Shirley Redpath explains how China’s economy, now the second largest in the world, could benefit the West – but not without political ramifications
China has a problem, and Klaus Regling, head of the European Financial Stability Facility (EFSF) was dispatched at the end of October with a proposal from the European heads of state to help her out. “We all know China has a particular need to invest surpluses,” Regling helpfully informed a Beijing news conference as he arrived with his begging bowl.
The surpluses Regling referred to are an estimated $3.2trn of foreign exchange reserves accumulated through just two short decades of trade imbalances with the world. The amount the EFSF is looking for is as yet unspecified, but would enable it to ‘leverage up’ its own facilities from a current fund of €440bn to a target of €1trn.
But although China’s pockets appear to be unfathomably deep, is it wise to plumb the depths? And what dangers might be lurking there?
Building a sound economy
The most remarkable aspect of China’s ascendancy to become the second largest economy on the planet is the breathtaking speed of its growth. Following decades of bitter philosophical and political in-fighting, the traditionally closed-door government of China embarked on a programme of reforms and economic liberalisation in 1978. Although considerable amounts of foreign direct investment were drawn in to the country looking for access to its cheap labour, domestic political unrest continued for at least another 15 years. It was the mid-1990s before Deng Xiaoping was able to secure official sanction for his agenda to create a market-oriented economy.
As recently as 1993, China’s trade account was in deficit, but foreign direct investment was rapidly building a base of cheap exports that were shipping to the powerhouse economies of the West. The dominant reserve currency of the world was the US dollar, and China’s foreign investors had ready access to liquidity in global markets.
Just 10 years ago, the US economy was three times that of China, but the Chinese export-led economy has been growing at an average of 10 percent per year. By 2006 China’s foreign exchange reserves first hit $1trn; they topped $1.9trn two years later and reached $3.2trn in June 2011. Looking at the comparative purchasing power of the US and China, the International Monetary Fund recently predicted that China will overtake the US as the world’s largest economic power by 2016. The country is clearly the one to watch on the international stage.
Internally, the story is very different. In 2009 the IMF calculated the gross domestic product per head in China at a mere £2,500, less than one tenth of productivity levels enjoyed in the US. Chinese official figures put household consumption at just under 35 percent of GDP the same year. Compare that to the West’s consumption rates of 65-70 percent and you begin to see the shape of the problem faced by the central planners.
According to a paper by Franco Modigliani and Shi Larry Cao, China’s household savings rates grew from below five percent before the reforms were brought in, to nearly 34 percent today. That is more than the Japanese were saving at the height of that country’s frugal period, and well above the US (4.8 percent), the UK (4.6 percent) and Germany (11.3 percent) today. China has a vast workforce that could be producing 10 times its current output, which has built a head of pent-up demand for personal consumption that could very easily lead to runaway inflation.
In order to keep inflation under control, the central planners have kept wage rates artificially low, ensured that export markets will continue to soak up its output by keeping the value of its currency artificially low, and are retaining payments in foreign exchange reserves that can only be invested outside the country.
It is no wonder, then, that Regling and his euro masters thought they were doing the country a favour by offering euro-debt to help soak up the surplus in China’s foreign exchange reserve account. The problem is, we don’t really know how much of Europe’s sovereign debt China already owns, or what its appetite might be for investing further in the profligacy of our governments.
Although the Chinese government has taken the pragmatic decision to participate in the global economy, it has retained its historic preference for privacy – some would say secrecy – in the matter of how and where it invests its money. China is known to be the largest foreign holder of US public debt, for example, yet even the US government does not have a clear idea of what the total holdings might be. Figures released by the Treasury in December 2010 showed a drop in China’s holding, alongside a curious increase in purchases from the UK, Canada, Singapore, Thailand and Egypt. Then in February 2011, those figures were revised to show downward adjustments in some countries’ purchases with a commensurate upward adjustment in China’s holdings.
It appears that while China continues to purchase US sovereign debt, it is covering its tracks in many instances by purchasing through agent accounts in other countries. The same is known to be happening in the country’s purchases of Eurobonds, making it impossible to arrive at an exact figure for China’s existing exposure to the eurozone (one estimate puts it at €600m). The problem is somewhat compounded by the fact that although Europe is a single trading entity with a single currency, each country has the ability to issue its own sovereign debt. In September 2011, it was Italian Finance Minister Giulio Tremonti who met with Chinese officials to solicit support for his country’s latest issue of euro-denominated bonds.
China’s response to the various investment ‘opportunities’ put before it has been vague at best. During a trade mission to Europe in June, the Chinese delegation pledged to support the European Union in its hour of need. Foreign Ministry spokesman Hong Lei said, “Since the European debt crisis broke out in Greece in 2009, China’s government has adopted a series of positive measures, such as increasing its holdings of Eurobonds and promoting its economic cooperation and investment in Europe, to help European countries tide over the current crisis.” A number of procurement delegations looking to sign contracts worth billions of dollars were subsequently dispatched to Europe.
Response to Regling’s offer was less committal. As the editor of a leading Chinese financial magazine commented, “Everything is up for discussion, but the most important thing for the Chinese government is whether the investment is safe.” Safety, however, is only an illusion; in truth, China will be exposed to the risks of the current eurozone crisis whether it purchases more Eurobonds or not. The EU is China’s biggest trading partner; a collapse in the eurozone would hit China’s exports hard, sending its fragile domestic economy into a tailspin. The same problem exists with the US, China’s second-biggest market, and it was partly to counterbalance its exposure to US economic instability that China began to diversify its foreign exchange holdings into euros.
The same reasoning may be behind China’s very sudden move into global philanthropy.
China and foreign aid
China joined the World Bank in 1980 to access the loans and technical assistance available to poorer countries. It received nearly $10bn in concessional loans from the International Development Association, which works with low-income countries. In 1999 it was classified as a middle-income country and was ‘moved up’ to the International Bank for Reconstruction and Development, from which it borrowed nearly $40bn over the next 12 years.
Now classified as an upper-middle-income country, China still receives loans from World Bank institutions, but in 2008 the country also became a donor, giving $30m that year and $50m in 2010. It has also, by virtue of its growing economic strength on the world stage, sought a more influential role in the governance of the bank, while at the same time embarking on its own independent programme of aid to developing countries.
In fact, according to research by the Financial Times, over the last two years the China Development Bank and China Export-Import Bank signed loans of at least $110bn to governments and companies in developing countries. That is at least $10bn more than World Bank commitments over the same period.
Many of the loans China advances are tied up in deals to supply natural resources to the country’s insatiable growth in industry and infrastructure. Deals reported in the press have included loan-for-oil barters with Brazil, Russia and Venezuela. In many countries, loans are made in renminbi, which the recipient country uses to purchase Chinese goods – a recent deal was made with Argentina to rebuild that country’s crumbling railway network, with finance provided to buy Chinese-made rolling stock.
In Africa, Chinese companies, with Chinese workers and funding from the China Export-Import Bank, are building much-needed infrastructure which the local country can later pay for with oil or other natural resources. Although these deals are helping to build the host country’s economy, they are becoming very unpopular with local residents who see vital jobs going to foreign workers. Recipient countries are also being flooded with cheap Chinese products, which inhibit opportunities for indigenous enterprise to develop.
Of greater concern to an international community that has been working hard to support the development of progressive democratic governments in Africa is the lack of transparency in Chinese aid contracts. Where World Bank loans attempt to promote corruption-free government in recipient countries, Chinese aid is not transparent and very often forgiven, enabling rogue dictators to pocket funds for their own purposes.
The underlying Chinese aid agenda is very different from that of the West, according to Jamie Metzl, executive vice president of the Asia Society. “The key difference between World Bank loans and China’s loans is that Chinese investments are not being made from an economic perspective, but from a strategic and national security one,” he points out. “China has national security motives in gaining access to natural resources and in gaining political support.”
A complicated web
The imperative to provide political support is one of the greatest concerns of even those Europeans who advocate asking China for a bailout. Benefactors in general prefer that their supplicants do not criticise them, for example. How will Europe, dependent on China holding vast quantities of euros to keep its economy afloat, be able to continue pressing for more human rights protection in China?
Some people, like Guntram Wolff, deputy director of Bruegal, a Brussels-based European economic think-tank, persist in optimism: “It is obvious that if you provide money to someone, you are going to want something in return,” he says. “But it is also possible that the Chinese will be content with the returns from interest and certain structural reforms, for example in Italy and other countries in the eurozone which will ensure the safety of investment.”
Others suggest the political costs might be much higher – a lifting of the EU’s weapons embargo and re-classifying China’s trading status to a market economy, for starters. But like all good pendulums, the economic swing from West to East may yet have a counter-balance – and in this case it is the economy within China itself. According to the government’s tight control on domestic finances, Chinese household savings must be deposited in state-owned banks, which are then responsible for all internal lending for infrastructure and property projects. In 2003 the authorities had sanctioned an expansion of lending, but with recent fears of a rise in inflation they have begun to raise interest and cut lending rates.
The result is reported real estate price drops of over 30 percent in the last 12 months and a growing problem with defaults on local government loans. Fitch, the New York/London-based global rating agency, has published concerns about financial stability in China’s domestic economy, and put a downgrade watch on its local-currency debt.
So while China’s foreign exchange pockets are very deep, at the bottom lies a sleeping dragon of domestic financial chaos. The prospect of public discontent in a nation of over one billion souls should have more than the local authorities in China worried.