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I would like to acknowledge the assistance of Sam Hurley in preparing this address. All errors remain my own.
Thank you for the opportunity to be here today.
This Conference occurs in what we might euphemistically describe as ‘interesting’ times. Indeed, for anyone with a passing awareness of global issues, ‘interesting’ doesn’t do it justice. The forces currently shaping, and shaking, the global economy – including excessive debt, deleveraging and deficient demand in major advanced economies, shifts in global industrial structure and comparative advantage, and the continued transformation and re-engagement of the emerging economy giants – are all interacting in ways which create great risk, but also great opportunity.
We have seen the consequences of inconsistency between underlying international competitiveness and fiscal policies result in excessive debt and fear of sovereign default in Europe. The result is playing out on a daily basis, with marked volatility in equity markets and a sharp decline in risk aversion.
Other forces, like the re-emergence of China and India, are more like the shifting of tectonic plates, slow moving but profoundly altering the global landscape.
As these forces play out, the decade ahead looks to be a particularly volatile one for the global economy.
Today I want to focus on China and on its role in the complex phase of economic adjustment which lies before us. This will cover both China’s own difficult policy choices as it seeks a more sustainable growth model but also the implications of China’s emergence, both in terms of patterns of growth and production but also in the approach to international architecture and policymaking needed to accommodate China’s rise.
Before turning to China, though, let me make a few brief observations on the current situation and draw out some implications for the global financial architecture.
Global economic developments
The proximate causes of the acute financial market volatility over recent months are well known: unsustainable sovereign debt positions among certain euro area economies; policy responses that are manifestly inadequate given the scale of the debt and related financial sector vulnerability; an ongoing fear that political institutions are incapable of implementing the right responses; and a growing recognition that the recoveries in both the US and Europe will be weaker than previously expected.
However, these growth and debt concerns ultimately reflect an underlying competitiveness problem. In short, in Europe, and to a lesser extent the United States, there is a fundamental mismatch between tax and transfer policies and the structural policies that drive competitiveness and growth, the result being weak fiscal positions and ensuing financial sector fragility.
In Europe, poorly designed labour market and social policies have led to these competitiveness imbalances, which are exacerbated by a common currency. In the US, in his State of the Union address, President Barack Obama described America’s current economic and competitiveness malaise as this generation’s ‘Sputnik moment’.
Despite a decade in which economic growth and job creation were artificially inflated by a damaging housing bubble, we can have confidence the US system will drive the innovation and investment needed to spur competitiveness and growth. However, the US’ medium-term fiscal challenge remains to be addressed and success will take time and sustained political commitment.
On the other side of the Atlantic, after “mucking around with this for 18 months”, as the Treasurer so aptly described it yesterday, the Europeans are now much more aware of the need for action. It will be important that a sustainable solution to the financial and sovereign debt crisis is unveiled in the next few weeks, but the competitiveness challenge will take much longer to address.
As a result, three years on from the depths of the global financial crisis the recovery in broad swathes of the developed world remains tepid at best. As of the June quarter this year, in five of the seven ‘major advanced economies’ – that is, in all of the G7 except Germany and Canada – real GDP still remained below pre-crisis levels.
The US, where the recession began in December 2007, is almost halfway to its own lost decade.
In the euro area, the combined investment level in Greece, Ireland and Portugal has fallen by almost 40 per cent, while in the rest of the euro area investment has fallen by more than 10 per cent. Together with unemployment that still averages 10 per cent across the euro area, this suggests a very real risk of a permanent decline in Europe’s already anaemic rate of potential growth.
Given this extremely weak lead from the G7 economies, overall growth for advanced economies as a whole has been disappointing. Based on IMF forecasts, by the end of 2011 real advanced economy GDP will be barely 1 per cent higher than the levels at the end of 2007.1
Of course, the other side of the global economic story is one you will also be familiar with – the ongoing strength of the emerging world, and particularly emerging Asia.
This has been particularly visible post-crisis, but in truth the strength of the emerging world has been apparent for some time. Between 2001 and 2007, developing economies on average contributed around two-thirds of annual global growth – up from less than half in the 1990s. Over the five years to 2016, the IMF is forecasting the developing world to account for around 75 per cent of global growth.
In turn, over that period the bulk of developing world growth – around two-thirds – is expected to come from developing Asia, with China expected to be responsible for lower than two-thirds of that – or around one-third of global growth.
These changes obviously have important implications for the global centre of economic gravity, which continues to shift from West to East.
These global economic trends mean that we have to manage an international environment where expectations around representation, engagement and behaviour in international forums are changing (and where such expectations can sometimes be mismatched).
Greater economic weight for emerging economies will bring greater geo-strategic weight. However, these shifts in global power balances should not be seen in simplistic terms as a clear transfer of power, prestige or influence.
Greater economic weight should bring greater representation for emerging economies if our global institutions are to retain legitimacy. That is why Australia has been a staunch supporter of IMF quota and governance reform for well over a decade.
However, for emerging economies greater representation and greater integration into the global economy also bring greater responsibility, more difficult policy choices and a greater expectation that they will contribute to the provision of global public goods.
For its part, the global financial crisis made clear that the United States can no longer provide a global market of last resort for consumer goods. It is increasingly looking to others to share the burden in ensuring a sustainable global recovery. Indeed, given its current domestic preoccupation, the US cannot be expected to singlehandedly lead the push for solutions to problems besetting the global commons.
But what should we expect of the new powers?
Improving the representation of developing economies through the pursuit of quota and governance reforms at the IMF and World Bank is important but representation does not guarantee effectiveness. For effectiveness of these institutions to be improved, emerging economies will have to be willing to play a significant part in resolving the challenges facing the global economy.
Indeed, by virtue of its sheer size, no m
ajor global public policy issue will be capable of resolution without China. But if China and the other large emerging economies are not seen as engaging constructively, their interests, as well as ours, will ultimately suffer.
The emergence of the G20 at Leaders’ level has been crucial in providing a forum through which emerging economies can make a contribution to addressing global challenges. It brings all the major economies into a manageable forum. But just as with the IMF and World Bank, the legitimacy of the G20 depends critically on its ability to deliver results.
The recent G20 Finance Ministers’ Meeting stressed the need to have a comprehensive response to the European sovereign debt crisis to avoid further contagion. This will require further measures to boost the European Financial Stability Facility – the October 23 meeting of the European Council will be critical in this regard – as well as ensuring that the IMF is adequately resourced to respond as needed. This plan to address the immediate crisis should be supported by a ‘roadmap’ of reforms to strengthen global growth – including a commitment to boost domestic demand in emerging economies through enhanced exchange rate flexibility.
As a trade oriented economy, and one that would not be in any smaller global grouping that emerges if the G20 fails, Australia has a vital national interest in the success of the G20, which explains the emphasis placed on these current meetings by the Prime Minister and the Treasurer.
Development challenges ahead for China
Our region is right at the centre of the transformative rise of emerging economies. Indeed the reintegration of almost 3 billion people into the global economy that we are seeing in China and India is an event without precedent.
It is tempting to weave a very general narrative encompassing both China and India but China started its reform process more than a decade before India, and India is a fascinating challenge in its own right. But as China is larger, has grown faster, and is more integrated with the global economy, it will be the main focus today.2
We’re all familiar with the broad outlines of the China story – and the implications for Australia.
It is fair to say though, that this story is occasionally portrayed somewhat crudely.
On some tellings, the rise of China and Asia is inexorable and will inevitably take Australia along for the ride.
On others, we’re hopelessly exposed to a supposedly imminent China collapse. In the meantime, if you believe what you hear, every strong feature of the Australian economy comes with a ‘Made in China’ stamp.
The truth is that the China story and outlook is formidably complex and that these complexities matter deeply for both Australia and the world.
Recently my predecessor Dr Ken Henry has been tasked by the Prime Minister to lead the work on a White Paper on Australia in the Asian Century. The very fact of such a project reinforces just how important the rise and transformation of Asia is to Australia, and underlines the importance of understanding the economic, social and strategic changes which are underway in China, India, Indonesia, Vietnam and elsewhere in the region.
For its part, Treasury has often been portrayed as eternally optimistic on the Chinese economy – in fact, our analysis is far more nuanced than that.
In the short-term, while there are certainly risks – not least the vulnerable international outlook – we believe that the outlook for China is strong and that a ‘hard landing’ is unlikely. Domestic demand continues to grow strongly and China has much policy space should there be a major slowdown in global growth.
In the long term we are optimistic about the potential drivers of strong growth in China, given by the large scope for urbanisation and industrialisation (Chart 1).
Chart 1: GDP per capita (per cent of OECD-15 average)
Note: OECD-15 = Australia, Austria, Belgium, Denmark, Finland, France, Iceland, Ireland, Netherlands, Norway, Sweden, Switzerland, UK, US and Canada.
Source: The Conference Board Total Economy Database and Treasury.
However, while the potential is there, continuation of strong growth in China isn’t pre-ordained. The medium term policy challenges China faces are daunting and even when the right policy decisions are made there will be risks in implementation.
As a result, we tend to describe a picture 20 years hence where, through the prism of history, even a highly successful China is seen as having had a rising trend in GDP but with significant economic cycles of a sort not seen over the last two decades.
On the international front China’s trade and overall balance of payments surpluses – and related issues around the valuation of the RMB and China’s massive accumulation of foreign reserves – are major sources of tension and potential instability in the global economy and at the same time serious inhibitors to more balanced growth.
The major domestic policy challenge facing China is the handover from investment to consumption-led growth. In 1980, investment accounted for around 35 per cent of Chinese GDP, and private consumption around 50 per cent. By 2010, these numbers had effectively swapped: consumption 34 per cent of GDP, investment 49 per cent.
Looking at the developmental experience of other economies, a sharp fall in the consumption share of GDP is exactly what we expect at the levels of per capita income through which China has been progressing over recent decades.
However, 34 per cent of GDP is an extraordinarily low consumption share of GDP by any reference point. Both major advanced economies and emerging and newly-industrialised in the region typically have shares around the mid 50s or higher.3
None of this is to say consumption growth has been slow in China. Indeed, over the last 5 years, private consumption has expanded at an annual rate of around 13 per cent in nominal terms. But investment has grown even faster – particularly following the infrastructure-heavy stimulus package introduced during the global financial crisis.
There are a range of factors behind this imbalance between investment and consumption, but central among them is that China has an industrial structure which, by design, systematically favours capital over labour, and corporations or SOEs over households and predominantly privately-owned small and medium enterprises.
The undervalued nominal exchange rate encourages investment for export production, while at the same time reducing consumer purchasing power. Suppressed deposit and lending interest rates reduce earnings on savings while artificially lowering capital investment costs, even as a lack of financial market development funnels savings into low-return deposits and reduces consumers’ ability to access credit and smooth consumption spending out over time. Regulated input prices favour corporations. State-owned-enterprise dividend policy promotes retention and reinvestment of funds at the expense of greater dividends and an improved tax take.
And yet despite all this the real exchange rate appreciates, as it must. But this occurs through higher inflation, which brings with it another set of issues for policymakers.
Layered on top of this suppression in the labour income share of GDP are a range of other factors which drive high rates of precautionary savings. These include a hukou or residency permit system which entrenches vulnerability of rural migrant workers, limitations in the healthcare system, and broader weakness in social safety nets.
Given the systemic nature of these factors, what are the prospects for rebalancing the role of investment and consumption in driving Chinese growth?
The good news is that urbanisation will continue to shift surplus rural labour into more productive industrialised sectors in the years ahead, driving increased wages and living standards. This increasingly urban population will, as incomes continue to rise, divert an increasing share of total spending away from basics like food and into durable goods and, importantly, services.
However, to boost the labour share of income these forces will need to be supported by reforms to lift minimum wages, free-up factor prices, progress financial market liberalisation, and improve the tax and transfer systems. Other reforms, particularly to residency laws, credit markets, pension systems and healthcare, also need to be taken further to reduce the need for precautionary savings.
Many of these issues are recognised in the 12th Five-Year Plan, which emphasised the importance of boosting domestic demand, and especially consumer demand; boosting the services share of GDP; reducing social inequality; and achieving targets for minimum wage and overall incomes growth.
However, the impact of the 12th Five-Year Plan will depend crucially on effective design and implementation of these policies. The targets are encouraging, but the market mechanisms and the political will necessary to achieve them need to be developed and applied. And just like in Western democracies, success will require China’s leaders to tackle stubborn vested interests.
Moreover, in managing these reforms and transitions China will need to maintain solid economic growth and avoid further increases in inequality, while operating in an international environment likely to be characterised by slow growth in major advanced economies and ongoing economic uncertainty and volatility.
Next year’s leadership transition is an added complication. The next generation of Chinese leaders will need to walk a fine line between maintaining stability and continuity and positioning China for continued sustainable growth.
Clearly, the transition that China faces between now and 2020 is a complex one. The strong long-term outlook for growth that we see in China doesn’t imply consistently strong growth, or rule out major fluctuations around the positive longer-term story.
If you look back over the last 100 years of strong GDP growth in the US – the US Century if you will – it is clear that there were some major deviations around that trend. Unfortunately, we are in the midst of one now. Shocks and policy missteps do occur, even in economies with strong growth potential, and China will be no different.
Moreover, the broader economic history of the last 100 or so years teaches us that countries have often experienced difficulties in progressing from middle to upper income status.
There are some important success stories (including in Asia) that suggest we should be sceptical about a fully-fledged ‘middle income trap’, whereby some emerging economies become stuck in the transition between labour intensive, low-cost manufacturing led growth and a more advanced capital-, knowledge- and services-intensive growth model. However, it’s equally apparent that economies like Japan and Korea have faced some major shocks along the way to high income status.
Similarly, while there are good reasons to be optimistic about the eventual ‘convergence’ of emerging economy incomes towards advanced economy levels, this process doesn’t happen by default.
There have been cases where economies and incomes have plateaued well before traditional convergence theory would suggest. It is relatively easy to identify a broad sweep of policy or institutional conditions which are associated with sustained longer-run growth. However, as Harvard economist Dani Rodrik recently argued, it is harder to be clear on the exact policy changes that are needed to deliver these conditions.4
On a more positive note, China’s urbanisation, industrialisation and growth still has some way to run before it reaches ‘middle income trap’ territory. And China’s strong reform credentials over recent decades suggest that while the process will be challenging, it is capable of making the structural adjustments needed to drive its economy through the next phase of its development.
It is also worth noting that, by virtue of the sheer size of the Chinese economy, the additional annual impetus to global GDP from China will remain substantial even as growth rates slow.
1 In contrast, Australian GDP is 7 per cent higher than at the end of 2007, an outcome matched or exceeded by only 5 other advanced economies (Taiwan, Singapore, Hong Kong, South Korea and Israel).
2 While I will leave a deeper consideration of India for another occasion, it is worth noting that Treasury now has a senior officer posted in New Delhi. Treasury has been represented in Beijing since 1994.
3 At levels of GDP per capita similar to China’s today, Taiwan, Korea and Malaysia all had a consumption/GDP ratio of around 50 per cent, while Hong Kong was at 65 per cent.
4 See Rodrik, D 2011, ‘The Future of Economic Convergence’, Paper prepared for Jackson Hole Symposium of the Federal Reserve Bank of Kansas City, August 2011.
5 Kharas, H and Gertz G, 2010, ‘The New Global Middle Class: A Cross-Over from West to East’ in C Li (ed), China’s Emerging Middle Class: Beyond Economic Transformation, Washington, DC, Brookings Institution Press.