Manchurian Paradox

Manchurian Paradox

Mini Teaser: The America-China symbiosis cannot be overstated. Beijing’s willingness to buy U.S. debt allowed us to live on credit, while our purchase of Chinese goods propelled their meteoric rise. But as the financial markets have soured, some in the United

by Author(s): Stephen S. Roach

From the May/June 2009 issue of The National Interest.


THE CHINESE word for crisis, weiji, includes elements of both danger and opportunity. This symbolic meaning has taken on especially great significance in recent years. The emergence of modern China as a global economic power can, in fact, be dated to the nation's willingness to seize critical moments of adversity. That was very much the case during the Asian financial crisis of 1997-98, which marked a critical turning point in the ascendance of China as a major economic power. And it could also be the case today.

But there is an important catch: unlike earlier crises, it is not altogether clear that China senses the gravity of the current danger. That leaves it caught in something much closer to denial-making it difficult to seize the opportunity that peril can provide.

The world is in the midst of its most wrenching financial downturn since the 1930s. From subprime to "no-prime," the once-proud icons of modern finance have all been turned inside out. An asset-dependent and increasingly integrated world has been quick to follow. The global economy is set for its first outright contraction since the end of World War II. Relative to a forty-year trend-growth rate of 3.7 percent in world output, a likely decline on the order of 1.5 percent in the world's gross domestic product (GDP) in 2009 is all the more stunning. For a $64 trillion global economy, such a shortfall translates into $3.2 trillion of foregone world GDP. Never before has the modern global economy had to come to grips with such a severe and abrupt widening in the so-called global output gap.

The Chinese leadership needs to deepen its appreciation of the global shock that is now unfolding. Only then can Beijing truly comprehend the threat this recession poses to its long-successful outward-facing economic-growth model. And yet there are worrisome signs that China just doesn't get it-that it is clinging to antiquated policy and economic-growth strategies that presuppose a classic snapback in global demand. That leaves China ill prepared for what could well be the defining feature of the postcrisis world-a U.S.-led shortfall in worldwide consumption. China's export-led growth model is aimed right at the heart of what could well be the new weak link in the global growth chain.

Notwithstanding these worrisome imbalances, a newly assertive China has stepped up its efforts to shape the global policy debate-warning America of fiscal excesses that could erode the value of China's investments in U.S. Treasury securities and proposing a radical revamping of the global currency system. China's views and voice are important and need to be heard. The world has much to gain from a sounder and more stable international financial system. But if China pushes too hard in trying to reshape international policies and institutions without attending to its own imbalances, it could trigger further instability-possibly even a dollar crisis-that would only deepen the world's malaise. In the construct of weiji, that could tip the balance from opportunity to danger. Therein lies the paradox of Chinese economic power.


RELATIVE TO all the Asian economic-development efforts since the end of World War II, China stands alone in the massive bet it has made on externally led growth. According to calculations made by the research staff of the International Monetary Fund, China's share of world trade increased eightfold in the twenty-five years following its economic takeoff in the early 1980s. That is more than two-to-three times the gains experienced by other Asian economies over comparable phases of their development journeys. Moreover, China upped the ante on this bet following its accession to the World Trade Organization, taking the export share of its GDP from 20 percent in 2001 to 36 percent in 2007. As the world's most open large developing economy-with exports and imports, combined, peaking at 65 percent of its GDP in 2007-China could hardly expect to get special dispensation from a global shock.

And it didn't. On the heels of a precipitous decline in exports, Chinese GDP growth slowed to 6.8 percent on a year-over-year basis in the fourth quarter of 2008, a major deceleration from the 13 percent increase in 2007. Significantly, the gain in the fourth quarter of 2008 turns out to be a number very close to "zero" if it is recalculated relative to activity in the third quarter. Moreover, with export growth turning sharply negative in early 2009-plunging 21 percent on a year-over-year basis during January and February-it is safe to say that the external-demand shock has brought the Chinese economy to a virtual standstill.

Chinese policy makers have been quick to respond to this extraordinary shortfall in economic activity. In November 2008, they adopted an RMB 4 trillion ($585 billion) two-year fiscal-stimulus package dominated by accelerated expenditures on infrastructure projects. Outlays on rural development, rail, highways, airports and the energy grid account for 47 percent of the total stimulus package and Sichuan earthquake-reconstruction efforts make up another 25 percent. This "proactive fiscal stimulus," as Chinese officials like to call such initiatives, borrows a page from China's response to two earlier external-demand shocks-the Asian financial crisis of 1997-98 and the mild global recession of 2000-01. In both of those instances, infrastructure-led fiscal support plugged the gap left by a temporary shortfall in external demand. When the global economy snapped back, China's export-led economy was perfectly positioned to capture the next upturn in global trade. It worked like a charm.

China seems to be betting on a similar outcome this time. In addition to its infrastructure-bolstering policies, Beijing is also providing support to export industries such as textiles, steel, equipment manufacturing, light industries and logistics as part of its recently announced "ten industry" industrial-reinvigoration plan. And it has provided assistance to exporters by increasing their value-added-tax (VAT) rebates. This allows them to further lower their prices and further bolster their competitiveness. The broad thrust of China's investment- and export-led policy focus is strikingly reminiscent of earlier countercyclical stabilization efforts.

By contrast, the Chinese government is only paying lip service to measures aimed at supporting internal private consumption-long the lagging sector of this rapidly growing economy. Spending vouchers have been distributed to rural households and the government has enacted a relatively modest national-health-insurance scheme-costing just RMB 850 billion (about $125 billion) over the next three years. While there is nothing wrong with these proconsumption initiatives, they are far too small, in my view, to turn around China's lagging consumption sector, which plunged to a record low of only 36 percent of GDP in 2007. China needs to get far more serious in funding a social safety net-especially social security and pensions-if it is to reduce the excesses of fear-driven precautionary saving and foster a more broadly based consumer culture.

By failing to embark on the heavy lifting of its own rebalancing, China is banking on the same export-led growth model that has worked so well in the past to take it out of the current downturn. In essence, that implies China is placing a big bet, not just on its own proactive infrastructure-led fiscal stimulus, but also on the efficacy of policy actions being taken elsewhere in the world. That latter presumption underscores one of the biggest risks to this strategy. If, as I suspect, the American consumer has only just commenced a multiyear compression in the growth of private consumption, China could end up being very disappointed in the lingering sluggishness of its external-demand conditions. Like the circumstances of 1997-98 and 2000-01, the design of China's current stimulus strategy is very much dependent on an external-demand-snapback scenario. While that strategy worked well in the past, there is a distinct possibility that it is going to be very different in today's crisis-torn, postbubble world.

Unfortunately, the Chinese leadership strikes me as being overly complacent in assessing the risks of just such a possibility. By failing to move more aggressively to rebalance its unbalanced macrostructure, China runs the real risk of facing a more pronounced shortfall in economic growth. For a nation long fixated on the perils of social instability, the rising unemployment that would come from such a scenario could be exceedingly problematic. Chinese government officials have already voiced concerns over the mounting joblessness of their export-dependent migrant workforce-admitting that some 20 million unemployed workers have recently returned to the countryside. In the external-demand-snapback scenario, such distress would be relatively short-lived. In a more protracted global slowdown, however, pressures on Chinese workers would only intensify-as would the risks of social instability.


ECONOMIC FORCES, of course, don't operate in a vacuum. That's especially the case in financial crises and recessions, when intensifying economic pressures often beget powerful political responses. China is no different from any other nation in that regard. In the depths of this crisis, its political machinery has focused not only on internal problems, such as rising unemployment, but also on external concerns, such as its trade relationship with the United States.

In the context of China's mounting economic challenges, the geopolitical dimension of its export-led macrostrategy is especially paradoxical. Recently, senior Chinese officials have singled out two key issues for special attention-their lack of confidence in U.S. Treasury securities and the role of the dollar as the world's major reserve currency. Premier Wen Jiabao has gone public-and loudly so-raising concerns about the safety of China's massive investments in dollar-denominated assets, some $700 billion in U.S. Treasury securities alone. At the same time, Governor Zhou Xiaochuan of the People's Bank of China has joined the debate over the reform of the international monetary system-raising concerns about the stability of a dollar-based reserve system in an increasingly globalized and unbalanced world.

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