Annual Report

China's 'New Normal' and the Global Economy

2015-5-16 10:57:05

I  am pleased and honored to be invited to give a keynote address at this signature event.

The theme of my remarks will be how China’s “new normal” will affect China’s integration into the global economy, with profound consequences for both China and for the rest of the world.

I believe that overall these consequences will be very positive. Under the “new normal”, a healthy and well balanced Chinese economy should continue to be a main driver of global growth and financial development. China will be a rising source of capital for the rest of the world and the RMB will emerge as a major reserve currency.

However, there are certainly challenges ahead. It is crucial that the continuing rise in China’s stature on the global economic stage be handled smoothly, to ensure that we live in an increasingly integrated world economy, not one that is increasingly fragmented. Rising cross border flows of goods and finance have been a main contributor to global prosperity over the past three decades.

By contrast, fragmentation of the world’s trade or financial system would be deeply damaging—particularly at a time when the global economy is already struggling to handle a number of headwinds including aging populations, rising inequality in many of our countries, including the United States, and a need to shift to greener technologies.

Three decades of strong growth

Let me begin by briefly reminding you how important China’s economic rise has been to the global economy over the past three decades. You all know that China’s sustained high growth since 1980 has been dramatic, and has helped lift hundreds of millions in China out of poverty.

What is important to stress is that China’s rise has also underpinned a remarkable period of strong global growth. Consumers in all countries have benefitted from falling prices made possible by the low costs and high productivity of China’s factories as they have been increasingly integrated into global supply chains.

Similarly workers and businesses around the world have benefitted from rising Chinese demand, whether for raw materials and commodities, for cutting edge machinery and equipment and for sophisticated consumer goods and services.

As China’s economy has grown larger, China’s importance to the global economy has grown commensurately. As shown in my first chart, China’s contribution to global growth measured just in terms of the rise in China’s own GDP has risen from under 5 percent in 1990 to Almost one third percent recently. Not because China is growing faster, but because China’s share of the world economy has risen from XX percent to YY percent, the first or second largest economy in the world depending on how you measure size. China’s contribution to global growth is even larger when you consider the sizable spillover benefits to other countries trading with China.

Of course, not all has been smooth. One key concern especially in the years up to the global financial crisis in 2008 was that China was contributing to an unbalanced pattern of global demand and a global savings glut. Suppressing the rise in value of China’s currency the RMB led to a very wide current account surplus, reflecting the downward pressure on real household incomes in China and the supercharged success of China’s exporters. This contributed to rising global tensions over trade and exchange rate policies,

This issue has been alleviated in recent years as the RMB has appreciated progressively since 2005 and as China’s current account surplus has come down dramatically. But certainly one important question as we think about the implications of China’s “new normal” is what will be the impact on China’s currency and current account.

China’s “New Normal” and Global Trade

So let me now look forward. China is now embarked on a very ambitious program of structural transformation, which has the potential to deliver sustained strong growth for many years. The key elements are moving to a better-balanced economy, less dependent on rapid credit growth, investment and exports, more reliant on domestic demand, market-based competition, and innovation.

Growth inevitably will be less rapid than over the past thirty years as the growth of China’s labor force slows and the huge gains from rising integration into the global economy become incrementally smaller. As shown in this next slide, China’s rise in global trade share has been dramatic, but there will be less scope to continue to make these gains in the future. But while growth will be slower it will also be more sustainable, more consistent with sensible use of resources and the environment and less subject to booms and busts in the credit cycle.

From a global perspective, slower growth in China will mean less upward pressure on commodity prices and slower growth in demand for imports from the rest of the world. But China will still be one of the world's fastest growing economies, and given its rising share, will still be making an outsized contribution to global growth. China may grow more slowly over the next decade but should still be contributing around a third of global growth.

With less scope for export growth, China needs to make the transition to stronger growth in consumption. Despite recent efforts, consumption is still a remarkably low share of China’s GDP, as shown in this chart. A key aspect of achieving the “normal” will be raising this share. This will provide opportunities for producers of consumer goods around the world, although commodity and raw material exporters will be affected as investment grows more slowly.

And rising household incomes and consumption will help to ensure that China’s current account remains close to balance rather than swelling again to levels that increase global trade and exchange rate tensions.

Some on the outside warn that China may have a hard landing with an abrupt fall in growth that could have quite negative spillovers to China’s trading partners.

I am more optimistic because there is still such a long way for China to go to converge to productivity and living standards seen elsewhere.

As shown in this chart, decades of rapid growth have contributed to sustained convergence towards high-income countries not seen in other countries over this period. But China’s GDP per capita is still only 25 percent of that in the US. There is still huge potential for strong growth in China provided that reforms are carried out effectively.

But also as the experience of other countries like Brazil and Russia demonstrate, if reforms stall or lack vision, it’s also quite possible to get caught in a middle-income trap, where incomes stagnate rather than narrowing the divide with high-income countries.

China’s “New Normal” and the Capital Account

One important aspect of China’s “new normal” will be increasing financial as well as trade integration with the rest of the world. Governor Zhou has been very clear about the priority being given to further opening China’s capital account, reducing barriers to both inwards and outwards capital flows. This increasing openness, going hand in hand with domestic financial sector reforms, is a key element of the overall strategy to achieve a more efficient and market oriented allocation of resources in China.

This “new normal” of capital account openness will have a number of important implications.

First, portfolio inflows into both equity and fixed income are likely to become much more important. In the past such flows have been relatively contained, discouraged by quite tight regulations. See my next chart where portfolio inflows are shown in the purple bar.

There is huge potential for such flows to increase. Key steps will be increasing transparency and liquidity, more reliable governance and China’s inclusion in global benchmark indices like the MSCI, all of which will encourage asset managers around the world to increase investments into Chinese securities.

Second, FDI should remain important. In the past FDI--the green bar in my chart-- has accounted for over half of inflows. FDI inflows should remain strong in China’s “new normal” as areas like services are opened to private investment, and as foreign investors receive better legal protection for their physical and intellectual property.

Of course this depends on making good progress in initiatives like the Bilateral Investment treaty (BIT) now being negotiated with the United States.

Third, China will become an increasing source of capital for the rest of the world.  China with its large current account surplus has been exporting large amounts of capital—but this has mainly been in the form of official reserve accumulation, the red bar in my chart, and largely channeled into US Treasuries.

Looking ahead, China’s capital outflows will be much more diverse. Official outflows will continue through a widening range of channels, including through contributions to multilateral initiatives like the Asia Infrastructure Investment Bank as well as bilateral flows.

But even more important will be rising outflows from businesses looking to develop international production and from individuals seeking to diversify their investment portfolios. To some degree these flows are already happening but sometimes through hidden channels. Liberalizing limits on individual overseas investment will allow these flows to be more transparent and more stable.

Capital account openness brings important gains to China from increasing access to financing, a better allocation of that financing, and greater opportunities for risk sharing by investors.

To be sure, there can be a downside too, as volatile capital flows can be hard to manage. Other countries have certainly experienced instability as a result of booms and busts in capital flows. This is why capital account opening needs to move in close coordination with domestic financial reform to improve transparency, market discipline and the effectiveness of financial regulation.

China’s “new normal” and the RMB

A crucial pillar of the “new normal” for China’s macroeconomic policy framework will be a continuing shift to more flexible management of the RMB.

As I mentioned earlier, inflexible exchange rate management in the past and the maintenance of an undervalued currency was a serious source of global stress in the past. A flexible exchange rate is now even more important as China has emerged as the world’s largest trader and a top economy. The international monetary system cannot operate in a stable fashion if the value of the RMB cannot move flexibly like other major currencies to help absorb shocks and to allow smooth adjustment to shifts in international competitiveness.

The increasing global weight of the Chinese economy, a more open capital account and more flexible exchange rate management will also underpin the continued rise of the RMB as a major reserve currency.

The internationalization of the RMB in recent years has certainly been dramatic, as the RMB is increasingly used to settle China’s trade and as investors have been willing to hold RMB-denominated assets. However, the RMB’s role remains relatively limited. The share of the RMB in central bank assets, the share of international securities issued in RMB, and the share of international bank credits in RMB all remain very low, below 1 percent.

In part the rising interest in RMB assets in recent years has been a product of a perception that the RMB will continue to appreciate against other currencies. However, in future, movements in the RMB will be more two-way and the RMB will only attract increasing investment if investors are offered a broad array of attractive assets.

In time, the RMB is likely to take its place as one of the major reserve currencies commensurate with China’s economic role. For now, the US dollar remains the dominant reserve currency because of the deep and liquid markets in dollar assets, which are backed by the strength of the US economy, the credibility of US macroeconomic policies and trust in its financial markets.

Thus it is important to stress that the RMB’s rising status as a reserve currency will occur not because of changes in design of the international monetary system but because investors and traders choose to use the RMB, and this will depend primarily on China’s own efforts to open its economy and achieve a reliable and transparent financial system.

China’s place in the global financial architecture

This brings me to my final topic, how China’s “new normal’ will affect its place in the global financial architecture.

My main point is the importance of ensuring that China’s rising economic stature is appropriately reflected in its rising voice and influence in the global financial architecture. Otherwise there could be risk of damaging global fragmentation.

Of course China’s voice and influence has already risen very substantially—as reflected for example in taking on the important lead role in the G-20 next year. But progress in some areas has been frustratingly slow.

One key goal for international economic policy makers must be completing the IMF’s 2010 quota reform. This would recognize the increasing importance of emerging markets and provide a significant increase in China’s voting share in the IMF.

Another step forward would be inclusion of the RMB as one of the currencies in the SDR, the IMF’s unit of account, along with the dollar, the euro, the yen and the pound sterling. There are still technical issues to resolve but given the progress being made to open up China’s capital account and the international use of the RMB, inclusion of the RMB in the SDR basket is a matter of time.

Summing up

Let me wrap up my remarks. Overall, the world should welcome China’s transition to a “new normal” that is better balanced and more sustainable. Provided the transition is smooth and well managed everyone benefits. The new China will continue to provide opportunities for exporters and investors around the world, and will also be engaging vigorously, investing overseas, and participating actively in the international monetary system. 

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