China's Economic Readjustment

Thursday, July 23, 2015
Reuters/Kim Kyung Hoon
Gao Xiqing

Former Vice Chairman, President, and Chief Investment Officer, China Investment Corporation

Nicholas R. Lardy

Anthony M. Solomon Senior Fellow, Peterson Institute for International Economics

David Daokui Li

Mansfield Freeman Chair Professor and Director, Center for China in the World Economy, School of Economics and Management,Tsinghua University

John C. Bussey

Associate Editor, Wall Street Journal

Introductory Speakers
Zheng Xinli

Deputy Director of the Economic Committee of the CPPCC; Permanent Vice Chairman, China Center for International Economic Exchanges; Former Deputy Director of the Policy Research Office of the CPC

Following introductory remarks by Zheng Xinli, deputy director of the economic committee of the Chinese People's Political Consultative Conference, the Peterson Institute for International Economics' Nicholas R. Lardy, Tsinghua University's David Daokui Li, and China Investment Corporation's Gao Xiqing join the Wall Street Journal's John C. Bussey to discuss emerging trends in China's economy. The panel considers the ongoing structural economic adjustments in China, as the ruling communist party shifts the country's economic model from an investment-driven paradigm to a more demand-driven one. At the center of the discussion is the question of China's future growth rates; the panelists consider whether the era of the "China miracle"—a period of high annual GDP growth—will give way to an era of more modest economic performance. Over the course of the discussion, the panelists comment on Chinese consumer spending, the country's recently volatile stock market, and U.S.-China relations.

BUSSEY: This is John Bussey. I'm with the Wall Street Journal. I'm delighted to be presiding at today's Council event.

Our subject is the emerging role of China's economy. It's probably the next phase of the emergence of Chinese—China's economy. You don't go in 37 years from being off the grid to the world's second largest economy without some bumps along the road and we'll describe some of those and—and—and explore some of those today.

You know, is the China miracle over? Are the days of faster growth gone for good? Can the transition that China's economy needs to now make be done without instability domestically or in some way destabilizing the—the global economy? We'll get into some of those subjects over the next hour and 10 minutes.

We have a fabulous panel of experts to hear from today.

Zheng Xinli—Xinli was—Xinli was the—one of the architects of China's current reform program.

Gao Xiqing was the former president of the China Investment Corporation, the—the very large sovereign wealth fund, the fourth largest in—in the world.

David Li is an economist and adviser to the leadership China, with—in Tsinghua University, which is a partner with the Council for this event, I should add.

And Nick Lardy, many of you know, is with the Peterson Institute, an expert on the—the Chinese economy and has written—written widely on it.

Just a—a couple of housekeeping notes. We'll have simultaneous interpretation for Mr. Zheng's comments and any other comments that are made in Mandarin in the course of the proceedings. You should have your devices there to—to hear.

If you can put your cell phones on mute or stun, something that doesn't, kind of, interrupt the—the—the proceedings, that would be much appreciated.

This is on the record. And when you are asking questions later on, if you would just please identify yourself.

So, what we'll do is we'll have 10 minutes of opening remarks from Mr. Zheng, describing—the Council has asked him to—to address what are the three big challenges that are facing the Chinese economy. But he'll also be able to update us a bit on where this reform effort stands.

Then we'll go to our panel discussion, which will react to Mr. Zheng's comments, but also add to them, for about 30 minutes. And then we'll have 30 minutes of Q&A at the end.

So, with that, please welcome Mr. Zheng to the stage.


ZHENG (THROUGH TRANSLATOR): Ladies and gentlemen, good afternoon.

Happy to have this opportunity to talk about the Chinese economy and the development of Sino-U.S. economic cooperation, the outlook for its future development. Happy to have this opportunity to share my views.

Rapid development in China has been experienced over the past three decades. To date, there are three major challenges that are faced.

The first: insufficient demand or you could say overcapacity supply. Over the past 30 years, there's been a very high rate of investment. It's gone from 30 percent to 50 percent investment proportion of GDP. And consumption has dropped from 50 percent to just 35 percent.

We have seen an ongoing investment in expansion of production capacity, whereas consumption demand has not kept up with that rapid increase in supply. So now, no matter what you produce, it's difficult to sell.

Over the past 30 years of reform and opening, the challenges that we have addressed have been very focused on immediate difficulties. Now we have to think about deeper, longer-term structural issues, in terms of supply and demand balances. That's the first challenge: supply and demand.

Second challenge is downward pressure on the overall economy. For the past four years, consecutively, we've seen a deceleration of economic growth in China. The first half of this year, GDP year-on-year growth was 7 percent, but these four consecutive years of downward pressure has led to an overall feel of deceleration.

Third, deflation. Our CPI has for the last 14 months been decreasing. This dampens investor enthusiasm and leads to deflation and negative or underwhelming economic forecasts.

So these are the three major challenges I think faced by the Chinese economy.

What is behind these difficulties?

I think, over the past several years, in terms of monetary policy, we've seen relatively tight.

The growth of M2 money supply, from 2011 to 2014, had an average growth of 13.5 percent. In the first half of this year, M2 growth dropped to 11.8 percent.

From 1991 to 2011, a 20-year period, the average annual growth of M2 money supply was 20.5 percent, at a time when the average GDP growth was 10.3 percent. So M2 growth was about twice the growth of GDP.

So, this is an interesting economic phenomenon (inaudible) Friedman curve; i.e., in the 1990s, when inflation was high and economic growth was very (ph) quickly, I came and spoke to Friedman in the U.S. and he had noted the experience of Taiwan, Korea, other economies, where M2 growth maintained at a rate of about twice that of GDP, which is normal.

So, China, once again, corroborates that ratio; the relationship between M2 and GDP.

But because of the challenges that I just mentioned, those three challenges, we can say that these are, kind of, objective results of macroeconomic policy. Only with the correct monetary policy can further sustained economic growth be sustained.

Compare our experience to the U.S. The U.S. has a per capita GDP that's six times that of China's. Consumer spending is also twice that of China's. A single Chinese person spends one-tenth of that of an American.

So it's very clear that the challenges that are springing up now are the results of structural policy deficiencies. Further reform and correct policy rebalancing can certainly provide the potential for ongoing robust economic growth.

At the Third Plenary of the 18th Party Congress, we heard about the plans for deepening comprehensive reforms in China. It's already been over a year, and of the 130 reforms that were listed the majority of them were economic reforms.

These reforms perhaps are different than those of the past. What we are seeing now is reforms that are talked about in a systematic and talked-out approach, as opposed to the, kind of, bottom-up pilot experiments that were done in reforms of the past decades.

Now, over the past year or so since that Third Plenary meeting, a number of implementation plans have been raised to the State Council and are being assessed and prepared for implementation to see whether they are in line with the spirit of the Third Plenary session. If they are inconsistent with that spirit, they are sent back for revision.

There have already been a number of these implementing plans that are seen as mature and being prepared to implement. This includes reforms aimed at releasing authority down to lower levels and streamlining approval processes, opening markets. Also includes opening for the banking industry and allowing more participation from small and medium-sized banks.

And also addresses a very serious issue, which is the rural land reform. Three types of land are both agricultural, collective farmer land, and land that has use rights but not ownership rights are subject to new land reform proposals.

These reforms would allow farmers or rural residents to take a financial ownership of the land and engage in transactions based on those assets. This would allow for the consolidation and, therefore, the mechanization of agriculture, increased productivity in rural China.

We know that there are over 280 million farmers working in the agricultural sector in China. There are 40 million of their children and 40 million (inaudible) spouses of farmers that are not working, so all told, we're talking up to close to—between 350 million and 400 million people.

If we are able to empower them financially using the land as an agricultural asset, then this could unleash a tremendous power in the economy.

Another reform is the reform of state-owned enterprises. According to the Third Plenary of the 18th Party Congress, we need to move from an asset-based to a capital-based public finance management model.

This includes the creation of hybrid public-private ownership models, in which private sector practices are introduced into public entities. Also allow for employee share ownership and management of all (ph) share ownership for state-owned enterprise. And these are all proposals that are being developed.

Not all of the implementing measures have been released, but the vision is very clear and it's certain that these reforms will come to take formation in policy.

Also, financial reform is also coming out on a regular basis.

All of these reforms are focused on having the market play a decisive role in the allocation of resources in the economy, allowing the market to play its full role in China's economy.

Now, the implementation of the Third Plenary spirit, some people are anxious. They think that it's taking too long. There's even doubts, "Will it be implemented?" But this I would ask you all to have faith.

When the central government identifies a clear vision for reform, it will be implemented. It is maybe a matter of time, but I assure it is a matter of when, not of if.

I would also take a moment to speak about economic cooperation between China and the U.S.

Over the past 30 years or so, economic cooperation between China and the U.S. has been critical for the development of China. But the old model of cooperation is perhaps ready for a change, based on the comparative differences between China and the U.S. today.

For example, the comparative differences between industry in China and the U.S. It used to be a completely vertical separation of labor. Now we are moving towards a horizontal collaboration.

In the past, it was U.S. capital moving into China. Now we are moving towards a bidirectional investment flow, especially with all of the treasury debt that China has bought, over a trillion dollars. Some of that has to be converted into equity rather than just debt.

Also, in terms of technology, in the past technology was brought from the U.S. into China. Now China is looking to develop its indigenous innovation capacities. For example, China's applications for patents since last year has already surpassed that of the U.S. We are the largest patent applicant country in the world.

In 2010, the U.S. had six times as many patents as China. In 2011, it was 3.8 times. In 2012, it was 2.8 times. In 2013, it was 2.5 times as many. That gap has been narrowing and has now been closed.

Collaboration in the future is going to rely on an investment protection treaty, or a BIT, a bilateral investment treaty. And we hope that in this year's visit from Xi Jinping we can see real progress towards signing such a BIT. And (inaudible) BITT, adding a T for investment and trade.

And third, signing an FTA, a free trade agreement, between the U.S. and China. We know that the U.S. already has an FTA with Korea. I would love to see an FTA become a topic for future U.S.-China relations.

And we would also like to see the U.S. helping China into the TTP and China helping the U.S. into the RECP, these multilateral trade frameworks. These would be adhesives that bring our countries closer together and allow for greater cohesion as we seek to deepen our cooperation.

I think standing together, cooperating, these two countries, tied by a common bond, will certainly find prosperity.

That's all the time I have for now, but thank you very much.


BUSSEY: So—so—so, Nick Lardy, Mr. Zheng just described a rather ambitious transformation. He talked about deregulation, about opening the private sector, about the reform of the SOEs.

The American business sector doesn't really quite see it that way. It sees a lot of industrial policy. It sees still very strong SOEs standing in the way of investment in—in—in China. It sees anti-monopoly wall (ph). It sees indigenous innovation drives.

Can you square the circle for us? Are we underestimating how much privatization is happening in China and the strength of the private sector?

LARDY: Well, I think, you know, it's a complicated situation. You can point to examples that would support different points of view. But I'm going to—when I look at the aggregate data, I think it's very clear that the private sector has been driving economic growth in China for a long time.

Yes, there are industrial policies. The state, yes, has complete control of very important parts of the service sector, upstream oil and gas and a few other things. But most of the rest of the economy, the private sector dominates in terms of output, in terms of employment and also in terms of investment.

We just got the first half numbers from the statistical bureau. Sixty-five percent of all investment in China in the first half was undertaken by private firms. So the state has become smaller, but it is still dominant in a few sectors.

Now, I'd also like to make a couple of comments on the—on the challenges that Mr. Zheng outlined.

I would say that the downward pressure is not—it shouldn't be thought of as entirely a challenge. In some way, it should be welcomed because it is primarily because of its moderation and the growth of investment in property.

China had been overinvesting in property for quite some time. 2010, before the downward pressure, property investment was growing at 33 percent, then it was 28, then it was something in the—in the mid-20s, then it was 18. Last year it was 10. This year it's probably going to 4 or 5.

And that has dragged down industrial growth: steel, electric power, and everything else. But China has been massively overinvesting in property, so this was a correction that had to come sooner or later. And of course, in the nature of things, sooner is—sooner is always better.

So yes, it's a challenge, but it's also, I think, a positive development.

And then the other one—I'll come back to it later, but on deflation, yes, deflation is an issue in China, but it's not the kind of issue you would expect to see in many economies.

First of all, China's still growing at 7 percent. I don't think it's likely to slip to 3, 4 or 5.

BUSSEY: If that's a real number that you can trust, that 7 percent.

LARDY: We can—we can go into that, yes.

Deflation's not a problem in an economy that's growing at the—at the mid-single digits or greater. And investment is still too high. You know, deflation, Mr. Zheng said, is leading to more caution on investment, but China's still investing way too much and so I do not share his assessment that monetary policy has been too tight.

If we're going to rebalance this economy and move even more towards consumption and away from investment, we need a—a continuation of—of moderately tight monetary policy.

And deflation—third reason I'm not so worried about deflation is that is, in significant part, due to declines in global commodity prices, so the—China's importing deflation.


Mr. Gao, we heard a lot of structural description, very big, broad themes. And yet we have episodic events as well in—in—in China that—that we take note of.

Notably, between November and a few weeks ago, the stock market had run up over 100 percent. Now, you've see that burn off in what's being called a crash, but it's—it's only a—you know, a—a fifth or—or so or a fourth of the—of the...


GAO: A third—a third of the market.

BUSSEY: ... of the market has come down, so people have made a lot of money since last November, but they—there's a sense of a kind of a reverse wealth effect. There's a—there's a crash undergoing in—in China. There's government intervention in the markets.

You were, among other things, a securities regulator. What do you make of this? Is this just a—is it just an episodic event? Or is it a sign of financial instability in China that we should be more concerned about?

GAO: Well, there are bifurcating trends there and very different views right now.

The one thing interesting about China today is that the views are so diverse now than ever in the past 60 years of China's history, because if you—I mean, not China's history; PRC history—that people—the first time, you can see 50 percent of people voting for one side and 50 on the other side. And the same is true with this so-called market crash.

I don't see so much of a problem as the—the redemption of the market value, which people say, "Oh, we lost 20 trillion yuan" (inaudible), but 20 trillion yuan, you know, in—putting it in perspective, it's only one-third of the market.

And the—and also, as you just pointed out, most people who claim that they lost everything, lost their shirt, is actually want to say, "Well, when did you get in?" you know.

The problem, of course, it's—it's a small (inaudible)—I know it's small, you know. By Chinese standards, a small group of people, they say 20,000 accounts of people with over 5 million yuan lost their shirts. They say. "Well, we wiped out a middle class," I think (ph). Middle class in China is about 20 million, so 20,000 is a very, very small number there.

So I worry about as much about the number itself, but I worry a lot more about a way that—you know, how it happened and how to deal with it.

(inaudible) recently (ph) so much debate on why would the government come in. They have this term; it's called saving the market by violence. (UNTRANSLATED)

And—and it's actually spelled out as a positive. Many people, they say, "Well, yeah, the government needs to use violence to save the market, because there's that much of a panic in the market."

I—I—I, sort of, panicked, especially those two days, so every day I'm not scared, you know, I still try to get a free lunch at the CIC. So I go there and all these people are at the CICs, everyone's like, "Oh, my God, you know, do you know what happened?"

I said, you know, "It's—by (ph) looking at the number, I don't—I don't see that much problem." They said, "(inaudible) panic." Well, it's because of two things: one, they—they—a kind of a leverage people use, 'cause by—you know, at first, (inaudible) leverage? I said we—"Our law is so strict that leverage is only at the margins and only allowed after 50 percent."

So—and it's not—it's actually coming down to, like, 10 or even 5 percent, very much like what happened in 1929 in this country.

Why is that? Simply because, you know, we have different regulators and the stock market regulators don't care about that much, because much of the money that's—that's lended for the—for the—for the margin is outside of the securities regulation.

And it's all from the banking firms. It's all in the banking side. It's their problem. And we actually—we want to encourage people to come into the market.

And in fact, you—if you read the newspaper in those days, and official websites, all of them were saying, "Oh, we are going to have a big (ph) bull market." And it's—it's more or less sponsored by the government, (inaudible) "OK, everyone, get in."

That, to me, was a big concern, because, you know, people complain about during the years of (inaudible) and Xie (ph), we also had, sort of, People's Daily articles pumping the market. I said, "No, there's a huge difference." Because even though at the time, I—I wasn't for it, at least twice during—during his time, he came out and said, "Well, the market's very—too high. This—this is what I would call irrational exuberance of the market, so be careful."

You know, when you say that, some people get nervous. But this time, the—the first time the government comes out and said, "Oh, the market's too low. Let's all go in. The market is never going to come down." And then, of course, a lot of people get in; you know, the sort of mentality there.

So I think that's an issue when you—when you actually state sponsor a bull market...


BUSSEY: Right. We—we—we—we would never have that here. We would have a Fed-sponsored bull—bull—bull market.


We don't call it a state-sponsored.


But, Mr. Li, Mr. Zheng talked about deceleration and metabolizing in the economy all of these changes that are happening, and seemed to suggest that some of the deceleration is as a result of the natural, organic process of the kind of rapid and the large changes that are—that are going on in China.

How—how slow—how—how long will the slowdown last? Give us—give us your sense of the trajectory before China's economy picks up.

LI: A wonderful question. I think many investors are very concerned about this issue. But before answering you, I can't help but making a side comment.

I was shocked. I am still shocked by the small size of the room. I claim (ph) the CFR must have the world's largest ratio of reputation divided by physical space.


In fact, this is our mission. Our mission of Tsinghua University to come here is to learn from CFR. So together with me, we have many, many colleagues and entrepreneurs from China, right? I don't have time to introduce one—one by one.

OK, anyway, also I'm very happy to see some of our old friends, colleagues. Robert Garris from the Schwarzman Scholars Program, of which I'm the dean. So, nowadays, I'm pushed to spend 100 percent of our energy in the Schwarzman Scholars Program, who lives next door from here, I guess. I was told. Not too far from here, right?

So, if—if I don't say things coherently, blame Stephen Schwarzman, OK?


That's (inaudible), Stephen Schwarzman—Schwarzman Scholars Program. (inaudible) will end very soon, OK. Call your young friends and apply, OK?


Anyway, so very important question. When will the slowdown end?

According to our analysis—we did careful, careful analysis. We strongly believe, by the end of this year, perhaps latest, the first quarter—the first half of next year, this big cycle of slowing down, starting—started four years ago. The trough will be reached in the coming half-year, at most one year. That is the economic growth rate will be stabilized just perhaps short of six, seven percent.

Why is that? Because I fully agree with Nick's point, because the current slowdown is mainly driven by the slow growth of fixed asset investment, which accounts for 40 percent—even more—45 percent of the GDP.

And within the fixed asset investment, the biggest chunk is property market investment, which usually accounts for 28 percent of fixed asset investment, but now we have—we are beginning to see early signs of recovery of fixed asset investment in the property market.

Why? Because in the first-tier and second-tier (inaudible) cities, we have already been watching, month on month—for example, May versus April, this past May—increase of property price, also sales volume.

As a consequence, the inventory of property in this first-tier and some of second-tier cities is coming down. So, according to our historical pattern, the investment in property market (inaudible).

OK, so therefore, my—my—my call—OK, you can call me six months, one—one year, maybe I'm wrong, OK?

OK, so my call is that in the coming six months, the—the GDP slowing down will be stabilized.

But the issue is when will the economy stay at the bottom? Was further sliding down our way to recover?

Also, based on our research, we strongly—I strongly argue that the economy, after staying at the bottom, will recover in term of GDP growth rates in the coming three, four, five years; we don't know, depending on the pace of reform.

So, therefore, we are reaching the bottom of a big U. I hope—I hope the bottom is not too wide, maybe as narrow as one year or—or three months.

BUSSEY: What's GDP growth rate at the bottom?

LI: At the bottom, just below 6—7 percent; around 7 percent, you know, depending on how you count it, because—by the way, the challenge, GDP is much more difficult to measure nowadays than before, because of the fundamental structure change.

The traditional sectors, like iron and steel and cement, are slowing down. However, there are exciting new sectors.

Actually, sitting with us, we have private entrepreneurs, like Mr. Zhan (ph)—Mr. Zhan (ph) sitting here.

He's been doing lots of investments...


BUSSEY: Walk us through what—what happens on the other side of the U. What—what takes China's economy back up? What—what fires the economy?

LI: Three new engines of growth have to be fired—have to be fired up; kickstart, right?

The first engine of growth is urbanization, which we're still not reaping the benefits.


BUSSEY: Slightly over half of China is urbanized.

LI: Exactly.

BUSSEY: You've got more to urbanize.

LI: Even the half of the population which supposedly have been urbanized are not really urbanized, because many of the people living in cities do not have live-in permits, residency permits, not enabling them—enabling them not to buy—buy a car or buy apartment. So they are not part of a city.

They are like—almost like illegal immigrants in New York City, right?


Live—they live under fear, OK? So that's the—that's the first engine of growth.

Second engine of growth I call greening up of the industrial capacity. Let me give you one quick example.

In Beijing, our sky, frankly speaking, is not as blue as New York City. Why? Because near (ph) in Beijing, we have 300 million tons of steel production, every day, going out.

The sky was cleaned up only before the APEC last November, when the production stopped...


... to welcome your president, among—among the leaders of the world, right?

So that production capacity has to be greened up. And in the process, there will be lots of investments.

If China spends one year—right?—to—even to green up 1 to 10 percent of the production capacity of steel, I calculate 1.25 percent of GDP growth will be there.

The third engine of growth is consumption. Consumption, according to my research, if you measure it properly—not official data. OK, I can tell many stories of that, right? Official data relies upon household surveys, where rich households refuse to cooperate with the National Bureau of Statistics.

Only poor households cooperate, because they get money by reporting their income and consumption. So, in the end, our national data only reports the low consumption of households.

Anyway, so consumption as share of GDP has been increasing since 2007. Now it's around 47, 46 percent. I think give us another five years, that ratio will go up as high as 50 percent, gradually moving up to the U.S. level. It may never be the U.S. level but, however, you know, 60 percent would do it. That will become a new engine of growth.


Nick—Nick Lardy, foreign investment into China has been one of the engines in the past for—for growth. You see—one sees a lot of things happening that could be interpreted as favorable to foreign investment companies looking to China to put more money in. At the same time, wage rates are rising. There's a different wage arbitrage calculation, labor cost arbitrage calculation undergoing.

When you talk to companies—when you talk—when you advise or speak with those who are interested in putting money into China, what are you telling people?

LARDY: Well, I—my view is, going off of what David said, there's a big structural change under way, so any—any foreign investment, indeed any domestic investment, has to take into account the fact that this is not going to be largely an investment-driven economy as it was for much of the past decade. It's going to be much more consumption-driven. That means the—the growth sectors are going to be particularly services, which follows also—follows from what David said.

So I think there's a big sectoral change that—that companies have to take—take into account.

So, traditional industries are going to grow much more slowly and new industries are going to arise. We see it in—in many Internet businesses and so forth.

So I think the landscape's dramatically changing. And foreign investment in China is not going up very rapidly these days. It's been—it's—it's going up a little bit. It's still very—it's still relatively large in absolute terms, but it's never really been very big in terms of the share of total investment, you know.

Foreign investment in China is a few percentage points of total investment. So, most investment in China is domestic. The real contribution foreign companies make is more in technology and marketing and management and other—and soft areas rather than—rather than the financing.

LI (?): Yeah, talking about service investments, the U.S. competitive advantage against China in investment, in my view, perhaps are in following in the following sectors: financial sector, very competitive. However, China's very careful with this, because...


(UNKNOWN): We're not opening it up.

LI: Yeah, they—they—most likely, they will be very cautious in China, right?

Second sector to be very competitive, your lawyers. Lawyers, New York City, right? Lawyers, you get some of that up here, right? So, again, there are issues there, because China is more—we have a lawyer here. We have a Duke-trained lawyer. That's enough (ph).


Lawyer, right?

(UNKNOWN): (Inaudible)

LI: Exactly.

Literally, Chinese security law for the stock markets. He's one of the architects of Chinese (inaudible). I don't blame—blame him for this freefall, OK?


BUSSEY (?): They took away all the sections that would cure the problem.

LI: Yeah. Internet service, frankly speaking, U.S. is not that competitive. Amazon, frankly speaking, is struggling in China;, not making money. I don't—I don't think this is—this is an open—this is a—like, this is open knowledge, right? I'm not revealing anything, right?

Anyway, so and consulting, consulting (inaudible), OK. I'm not sure, McKinsey—McKinsey's there. I'm not sure, OK? I would bet they are—they are equally competitive as some local ones, OK.

So these are—this is the landscape of service investment.

BUSSEY: Neither of the two economists picked up on this notion of a concern about deflation that Mr. Zheng added to his list of issues. Are you worried about that? And what's the chance of a deflationary trend in China having a contagion effect in the rest of Asia, perhaps globally?

LI: I am not worried about deflation, because deflation's an enemy, because usually it's a cut in your wage rates (ph)—right?—Japan. Japan faced inflation, because the nominal wage is coming down.

So I was told, in Japan, husbands are having smaller, smaller amount of money in their jackets, in the pocket. The housewives are not giving them money—right?—so they don't go drink after work, I hope (ph), I was told. I read New York Times, OK, right?


Your newspaper, OK.

Anyway, in China, to the contrary, wage rates of blue collar workers have been increasing double digits, nominal, faster that GDP, because we're facing a shortage of blue collar workers. A construction worker with four years of experience is earning much more than a graduate of Tsinghua University Finance Department.


In four years. I'm not saying 10 years, right? In four years.

So this is—so I don't worry too much—too much about deflation.

BUSSEY: Mr. Lardy?

LARDY: Well, I—I gave my view on deflation. I think I tend to agree with David.

And I don't think it's going to—I mean, obviously, China has transmitted some deflation to the rest of the world, because of the slowdown in demand for certain commodities—iron ore and copper and a number of others that we could mention—has contributed significantly to this very continuous and sharp decline in—in commodity prices globally. It hasn't been the only factor, but it's been a big factor.

But, you know, if David's right that we're near the bottom of the U, you know, that—that factor will disappear.

Remember, the overall—you know, the GDP deflator in China is still in slightly positive territory. This is not an economy with a big decline in prices, as you measure—measure it comprehensively by the GDP deflator.

BUSSEY: And you see the U shape? You agree with that prognosis?

LARDY: I think it's—I think it's a possibility. I don't know what—what—what percentage I would put on it. A lot depends on whether or not this big pickup in sales that David mentioned really continues.

In the first quarter, sales were down over a year ago. But you take the data for the first half, sales were up 10 percent—the property sales were up 10 percent in value terms, and 20 percent in terms of area. So that's contributing to the decline in the inventory that David—that David mentioned.

I don't know if this spurt of sales in the second quarter is caused by some, you know, one-time factors or whether—whether it will be continued. I'm—so I'm—I'm a little more agnostic.

GAO (?): Well, (inaudible) about that part, regarding the—the increase of real property prices, 'cause, you know, the—the—for most Chinese, they—for them, they save a lot. And the money—where do we put the money in? You know, tradition was always in the bank and now stock market or real estate.

And a while ago, when—when everyone was investing in real estate, because the price was going up so fast, but then, the stock market started (ph) coming up. People pulled it out and put the money in the stock market.

And now, this time, you know, the recent years—recent months, if you look at the real estate prices in—in most of the large cities, big cities it's—it's all coming back and prices will start to go up again, after so many months with stagnating or even going down.

So now with this—this drastically violent (ph) saving the market measure, I don't think many of the—the longer-term investors would do—would try to stay in the market. So the money is probably going to come out and go back into the real estate market again.

And that accounts for a big part of consumer price, because, you know, of course you don't have that price but you have the rent. Well, rent has been going up all the time for Beijing. Even during the whole past few years when real estate price is stagnant, rent still keeps going up, just like the—the wage for blue collar workers.

So I think that's still a big factor. When people say (ph), wells factor (ph), that's something that you have to take into consideration.

LI: The demographic picture of the whole country in terms of regional distribution is changing rapidly. (inaudible) people are getting richer, of course, in comparison with 30 years ago. When people get rich in China, people do two things.

Number one, they move to warmer cities—warmer cities. They stay away from the cold cities near Russia's far east—right?—the north-eastern part.

Second, they move to large cities, especially young people. That's why Beijing, as Dr. Gao just said, the rents have been increasing rapidly. In Shanghai, same thing. In Shenzhen, same thing, right?

So there's a tremendous structural change in the—in the property market. So the first-tier cities are still expanding in terms of construction or property investments. Some second-tier cities where the weather is—the climate is warm is increasing. Others are decreasing. So there is tremendous change.

So I would argue this structural change in the property market is driving investment in China. So if you go to invest in China, watch very carefully the demographic change across locations.

BUSSEY: Mr. Gao, we—we've talked about investment in China, investment into China. You used to run investment out of China into the—into the rest of the world.

I know that you're not president anymore, but given the trajectory that you set the CIC on, what does all of the activity in China now, the reform, the restructuring, the inward-looking aspect of economic policy in China at the moment—what does that say about the CIC's activities and—and the momentum for investment abroad? Is that a critical part of the economic reform effort in China? Is it likely, do you think, to stabilize, to diminish as a result of the activities at home?

GAO: Well, I don't think that has that much to do with it, because CIC was always—it was created—from outside, we say, "Oh, this is (inaudible) fund." It sounds like a lot of money. But in China, it's sort of marginal—a marginalized organization, it seems to me, because we have over—almost $4 trillion and you give us $20 billion; that's small pocket money.


And then when we first started, every government ministry warned us not to come back (inaudible). OK, now you're out. You go out, (inaudible), don't take any money back. Every time I saw the minister of commerce and saw, you know, the minister of the (inaudible) he says, "Don't come back."

So for CIC, whatever happens in China only has a sort of marginal effect. But one thing does affect CIC tremendously, which is the policy, the reform of state-owned enterprises—that the top management people's compensation is coming down. And that comes to haunt CIC (inaudible), "OK, you need to come down with your salary as well."


Our salary—for the first two years—I mean, we had an order from the central government that top management salary come down. But that effect only six people. But then, you know, gradually they say, "Oh no, everyone else will have to come down."

Up until the time I left, I mean, I had been resisting. I said, "No, absolutely not, because if that comes down now we may as well go home because, you know, nobody's going to be hired."

But now that's still a major pushback from—I won't say who, but various government agencies, that if you want all these people who make ostensibly too much money—which, you know, according to, you know, the market, we are the highest paid M.D.s; I mean, we get probably 40 (ph), 30 percent of the market in their comparable profession. But it's, "Oh, this is way too high. This is much higher than the migrant workers." Of course it is.

So that effects people, you know, their morale. And some people would leave just for that reason because they—they are afraid that that may effect their family welfare. But I hope that's a short-term thing. I hope eventually that will change.

BUSSEY: So we see some deflation some place in—in China.


Let's go—let's go to questions, if we could. And if you could tell us who you are, identify yourself and just remember that this is on the record.

Yes, please. Right back here in the middle?

QUESTION: Jeff Schaffer (ph), J.I. Shaffer Insight (ph).

Mr. Zheng talked about a reengagement of the U.S. and China on the BIT, which he would even extend on TPP accession by China, and even on a—a bilateral free trade agreement. Zhou Wanji (ph) used joining the WTO to drive reform in China for quite a number of years. Is it likely that this kind of process, if it were to be activated, could help to energize the third plenum reform process in China, or does it really not matter for what happens in China?

BUSSEY: A little bit of foreign pressure. Who'd like to answer?

Mr. Li, do you want to?

LI: It's hard this time around because—because of the Internet. In the Internet, people see (ph) many things and our leaders do read the Internet. They're extremely savvy. They have teams of people summarizing the views of the Internet. And these views in the Internet do influence their policy. Even though we don't have election—you know, election-based democracy, in terms of opinion, we are very democratic.

And in the Internet, you know, you know the game, right? The radical views oftentimes are—win the game, right? And unfortunately, the nationalistic views are much more favored, weighted in the Internet. So this time around, using foreign pressure to push domestic changes would be very difficult.

BUSSEY: Mr. Gao?

GAO: Well, I have a similar view.

This time around, the populist movement in China, the overall sentiment is such that people—every time you come up with anything, there immediately will be a—you know, a circulation of articles, claims, usually not very logic and very—all sort of slogans saying that, "OK, we're selling out now; we can't do that."

And the problem (ph) government sometimes doesn't listen to that. Governments get nervous about the popular sentiment.

But overall, I think we—you know, Mr. Xi is a strong leader and I hope he stays that way for a long time. And eventually if—you know, he would have to bite the bullet, so to speak, and, you know, shut up those people who are making noises and do something about it. But at present time, it sounds like it is a major problem.

BUSSEY: Another question? Yes, right back here, holding up that piece of paper.

QUESTION: Thank you. Dan Rosen (ph) with the Rhodium (ph) Group.

Dr. Zheng, and I think all the panelists, pointed to very near-term additional reforms being on track that are very important to getting to China's positive outlook for GDP growth, 7 percent or so: things like additional capital account opening, full liberalization of deposit interest rates.

Given the experience with the ability to regulate capital markets over the past month, do you think there's been a change in thinking in the leadership about how competent and ready China is to oversee something like an opening of one's capital account to global capital markets?

LARDY: I'll take that.

BUSSEY: Mr. Lardy?

LARDY: Well, I certainly take—and I have no inside information, obviously, but I think if you're talking about the top Chinese leadership in the financial sector, I don't think they've really changed their views and I think they don't—I'm not sure. I don't think they're reading the lesson that we should slow down or put the brakes on financial reform.

And in part, this is—my—this judgment is informed by, you know, what Governor Zho (ph) has said. He has said repeatedly that China's capital account opening is going to be managed and gradual. And frequently he is quoted as—or is incorrectly quoted as saying that China's going to have a fully open or freely open capital account. I don't think that's what he has in mind at all.

I think he has in mind a very gradual process in which there will still be quotas on most channels of flows, both inward and outward. And I—he may be wrong, but I think he believes that that can work. And so the failure of CSRC to regulate the market for equities, I don't think he would believe is a good reason to slow down on this kind of more general financial sector reform.

But as I say, this is just my analysis. I have no, you know, near-time insights into his thinking.

BUSSEY: Mr. Gao?

GAO: Well, I agree with you about the part about Governor Zho's (ph) view, which I'm very familiar with. But the problem is that he—you know, he has responsibility for his part of the government. There are other government agencies which, you know, have—obviously have their own views. And one of the problems to this so-called crash happened is exactly because of the non-cooperation of these different government agencies.

So right now there's so much, you know, all the—all the hoopla is about shutting down the financial derivatives market, shutting down financial futures, stomping all the short selling for six months. And people actually came out with all these articles saying that, "Oh, look at Americans; they shut down the market when the stock market crashed." So I had to—you know, at first, I was—I was very determined not to say anything but then people asked me and I said, "That's really nonsense. You know, they don't shut it down for six months. They shut it down for one minute, five minute, an hour, OK?" So you have to educate a market.

But the regulators definitely would be influenced by that. And right now they—they've already put up all these orders for the market to stop functioning and—in certain pockets. That's going to take for some time because, in my experience in the past 20-some years in—you know, in and out of regulators, every time we shut down something, it's usually during a (inaudible), and that's easy. You do it in one minute but then it takes forever. One market will shut down. 15 years go; still not open yet. Why? Because, you know, every time you—when you open them everyone has to sign off and if—and any one of them say, "Oh, I have some doubt about that," then you can't do it.

So the overall macro side I think we're still on that track. But the problem now is all in details. China's market is a lot more sophisticated today and you have all these small pockets of things which incrementally will see the reform going forward, but now, one by one, they're stopping it, just because of some crash.

BUSSEY: Should the government have stayed out and just let the market correct?

GAO: No, I wouldn't say that. The government is already in, the problem is. So you can't stay out. But my proposal to the government is that government form a committee and (inaudible) study (ph) in and within three months' time come out with a proposal and say, "This is the reason why it happened and this is what we need to do," because otherwise people are going to be always wondering.


Let's get to more questions. Right here.

QUESTION: William Hesseltea (ph), Access (ph) Health International.

You didn't talk about health care at all. Health care has a potential to be a major source of investment. In our economy, it's 17 percent of our GDP; maybe too much, but a lot. It has a major capacity for input from overseas, both in terms of capital and knowledge. So I wonder your thoughts about the importance of health care.

And it also has the possibility, if people think they're going to get health care, of encouraging more consumption.

BUSSEY: And more saving, right? People fear that they don't get health care. That's why the savings rate is so high.

Who would like to...

LI: Dr. Gao is much closer to retirement than I am, so he knows more.


BUSSEY: But you look rather robust.


Don't take that the wrong way.

GAO: Well, I have to explain to people why I'm involved in a lot of these neck-breaking extreme sports. I said, "Well, having worked for the Social Security Fund for so long, I am determined to try to die quickly."


BUSSEY: Keep it funded that way.

GAO: Joking aside, health—health care reform is a major thing. It's one of two things that's constantly on the mind of not only the leadership but really all the masses.

And we know, you know, you go to—on any given day, you go to the hospital—you know, I constantly go to hospitals for my injuries and my shoulders, my leg, you know? I break my legs all the time.


But when you go there, you know, you—one hospital in China, number three hospital in Beijing, which is good for sports injuries, any given day, you have, like, you know, 3,000 people. It's like a supermarket. People are going everywhere. And the doctors' office are all way overworked.

So we are—I think the government is very—is very keenly aware of that and they're trying to do a lot of things to change this. So I—you know, just sort of—I agree with you. This is a huge market and we have to do something about it.

BUSSEY: Mr. Zheng has a comment.

ZHENG (THROUGH TRANSLATOR): If China were to enter the TPP, would that help to implement the domestic reforms?

I think that, in fact, it would have a big impact in promoting the implementation. Even reforms that were not written into the Third Plenary documents (ph) would be helped forward by the entrance into TPP because the reforms that we've seen over the past 30 years have been largely promoted by China's integration into world trade frameworks.

BUSSEY: So—so the importance of foreign pressure, gaiatsu, as they say in Japan—do you—do you buy that or is it not going to be a factor in what happens?

LARDY: This comes back basically to Jeff Schaffer's (ph) question. And my answer to that question would've been yes, if—if we had an ambitious BIT it could be a catalyst for change in China, particularly in the service sector, which should be the big driver of growth but is one of the most closed sectors in China, or at least certain parts of it are.

The reason that I'm cautious, and maybe, again, sharing David's view, is it's not clear what China is going to gain from a BIT. There was something very clear that China was going to gain from joining the WTO that allowed Zhou Wanji (ph), or at least contributed to his ability to overcome a lot of opposition, and that was getting permanent normal trade relations in the U.S. market. This was a huge challenge for China in the '80s and '90s. Every year they had to worry about whether or not they were going to get renewed for MFN status in the U.S. market, which even then was the most important market.

I don't see any immediate plum that China gains from formulating and agreeing to an ambitious BIT with the United States. Yes, in the long-run there would be substantial gains, but the—the negotiators can't point to something that is as prized as that was, and so I think they have less leverage overcoming vested interests in certain sectors that are not interested in seeing more foreign competition.


GAO: There is one thing, though. Next year, the, sort of, grace period for the so-called market economy status is going to be gone and many people there are very nervous about it.

You know, one—that means that by 2016, China will have to renegotiate with every one of these major countries about their recognition of China's market economy status. If they don't, let's say, then immediately, you know, our prices are going to be affected. I mean, immediately many of these courts or their regulators are going to treat China as a, sort of, a non-market economy and they'll have the surrogate country to have a different price. That would be, you know, regarded as a dumping country or—if that happens, then of course it'd be a big issue.

But I think a lot of people in China are very much aware of that and that may be a major—you know, we all know every time anything happens, "Oh, this is the Americans doing it. So let's sign a contract with Americans and if Americans agree that we're a market economy then we're fine, right?"

BUSSEY: Other questions? Yes, please. Right here in the red.

QUESTION: Hi. Thank you very much for joining us and sharing your comments today.

My name is Mili Gilbert (ph) from Matan (ph) Capital Management.

I was wondering if you would speak a little bit about Hong Kong. How important do you see the economic relationships between the mainland and Hong Kong today? And—and how do you see those economic ties influencing the political dynamic?

BUSSEY: We have not talked about political reform in China.


Can you have—I'm tagging on to your good question. Your question should be answered first but we have not talked about political reform.

Can you have economic reform without inevitably people wanting to be politically enfranchised as well?

But anyways, let's go to Hong Kong first and then if you would touch on politics.

Mr. Li?

LI: The Hong Kong issue actually is a bit more complicated than just simply political reform.

The Hong Kong issue is that over the past 15 years, the mainland policy towards Hong Kong is that we'll keep you—your business being prosperous, we'll send you tourists, (inaudible) your streets—right?—making the people on the street becoming inconvenienced, you know, compromise their life. However, business owners get the benefits, right? So—and also give your business tycoons good deals to develop in mainland China.

That kind of policy has—has been making the society more and more fragmented, right? The younger—the young generation feel very angered. They are not only becoming—complaining about the—the streets becoming more crowded. They are also competing with the mainland students who work much harder, almost by definition, because they're poorer, right? The mainland students are coming to Hong Kong, crowding out the Hong Kong students going to their own universities. I know this because I used to work (ph) in Hong Kong. So the young people are revolting against these kind of policies.

So, before talking about political reform, I think—in Hong Kong, I think mainland policy—economic policy towards Hong Kong definitely will change and it's changing now.

And also, let me add one more thing. The importance of Hong Kong is not Hong Kong per se; it's Taiwan. Because Hong Kong was held as a model for the future for the potential solution of the cross-Strait relationship. So the central government (inaudible) in make sure Hong Kong is not only economically prosperous but socially less disharmonious.

BUSSEY: Is there a future for political reform in China, Mr. Lardy?

LI: Depending on how you define political—really, I mean it. I mean it.

There are a lot of subtle changes in the political system. For example, two months ago, the Central Committee published a document about how to involve those non-Communist Party members in politics through the political consultative process. And that's regulation—that's party regulation saying that at all levels of government, some positions—say out of five key positions, one must be reserved for non-Communist Party members. And also, that says, for example, every—twice a year—twice a year, a local government has to hold consultation meetings with non-party members. This is a very significant document.

By the way, the Central Committee's documents sometimes, as a fact, can be more binding and more important than the legislation. That's why a person like Mr. Zheng is very important. He's (inaudible) documents.

BUSSEY: Mr. Gao?

GAO: Yeah, I can—I can give you some examples of what I would regard as the progress on the political reform side, even though, you know, we don't want to say the word because sometimes political reform is still regarded as being the effort of the Westerners trying to influence China into a more Westernized country.

BUSSEY: Or diminish the Communist Party.

GAO: Exactly.

So what we're doing—I think the Communist Party knows very well that it has to reform. And it started from Deng Xiaoping, who said that it would start to reform. Even though they don't say that anymore, just look at several systems, judiciary reform, you know? There (inaudible) Party Congress was devoted totally to reform (ph).

And many people say—after the communique came out, many of my friends came to me and said, "(inaudible), aren't you disappointed at the document (ph)?" I said, "Why?" They said, "Well, just look at it. Mao (ph) said the same thing." I said, "No, no. You don't see—you don't know how to read between the lines."

In fact, we have been talking about a rule of law for the past 30 years, but today, for the first time, I say there are all these things—detailed things that you actually look at. It starts to cross this line beyond which it can't return.

For instance, we—now we have—you know, in China, we always have this Communist Party group called Politics and Law Group, which is really a overwhelming czar of all the laws. The police, the courts, the procurement (ph); they all come under that committee. But while they (inaudible) saying that, "OK, now we want that committee to rise from every level of government, which, you know, starts from the township to the county, prefecture, province." Now they're reining it down to provincial level.

So the courts below the provincial level are all much more independent today than before. Because, you know, before, when you have a court and the party secretary there in that leading group will always have something to say. And now they say, "Well, you can't—we can't do that."

And some people say, "Oh, that's not right because, you know, the country—the People's Republic do it." I say, "Look, every province in China is about the size of one of the, you know, 10, 20 large countries. You can't just do that that (inaudible)."

So in that regard, I think we have already made progress.

BUSSEY: Let's get to a couple more. We have five more minutes left. Yes, please. Right over here.

QUESTION: Perhaps this is too simple a question. Michael Evans from a firm called Tiden (ph) Steel.

When China wanted to grow, China grew very quickly. Resources came together. Great improvements were made, like at Tsinghua University. The aluminum industry grew. The car industry grew. The steel industry grew. Everything happened very dramatically, very quickly and made an impact on the entire world.

Sitting and listening to you today, it sounds to me like change on the way down is very slow, very political, very mired in process. What happened to all the action on the way up and the slowness on the way down? This U that you're talking about could go on for years and years.

And although only one of the major economic developments that you talked about was over-supply, over-supply won't change. The demand growth over the next few years in aluminum, in cars, in steel, in a lot of the other things that China has become major exporters of won't eat up the excess capacity. It has to be blown up and destroyed and buried.


QUESTION: So that's a dramatic act that you could take.

And I believe, by the way, if you take something like steel—that's my own industry—there's 300 million tons of too much capacity in China. Were that to be removed from world markets, the increase in global prices would more than pay for the unemployment of the 300,000 workers no longer employed.

What do you think?

BUSSEY: So, Mr. Lardy, is the U going to be—is the U going to be an L?

LARDY: There are a lot of—a lot of variables at play here, I mean, in determining what David described, the bottoming-out. Will it be a few quarters or could it be a few years, or even longer?

I tend to think the dynamic is already in play. Consumption as a share of GDP is rising, even by the official data, which may understate it somewhat. It's been going up for four years.

That's what's driving economic growth now. We're in this virtuous cycle where the service sector is the big driver of economic growth. It's been growing more rapidly than industry, beginning in the second half of 2012. It's generating a lot more employment with a lower GDP growth. So the leadership is much more comfortable not, you know, having a rapid expansion of credit, as they did back in '12 and '13.

And I think that process will get more traction over time. And, as David said, consumption share will rise further and the structure will continue to change.

And, you know, the steel thing is a little bit complicated. 300 million tons of excess capacity, but it's not being used. They're not making 300 million tons that's going into inventory. They have the capacity to make 300 million more tons if the price were high enough, but it's not. And, you know, more than two-thirds of the steel industry is private companies, and when demand falls they cut production.

BUSSEY: We have one minute left. Let's get one quick question, if we could. Very quickly right here.

QUESTION: Mr. Zheng mentioned that China has now increased its patent production enormously. In the past, we were always concerned about protection of intellectual property. Now that China has more of its own patents, do you think the protection of intellectual property will be enhanced?

BUSSEY: Now that they have something to lose, are they going to protect other people's intellectual property as well?

QUESTION: That's the question.

BUSSEY: Who'd like to...

LI: Yes, just want to give you one example. There's already a court set up just for intellectual property rights protection in Beijing and also in Guangzhou. That's a sign.

Let me quickly go back to the first—the other question. The challenge today is not to grow, but how to grow cleanly, not only in terms of environment protection but also in terms of politics. Cleaning up corruption and push for fast growth are very difficult to combine. So right now, cleaning up corruption, which in the short-run is—frankly speaking, is becoming the impediment to a lot of reform programs, because people want to be clean first before pushing for things. So that's why the (inaudible) might be there for quite some time.

BUSSEY: We're at the end of our hour. I just want to thank Mr. Zheng, Mr. Li, Mr. Lardy, Mr. Gao, the Council on Foreign Relations and Tsinghua University. Thank you.


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