Understanding the Chinese Economy

Tuesday, June 16, 2015
Aly Song/Reuters

Robert Hormats, vice chairman at Kissinger Associates, and Olin Wethington, former special envoy on China at the U.S. Department of the Treasury, join the Peterson Institute for International Economics' Steven Weisman to discuss the Chinese economy and how Chinese President Xi Jinping's policies might affect global markets. The panelists discuss a range of issues, including the slowdown in China's year-on-year growth rates, the readjustment of state-owned enterprises, and the prospects for growth in China's consumption rates.

WEISMAN: Well, good afternoon, everyone. Welcome to the discussion here at the Council on Foreign Relations on China on the eve—not literally but almost—of the newest session of the U.S.-China strategic and economic dialogue.

My name is Steve Weisman. I'm with the Peterson Institute for International Economics. And our guests couldn't be more qualified today to talk about the situation, the economic tensions and difficulties facing the U.S. and China in their relationship.

We'll start with a look at the domestic situation in China, broaden it to the U.S.-China and international situation. And I'm sure hovering in the background will be the security issues that have grabbed so many headlines in the last month or two.

First, Bob Hormats, Robert Hormats, who is now vice chairman of Kissinger Associates. I've known Bob for many years and he's been in and out of government for longer than either of us would care to remember and has most recently served as undersecretary for economic issues, the—energy and the environment in the State Department under Secretary Clinton.

Olin Wethington, also now is chairman of Wethington International; he has been a former special envoy on China in—for the Treasury. And both these speakers have been traveling and visiting China on and off for over many decades and bring a huge amount of experience and understanding and knowledge. So, without further ado, we should get started.

I think, gentlemen, let's start out by noting that I—actually, I was in China myself a month ago for several days of meetings with economic officials. And they seemed pretty confident about Chinese economic growth, which as we all know, has been slowing down some recently. And there's a lot of concern expressed of is this going to be a soft landing, is this the new normal for China?

So, let's start, Olin, with you discussing your view of how much difficulty and the challenges China faces domestically. And from there, we can expand into the international and U.S. China situation.

WETHINGTON: OK, thank you. Very pleased to be here. I look forward to the questions from the audience and glad to share this panel with you, Bob and Steve.

I think the rubric for thinking about the Chinese economy today is the term you used, Steve, the new normal. This, in short, is a set of policies not yet implemented in full, certainly, but a set of policies that are designed to steer China toward a lower but more sustainable growth trajectory.

This is out of awareness that the previous model, the model driven by capital formation of fixed asset investment exports, is not long-term viable. That is so because of declining productivity, linked to misallocation of capital, of rising debt, rising inequality, social issues that extend to the cost of corruption on the economy.

I would say at this point the policies that have been articulated are the right direction. There is broad consensus behind those. The implementation I think is another matter. I think the new normal is directionally correct; it's directionally pointed the right way, in general. But the pace is very, very slow, and the resistance is very, very high, in my judgment.

From a macro perspective, if one were to start there and look at some numbers against which one can judge progress under the new normal, although there's been a decline in the rate of growth of investment and because the economy as a whole has slowed, there's also been a decline actually in the rate of growth of consumption.

The move toward middle class demand, toward larger consumption I would say has not made, at this point, a whole lot of progress. If one looks at household consumption under the new normal, it is still stuck in the high 30s, which is about where it's been as a percentage of GDP, which is about where it's been for the last six to eight years.

So the challenge is that the regime faces are quite large. As I said, I think the resistance is quite formidable. And Xi Jinping and the leadership still have quite a ways to go. They are saddled by what I would call the legacy issues of debt, of the—of the predominance of SOEs, of inequality. And I would also add to that list the cost of environmental degradation for which they do not yet have a clear solution. Let me stop there, to kick it off.


HORMATS: Well, I think Olin's laid out very thoughtfully what the issues are. And I think he is right that it is proved more difficult to implement a lot of these policies than perhaps was anticipated at the outset.

I think when you look at China, there's a tendency to look at the growth rate and the Chinese now are predicting something around 7 percent. What's very important is to look deeper than that and look at the sources of growth.

And I think this is the problem that the Chinese are now tackling. That is, the sources of growth have been in part exports, in part investment, particularly real estate investment, and lots of bank lending to state enterprises. The difficulty with that is that the export-led model is not in the volume that we have seen over the last decade or so sustainable because a lot of the bigger markets, particularly the industrialized country markets, are not growing as rapidly.

The debt creation problem is not sustainable for reasons that Olin has just indicated, and that is they're building up a lot of debt, particularly real estate debt, that is going to be very difficult to repay. And indeed, in some cases, companies that had that debt are trying to get rid of it by issuing equity; the equity market's booming, so it's easy to do that today, far easier than, say, two or three years ago. And a lot of that has been local debt.

I think it's important to realize that a lot of the construction in China has been not delegated to localities by the central government and not sponsored by the central government, but actually initiated by localities who want to create jobs in their areas. So, they have utilized special corporations that issue debt or borrow money from banks to finance a lot of this building and then foreigners have done some of it.

But a lot of this building spree can't continue. So you've got a lot of companies that have to deal with this debt problem and a lot of municipalities who own or sponsor entities who have very large debt exposure; this has to be dealt with.

And in fact, the government has indicated and has announced that it is going to do a number of things, particularly two major reforms, and that is separate localized corporate debt, which is essentially enterprises that do things like building buildings or doing other kinds of things, and municipal bonds of a traditional nature that finance more direct government services like we have here.

So this is designed to separate the municipal debt from what we would call corporate or enterprise debt, and make a distinction between the two. Then the localities now have to issue municipal bonds.

They're going to be under a very, very clear government mandate which is going to watch what the money is used for. The goal is to hold down the creation of municipal debt or debt in the provinces—provinces and cities. So this is one major change.

One other major change that's important is land use rights in rural China. They've made a number of very important breakthroughs in dealing with this so that people can in effect keep their land or keep contractual ownership of land and have others farm the land. The aim is to restore a greater degree of—of growth in rural areas by utilizing the land more efficiently.

But it goes back to a point that Olin made. You've got to use your resources in China if you want to grow to the next stage much more efficiently.

And I think, say, if you look at the source of growth, one of the reasons it's not growing—China's not growing as rampantly is they've not been using their resources as efficiently, particularly financial resources efficiently. And I think the government knows that if it's going to grow more rapidly, there has to be a much more market—market-oriented use of resources.

The government has said the market should drive the economy and drive allocation and in fact determine the allocation of resources. But it's very hard to restructure the system to enable that to occur.

WEISMAN: So, let's plunge into the—some of the irritants that are likely to come up at the U.S.-China dialogue. The—a major irritant over the last 10 years or more has been the Chinese manipulating or, is the loaded word, its currency levels to drive its exports which led to this huge accumulation of Chinese dollar reserves.

That has exercised Congress, successive administrations. It seems to have gone away as an issue because the deficit has shrunk, but been replaced right now by another irritant, which is what is China going to do with all these reserves.

They want—and what I heard, and I'm wondering if this is going to come up, is they resent that the U.S. has opposed their desire to create an infrastructure bank in Asia. That, combined with the U.S. policy on TPP, which the trade issue is in limbo now, get - has—the Chinese are increasingly saying that the U.S. is holding them back or wants to hold them back economically and by extension politically and maybe even militarily.

How big of an issue do you think that is right now? Bob first.

HORMATS: I don't think—I think it's something that the Chinese have, as you quite rightly point out Steve, have pointed out to us in conversations. But it is certainly true, the first point you made, is very important. They have a lot of resources; they have a lot of financial resources, they have a lot of reserves. And as any entity, corporate or government that has a lot of reserves, they want to diversify them.

They don't just want to have them put in treasuries that pay relatively low rates of interest. So, they're going to be, and in fact, are already increasing their foreign direct investment in the United States and many other parts of the world as well. And we are actually beneficiaries of some of that investment. They're buying companies here that need capital; it's a market-oriented process.

We have CFIUS that deals with a very small sliver of Chines foreign investment. That sliver is the investment that relates to national security issues, but it is a very minor portion of the overall range of possibilities for China to invest here. And I think they've come to understand CFIUS if not to feel totally comfortable with it.

The issue of TPP, it used to trouble the Chinese a lot. It doesn't trouble them as much anymore.

WEISMAN: Not today, anyway.


HORMATS: Not—certainly not today, that's true. And even before today, it didn't trouble them all that much. In fact, Li Keqiang, the premier, had made comments that there were possibilities of cooperating with TPP.

The reason it doesn't trouble them so much is, first of all, they have their own group, the RCEP, the Regional Comprehensive Economic Partnership, that they're working with on—for ASEAN and ASEAN's free trade partners, which will be also very important. There's some countries that are participating in the RCEP negotiations that are also in TTIP, in TPP, like Australia, for instance, or Singapore, Brunei, Vietnam and Malaysia.

So there are - there are two negotiations going on. TPP is in the negotiating process, if not the legislative process here, well beyond the other one, the RCEP. But they're less uncomfortable with that. And they—by and large, virtually every country that's in TPP is the first, or in some cases the second-biggest trading partner, from their perspective, with China. So they're not particularly concerned about the U.S. boxing them in or containing them, but the question is is there somewhere down the road an opportunity for China to join TPP. I think the answer is probably not yet.

But if TPP does come up with the very high standards, it's going to attract other countries in the Pacific. And China at some point, if it doesn't join, may try to find ways of developing a relationship with TPP to reduce trade barriers between the two or RCEP could decide to do this itself in a collective fashion. So I don't think that problem is as substantial as in the past.

I do think that it's very important—we have something going on with China now which is the bilateral investment treaty. The quality of that treaty is going to be very important. I like the idea of a bilateral investment treaty with China. I think we're going to be able to do a bilateral investment treaty before we're able to do a full-scale big trade negotiation. But I do think it really has to be a very high quality.

The E.U. is also negotiating one. I think the standards in that, how it deals with state enterprises, how it deals with intellectual property, how long the so-called negative list is. These are all very important parts of this.

If you can get a really good one, a robust one that addresses some of the 21st century kinds of issues, then it will facilitate investment. If it's—if it does not have high standards, it really will look good on paper but won't achieve the goals that the American business community wants in order to feel more comfortable in investing in China and it won't deal with some of the issues that Chinese companies that are now seeking to invest more in the United States want.

So a high quality, and I mean high quality in terms of dealing with the real issues of state enterprise, intellectual property and a variety of other things, negative list, is going to be very important.

WEISMAN: Olin, do you think as the Europeans seem to think that the U.S. has made a mistake in opposing the Asian Infrastructure Bank that China has launched with great fanfare, as a segue into addressing these larger irritants?

WETHINGTON: Well, opposing I think may depend on what timeframe one's looking at. I think there was a sense that the dominant feature of U.S. policy toward the AIIB some months past was one of opposition. I'm not sure that's quite an accurate read.

But today, the view has shifted. The view now is let's work with the AIIB, let's encourage other multilateral lending institutions to collaborate with the AIIB, let's also insist that the AIIB function on the basis of high standards. And that is the way in which the Chinese today are framing this initiative.

I think the—going back to the U.S. position for a moment, I think the U.S., even at the outset, got the policy right.

But they got the diplomacy wrong, which is to say the policy focus at the outset I think was predominantly on saying to allies, to the Chinese, to the policy community generally, that if this bank is to come into being, it must operate on the basis of high standards, the kind of standards that other multilateral lending institutions over many decades have come to determine are the correct kinds of framework standards for a multilateral lending institution. Transparency, openness, safeguards, open procurement; these are the kinds of principles that should guide the AIIB.

But I think—I think the U.S. got the diplomacy wrong. And I think it was misplaced for maybe three reasons. One is I think the U.S. had—did not realize the depth of Asian desire for infrastructure development. This is in a sense a very on-the-ground observation. And I think—I think Asia in general and other parts of the world reacted very favorably to that—to that dimension.

We have tended to rely in our international economic policy on creating the rules of the game. We focus on trade, high standards on trade. But we've not had I think historically a strong development agenda.

I would say in contrast, China has focused more on the economic development agenda in its foreign policy; large, enormous amounts of bilateral lending that are directed toward development. And I think we do not sense the extent that this is a requirement, a political requirement, on the part of Asian governments.

I think secondly, we underestimated the desire that exists globally for China to become part of the international, global, institutional order. And we I think somewhat reflexively tended to see this as a distinct parallel Sinocentric institution, which it may turn out to be. But the broader desire for China to be integrated into the international order on the part of many countries, and I think this was what was driving European opinion; I think we underestimated the depth of that—of that feeling.

So I—we badly, I think, misplayed the diplomacy of it. But we do have and should have I think very legitimate concerns as to the rules and the standards by which the AIIB operates. And we ought to continue to pursue that set of issues and we ought to do it in cooperation with our allies, many of whom are now members of this bank.

HORMATS: And I think—and I think it's important to put what Olin said into context. China, while the United States is sort of fumbling around on this question of TPP and TPA and TAA and doesn't seem to have any sort of consensus on where we're going or the importance of TPP from an economic point of view or from a geopolitical point of view in Asia, the Chinese have a very well thought out and very broadly based strategy. And I think this is very important to understand in terms of what is going on—the thinking in the mind of Xi Jinping and Beijing.

The Chinese have recognized the fact that they, for political reasons and economic reasons, need a more integrative approach with Asia. They want it to demonstrate to the other Asians that the rise of China can be also beneficial to them, which is as Olin said why they've done a lot for development in the Asian region and also South Asia and elsewhere; Pakistan's a good example of that. So it's to create what they call win-win situation.

Second, it's good for China from an economic point of—point of view to improve the prospects of countries in the region, economic prospects, because they become bigger markets for Chinese goods.

The third is that geopolitically, China understands that this is an area where they have tensions on some issues like the islands of the South China Sea and the barriers and the—and the all kinds of other factors that are in the South China Sea; but the—and the Chinese recognize that this is an issue. But at the same time, they're trying to demonstrate the region that what they're doing is going to help their prosperity. So from a geopolitical point of view, it sort of cushions some of the kinds of frictions that are emerging in the region.

So they have the Infrastructure and Development Bank; they have a Silk Road Development Fund, an infrastructure fund. They have the Silk Road silk belt project or what they call One Road, One Belt project, which is to integrate the countries from an infrastructure point of view by land and by sea.

They're increasingly building up a series of relationships on the financial side. China's beginning to open up its financial markets to foreign investment, first with a link between Shanghai and Hong Kong on equity. But more broadly, China is now trying to integrate itself more into the global monetary and financial system. They want the RMB to be part of the SDR, to be a reserve currency.

So what the Chinese are doing, they have probably the most comprehensive and proactive international economic policy or set of international economic policy initiatives that any country has had over the last couple of decades. It's well thought out, it's very comprehensive, it serves China's domestic interests, it serves our interest in a broader network for integrating with global energy markets, it serves as a way of integrating global trade and global finance.

So China's very proactive on international economic policy and—which makes it all the more important that the United States not back off from the one single economic initiative we have in the Pacific, which is TPP.

WEISMAN: Olin...

WETHINGTON: Let me just...

WEISMAN: We can go to questions...


WEISMAN:—in a minute. But I just—I don't know what you—make your comment quickly.

But address also, I wonder if it isn't unrealistic to think, though, that the political dimension of these economic ambitions in the South China Sea—I mean, it's all Silk Road. You know, One Belt, One Road is fine, but when they start building ports in Sri Lanka or whatever that could be used by the Chinese navy, whether the security establishment's concerns are going to enter into the discussions.

Olin, why don't you...

WETHINGTON: Well, I was going to say I think—I think as Bob's indicating, Xi Jinping is different I think than his predecessor. He is fashioning a more assertive policy in economic—international economic matters; AIIB is only one component. But he is not leaving the existing order. I think he is hedging his position and seeking to create alternative institutions that over time might be more suited to some of China's interests.

But I think—I think the AIIB's a—should be a wakeup call for the United States in the sense that it needs more in Asia than simply a trade policy. It needs a broader policy that includes a very significant developmental component. We've got to up our game; we've got to up the level of commitment, the amount of resources.

We have in the Asian Development Bank a very mature institution. It can certainly be criticized, and rightfully so. But we ought to be asking ourselves now, is this a moment for reform in some of the multilateral lending institutions that we have relied on post-war? Because my guess is the status quo will not continue to serve us well and we will see other initiatives pursued by the—by the Chinese.

I would also add, simply because we haven't mentioned it here today, legislative dimension again, the IMF quota bill. The significance of this as it relates, I think, to the legitimacy, at least medium term, of the IMF is central.

In my view, it rises on the monetary side to the same level of significance as TPA does on the trade side. And I think if the Congress does not pass the IMF quota bill, China now this year is—holds the presidency of the G20. We will be approaching I think a moment of some legitimacy in that institution as well.


WETHINGTON: Let me stop there.

WEISMAN: Thanks (ph)...

HORMATS: I agree on the trade. We need to go beyond trade. I think we've got to get the TPP first and then build on that.

The critical part of the TPP is it demonstrates, if it passes on a bipartisan basis, that the country is supportive on a political level of a more proactive set of policies in East Asia and the Pacific which can enable us to build.

We did have—and when I was there, I don't know where it is now, what we called an interconnective policy for ASEAN. So the United States was providing a lot of support for ASEAN connectivity on electricity, electric grids, things like that. And we also had our own Silk Road project, which was designed to connect Afghanistan with the rest of the region, particularly East Asia and South Asia, after American troops left so they wouldn't have to have its economy rely on poppies.

The fact is, however, that it took a lot of money. We didn't get a lot of money from the Congress and therefore, a lot of the projects that we thought would be helpful aren't.

So the Chinese are willing to create a lot of money—provide a lot money to create these relationships, build these relationships. The United States is not in a position or willing to put a lot of money into these infrastructure projects and that leaves China giving the Gwadar in Pakistan $46 billion; we're not even going to come close to that this year.

So I think they're—they're really, they—not only do they have a strategy, but they have a lot of money to back that strategy up. And it will have geopolitical and geostrategic implications for sure, as you've indicated.

WEISMAN: OK, thank you. So let's turn now to the portion where audience members are invited to join in the discussion. Please wait for the microphone, speak directly into it. Please stand, state your name and affiliation. Please keep questions and comments concise to allow as many questions to be heard. And to remind you all that this meeting has been and continues to be on the record, got it? OK. Yes?

QUESTION: Hi, Esther Lee, formerly with the Obama administration. So today, I think Donald Trump announced his bid for the presidency. I don't know if that brings our number to 20-something.

Of all the presidential candidates that are announced, which do you think has the most informed policy when it comes to China?


WEISMAN: All right. Well, we can move to the next question.


HORMATS: I would just—having worked for Hillary Clinton for four years and visited China with her on several occasions and the other parts of the region, I think she has a very thoughtful, knowledgeable approach and understanding of China. I think she understands the issues, the positives and the negatives.

And, you know, she's got a great deal of experience there from her conversations with Chinese leaders, including Xi Jinping, Li Keqiang and many of the others who were—Wang Yang, people like that, who really are at the top of the leadership in China. So she would know these people already and be able to work with them.

WEISMAN: Olin, unless you want to address something (ph)...


WETHINGTON: I'm going to—I'm going to duck the partisan question.


HORMATS: Because there are 21 Republicans...

WETHINGTON: I don't know where she was on TPA, but...

WEISMAN: Yeah...



WEISMAN: For example. OK, let's go here and then to the back.

QUESTION: Thank you. We're already off to a stimulating start on the questions. Esther Brimmer, now at George Washington University.

HORMATS: My former colleague.

BRIMMER: Indeed, indeed, Bob. Very good to see you. And also at McLarty Group.

WEISMAN: See if you can come up with a less of a softball for him.


QUESTION: Well, it's actually a question about institutions. When Bob and I worked together, I was then an assistant to the secretary for international organizations.

I wanted to pick up on this question of reforming our international financial institutions. Indeed, we created great global institutions; China's following our model, in effect.

But on global institutions, we created a time when we basically had wealthy countries and poor countries. And now happily, over decades of development, we now have middle income countries who care about investment, who need different types of things from international institutions.

WEISMAN: So, could you ask the question?

QUESTION: Yes. In terms of what would be the specific recommendations to improve both our—the—let's say the International Monetary Fund, assuming we pass—pass the expansion of the quota?

And secondly, particularly there's a network of agencies within Asia and we've looked at how to improve that. Are the specific next steps that perhaps U.S. China could cooperate on, in terms of updating our institutions?

WETHINGTON: That for me?

WEISMAN: Go ahead.

WETHINGTON: One I would start with would be, as I mentioned earlier, the Asian Development Bank. I think already internally, President Nakao of the—of the bank has taken an initiative to expand their lending capacity. He would increase it I think by 2017 to about 50 percent more. That would bring it from about 20 billion a year up to 30 billion; still only a small piece of what's required.

But I think secondly, the ADB could do more by way of mobilizing private resources. It's in a position to address issues of governance, perhaps more aggressively.

If financial institutions, private financial institutions are to be drawn into the infrastructure game more than they have been in the past, issues of governance, of rule of law, of the climate within borrowing countries, those badly need to be addressed. And so, the process of raising standards in countries I think the ADB has a - has a role to play there, as does the World Bank, I think more than it has to-date in elevating those standards. That will probably do more than any other single thing to draw private money into infrastructure projects.

I think the fourth thing the ADB could do is to shorten the processing time, the design all the way through decision making. It does take longer than it should.

But I would also put on the table a fifth thing I think for consideration. And that is whether the time has come, particularly in light of other initiatives that we're seeing in Asia that we've mentioned, for the Asian Development Bank to consider a further capital increase.

Now, that may sound like a preposterous suggestion; in today's climate, it would take some years. But this question of lending capacity of resources, if we're going to play in the developmental space more aggressively, I think has got to be confronted.

Prime Minister Abe has already spoken to this in the last several weeks. He's proposed a very significant expansion in the ADB's lending capacity. And I think the question for us is are we going to join with other shareholders in that institution and boost its capacity and leverage it through more assertive policies that bring in private financial institutional funds into infrastructure development.

There's a lot of history there, and the AIIB itself is going to have to face the same kinds of market-related and governance issues that other multilateral institutions have faced historically. The market will have a great deal to say about whether the AIIB is successful. And my guess is it will not be successful unless it comes to many of the same conclusions that other development institutions have reached. Let me stop there.

WEISMAN: I—there's a gentleman in back that I sort of promised to have a question. And then we'll come back down here.

QUESTION: Chang Shin (ph), Voice of America. I have a question about—you mentioned about China, it seems that obviously it has its own strategy. And we're talking here—we're talking about AIIB.

Actually, previously we talked about China's footprint in Africa. And recently, they also talk about something like China's pivot in Latin America or so and also our allies in Europe and they're just talking about more like how important is China to the U.K. economy that, like, recent press release on the U.K. report.

And does it mean that—we talk more about the AIIB. And what do you understand—what's a clear Chinese strategy here at this point?

And also, how do...

WEISMAN: OK, why don't we stop there?

HORMATS: Well, I would say China has a broad—it has a very clear regional strategy which I've described which is One Road, One Belt, New Silk Road, AIIB, the Silk Road Infrastructure Fund, trade negotiations with ASEAN and ASEAN's free trade partners. It just concluded a free trade area with South Korea and a free trade agreement with Australia and is now negotiating a bilateral investment treaty with the U.S. and with Europe.

So it has a very broad, very proactive, very creative and very well thought out international economic strategy, far more extensive than any other country in the world and historically expansive compared to things that have been done in the past.

What China also wants to do is while preserving the broad global system—because the broad global economic system is largely in China's interest, but there are parts of the system—Olin's pointed out one of them, which is the votes in the IMF. But part of the system, the Chinese would argue, is based on rules that were developed by Western powers largely after World War II, although they've evolved.

So what China has understood and President Xi Jinping has said repeatedly that China wants to have a greater say in shaping the rules of the global economy in the future and looking at some of the rules that are on the books now and seeing if modifications are needed.

Because the view in China is that if China's to succeed in the next 10, 15 years, the global rules need to be positive from China's point of view, or at least not adverse to China's interests and the China model, which is a more state-centric model than of course the American model.

So it's trying to recruit allies to support changes in the system that benefit China; not undoing the system, but modifying certain parts of the system. So it wants to have closer cooperation with Europe, it wants to have closer cooperation with the developing countries of Latin America, certainly. In Africa, it's a huge investor, particularly in East Africa. It's recruited other countries of the region to work with China.

So I would say that it has a very strong regional strategy but it also has a much more proactive global strategy. It's no longer a passive player in the global system which is was five or 10 years ago. It now wants to play—and this is a big difference—it now wants to play a much more proactive role in shaping the global system because it realizes that its own domestic economic depends on the global economy more and more and it wants the rules of the global economy to be more congruous with China's interest.

WEISMAN: I'm going to use my prerogative to go to Professor Negroponte.

QUESTION: Thank you. John Negroponte. I had the pleasure at various times in my career of working with both of your panelists and it's been a great discussion.

Olin, I have a question for you about the word development. I don't want to drill down too far into this, but in this town, and given the history of AID and our foreign assistance policies, I mean, development markedly shifted in philosophy a number of decades ago from major infrastructure projects to all sorts of other stuff, I mean, whether it's policy issues or community development or appropriate technologies and so forth.

Aren't you suggesting here a fundamental reevaluation of what our foreign assistance philosophy ought to be or might want to be, in terms of contemplating, once again giving priority to infrastructure issues if we're going to compete in this global economy?

WETHINGTON: I think I'd like to say a qualified yes to that. I mean, I think we have to be much more engaged on infrastructure issues in Asia, maybe other parts of the world, because those issues are important to governments that we seek to have a relationship with.

I do not think that that necessarily means large budgetary outlays or direct lending from U.S. government entities into infrastructure. We will not do that; we should not do that, but I think we can be part of mobilizing broader resources, particularly from Asian allies, that could substantially lift the lending capacity of existing institutions with relatively little budgetary outlay on our side.

I think secondly, our strength in Asia in the economic field comes not so much from our lending as from our values with respect to governance. Asian countries want us there; they do not want us to leave.

I think among the majority of countries who I consider either friends or like-minded in a macro sense, there's great receptivity to our values of open markets and diplomacy. And we ought to play that in a very active governance agenda, I think, that can be accomplished for very little budgetary resources. And that is the key to drawing in global private financial institutional money which wants to invest long-term.

Unless we change the governance environment, the political, the regulatory environment in these countries, even Chinese projects will not succeed, in my view.

And I guess I might take a little bit of issues with Bob and his sense of the comprehensive, well thought out nature of Chinese international economic policy. Yes, I do think there's a significant strategic dimension to it and they are moving in some areas that—outward that they haven't done before. But I see less consensus within China than maybe your comment suggests.

There is a significant, in my observation and dealings, a body of opinion at senior levels in that government that recognizes the limitations of checkbook diplomacy. The examples of failures are multiple; they are large.

Institutions that have been major lenders, policy banks, do not want to lend into situations that are questionable in governance terms, in political stability terms and regulatory terms. They are, to some extent—and I would extend this to the financial agencies within the Chinese government—somewhat cautious.

There is, therefore, a kind of—this is simplistic, superficial, in many ways, but I think it's real. There is a kind of division between those who wish to pursue for national power reasons, big power reasons, issues of prestige, of projecting global influence versus those that are more attune to making sound financial decisions. And that is a—that is a divide that is very real within the Chinese government and within the Chinese financial community.

You need look no further than Venezuela. You mentioned Sri Lanka but Sri Lanka has kicked the Chinese out—and Burma. And there are many other examples; one can go to Africa other parts of the world. But there are limits to checkbook diplomacy if issues of governance and environment—that is, regulatory environment and political stability—are not addressed.

WEISMAN: That's very interesting.

HORMATS: You see less of a consensus there than here?


WEISMAN: Good point. But there is...

HORMATS: I mean, I think there...

WETHINGTON: Hard to...

HORMATS: ...I think there are differences of opinion; there's no question about that, as there are in the United States. But—and I do think they have made mistakes, no question about that. And I do think spending money itself is not the answer.

But I do think that if you look—first of all in China, you don't need a great consensus to take great initiatives. We've seen that. If you needed a consensus to take an initiative, China wouldn't be in the WTO because Xiu Wonji (ph) pushed this; most Chinese didn't agree with it but he did it because he thought it was in China's interest, which it turned out to be.

So, I would make the argument that while, yes, there are—mistakes have been made. You can't look at money as buying you friendship because it doesn't always do that; Sri Lanka is an example.

But they have at least a strategy of building out this infrastructure in ways that will strengthen China's economic ties with the region which will in turn benefit China. It will give them more opportunities to find sources and transport oil back to China from various parts, even through Myanmar, where they—where the relationship has deteriorated a little bit but the pipes are still being built. They've built this relationship with Pakistan including focus on Gwadar, which will be a strategic port.

They're going to make mistakes as always—every country does. But they have a broad strategy which says, look, the world around China is important to Chinese security and Chinese economic growth.

They need to take a more proactive role in building their cooperation with other countries of the region and of the world so they can have more influence in the global trading system and the global economic system. And they want to strengthen their lengths with the global financial system because they would like to see more money coming into China to help them to deal with some of their own domestic financial issues.

So it is certainly true. Olin's exactly right. Money isn't going to buy you friendship or love or happiness, but there's a strategy there which depends on part on money but in part on these linkages which will create the kind of win-win situation China wants. Not without mistakes—mistakes being made, not without problems. But nonetheless, this is a positive direction for them...


HORMATS: ...and proactive.

WEISMAN: There was a question, this gentleman down here has been patient.

QUESTION: Scott Harold from the RAND Corporation. Bob, good to see you.

HORMATS: Hey, how are you, Scott?

QUESTION: I'd just like to ask Olin and Bob, if you could, talk a little bit about what else beyond BIT we're likely to see out of the S&ED next week. Obviously intellectual property is an issue, cyber's been in the news; not just the hack of OPM but a lot of the industrial espionage. Other areas you might be looking at, currency? What would you like to see?

WETHINGTON: Well, I think they'll have the—I don't mean this to be too glib a statement, but I think they'll go through the normal agenda. I mean, you mentioned many of them. But the good stuff, new agreements, they're going to save until the head of state meeting in September.


WETHINGTON: So expectations, reasonably low.

WEISMAN: What do you—he asked about cyber. How high on the agenda is that these days?

WETHINGTON: Pretty high.



WETHINGTON: Right at the top, I would think.

HORMATS: Yeah, I think—I think the—cyber and protection of intellectual property, trade secrets, business secrets, they're—they—they've come up in every S&ED I was in. They've been very high priority items and I think they are likely to be priority items this time around.

WEISMAN: How do you think we're doing on, you know, this idea of cooperating on cyber rather than complaining about these attacks?

HORMATS: Well, I think there is—I don't—we were actually making a little progress when I was there, particularly on the protection of intellectual property in the area of software where a lot of progress actually was made.

So there is—there's room for progress and I think opportunity for progress for two basic reasons. One, Chinese companies are becoming more and more online. The sort of—the online Internet economy is, as you know, very important.

I just spent some time with Jack Ma of Alibaba. I mean, they're—they're dealing—they have a major campaign to deal with knock-offs because they don't want to be selling knock-offs on the Alibaba website. They also are concerned, as are many other companies in China of that nature, with their own intellectual property. They want the Chinese government to protect it. So China's actually developing courts that will deal with intellectual property.

And I think as more and more Chinese want to have their intellectual property protected because they've developed it themselves, they want rules in China and global rules that will protect it. This is not going to happen overnight but over a period of time.

And the question of cyber, broader cyber issues, cyber espionage, things like that, China's interests and our interests are very similar. The Chinese are vulnerable; they have a system. They're very interconnected; not as interconnected as we are, but they have a lot of new parts of the Chinese economy that are linked to the Internet just as we do.

And I think there is at least a chance with China that their government and our government can say, look, we are both big economies; we're both hyper-connected to one another and to the—and internally and we need to have some rules to deal with, you know, rogue governments or terrorist groups that want to use cyber sabotage.

If you look at Western China, they're worried about, you know, al-Qaeda, they're worried about ISIS, they're worried about extremist groups doing very bad things in Xinjiang Province. So I think you will find that over a period of time, while there may not be agreement next, this may not be an impossible area for real cooperation between the two.

WEISMAN: Thanks. We have, alas, time for one more question. So who wants to ask a good, succinct question? Everybody.


Gentleman here.

QUESTION: Hi, thanks. Jeff Kearns, Bloomberg News. What does One Belt, One Road mean for RMB internationalization?

WEISMAN: Succinct?


WETHINGTON: It'll boost the RMB as a currency for trade settlement but it will do virtually nothing to enhance the RMB as a currency held by central reserve managers.

WEISMAN: What is the U.S. current position, either of you, and we can close with this, toward the internationalization of the RMB, including it in the IMF basket?

WETHINGTON: The U.S. has not supported it yet. Germany has, interestingly enough; Germany, which is a country that has very, very scrupulous rules on these things, has actually gone along with the notion of including the RMB as a reserve currency and as a part of the SDR. The United States has not done this yet.

I actually think that over a period of time, the U.S. will do it. I think it is appropriate that China as a large economy with a growing amount of trade and a growing amount of settlements being executed in RMB should have its currency as part of the SDR and as a reserve currency.

In fact, by the way, the United States does hold some RMB in its own reserves. So this is something that may not be on the American agenda today or tomorrow, but down the road I think, A, is appropriate; and B, I think the United States is going to ultimately support it.

I don't think the United States wants to get into this awkward situation that it faced after it rejected the AIIB and other countries supported it; I think the United States doesn't want to be too far behind the curve. It should work out, particularly with the PBOC, People's Bank of China, the kind of rules and understandings that are needed to allow the RMB to play this role.

But this is something that will happen and is likely to happen I think relatively soon. It requires cooperation, the Fed and the PBOC and other authorities. The Chinese have an authority that deals with foreign currency. But they're opening up their capital markets, which is one of the preconditions. It's easier to do trading in RMB. So it's around the corner and it should happen.


WETHINGTON: I think—I think we ought to play this one on the merits, if you will. The standard, the IMF standard is is the currency freely usable; freely usable is the term of art. Now, one may—there may be some differences as to what that means. But certainly in common sense terms, the RMB, at least in a—in a cross-border investment context, is not freely usable.

Now, that doesn't necessarily suggest how the U.S. should play this politically. I could see a scenario with I think is actually very close to the German position where we say, yes, we want China to become part of the SDR basket, provided—and the provided is a big word here—it achieves, not that it commits, but that it actually achieves full convertibility, complete elimination of capital controls and full disclosure of its market intervention on its currency.

If it's prepared to agree and to achieve, underline the word achieve, those three things, then the U.S. would support it. But certainly we, as a major currency, we ought to welcome it in, provided it meets those three criteria, but not before.

WEISMAN: Bob, it's—go ahead.

HORMATS: I think it's moving in that direction. But it's not fully convertible and probably won't be for a while.

WETHINGTON: Yeah, that's—I mean, that's why we have our QFIs and QDIs and quotas and, you know, you simply cannot as an investor, move your, if you want to, move your funds into the Chinese share (ph) market. Or if you're already there, you're limited in your ability to move them out.

So that the controls, the capital controls on cross-border movement of funds is not, I think at least by any common sense definition of the word free, free.

HORMATS: It's not totally free but I would say the direction is...


WETHINGTON: The direction is there, but is that...

HORMATS: I'm not...

WETHINGTON: Shouldn't we...

HORMATS: I'm not saying doing it—do it today, but...

WETHINGTON: Right, but shouldn't we—shouldn't we bargain, use this as a moment to accelerate...

HORMATS: And I think...

WETHINGTON: China's movement toward...

HORMATS: ...and I think there are Chinese that would welcome that...

WETHINGTON: The objective?

HORMATS: Because I think there are Chinese that would like to see a freely convertible currency.

WEISMAN: So before I have to pry you two apart...


...let me say thank you both, it's—for a wonderful, detailed, informative conversation. Thanks to the Council.

A reminder, this was on the record. And thank you to the Council for setting this up, inviting me to moderate. I enjoyed it. Thank you, Bob. Thank you, Olin.

HORMATS: Thanks.