and financial services, investment, economic developments and international debt. And he also coordinates financial market policy with the Group of Seven countries. You already received his biography, which is in your packet, so I won't go into the impressive details of his resume, which includes public and military service, academic and business achievements. So I think we all look forward to hearing from David.

David, please. Thank you. (Applause.)

DAVID H. MCCORMICK: Good morning. Thank you for that - than you, Paul, for that nice introduction. And thanks to all of you for coming on a rainy New York morning. I'm grateful to the Council on Foreign Relations for bringing us together to discuss what is most certainly an issue of great importance, and that's U.S.-China economic relations. Indeed, maintaining a mutually beneficial and open and politically sustainable relationship with China is one of the United States' most pressing challenges. And it's arguably one of our greatest opportunities in the realm of international economic policy.

The challenge is great because the stakes are so high. The stakes are high for the United States, the stakes are high for China, and the stakes are high for the global economy. For the United States, China is the world's fastest-growing market for our goods and services. Since China's accession to the World Trade Organization in 2001, U.S. exports to China have grown five-times faster than to the rest of the world.

At the same time, China's prosperity depends on the United States. Last year American consumers and companies purchased one-fifth of all of China's exports. Even as China diversifies its export markets, American demand continues to shape China's economy. Investment flows between our two countries are expanding rapidly. For example, between 2002 and 2006, U.S. foreign direct investment in China more than doubled from $10 billion to $22 billion while in 2007 alone, China's direct and portfolio investment in the United States totaled nearly $10 billion.

Now, as a consequence of this growth in the U.S.-China economic relationship, it's been forced to mature very, very quickly. With the increasing volume of trade and investment, it was inevitable that we would experience a range of frictions, as we do in our economic relationships with other major trading partners. These frictions include growing concerns about trade imbalances, product safety, the Chinese government's large holdings of foreign exchange reserves, and China's foreign exchange practices.

While not surprising, these frictions have caused some in the United States to question the benefits of maintaining an open and expansive relationship with China. The Bush administration's answer to this defining question is unwavering. We are committed to strengthening our economic relationship with China and opening its markets to create new opportunities for American firms and American workers. And in this effort, we are making full use of the policy tools available to us to include developing new approaches, most notably the Strategic Economic Dialogue which was launched by Presidents Bush and Hu in 2006.

In short, this administration is taking a thoughtful and effective approach to accelerating reform and promoting U.S. interests in China. Would we like to see more rapid, deeper reform? Sure. Of course, we would. But, we are making steady progress and bringing clear benefits to America's workers, businesses, and consumers.

Now China's growth over the past three decades has been nothing short of miraculous. It has transformed itself from a poor, mostly agrarian, and mostly closed economy into the world's third most important trading partner. In the process, China has benefited from economic growth averaging nearly 10 percent per year, that has lifted hundreds of millions of people out of poverty.

This growth model that's produced such enormous success has also been highly resource intensive, and it's been driven by heavy investment in industrial production and exports, rather than growth in domestic household consumption. We see evidence that this model is no longer sustainable. We see evidence in increasingly wasteful Chinese investment, in rising inequality, in a large and growing current account surplus and in accelerating environmental degradation. We also see evidence of this in the weak growth in Chinese employment and in household income growth that lags well behind the rise in GDP.

But China's imbalances at home are mirrored by imbalances abroad. High national savings, and its counterpart, weak consumer demand, provide the structural basis for large Chinese trade and current account surpluses. This makes China's economic growth increasingly dependent upon foreign demand and this creates, sometimes, friction between China and its major trading partners.

Now, this is not simply an American critique of China's economy. China's most senior leaders tell us that they are committed to addressing these imbalances: the imbalances that exist between growth in rural and urban areas, between coastal and interior regions, between domestic and foreign demand to drive growth, and between rich and poor households, between economic development and environmental protection. They are coming to realize, as we do, that their success in addressing these challenges would have enormous benefits for China and for the United States.

Now, the critical question for us, the critical question for U.S. policymakers, is how can we best support and encourage this economic transformation? For our part, we understand that we will be judged by our success in helping the Chinese to address this rebalancing challenge in a manner that brings continued benefits while minimizing the risk to the U.S. economy. China's exchange rate is one issue that's been viewed by some, mistakenly I think, as a litmus test for our success.

The untold story of our approach to China's currency policy is that it's working, albeit more slowly than we would like. Initially, after moving away from a pegged exchange rate in July of 2005, China's actions were cautious, with the renminbi appreciating slowly. More recently, however, the pace of appreciation has increased sharply, to roughly 7 percent in 2007 and 4 percent in the last three months alone, or 17 percent annualized. Since China abandoned the peg to the dollar, the renminbi has appreciated roughly 15 percent against the dollar and 9 percent against other major currencies on a real trade weighted basis.

The foreign exchange market in China is also developing. Daily renminbi fluctuations are larger, the market is deeper, and we have seen rapid expansion in the use of foreign currency hedging instruments. And although the renminbi adjustment is far from complete, the accelerated pace of appreciation is significant, it's welcome, and it should continue.

China and the United States must be careful not to derail this reform through protectionist actions on either side that risk disrupting this relationship. And the leadership and the interest of the U.S. Congress on China's currency reform, and China's economic reform more broadly, is both needed and welcomed. But, but, it's especially important now during this time of turmoil in global markets that we remain steadfast in our commitment to an open and expanding trade and investment relationship between the United States and China.

As Secretary Paulson has often said, greater exchange rate flexibility is in China's own interest. The renminbi movement that I have noted reflects the Chinese leadership's growing recognition that more rapid exchange-rate adjustment allows for more effective management of the Chinese economy, including the risk of rising inflation. And a continuation of the recent renminbi appreciation is also important to the United States, although it's important to note that it will not eliminate or decrease significantly the U.S. global trade deficit and it won't mitigate the challenges that U.S. industries face from overseas competition. It will, however, remove a major source of perceived unfairness in the U.S.-China relationship and it will permit us to devote greater attention to other issues that could have even more significant impact on our economic relations with China.

Under Secretary Paulson's leadership, the Strategic Economic Dialogue has created an unprecedented channel of communication between senior U.S. policymakers and the highest level of the Chinese government, and it's focused on doing just that - focusing on those other issues. Specifically, the SED is premised on the fact that China and the United States have shared economic interests and we benefit from expanding our cooperation over the longer term. Central to our shared interest is leveraging U.S. expertise and support in helping China transition to a new model for economic growth that addresses these imbalances. This reform agenda runs broad and deep. It ranges from macroeconomic policy to domestic regulation, from investment policy to environmental protection.

For example, to assure China's future growth without heavy domestic costs and huge trade surpluses, China must put more income in the hands of households and it must change the policies that force these households to save as much as they do. This involves increasing the dividend payments from China's profitable companies, including state-owned enterprises, a reform that China has recently started. It also requires a much stronger social safety net that reduces the need for Chinese households to save for a rainy day or for old age. On these issues, we in the United States can contribute much in terms of expertise and capabilities in our ongoing dialogue with China.

To create more sustainable growth, China will also need to develop a vibrant and efficient financial sector to provide Chinese households and firms with better opportunities to build wealth and hedge risk. Clearly the American financial services industry has much to offer China in this regard. As you know, we are working hard to improve access to China's market for American financial services firms. And like many of you, we are unsatisfied with the progress to date.

But the SED has produced some significant Chinese commitments in financial services, such as China's agreement to allow greater market access in banking, securities, insurance, and asset-management markets. As I have argued to my Chinese counterparts, building a modern financial services sector is not an easy task but foreign participation, and in particular the knowledge and the skills and the technology that come with it, can play a very significant role in accelerating this process within China.

Ensuring markets remain open to investment is every bit as important as ensuring that they remain open to trade, so we are also committed to focusing the SED on maintaining and expanding investment flows between our two countries. This is a critical component of rebalancing China's growth from coastal to interior regions. As an example, we are intensifying our discussions with China on the prospects for a bilateral investment treaty and we've also recently established a U.S.-China investment forum where we'll discuss a full range of investment issues of importance to both of our countries.

And finally, the SED has made important progress in helping China address other barriers to its continued development. For example, in the area of product safety, China recently agreed to allow U.S. quality inspectors to conduct onsite audits of key Chinese exporters. This is a step that will help China develop improved standards and improved capabilities for critical export industries.

Similarly, the SED has provided a forum to collaborate with China on addressing the terrible, terrible environmental costs of its rapid growth. And we see this cost in the air, in the soil, and the water, which looms as a very significant challenge to the next chapter of economic prosperity for China. At last December's Strategic Economic Dialogue the United States and China agreed to work together to tackle this problem with an ambitious 10-year plan for cooperation.

As these examples demonstrate, the SED is focused on critical strategic issues of interest to both of our countries that require long term policy prescriptions. That's why it's so important that we look past the next month, the next year, or even the next election as we think about our economic engagement with China.

In practical terms, that means we, we currently serving in government, have an obligation to turn over to the next administration a healthy U.S.-China economic relationship and a robust, enduring dialogue that's capable of continuing the progress I have noted. And as I hope I've made clear to you this morning, I think we're on track. Through the SED we are making progress across a rich and full agenda of opportunities and challenges that are every bit as important to the United States as they are to China.

Now, I understand and I share the frustration of those who believe that the Chinese are moving too slowly on many issues. On those issues we must push, we must cajole, and we must support. We have been, and we must continue to be, firm and clear when engaging with China, that accelerated reform is every bit as much in their interest as in ours. And when we're unsuccessful through dialogue in resolving key differences, we will not hesitate to take cases to the WTO or to make full use of WTO-sanctioned trade remedies that have been established under U.S. law. But, we must also take care not to vent our frustration in the form of punitive legislation or elevated rhetoric that could ultimately cost the American economy and could set back the process of reform in China.

Ladies and gentlemen, America's economic relationship with China is of equal importance to Republicans and Democrats, to Congress and the Executive branch, to this Treasury secretary and the next. I firmly believe that the next administration will inherit a U.S.-China economic relationship that reflects more meaningful progress across a broader territory than ever before. To be sure, the road ahead is a long one. But we are taking important steps in the right direction.

Thank you.

(Applause.)

CALELLO: Thank you, David. Again, we'll open up to questions from the audience in just a minute. And I'll take the opportunity to start out maybe a few questions on several people's mind.

I think it was just back in March of '06, I was still in China and Senators Schumer and Graham headed to China threatening all kinds of protectionist trade legislation. They were accusing China of illegal currency manipulation. And China seemed to do an extraordinarily good job of rolling out the red carpet and engaging them. They came back with a willingness to just work with the Treasury in seeing progress made along the lines, particularly with regards to currency. I wonder if you could comment more on how you believe the congressional and Treasury relationship is going and whether you believe that, particularly moving in this election year, whether you think the possibility of legislation, again, is a real possibility?

MCCORMICK: Yeah, thanks for the question. I'd make a couple comments. One, we certainly - as I tried to say in my remarks, China is of interest to the Congress. The Congress has been very engaged on issues of economic reform in China. That is a very welcome thing and we have a lot of great interaction with members on these issues and certainly welcome their input on these issues.

The legislation we have consistently said we don't think is the appropriate step forward and there's three reasons I would say that. First, as I tried to elaborate on in my remarks, we're making some progress on the approach we have. It's not as fast as we'd like but there's significant movement there and we want to encourage that. And we don't think legislation would be the way to do that.

Second, particularly in a time of market turbulence, the prospect of legislation poses additional risk. And third, we don't think the legislation is necessarily the most effective way of continuing to push the reform process forward. Many in this audience are true China experts. I am not. But my experience with the Chinese has not been one that suggests that punitive action typically leads to more rapid movement on their part. And so, we think the path we're on is one that's been effective and we'd like to continue on that path.

CALELLO: I think we were both in Davos last week, and looking around the room, I think many of you were Davos last week. I think everyone was in Davos. (Laughter.) And this year, obviously, sovereign wealth funds were very much a focus of a lot of the conversations. I read that you were shoveling back and forth between various interest groups and sovereign wealth funds. I wonder if you can share with us, particularly with China's role in sovereign wealth funds, your views in what role they play. You know, it goes beyond just CIC and their investments obviously in Blackstone and Morgan Stanley, but certainly with some of the state-owned industries, and what your view is on that and how that should shape up in the year's to come.

MCCORMICK: Well, in our - in thinking about sovereign wealth funds in China in particular, we've tried to think about two separate policy issues. One is the process by which the reserves are being accumulated at an accelerating pace, which has a lot to do with the fact that their currency is not a market-driven currency, and we've got a very strong policy position on that, which is that we think China needs to move more in the direction of a market-driven currency more quickly. But that is a separate question from the fact that there are these significant reserves and those reserves, a portion of them they've identified to invest through a sovereign wealth fund.

A comment on sovereign wealth funds in general: investment, broadly speaking, is a critical driver of the U.S. economy and prosperity. So our open investment posture needs to be a very forward-leaning one, and that is something the president has elaborated on a number of times in the last year, as has Secretary Paulson. Second, sovereign wealth funds are not a new phenomenon; they have been investing in the United States for 30 years. The track record on sovereign wealth fund investment is one of long-term, stable, commercially driven investment.

With that said, there is this enormous growth in sovereign wealth funds, which raises legitimate policy questions. And whether it's China or other funds, we're trying to work with those funds and the IMF to help ensure that those investments going forward continue to be commercially driven. One way to do that is potentially through a voluntary set of best practices that the funds develop with the IMF.

CALELLO: And you think, again, given the election year, is that something that you're concerned that it becomes more a political issue in terms of some of the investments from the sovereign wealth funds including China into particularly the U.S. financial system? I think we all - many firms should be very - all of us should be very pleased with the liquidity that is provided in these markets.

MCCORMICK: Yeah, I think I'd frame the question a little more broadly, which is, I think in this election year, particularly one of the great fears that the president has articulated and Secretary Paulson has articulated is a tilt towards protection within the country writ large. And that could be in the area of investment policy; that could be in the area of trade policy; that could show up in a number of different forms. And so I think during this time in particular, it's important that people within the government, people in the private sector are out actively making the case for economic engagement through free trade, through open investment, and the sovereign wealth fund issue is a subset of that broader debate.

CALELLO: Great. Another area of interest to many people in the audience is the whole issue around environmental sustainability. And you mentioned that it's very much a topic in economic agenda and of the SED. And certainly it's something that the council has been very involved in - (a list of ?) economies - if anyone hasn't read their work from the council, you certainly should, and impacts from China in the economy. It's - rather, I think some people see it as a rather odd one for the Treasury to be engaged in, maybe with the exception of the secretary's own personal interest in this important topic. But maybe you can comment a little bit more on that. I know I've seen that you've spoken quite a bit on environmental sustainability and role in growth of economies.

MCCORMICK: Yeah, the - you know, it's interesting. I think if you step back and look at this intersection of environmental policy, energy policy, and economic policy - and they all intersect in very important ways - that issue is going to be a prominent issue for the next several decades for policymakers in the executive branch.

And if you think about it, what's changed in the last several years, is - those are no longer siloed issues where the Environmental Protection Agency is working on the environment and the Energy Department is working on energy; this is a core public policy issue both domestically and internationally. And it's absolutely critical that the economic policymakers within the federal government are actively engaged in this process. So if you think about all of the major questions, whether it's funding R&D or it's a set of policies that addressing greenhouse gas emissions, the economic policymakers need to be actually at the table.

So the Treasury Department needs to play a role in institutionalizing a set of capabilities where we can be active contributors in that discussion, not the lead on that discussion, but active contributors in that discussion. And we see that happening in governments around the world. So in Bali, interestingly enough, there was a finance minister's meeting hosted by the Indonesians to focus specifically on the role that treasuries should play in this particular issue. So I think as the issue evolves, you'll see more and more of core economic policymakers involved because it's of such significance to the overall growth of our respective economies.

CALELLO: You spoke quite a bit about SED. And do you believe that is something that will survive the Bush administration?

MCCORMICK: I hope so. I mean, whether it's called the strategic economic dialogue or not I think remains to be seen, but the notion that there needs to be at the highest levels of the Chinese government and the United States government an ongoing discussion around the broader structural reforms that are not next-month or even next-year kinds of things that you can accomplish, but a broader agenda I think is critical.

And what I think Secretary Paulson has effectively done within this dialogue is shifted the debate around many of these most contentious issues to what's in China's best interests. And whether we're talking about currency reform or whether we're talking about market access to financial services, what he has tried to do I think quite successfully is in a very fact-based analytic way make the case for why China needs to take steps in this area to help it achieve its next chapter of growth and evolve to a new growth model. And so that philosophy I think and hope is one that will transcend any particular administration.

CALELLO: You've also mentioned in your remarks that American demand driving Chinese growth. There is a lot of discussion among some of the economists - some of them are in the room - with regards to the decoupling of the Chinese economy and - a term I think overused. What is your view on potential slowdown in the U.S. economy and its impacts on China in particular?

MCCORMICK: Well, there's lots of experts in the room. They probably have more insight on that question than I do. I've always been somewhat dubious of the broad decoupling pieces based on the fact that the United States continues to be 20 percent of global GDP and 30 percent of demand for global imports. So it struck me as - as decoupling in the true sense of the word was unlikely, although there will be certain economies that are less dependent on U.S. demand than others. That is inevitably the case, and we have a great story to tell I think globally, which is that 50 percent of the global growth is being driven by these emerging economies, which is something we should all apply. It's a great transition and transformation in the global economy.

But for the decoupling pieces - to believe the decoupling pieces, you have to believe two things. You have to believe that the forces that are slowing the U.S. economy do not exist in other places. In some cases that's true. Housing is pretty isolated, and in other cases, that's not necessarily true: credit market or commodity prices. And the second thing you'd have to believe is that the emerging economies could - would offset any slow down in demand. And certainly the growth that we're seeing in the emerging economies will offset some of that slowdown, but I don't think all of it. So I would expect that there would be some impact.

CALELLO: Great. Rather than monopolizing the floor, let me open up to all of you. The ground rules, simply: If you could just raise your hand, someone will get you a microphone. If you could just identify yourself and your affiliation, that would be great. Why don't we start right here? Thank you. And I'll move here next.

QUESTIONER: Yeah, Rick Thoman, Corporate Perspectives and Columbia University. I wondered if you could talk a little bit about intellectual property. You know, one of the historic debates we've always had with China - I was involved with two large technology firms, and there was always issues around what would stay within your firm and what would distend. There is the obvious fashion industry and other things. And obviously there are examples now with European firms that are having trouble with local Chinese courts, making interpretations of when technology was invented and owned that are pretty spurious appearing. So I'm wondering if you could talk about the whole notion of where China stands with regard to intellectual property. How important - how important that platform is now because innovation is what we all talk about in terms of world growth.

CALELLO: David's in a unique position also to answer this given your business background. So I think you've got a few perspectives on this one.

MCCORMICK: I would say that it's a story of some good news and lots of bad news, unfortunately. On the good-news front, I think that at the federal level, the national level, the Chinese leadership has begun to internalize the importance of intellectual property protection and I think has taken some steps which we could point to as evidence of real progress. The licensing of the operating systems or for operating systems purchased for the national government I think was a notable step in that direction. I think the bad news is that the ability to drive that down to the provincial level in terms of true intellectual property protection and enforcement I think is very limited.

And even in the case of - a similar case in some ways - product safety, where the national government tried to respond very forcefully and quickly, I mean, we still see challenges. I think intellectual property is a much more diffused problem. It's very difficult to overcome. So I think even with commitment, the ability to execute on an intellectual-property-focused regime is going to be very difficult.

Just a very brief story that I think conveys what will ultimately move China in the right direction. I visited several years ago a big Chinese high-tech firm. You would know the name immediately if I said it. And I sat with the chairman, and we had a discussion, and it was really exciting that they were expanding their business globally, and I said, what are your biggest challenges? And this was, again, a Chinese firm that had grown up in China. And he leaned across the table and he said, and my biggest challenge is these small Chinese companies stealing all of my intellectual property. (Laughter.)

And I think that both is a challenge but the opportunity. As Chinese firms begin to grow and begin to see some of the implications for their own businesses, intellectual property protection or the lack thereof, I think the political forces that will come to bear provincially and nationally will be more significant. But it's a real - it remains a real challenge and a real frustration for the U.S. companies and also the U.S. government.

CALELLO: Great. We have a question right here.

QUESTIONER: Thank you. Jacob Frank (ph), LAIG (ph). I really welcome very much the broader perspective of your presentation on the exchange rate, in particular, shifting it to the more fundamentals of - they need to lower saving rates and for - to develop pension system, Social Security system, dividend policy, et cetera. Now - and I think that is the right way, except that developing these structures and changing those behavioral patterns, it takes a long time, and probably longer than the political system of the sentiments of protectionism give.

I wonder if we can move one step further. Much of the - the was a political decision some time ago in China to accelerate the process of urbanization. Tens of millions of people are moving or being moved from the rural to the urban area. They need to provide them with employment; they need to grow, therefore. They don't have markets; they need to export. If they don't export, they have a problem.

As long as this continues, it will be very, very difficult, unless they want to lose their regime, to tell them and to bring about the fundamental reduction in reliance on foreign markets. Since the decision for urbanization is a purely political decision, I wonder whether one can also put this on the table in slowing down that process. And frankly, the faster the organization, the lousier the inequality of the distribution of income, the less liberal will be the political system and the economic system because they are not going to allow that steam to jump up. So I think the issue of urbanization is an important issue that can be a policy discussion.

MCCORMICK: I'm sorry, Jake, what was the last sentence you said?

QUESTIONER: So the last sentence was, is there a way to put on the table an argument that says that they should try to slow down the implementation of the political decision for urbanization because this really underlies much of the process?

MCCORMICK: Yeah, you know, I think it's a very good question. I mean, we visited over the last six months or so - and again, there's many in the room that probably have an inside track on much of the internal politics. But my sense is there is very much a debate going on within China between those that were proponents of openness and the current economic path and those that are fearful that it is starting to get away from the leadership and that as a consequence of that, the political situation is becoming increasingly unstable. And therefore, there is a need to retract and retrench on many of the reforms. I think that debate is underway.

And one of the things that Secretary Paulson always says, which I agree with, is that his fear is that in not reforming quickly enough, they will be in a position where they will not be able to manage their economy effectively. And that will feed into those who are critics of reform, and ultimately further facilitate the retrenchment. So I think there is a very difficult balance that will be struck over the next couple years. And we see this even playing out recently in some of the leadership selections in that balancing.

And I think from the standpoint of U.S. policy, we need to be very focused on helping those reformers and also ensuring that we're advocating - and hopefully the Chinese moving in the direction of policies that are going to accelerate that reform to guard against that risk. I think that's consistently been our posture. And I think as we see the leadership selections that played out late last year and will play out in March, there will be a lot of China watching to see who is in what spots. And that will ultimately dictate the next five years in terms of which direction some of these policies go.

CALELLO: Question right here?

QUESTIONER: Jean Biti (ph) from UBS. Due to the size of the U.S. current account deficit and the low level of domestic savings, the U.S. needs to attract a large amount of foreign investment to finance this deficit. Since China is one of the - if not the largest holder of foreign exchange reserve - and most of these are denominated in U.S. treasuries, in the short term at least, isn't it in the U.S. interest for China to manage its renminbi levels by investing in U.S. Treasuries as opposed to moving towards a managed exchange rate - I mean, I'm sorry a calling peg or a freely floating exchange rate?

QUESTIONER: Maybe I can just add to that a question because there's been some research written that the amount of treasuries that the Chinese government has held has not kept pace with the growth of the foreign exchange reserves to 1.3 trillion. And maybe associated with that, I'd love to hear that answer.

MCCORMICK: Yeah, I guess that again, sort of back to the context for all of this is from an open investment standpoint, we're welcoming all investment and that our capital markets continue to be the deepest, most attractive in the world. We actually don't release the data that we have on the distribution of China's foreign exchange holdings. But what is clear is that there's been roughly $500 billion of accumulation over the last 16 to 17 months in their reserves. And I think just as a general rule, what we see is that as China's holdings grow so dramatically, their holdings in a variety of U.S. investments grow dramatically as well. So there's been no macro-trend along the lines of what you suggest.

In addition, you know, there's been a fair amount of speculation around whether, given the market turmoil, that there's been a significant change in inbound investment into the United States. And as we've seen in the data that's been announced over the last couple months, there was a decline in investment in the United States in the months around August and September in the international capital data that we collect in some of the most tumultuous times in the market.

What we saw in the months of October and November was a significant inflow of investment into U.S. asset classes that even exceeded the previous 12 to 18 months in terms of average flow. So I think it's an important point to make as well.

CALELLO: Lots of questions here. Why don't we take this one here and we'll take one from the back next?

QUESTIONER: I'm Hunter Schmidt with Bungy (ph). Despite record harvests and tremendous global stocks around the world, grain prices are at all-time highs in all complexes on a nominal basis. This phenomenon can be directly traced to the renewable fuel standard, which was increased in the most recent energy legislation in the United States, and to the biodiesel inclusion mandates that exist in the EU. There are numerous signs that this is triggering several forms of food price inflation in China, in Indonesia, and now - if you listen to Tyson Foods announcements yesterday that they're suspending earnings guidance, that they see a variety of foodstuffs showing category price increases - in the United States as well.

My question is, do you believe in an environment where food price inflation is demand and/or fiscally stimulated due to government policies, that core inflation still represents the best leading indicator of changes in the price level? And secondly, have we reached a point at which those policies have become destructive to our economic interests as well as our bilateral relationship with China? Thanks.

MCCORMICK: Thanks, and that's a good question. I think this global phenomenon, the commodity prices and particularly food prices, is a real concern and something that we hear consistently about. My understanding is some of the drivers of that is not only some of the policies you mentioned, but also a significant drought in Australia, which I think contributed at least somewhat to what we're seeing. But I think it's a real issue. And if you listen to what Bob Zoellick at the World Bank is saying and lots of other people are saying, there's a significant impact around the world.

I mean, this sort of brings together some of the challenges I mentioned earlier in terms of energy policy and environment and economic policy. And the initial logic behind the 20 in 10 and some of the policies the president put in place was that by dictating a certain percentage of biofuels that you would create certainty in the market, which would ultimately lead to incremental investment, which would push us down the path that much more quickly to a transition to cellulosic, which is still the bet. And we're hopeful and we'll see if that plays out as expected.

But if that does happen, as is hoped, then that would ultimately mean that this is a short-term problem not a long-term problem because you're moving to a whole new series of fuel sources, which is ultimately what the goal was. And this is within the broader context of energy security and reducing our dependence on foreign oil.

To go to the question of core versus headline, I mean, I think it's something we have to factor in. It clearly has an impact on the economy. I'll let the experts at the Fed and elsewhere determine what the best measures for their evaluations are. But it's something we need to certainly watch very carefully.

CALELLO: Elizabeth?

QUESTIONER: Thank you. And thank you for your terrific comments. They're really interesting. It often seems to me that, not just with the strategic economic dialogue but with the full range of dialogues, that we're very good at identifying the Chinese interests for them and their needs for them in ways that serve our own interests, which I think is perfectly reasonable. But I'm wondering what happens when you sit across from the Chinese? What's their laundry list? What do they bring to us and say, do they say, why don't you raise your savings rate? You need to do a better job. What do they want from us that might give us some leverage?

MCCORMICK: Well, there's sort of two areas which are raised consistently. And there's an along with. But let me highlight two that are raised consistently. One is the investment climate in the United States. And this is one of those cases where I think perceptions have outstripped reality in terms of what our investment climate is. And I think by any measure, our investment climate is generally very good. But a couple high-profile events over the last couple years have led many around the world, in China, in the Middle East, and elsewhere to think that we're less open than we used to be.

And that's a real concern to the Chinese, particularly as they think about some of the challenges around their reserve accumulation and how they should be investing with CIC and elsewhere. So that's a big issue.

The second issue, which is really a case where perception outstrips fact is in the area of export controls where there's been an ongoing dialogue with the United States for many years about the export of technology to help China transition to this next chapter of their growth. And a very small percentage of those technology exports are restricted, less than 1 percent because of the sensitivity of the technology involved. But the Chinese routinely point to that as the driver of the trade deficit and a number of other things. So that's an issue that consistently comes up.

And I guess then the third area is sort of macroeconomic policy in general. And so, we have an ongoing discussion about imbalances and respective responsibilities in imbalances. And as China becomes a much more significant player, then the United States and China really need to be thinking together on some of these macro challenges.

CALELLO: Just how many times have you had that CNOOC-Unocal deal thrown back at you? Another question right here, middle table?

QUESTIONER: I'm Dick McCormick from Merrill Lynch. What parallels do you see between the Japanese bubble in the late 1980s and what is going on now in China? And what are the potential implications of this to the post-Olympic period in China?

MCCORMICK: It's a really good question. I hope that what we're seeing in China will be a steady transformation to a different growth model that won't have a bubble popping. And ultimately, the Chinese are going to be able to make that transition in a thoughtful way and - based on some the reforms that I tried to discuss - we think that's - taking Elizabeth's point that this is through the eyes of the Americans in terms of what is in China's interest - but we really have tried to be thoughtful about positioning what our common interests might be around that reform agenda.

There is a specific point on the Japanese comparison I'd like to teas out a bit, which is - I know I sound like a broken record - but it's this investment question. And if you go back to the early '80s and much of the talk around the Japanese buying up America and some of the challenge that presented in Pebble Beach and Rockefeller Center and everything else, and sort of look with the benefit of time and history on what really happened, I think it helps inform some of the concerning commentary we see even in yesterday's newspapers about China buying up U.S. assets at bargain basement prices and that whole debate that could play out in unfavorable ways if we're not careful.

CALELLO: Quite a few questions here. Why don't we move to this table here?

QUESTIONER: I'm Orville Shell (sp), director of the Center on U.S.-China Relations at the Asia Society. Thanks for your very thoughtful remarks. Clearly, with the U.S. and China being the major emitters of greenhouse gas, we have a daunting problem ahead of us. I wonder, first, have you been satisfied with what has been accomplished so far in terms of broaching this issue bilaterally with China? And what would you imagine could be done over the next year or - perhaps more interestingly - should be done to bring these two countries into some more constructive framework?

MCCORMICK: Yeah, thanks for that question. You know, it's interesting, this debate politically is moving so quickly that one sometimes loses a sense of how much has changed just in the last year. So if we went back to May of - it was just May of 2007 where the president gave a speech talking about perspectives on climate change and the role that he thought the United States could play in bringing the major economies and the major emitters together around a post-2012 framework.

Now, at the time, that was viewed - I think by many - as a very significant statement. That was followed up by the first major economies meeting in September and then followed by the Bali road map last month. So there's been a fairly significant amount of focus and, I think, leadership on this issue in the past 10 months or so. The key principle that the United States has tried to highlight in all of this is that for us just in practical terms globally to address greenhouse gas emissions in a meaningful way, it would have to be both developed and developing countries coming together.

And that's just a simple issue of the numbers. If you look at the 50 percent growth we're supposed to see in greenhouse gas emissions over the next 20 years, 75 percent of it is driven by the emerging economies. And within that 75 percent, 80 percent of it is driven by China. So simple math means that we need to come together on this. That means the United States needs to show real leadership. But it means the emerging economies need to come together as well.

And if there's a philosophical disagreement among any of the major developed economies at the table, that would be an area that it might exist. I think we feel very strongly about that. And the Chinese, to their credit, are starting to play a much more proactive role in engaging in this discussion. And their own 10-year plan that they announced at the end of - or their own five-year plan rather that they announced at the end of last year, their participation in Bali, their agreement to the Bali road map. I don't want to paint too rosy a picture because there's a lot - there's an enormous amount of work to be done around some incredibly contentious issues. But we're beginning to see a pathway to a global agreement here. And I think the one thing that I'd like to highlight is I think the president has voiced a very strong commitment to try and be constructive in pushing that forward.

CALELLO: Question right here.

QUESTIONER: Lester Wigler (sp), CitiSmithBarney. To what degree - thank you for addressing us today - to what degree is the United States engaging with China insofar as they are manifesting their economic might in places, most noteworthy, such as Africa and perhaps are using a different set of rules than we are?

MCCORMICK: Yeah, this is something that we are talking to the Chinese about, and many countries are talking to the Chinese about. If you went back to the G-8 statement last year and many of the G-8 discussions, part of it was focused on development and development assistance and then assuring that that development assistance is principles-based and really focused on helping countries make the transition to a higher level of economic growth and success.

It's a challenge, I must say, because when one goes to Africa and visits these various countries, which I did about six months ago, there is a good bit of feedback that the Chinese have been enormously successful in building great relationships in those African countries in particular and are seen as real contributors. So they're building roads and bridges and being very supportive of what is viewed as key priorities for the government. And there is clearly in many of those situations a resource focus on the part of the Chinese. But within the grand bargain that many of these countries are developing with China, that's all viewed as appropriate and acceptable.

So there's two sides to the equation. One side is helping the Chinese understand some of the challenge and the mistakes we've made in the United States and the developed world in terms of our approaches to development, and helping them understand what some of the long-term implications might be. The other part is working with the recipients to help them understand the long-term implications of going down a path that is not principles-based in terms of their development strategy. Not easy - and the Chinese have been brilliant about this. They had a terrific conference with African leaders in Beijing, a year, year and a half ago, where they brought together 50 global African leaders and spent a lot of time talking about their vision for Africa.

CALELLO: Probably have time for two more questions. And I appreciate this overwhelming interest; appreciate that very much. Why don't we move to this table right here, the gentleman in the red tie and then the gentleman behind him we can do after that?

QUESTIONER: Nick Bratts (sp) - (inaudible) - I'd like to bring the conversation back to currencies. You indicated in your comments, I think, a certain degree of satisfaction that the RMB had appreciated. But I wonder if you could give us a sense of what your office thinks the RMB should go to? To what extent is it still undervalued? And secondly, what is you best guess as to when we'll get to broad liberalization of the foreign exchange markets?

CALELLO: Yeah, let me take down where RMB is going to go.

(Laughter.)

MCCORMICK: Yes, this is my opportunity to make news. I didn't mean to convey a sense of satisfaction. What I meant to convey is a sense of progress. And by that I mean that the Chinese have consistently told us that they believe that a market-based currency is in their best interest over time. And the point of disagreement has always been around pace. And what we've seen, as I noted, is a significant shift in pace just in the last three or four months in particular. So one can imagine fast-forwarding, if that pace continued, that would be a very significant development. I'm not going to suggest. There's lot of people that have spent lots of time modeling what the ultimate change in adjustment should be. I won't talk about that other than to say that to date our view has been and continues to be that it needs to be more, sooner, faster. And that's the message that we continue to share with the Chinese?

CALELLO: I didn't get any headlines with that one.

(Laughter.)

MCCORMICK: Mission accomplished.

(Laughter.)

MR CALELLO: One more question, I think, just probably in an effort to finish up on time.

QUESTIONER: (Inaudible) - Credit Suisse. As you know in a fixed-exchange rate system, reserves accumulate, which leads to increase in home money supply. And that would eventually lead to pressures in the home price level, as it would in financial asset prices. Would you care to comment on the mechanism and how you see that evolving?

Thank you.

MCCORMICK: Well, only just to reinforce what I said earlier, which is that I think the Chinese are beginning to acknowledge that their ability to manage monetary policy -and particularly their ability to manage inflation is somewhat hindered by their current exchange-rate regime. And as a consequence, I think that helps feed into the decision-making process that we hope and believe is leading them to liberalize more quickly. And so, we hope to see more of that. And It think that's all I would say on that.

CALELLO: Well, I'd like to thank all of you for you encouragement and your terrific questions. I'd like to thank Council of Foreign Relations for hosting this event. And I think all of us join me in thanking David for his candid and insightful remarks. Thank you, David.

(Applause.)

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