Is China a Google or an Enron?

Wednesday, December 15, 2004

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Presider: Henry Kaufman, president, Henry Kaufman & Company, Inc.
Speaker: Gordon Chang, author of "The Coming Collapse of China"
Speaker: Albert Keidel, senior associate, China program, Carnegie Endowment for International Peace
Speaker: Nicholas Lardy, senior fellow, Institute for International Economics

Council on Foreign Relations
New York, N.Y.
December 15, 2004

HENRY KAUFMAN: (In progress)--is going to be open to questions. As you know from the announcement, this session is on the record, not off the record. So feel free to speak. I know our three participants here will be candid and forthright. So let me begin not in alphabetical order, but let me begin at the far end with Mr. Lardy, and ask you: What do you think the near-term challenges are in the China situation?

NICHOLAS LARDY: I think obviously there's a very long list of challenges, short and medium term. I think probably the most pressing one is continuing to moderate credit growth and bringing the economy to a more sustainable rate of investment and economic growth. We're at or near the peak of a cycle, with a very high rate of investment, a very high rate of growth. I think there's a lot of waste of resources associated with that peak, and I think the challenge the regime faces is to continue to moderate the growth of the economy by controlling the expansion of credit. They've had considerable success at this over the last three to four months following a complete all-time credit blow-out in 2003 and the first part of this year. They need to bring down fixed-asset investment. I think that will slow growth. That will create a whole series of challenges, but I think it's absolutely necessary for long-term sustainable economic growth.

KAUFMAN: Mr. Chang, do you agree with that?

GORDON CHANG: I think there's very little to disagree with that. I would just sort of look at a different emphasis, though, and that is that essentially what we have in China is an unstable system, largely because Beijing is beginning to lose control of some elements of it. Of course, once it was in control, but 25 years of reform and change— and there is a difference between those two terms— have really transformed China. And essentially what we see, for instance, in the financial system if we talk about credit growth and the banks is that there has been this tremendous expansion in the Chinese economy, but it has been fueled by credit growth. And many of the new loans are of dubious quality. So, for instance, you have 50 percent of the car loans [that] may be bad, and many of the mortgages that secure the bank lending are unenforceable.

So essentially what we have is a banking system which is in a slow-motion crisis, and Beijing has to do something about it and they've got to do something quickly, largely because they've got the WTO [World Trade Organization] deadline of the first day of 2007. And although they're moving in the right direction, I'm not sure that they're moving fast enough. What we see is the growth of the underground banks and the informal lending pools and all the hot money coming in and out of China, and essentially what we see is a country, a government that doesn't seem to control this economy. When they try to slow it down, the consequences could be severe.

KAUFMAN: How do we get over the banking problem as expressed by Mr. Chang?

ALBERT KEIDEL: I like to say, "The what problem?" because I don't really think China yet has banks. It has a system of government-controlled deposit-taking institutions. And the system is managed not through instruments that we would call market instruments but by extra-market instruments that have been fairly effective. As they build the institutions, they will eventually allow market forces to play a greater role. And the key agency in this, besides the Politburo and the State Council, which is their Cabinet, is the National Development Reform Commission, the former Planning Commission, which has the job of coordinating fiscal and monetary policies. And they do it through a variety of instruments, including through the central bank and the Ministry of Finance and others that are underneath the Cabinet.

And so I think that they're managing this current expansion. Nick is right to say that it's near the peak of a cycle. I think it has a while to go before the cycle peaks, because we haven't yet seen inflation rise high enough above deposit rates so that there is disintermediation from the system, which has happened on several occasions over the last 25 years and caused a real rush of buying and inflation. That part of the cycle hasn't happened yet. But what has happened— and this is something that is a healthy part of the cycle— is that Beijing has experimented with new channels for credit, new institutions, and, as Gordon has mentioned, some of these clearly are problematic. But every time they introduce, whether it's finance companies or stock markets or something else, there are abuses, because they don't have the regulatory mechanism to manage it properly, and so then they pull back. And so the cyclical introduction of new institutions, I think, is a healthy process that is ongoing and represents really the medium- and long-term strategy and goal of this system.

KAUFMAN: We have here in this audience a lot of business and financial people. And, of course, one of the elements of concern, of critical interest to them, is the value of the Chinese currency. There have been a lot of suggestions made about revaluation. How do you think the revaluation procedure will continue, if at all?

LARDY: Well, I think it's impossible— I have no insights on when they might change their currency regime. I would simply begin with the observation that we're in a very unusual period. If you go back to the beginning of the reform period through the mid-90s, China made many, many major adjustments not only to the exchange rate, but to the nature of the system, the way it was done. They had a dual exchange-rate system, then a unified system, various complicated arrangements. Then they went to the system that has been in place since roughly the mid-1990s, and they've had a fixed nominal exchange rate for now a very, very long period of time. So we're in a very unusual period, if you take the whole sweep of reforms that began in the late-1970s.

I think eventually they're going to have to change their system. They have a very large capital accounts surplus. They have a significant ongoing current account surplus, very large inflows. I think [there are] lots of challenges in controlling the growth of money because of the growth of base money associated with the huge build-up of foreign exchange reserves. The build-up of foreign exchange reserves last year was equal to 11 percent of gross domestic product [GDP], and they are on track to do roughly the same this year.

So I think there are challenges. I think eventually they will move, but I think the current leadership is very cautious. They are— don't want to change unless they absolutely have to, and they're very concerned about jobs. And I do think this is an area where the regime has not done well in terms of economic policy. Mr. Keidel was mentioning the interest rates. The real interest rates for borrowers today remains negative, and they are subsidizing the most capital-intensive sectors of the economy. They have very rapid growth, but not very much job growth, and they're worried about revaluation, which might slow down the export sector. What they really should be doing is adopting a more flexible exchange rate regime. They should have more independence on monetary policy. They should have higher real interest rates, and I think they'd get a lot more job creation with that kind of a mix of policies than they're getting from their current system.

KAUFMAN: But if I had to pin you down as to what they're going to do with their currency, let's say over the next 12 months or so, I suspect the way you answered the question, you would say, "very little."

LARDY: Well, I think there's a reasonable chance over the next 12 months they will make some adjustments in the peg and maybe move to a basket of currencies instead of the single currency peg. But I don't have, you know, any confidence in anybody's ability to forecast precisely when this is going to occur.

KAUFMAN: Al, how about you?

KEIDEL: Well, I think nobody except the Chinese really knows what the Chinese are going to do on this issue. But in terms of what they need to do, I would say there is absolutely no urgency to either change the value of the peg or to change the system and make it more flexible. I don't see a really credible argument out there for the currency being undervalued. Their current account surplus globally is just not that large. It's not very big. And I don't think capital flows are something that an adjustment in the exchange rate is going to have much impact on.

So in terms of the level, I don't think an economist can tell you where it ought to be. What an economist would say is, "Well, you ought to let the market determine where it goes." But China's system has so many restrictions, in particular, on capital outflows, that to release one section of your system and allow what you would call market forces to determine some sort of rate isn't letting the market determine it. It's letting a portion of market forces, and some of those are, I would say, biased in the direction of an upward pressure anyway because of the restrictions on capital outflows. So what has happened in the debate is there's been confusion, and people call for flexibility. But they don't call for flexibility because of trade— that the level is at the wrong rate for the exchange; they call for flexibility because, in an economist's world, if you're going to open your capital account, then you cannot have a peg or you're vulnerable to attacks. But if you're not going to open your short-term capital account very soon, there is really no pressing need to introduce flexibility in the exchange rate. And that, I would argue, is where China is right now.

KAUFMAN: Do you share that view, Gordon?

CHANG: Well, I think part of the problem now is we think of China as this large authoritarian state that controls everything. But we've seen so many irregularities in money going in and out of the country that, to a certain extent, I think at some point, they're going to have to do something to get this problem under control. We have some sense of what it is, but in terms of the dimensions of it, you know, Chinese statistics are Chinese statistics. So I do see at some point they are going to be under pressure to do the right thing, but I don't see it happening within the next 12 months, because there are so many other changes in the Chinese economy that are taking place that by their very nature they're conservative and they're not going to want to change the exchange rate.

But at the end of the day, you know, they participate in this international system, and they're benefiting from it because of trade, open trade. They're in the WTO and all of it. And I think that essentially they're going to have to buy into the entire system, which also means a flexible currency and open capital accounts, because the rest of the world at some point is not going to put up with it. We've seen some attempts on other countries, like South Korea and Thailand and Japan, to fiddle with their currencies in response to China, and eventually that force is going to get stronger and stronger, and the pressure, I think, will be too great.

The unfortunate thing is that the pressure is going to occur and China's going to have to do something precisely at the moment that it's weakest. Of course it should do it now, when it's in a strong position.

KAUFMAN: Well, let me back into a related issue. Japan and China are very substantial buyers of U.S. government securities and help to finance our debt; Japan somewhat more than China, but China is a very large participant as a buyer. As you look at it over the next year or two, assuming that we continue to do a lot of importing from China, are the Chinese going to continue to be ready and willing buyers of U.S. government securities?

KEIDEL: Well, I would make a correction. I don't think we're importing that much from China. That's what the bilateral trade statistics show. Superficially, if you look at U.S. imports and ask where our deficit is coming from, just look at our partners, it looks like most of it, or more than anywhere else, is coming from China. But that's a false picture. China's reprocessing imports from the rest of the world, so China has a large deficit with all— with a combination of its other trading partners.

If you want to understand the U.S. deficit, you need to say who in the world has a global surplus. And there, 28 percent, the largest share of the U.S. deficit, is the euro zone. It has a global surplus equivalent to 28 percent of the U.S. deficit. The Japanese have 19 percent. Oil exporters have 20 percent. Non-China, the rest of Asia have 20 percent. So you get up over 80 percent. China's only 6 percent of the U.S. deficit. So China is in a position to hold so many reserves not because of its trade surplus, and not even mainly because of FDI [foreign direct investment] inflows, but rather because what had been a modest leakage of capital flowing out reversed itself at the end of 2002 and began coming in in a large speculative rush. And so that's been hot money that has pushed it up.

Now the Chinese are holding onto that in the denominated currency, the U.S. dollar, where most of their obligations will be if that turns around and tries to go out again. So in that sense, they— they're avoiding a mismatch in the currency denomination of their overall balance sheet. But if the dollar continues to weaken, you could say, "aren't they being hurt?" Well, this crowd is the one that knows how to deal with that, I would think. If you think it's down about as far as it's going to go, that's not the time to unload your holdings, I wouldn't think. But in any event, the Chinese— the U.S. is still the best long-term bet for holding a currency that represents a productive economy, and that figures largely. And also the euro market is extremely thin, because the Europeans are running these surpluses. There aren't that many euro instruments, in my understanding, so that there's a lot of price volatility if you try to move large amount of your holdings and your assets into that currency. So I don't see any— you know, people point their finger at the U.S. and say, "Well, it doesn't save, and it's got twin deficits." But the U.S. is also basically providing a monetary cushion for the global economy, and Japan and Europe aren't pulling their weight. And I think if we didn't do that, we would see much more serious consequences for the whole global—

KAUFMAN: Do you have a different view, Nick?

LARDY: Well, I think if they're not willing to revalue their currency, they're going to have to buy substantially more U.S. financial assets over the next few years. The slowdown that I mentioned, which I think will start in 2005, could easily go on for several years. That's what happened in the last cycle. And in the last cycle, as their economy slowed down, their import growth slowed substantially more than their export growth. And their current— their net exports strengthened by six percentage points of GDP. And so they're currently— they had a current account surplus last year of 3.3 percent. This year it'll be in the neighborhood of two, maybe two and a half percent. But that is likely to go up significantly as the economy slows in '05, '06, and '07. And if they don't want their currency to appreciate or if they don't— aren't willing to revalue, they're going to have to buy substantially more dollar-denominated financial assets over the next few years than they have in the recent past.

KAUFMAN: I'm going to ask one or two more questions, and then we're going to open it up here. I know many of you are wanting to ask quite a few questions. If you were to describe the relationship five years to 10 years out between Taiwan and China, what would you say?

CHANG: I'm just not smart enough to answer that question. [Laughter] I think, though, that a lot of people talk about how Taiwan is being irresponsible because it wants to declare independence, as we put it. But I think, to a certain extent, we've got to remember that the United States is a country that is founded on revolutionary principles. We wanted our own freedom and independence. And so I think that therefore it's very important for us to support Taiwan, for the same reasons, because it's the right thing to do. I mean, if we try and look at five, 10 years, to answer your question, I essentially see Taiwan being Taiwan. I don't think that China has— it may have the military capability to invade. It may even have the economic power to attract Taiwan. But the problem for the Chinese government is that, in Taiwan, there's a very strong feeling that Taiwan has a separate identity. And I think that that will carry the island through some very, very difficult times. I can remember being in Hong Kong in the early '80s, and people were saying that it was just inevitable that Taiwan would be reabsorbed. But, you know, here we are today with a Taiwan which is completely different and almost inconceivably different than it was 10 years ago. So I tend to think that as we look five years, 10 years down the road, there is going to be an independent Taiwan, largely because China just politically cannot afford a war. It's because, essentially, they have got an economy which is now dependent on American consumers and consumers around the rest of the world. They cannot afford to go through another era of Tiananmen sanctions [imposed in response to China's suppression of the 1989 pro-democracy demonstrations in Beijing's Tiananmen Square]. So I see the status quo pretty much remaining, with Taiwan being independent.

KAUFMAN: How about it?

KEIDEL: Well, I mean, you can go back to the Revolutionary War, but I would say we have an historical precedent in the United States that shows the serious damage done by civil war. That's our history of part of a country trying to separate itself out, and the legacy of our Civil War stays with us through today in the division in the country and the lingering sort of hatreds that certain regions have for other regions. And I think for us, as the United States, we need to say: "What's in our interest? Is it in our interest to have a fight with China over Taiwan?" Now the answer is clearly no, in my mind. So I think we need to continue to manage the process so that there is no change in the status quo. And what happens then— the only right answer— and I'm smart enough to give this answer— is "it depends." [Laughter]

KAUFMAN: I wish I'd thought of that. [Laughter]

KEIDEL: And the main thing it depends on is what happens to China in the next 10 years or more. If China continues in the direction that Taiwan went through and that you could say South Korea went through, as rising incomes increased the flexibility of the government's handling of people and of dissent, then I think there's a chance that this whole process will eventually evolve into one where it's not so important whether Taiwan is independent or not. And in that sense, if that's true, then time is not on Taiwan's side, if certain leaders want independence because of what it does for them. But I think leaders on the mainland, given the consciousness of this elite as serving China as it has existed through the millennia, cannot survive in power if they allow a Taiwan to declare its independence and get away with it. It could not survive.

KAUFMAN: Let's go back to the near term, over the next three, four years. From what I sense, at least from the two of you, the two of you at least do not expect a classical recession in Western terms, meaning no growth, negative growth at any time. I'm going to ask Mr. Chang later. What do you expect in terms of the economic pattern of the next three, four years in China? And I'll begin with you, Nick. Do you expect 6 percent real growth, 7 percent— which by Western standards is substantial— or something less?

LARDY: Well, let me begin by saying I'm not here to argue for the official data. I'm not sure exactly how rapidly the economy is growing— you know, whether we take the 9-point-something percent that is the headline number the Chinese announce. Bert can make a very persuasive argument that you ought to look at some of their other data that suggests it's closer to 10 or maybe even 11 percent for its current growth rate. I am reasonably confident, whatever the current growth rate, whether it's 10 or 11 or 9 [percent], it has to come down, and the reason's very simple. They're investing a higher share of GDP than any economy has ever done in any point in history— about 45 percent of GDP. That has to come down or they will have a massive, massive problem of nonperforming loans in their banking system once you move forward a few years. Just a lot of bad investment decisions are being made at a 45 percent rate of investment.

Since that growth of investment has accounted for the lion's share of economic growth over the last few years, the only way to bring the investment share down is to have much slower rate of growth of investment— fixed-asset investment. And as fixed-asset investment growth slows— remember last year it was something in the neighborhood of 20 percent— as that slows, the growth of the economy is going to come down significantly and consumption demand is not likely to rise enough to offset the negative effect on economic growth from the declining rate of growth of fixed investment.

So from wherever we are today, I think the growth rate could come down by 3 or 5 percentage points— 3 to 5 percentage points— but it will take two, three, four years. So I'm looking at a trough that would be, you know, in 2006, probably 2007. But certainly would not be a recession in classic Western terms, because the growth rate will still remain well into positive territory, regardless of what particular starting point you take. It will, however, create some challenges for the regime, and we saw some of these in the last cycle. But I think if they make other adjustments along the lines I mentioned earlier, they can still do reasonably well on job creation.

Longer term, I'm very bullish, because this is a very open economy. The economy has really been largely transformed into a competitive market economy. The ratio of imports to GDP, for example, more than doubled in roughly the last decade. It's twice the level of the U.S., about four times the level of Japan. This is a very, very open economy, and huge increase in competitiveness as a consequence of that, which I think is going to serve them very, very well in the long term. But I think the next three to four years— as I said earlier, we're near the peak of a cycle, and I think starting in '05 we'll see a significant slowdown.

KAUFMAN: Do you agree, Gordon?

CHANG: In general terms, of course, I agree there's going to be a slowdown, but I think it's going to occur even later than Nick thinks it will, because we have to think about what the political calendar for Beijing is. It has the 2008 Olympics. It cannot afford really to have too much in the way of change in that time. And I think that, even though they talk about China slowing the economy down, I'm not sure that they're going to actually try to implement that, because they've seen the dislocations that can occur when there is some slowdown. So I think essentially what they will do is keep the economy running at least through the 2008 Olympics.

But even more than that, you know, even if Beijing wanted to put on the brakes today, I'm not sure that they can do it, because much of the growth is driven at the provincial and city level. And as we've seen over the last half-year or so, [Chinese Primier] Wen Jiabao has not been able to really affect decisions where it counts, which is where? At the local banks and also at the mayoral offices. So essentially we can listen to what Beijing wants, but I'm not so sure that it can get its way. And anyway, I think that they're going to keep the economy going at full speed at least through the Summer Olympics.

KAUFMAN: All right. We're going to open the session here to questions and answers. I only have a couple of observations. One, please state your name. If you have a comment, keep it short. If you have a question, make it precise. So let's begin. Mr. Lord. Are there microphones?

QUESTIONER: Winston Lord, International Rescue Committee. So far, the panel's focused on the economic challenges and contradictions. I'd like to address the political dimensions. How long can this economy grow? And, Nick, you say you're bullish over the long term because it's becoming more open. But the political system, if anything, is going backwards. So how do you grow this economy, a globalized economy with control of information, including the Internet, or at least attempted control, where a free press can't attack corruption? There is no free press, and those losing their jobs and who have less income in the interior, for example, can't express themselves peacefully. How long can they go with opening the economy and closing the political system?

KAUFMAN: Nicholas?

LARDY: Well, I'm certainly not an expert on China's political system, but I'm not persuaded that the economy has— that the political system has become more repressive or that it has become more closed. I think if you look— obviously, if you're out to overthrow the government, your chances of having any liberalization are remote, but in other domains I think the system is far more open and liberal than it was 20 years ago. After all, now we have— you know, local governments are holding hearings, public hearings to deal with public policy issues. This is something that would have been unheard of 20 years ago. The party decided what to do and they did it. They may still decide what to do, but the fact that they're holding a hearing and suggesting that anybody can come and make a presentation, I think, is a very substantial change. And I could go down a whole long list of those kinds of things. Obviously, it's not parliamentary democracy. I don't think we'll see that soon. But I am of the view that the political system has changed much more than we give it credit for.

CHANG: Well, if the political system has changed, it's not because the Communist Party made a decision, Nick. If the political system has changed— and it has— it's because the Chinese people have pushed the government. And that's really the problem because— you know, we all think of prosperity as sort of political stability. We equate the two. But if we look back at history, whether recent history or back to the French Revolution, sustained modernization is the enemy of one-party states. And really, what we've seen in China is incredible social change which has been caused by 25 years of reform, but the political system hasn't changed really that much at all. And so we're getting this classical gap between what the government says and what the people want, and, essentially, this gap cannot last forever.

And I believe that within the end of this decade, by 2011, we're going to see basically the Communist Party out of power because, you know, if we look at every single system that has tried to do what China's doing, this going from a command economy to a functioning free market, no country has been successful without regime change. And why do we think that China's going to be successful? You cannot have a stable economy in an unstable country, and every day there are hundreds of protests in China. So inevitably there's going to have to be some political reform. Whether as part of South Korea or Taiwan as we talked about before or whether it's going to be a Soviet Union-style crackup, it's going to have to happen. And probably because of all this economic growth we're seeing and all this social change, it's probably going to happen fairly soon.

KEIDEL: I think this question is often [inaudible]. I would agree with Nick; there's a lot of change. I think people underplay the change because they don't see headline elections for national leaders. But the way the society has opened up, the kinds of flexibility people have means there is a lot of change. There's a common view that the political system is rigid and unchanging, and this represents a restriction on the development of the economy. I find that sort of hard to understand, because the process they're going through is so disruptive to people's lives, and it's got to force people to change where they live, the kinds of work they do, the privileges that they used to enjoy that were non-market privileges, that there are enormous opportunities for protest. There also has to be a great deal of inequality, because people need to move voluntarily to where they can get a better job, and where that work is available.

So I find it really almost inconceivable that they would have a New England— one sort of meeting kind of a democracy in a situation where they're so poor— this is a very poor country; a little over a thousand dollars per capita— and where these wrenching changes in people's lives have to happen. And so, in a sense, in my view, as an economist, and I look at democracies around the world, so-called, every democracy in the world is basically determined in terms of its nature by non-democratic forces that influence it from behind the scenes in various ways. The Communist Party is behind the scenes in China's case. And I think if you didn't have a kind of a hand on stability, then the economy's development would be restricted.

So I'm looking for the evolution of underpinnings for democracy that are occurring rather than for the headline democratic sort of electioneering. And I think they're going in the right direction. They need much higher per capita GDP before they can make the transition that Taiwan and South Korea made [from authoritarian to democratic governments], but I think they will eventually get there, and it will be much later than Mr. Chang thinks.

KAUFMAN: Next question.

QUESTIONER: John Shu at Simpson, Thacher & Bartlett. Mr. Chang, you just used the phrase "crack up like the Soviet Union." Are you suggesting that China is at risk of breaking up like the former U.S.S.R.? And if so, why?

CHANG: Well, I do see that there will be destabilizing, discontinuous political change. In other words, I do think that there is going to be a time when the Communist Party will be forced out of power. In terms of the actual break-up of China, which many people call the last multi-cultural empire, in a sense, if Taiwan is able to go its own way, that's the beginning of the process. I don't actually think that Tibet and Xinjiang [predominantly Muslim province in northwest China], the two places where there are substantial minorities, are going to escape the Chinese tent indefinitely. I mean, all we have to do is look back at 1949 and see that they both were independent, but that [former Chinese leader] Mao Zedong was able to reassemble the country. I think that essentially we can see that same thing again. When China does go through its next round of political troubles, I do believe that the Uighurs [Muslims of Xinjiang province] and the Tibetans will try to escape. But I also think that the Han [ethnic Chinese] majority is much too strong over the long term for that to happen. But I do see Taiwan being able to maintain its own separate identity.

KAUFMAN: Mr. Utley.

QUESTIONER: Garrick Utley, the Levin Institute. Mr. Chang, you wrote the book, "The Coming Collapse of China," four or five years ago. Has your thinking changed since then? Why did you choose that title and make that argument? And do you still hold it, or have you refined it? Do you still see a collapse coming?

CHANG: All of the above. [Laughter] I have in a sense— you know, obviously, as events have occurred since 2001, I do think that what we are going to see essentially is [that] the Chinese people have really been changed more by modernization and by economic growth than I thought at the time. But I do see that as really more destabilizing, because it does fit into the pattern of what has happened. I mean, if we look at China, it is following in many of the same steps as the Soviet Union in the sense that we see a Communist Party trying to become a party of the whole people. [Former Soviet leader Mikhail] Gorbachev did that, and [former Chinese leader] Jiang Zemin tried to do that with the theory of the "Three Represents" [his effort to reposition the Communist Party's relationship to the Chinese people.]

So you see this change in the ruling party, and at the same time, you see the social dynamics that are occurring, which really are breathtaking. You know, I can agree with Bert and Nick that there has been a lot of change, but not because the Communist Party has sponsored it; only because the Chinese people have pushed it out of the way. And we saw that during the SARS [severe acute respiratory syndrome] crisis, where essentially the Chinese government initially took a very, very tough position, saying that the disease did not exist. But essentially the Chinese people made the cover-up untenable by talking to the World Health Organization and Time magazine and essentially forcing the government to concede. I see that occurring more in the future, but I also see the party being intransigent. So in a sense, yes, I've refined the view, but I do believe that by the end of this decade we are going to see a transformation in China's political system, which means that there will be a different type of government. I don't know whether it will be a better government than the one that is now or not, but I do see it as being different.

QUESTIONER: But that's not a collapse.

CHANG: It's not a collapse, but a collapse essentially [in that] the Communist Party is no longer running things, because the Communist Party as a system— I don't think that the Chinese people are going to substitute it with another communist party. I think that essentially in the beginning, at least, we are going to have a period of instability and it will be a very different system.

KAUFMAN: Let me just stop for a second. Nick, do you share that view? Is it collapse or transformation?

LARDY: I think it's much more likely to be— collapse cannot be ruled out, obviously, but I think it's much more likely to be transformation. And certainly one of the concerns that Gordon highlighted years ago in the book was the weaknesses of the financial system. I do think that they have embarked on a very vigorous program to try to improve their financial system, particularly since about 1998, '99. We could talk about this in great detail on some other occasion. But I think they have made some progress. It may be there will be a bit of setback because they lent too much money in recent quarters, but structural transformation is ongoing within the financial system. I think, that makes it increasingly unlikely that there will be a collapse that's triggered by a financial crisis.

KEIDEL: Let me just say quickly that I think the only chance for collapse is if they do something really stupid, like accelerate reform of the financial sector, open their capital accounts, make some political reforms that are too rapid; the system is changing already so fast. And I would argue that many of the changes we've seen are things that were tried, experimented, maybe went too far and were pulled back. And we notice the pullback, but we don't really put emphasis on the change which has been promoted in many levels in this government.

And I think one lesson they learned was at Tiananmen. And the popular vision of Tiananmen was [that] it was a pro-democracy movement. I was there that May [of 1989], virtually all of that May, and talked to students and researched it later, and my analysis is that that Tiananmen uprising is what happens if you do not compensate the subsidized, cushioned urban population that's damaged by reforms. They will rise up. And it was an economic uprising that legitimized itself with a democratic sort of gloss.

QUESTIONER: Alice Young, Kay Scholer law firm and Committee of 100. What would you say are the three biggest issues that the United States should be focused on vis-à-vis China relations; not what we are focused on, but what we should be [focused on] in the next couple of years. And what would you say are the strengths and weaknesses of— or whether you can identify who you would consider the next generation of emerging leaders in China that we would be facing in dealing with these issues; not the current group, but who's the next group?

LARDY: Well, I'll just talk about one. I think the biggest challenge, quite frankly, is in the trade area. China is moving ahead very dramatically, forming trade agreements with ASEAN [Association of Southeast Asian Nations], and a number of other countries. We're seeing a great deal of trade integration. Of course, it's built on China's massive import growth of the last three years. China's responsible for most of the growth of exports of Asian countries, East Asian and Southeast Asian, and even a significant portion of growth of exports of several Latin American countries as well. But I think we are seeing a very determined push outward on the Chinese part as reflected in their trade diplomacy. And I think the biggest challenge to the United States is whether or not we are going to be able to participate in that or whether we're back to a system in which most of the trade liberalization that occurs is going to be within Asia. APEC [Asia Pacific Economic Cooperation], of course, was a hope at one time, but we have seen very little success, so that would be a bridging mechanism for bringing in the U.S. and other countries in our hemisphere. So I think that's the biggest challenge. I think it's something that has gotten inadequate attention in the current administration. We have negotiated trade agreements all over the world, and very, very little in Asia, and those that we have negotiated and completed are with insignificant trading partners. So I think that's the biggest challenge China currently poses on the economic front.


KEIDEL: It seems to me that the United States is prepared to deal with an emerging China as a confrontational force in the world. We're not so well prepared to deal with it as a collaborator in facing many of the world's problems. And so, for me, that is an essential shift in thinking, particularly at the top of this administration and in the Congress, that has to take place. What it might look like, for example, in the short term would be not much different on Taiwan, which is clearly the only thing in my mind that could erupt. I think there the relationship is being managed quite well. We are making contingency plans, although we may not have the capability right now to do much about problems in the Taiwan Straits. But there are contingency plans to do something. But military exchanges have been really underplayed, to say the least, in this administration. And that kind of cooperative buildup, I think, is really called for.

In terms of leadership, I, as an economist— maybe I'm biased, but just watching, I think this focus on individual personalities in Chinese leadership, particularly in the post-Mao, post-Deng [Xiaoping] era, is grossly overplayed. You have really collective leadership. They're looking for people that as figureheads can poke their heads up and be visible in the world, but the decisions are made within the party, the Politburo, and hammered out in day-to-day policies at the Cabinet level and then implemented by the ministries.

And I— so I basically don't get very excited about who's the next person, because I think, in fact, if Deng Xiaoping had died when he was in prison in early 1976, someone else would have led the economy. The forces behind what's happening in China go way back to the 19th century, and in this regime they go back to preparations for the second five-year plan in the 1950s, reforms in the early '60s, and that that practical bent is really what's driving this government, not any particular leader.

KAUFMAN: Any thoughts, Gordon?

CHANG: I think the most important issue— I know this is a breakfast devoted to the economy— but the most important issue for the United States is also the most urgent one. That is China's stance on proliferation and especially its relations with North Korea and Iran. These are issues which are life-and-death ones for the United States. This is not just a question of a trade balance, about little bits of money here and there. This is something which affects the vital security of the United States. And China has been— over the course of the last 30 or so years— been the arch-proliferator in the world. Obviously we're going to face a very difficult decision about whether we confront or engage China in terms of its proliferation activities. We've tried to engage it, and success so far has only been limited.

In terms of the second aspect of your question, which is the political system, you know, we've got to remember that Deng Xiaoping not only picked Jiang Zemin; he picked [current Chinese President] Hu Jintao. So the real challenge for this collective leadership— and I think it is a matter of importance, Bert— is whether this collective leadership can have a smooth transition, where there's no dominant political figure, like there was in the form of Deng. So in a sense, I see that this is going to be a very important transition, much more important than the one to Jiang Zemin or the one to Hu Jintao. And we are facing a question of whether a collective leadership can actually replicate itself. And that's a very difficult thing to do. The Soviet Union did it, but eventually it picked a Gorbachev, and essentially the challenge for China's leaders will be not to pick another Gorbachev for China. But I'm afraid that when you look at the moods and the attitudes of the lower bureaucracy, there clearly is a desire for change. And so China's leadership is going to be very hard put to find somebody like— who's another Hu Jintao.

QUESTIONER: Scott Greathead, Wiggin and Dana. I want to pick up on what Bert Keidel, with that fascinating statistic that China represents only 6 percent of the U.S. export deficit. China's big commodity, of course, is labor. Nobody's mentioned labor issues this morning yet. But an independently organized labor force in China represents big changes, potentially, in the economy— the price of labor goes up. And it's a big issue for foreign exporters, of course. There has been some grass-roots organizing in foreign-owned factories. But China's labor union is kind of like the banks Bert described. It's not a labor union at all. There is no independent labor force in China, and the Chinese government has always opposed that.

There have been doors opened though in the last few months with the government suggesting that foreign-owned factories should let their workers organize. They've told Wal-Mart that they should let their workers organize. They may— China's Wal-Marts may be the only Wal-Marts in the world that have organized work forces in them. [Laughter] And there was even scheduled this week in Beijing a remarkable meeting of the OECD's [Organization for Economic Cooperation and Development] Trade Union Advisory Commission, which happens to be headed by [AFL-CIO President] John Sweeney. Last week that meeting was abruptly canceled. Sweeney and— the visas for the other labor leaders that were going to appear were canceled. What is behind this strange ambivalence in the government's attitudes toward labor issues? And to what extent are labor issues going to be important factors in the next five or six years on the economic and political scene?

LARDY: Well, I'm not sure there's any ambivalence. I agree with your characterization. The All-China Federation of Trade Unions is a sham organization. And this is the organization that China wants Wal-Mart to install in its operations in China. So I think they've been against organized labor and labor standards. So I don't think there's any ambiguity in the PRC [People's Republic of China] policy.

KEIDEL: I would say that the fact that it's a sham organization is a way to characterize it. It is an organization. To my mind, the Communist Party and urban registration with special status as an urban citizen is probably the largest union and probably one of the most effective unions in the world in terms of elevating the perquisites and standard of living of its workforce well above their productivity. And that's one of the reform problems— that you've had to accommodate this labor force that came into the reform era enjoying a standard of living high above its productivity, supported by relative price differences with the rural sector. And as those prices changed, all the pressure came to bear on state-owned enterprises to continue to raise their wages and their costs, which then effectively bankrupted many of them. So I think, in that sense, they have a dual labor system— that they've had almost too much protection of their labor force traditionally and they're now in the process of refining it.

Where they really need labor organization is in the rural sector and in lots of foreign-funded firms by Taiwan and Hong Kong where the safety conditions are abysmal, the working conditions are abysmal. And so I think that there you often get the central government at odds with local governments. And here we have a failure of the Chinese overall political system. It's not a federal system. You don't have a local on-the-ground presence of the central government in every county doing its checking and sharing. They have to work through the local government. And so I think there's a lot of work to be done there. I wouldn't put organizing the urban labor force high on that list because it already has such a privileged position.

KAUFMAN: Thank you. All the way in the back.

QUESTIONER: Nick Platt, Asia Society. Given the rapid economic integration between Taiwan and the mainland economies, is declarative independence for Taiwan even a— in any way a tenable position or a sustainable position over time?

CHANG: I really don't see why not. I mean, we always tend to think that economics determines everything else. But if we look at American history we can see that probably one of the most important factors determining political behavior is cultural. And, essentially, what's happened over the last 10, 15 years is the creation of a Taiwanese identity. Even with the growing rapid economic integration between the mainland and Taiwan, which we've seen, we've nonetheless at the same time seen the rise of the Democratic Progressive Party and see the rise of independent sentiment. So, essentially, the two are not incompatible.

And you know, from Taiwan's perspective, they don't really have to declare independence. They are in their own sense independent. They've got a different name to the country, a different flag. And essentially we could see a continuation of the status quo, especially if there is marginal change in Washington's policy. But what you've got is a population that has decided it is not part of the mainland, and despite what Beijing thinks and what it tries to do from time to time, there really has not been a growing connectedness between the people in Taiwan and the mainland, despite the economic integration.

QUESTIONER: Thank you. Ralph Buultjens, New York University. I'd like to ask the panelists a question in simple layman's terms, and especially from you, Dr. Kaufman, too. Assuming China was a stock, would you today buy, sell or hold? [Laughter]

LARDY: Yeah, I think the answer is clear. It's a buy because it's the most rapidly growing economy in the world, the long-term fundamentals are quite favorable, high savings, very competitive markets, very open. Some of the key problems, for example in the financial sector, I think, to some extent, are being addressed. I mean, it's been a terrible place to invest, particularly in stock markets. They have a terrible stock market. There is nothing to buy. The country's a screaming buy, and most companies that are listed on the domestic exchange you'd want to sell.

KEIDEL: Yeah, I would say the important premise is your "if," if China were a stock. China's not a stock. There's no identifiable instrument that you could say will be an index for China. If you can find one, buy it as fast as you can and as much as you can get.

CHANG: Well, the title of this program is "Enron or Google," but we should remember that every Enron was once a Google. [Laughter] But I will give you a definite answer to your question, which is if China were a stock, well, I'd buy today but I certainly would sell tomorrow, especially after Nick talks. [Laughter]

KEIDEL: I would just footnote and say, "But not every Google becomes an Enron." [Laughter]

KAUFMAN: Next question.


KAUFMAN: I think I have some friends here who are traders and they would be much more nimble than I am. I think right now it's a trading stock if you could really trade it.

QUESTIONER: Thank you. Louis Kraar, journalist. China seems to be flogging a lot of Enrons on stock markets these days. In Singapore, China Aviation Oil, a subsidiary of a state company, lost a half a billion dollars, didn't tell the shareholders, but gave the parent company time to flog more stock to unsuspecting shareholders. Air China, selling stock which— if you read the prospectus, selling stock in Hong Kong, the money goes to an internal bank that can be lent on to anyone else in the group. Tell me, how long can China go on flogging these Enrons and have people buy them?

UNIDENTIFIED: Well, I'll make an observation, not just as a presider. There's a lot of money slushing around the world, and money wants out, and— whether it's in the United States, in China, or in Europe. And this is just one of these manifestations of substantial money availability and go-go attitudes. I don't know.

KEIDEL: Well, I would say— just as I would say about the banking system, the "what" system, if you say stock market, I say the "what" market because these issues or so-called issues are brought to market in an administrative process. And my whole approach to financial-sector reform in China is that it can't go very far in terms of on-the-ground effectiveness before it's done something about the client base. And so enterprise reform, accounting transparency, those things have a long way to go before you have a client base where you can identify a business plan; the management isn't appointed by the Communist Party, which is the case for most— virtually all major Chinese corporations today; and where you have a sense that you know what's really on the books. And until that happens, whether you're a so-called bank or whether you're an investor in the stock market or you want to buy a bond, you're groping.

And so I think that's what's happening. We are in a process where China's building what I call— you know, that they reverse the role. Architects have form following function. The Chinese are putting form first in terms of what a banking system may look like, and then the function will have to come later, after the client base has sort of been sorted out. And that's— I think this is just one piece of that overall process.

KAUFMAN: In a room full of investment bankers, I would never dare to even touch that question. [Laughter] Last question.

QUESTIONER: Frank Weil, Abacus. Going on, the question about how you would do it— the answer was "buy China, but you can't." How would you invest in China today if you wanted to invest?

KAUFMAN: Well, I'll make an observation. [Laughter] I would want to make a direct investment with a well-connected indigenous Chinese partner who is highly reliable. [Laughter]

CHANG: In other words, you wouldn't do it. [Laughter]

KAUFMAN: I didn't say that! I didn't say that. I gave you my premise for doing it. [Laughter] Any other thoughts?

KEIDEL: I think the direct way right now, but I would make it [inaudible]. I don't think you want to be tied up with a partner that has all of the baggage of Communist Party management and so forth. So I— but you also need to be big. I think you may have trouble if you're just a loner. And you may want to have presence in several regions so you can play one off against the other. But I don't think it's a time for an easy guess on portfolio investment.

KAUFMAN: Well, I want to thank our three panelists. I want to thank all of you for being here. And we could continue this for another hour. And a year or so from now, there will be another session probably on the same topic. Thank you all. [Applause]






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