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Briefing Report

The Chinese Economy and Japan

President, Institute for International Monetary Affairs
Mr. Toyoo Gyohten

[International] November 16 , 2006

I gave a talk on the same topic here two years ago. To see how things might have changed between that time and the present, I had a look at the transcript of that talk, but I couldn’t find anything. In other words, the chances and risks in the Chinese economy have hardly changed at all over the last two years. During this period the Chinese economy has continued its spectacular growth, and at the same time the latent problems relating to the Chinese economy remain unchanged.

Why has the Chinese economy been able to maintain rapid growth despite the fact that it has faced various problems? There are a number of reasons. First, there is China’s huge population of 1.3 billion people. As before, these people have a strong desire for economic improvement. I think this is probably the most fundamental reason. Second, the large economy of China still has plenty of room for development and expansion in the areas of consumption, investment, and the construction of infrastructure. Third, overall China has an extremely talented and outstanding group of leaders, and, again generally speaking, the people’s support for these leaders is strong. Fourth, as a background to the high economic growth, naturally tax revenue is gradually increasing as well. This has steadily increased the financial strength of China, which in turn has increased the government’s power to deal with the various problems in the economy. Fifth, I think it can be said that the international environment generally has been favorable. In particular, in a variety of areas there are latent factors that could cause economic friction and collision between China and the United States, but at the same time, as a result of the increased economic interdependence of these two countries over the last few years, I think there has been an environment in which the latent factors that could spark friction have been restrained to a considerable extent by the relations of interdependence. Sixth, the Chinese government has endeavored to tackle the various economic problems in a variety of ways, mainly through administrative guidance. This response by the government has not brought about any fundamental solutions, but it has been quite effective in a way. And finally, the economic policy of the present administration of President Hu Jintao is basically a moderate one, a step-by-step approach, and I think it can be said that the gradualism of the Hu administration has been achieving results to an extent economically, politically, and socially.

I believe that these are the reasons why the Chinese economy, despite various problems, has been able to maintain high rates of growth of over 10 percent until now.

Now, I think that I must say something about the risks that the Chinese economy is clearly facing. The biggest risk at present is the problem of excess investment, especially in such fields as production equipment, construction, and infrastructure building. Needless to say, because of these extremely lively investment activities, the Chinese economy has a strong export capacity, and it has been able to maintain high growth as a result of its increase of exports. On the other side of the coin, however, this excess investment clearly is supported by excessive lending by banks, especially the People’s Bank of China. Also, the rapidly increasing exports are giving rise to a rapidly increasing trade surplus, and in addition to this trade surplus, the capital inflow to China from overseas, and especially capital inflow in the form of direct investment, is growing as well. Despite this large deficit, in order to avoid a sharp rise in the exchange value of the renminbi, the People’s Bank of China is carrying out large-scale market intervention. As a result, China’s foreign currency reserves are spiraling. Indeed, China is now the world’s largest holder of foreign reserves, with the amount exceeding $1 trillion. The People’s Bank of China is adopting a large-scale sterilization policy so that this huge increase in foreign reserves does not bring about domestic inflation.

When we look at what is happening against this background, first of all, we can see that the condition of company management is deteriorating quite a lot. That is to say, the three surpluses: surplus borrowing, surplus plant and equipment, and surplus labor, have come to be evident in many companies. In addition, with regard to the banking sector, there is the problem that, as a result of excess lending, assets have increased a lot, but the quality of these assets is steadily deteriorating. Furthermore, as a result of excess investment, as you will be aware, prices are rising in the asset sector and a bubble is occurring. In particular, land is being expropriated by local governments in order to build housing, secure industrial land, or construct various infrastructure, and as reported in the newspapers, there has been a sharp rise in the number of conflicts over land expropriation between local governments and the farmers currently using the land. Also, the increase of the trade surplus, and especially the surpluses with the United States and the European Union, is giving rise to trade friction, and this in turn is leading to international pressure on China to revalue the renminbi.

Looking at the situation from a slightly more society-wide perspective, we can see that as a result of the high growth, income gaps are appearing in various forms, and this is becoming the source of social and political unrest. In addition, the expansion of production scale is increasing energy consumption and also increasing demand for various primary products, which is causing the prices of these products to rise. In particular, the problem of environmental destruction is arising, including degradation of the environment in connection with water and air pollution resulting from the use of coal.

So, excess investment and excess production expansion are not desirable. Accordingly, the Chinese government recognizes the need to slow them down a little. The government and the People’s Bank of China therefore have adopted various measures aimed at moderating and prolonging economic development if possible.

As you know, in the area of administrative guidance, the government has advised banks to restrain their lending and local governments and others to control investment. In the area of monetary policy, the interest rate on bank loans has been raised a little on several occasions, and the bank reserve ratio has been hiked as well. In the field of taxation, the export drawback has been lowered. With regard to direct investment in China from overseas, selection has been tightened. And conversely, measures have been taken to encourage overseas investment from China. And regarding the problem of the exchange value of the renminbi, as you know, small revaluations have been made since the system was revised in July of last year.

I do not think that these measures by the government and the People’s Bank of China have been totally without effect. They have been effective to an extent. However, in the sense of placing a full-scale restraint on excess investment and excess growth, the effect has not been adequate. There are signs that bank lending has begun to increase again recently, and regarding various investments in China, the fact is that the government’s countermeasures have certainly not had an adequate effect.

I think there are two basic problems. First, interest rate and exchange rate changes, which essentially should be the prerogative of the central bank, are still matters decided by the government in China. That is to say, the independence of the central bank is not properly ensured, because it cannot change interest rates and exchange rates without the approval of the people. That is one problem. The second problem is that while the government realizes that excess investment and excess growth are not desirable, it is negative about putting a sudden damper on investment and growth. In other words, a situation is simultaneously existing in China in which the government actually does not want to restrain excess growth and excess investment. The main reason is that, as you know, cooling down the economy would exert an adverse impact on employment, and unemployment would increase. And in connection with this, such a move would worsen the management of state-run enterprises, which still account for about half of the Chinese economy. This problem also involves the role of the leadership in the 17th Congress of the Communist Party of China in the fall of next year, so the current administration does not want to put a damper on the economy very soon. This really is a contradiction.

Accordingly, the goal of the Chinese government’s economic policy at the moment is to somehow achieve a soft landing. It wants to continue the present situation by maintaining and moderating levels so that the excess investment and excess growth do not explode. In other words, the most important target for the current Chinese leadership is to achieve a soft landing through gradual measures. I think this policy will probably be successful. Naturally there will be some doubts about the timeframe for this success, and I cannot say definitely that the Chinese economy will be all right after so many years. But if you ask, for example, whether it will be all right for the next five years, I would answer “Yes.” To repeat myself, the main task for the Chinese leadership at the moment is to endeavor to moderate the activity of the economy as a whole by utilizing various measures and especially by fully utilizing gradual measures. In that sense, ironically, what the administration of the Chinese Communist Party should fear most of all at the moment is a revolution.

That is all that I will say about the immediate issues facing the Chinese economy. Now let me talk a little more about the future of the Chinese economy from a medium- and long-term perspective. In this respect, the same is true for Japan, but there are various issues, challenges, and risks involved. First of all, whatever the economy, if a dependence on investment and exports and an undervaluing of the currency---in China’s case, the weak renminbi---continue for too long, they end up distorting the country’s industrial structure. Improvements take an extremely long time, and friction arises in various forms. The Japanese had exactly this experience in the past. In 1949 the exchange market was fixed at the low level of \360 to the dollar, and this situation continued for more than 20 years until 1971. It is a fact that this economic policy of a weak yen and dependence on exports supported Japan’s high economic growth, but it also resulted in forming an economic structure of excessive dependence on export industries, and that clearly was the underlying cause of the economic hardship that Japan faced in the 1980s and 1990s.

Regarding long-term issues, I won’t go into detail since I mentioned them earlier, but there is the problem of energy, in particular the serious problem of water resources, and the closely related problem of environmental preservation. These problems of energy, water, and the environment will be extremely important issues for the development of the Chinese economy and society over the coming decades.

The third issue relates to population. As a result of the one-child policy, eventually an era of few children and aging is going to suddenly arrive in China as well. Considering the inadequacy of the social security system, this is going to be an extremely serious problem in the future. Furthermore, the flow of population from rural areas into cities in China is going to continue for the next few decades, so the ensuring of employment in the cities is going to continue to be a major problem. Conversely speaking, there is also the problem of the rural villages. In China the three agricultural problems, namely, the problems of the rural villages, the agricultural industry, and the farmers, are fully recognized, but solving these problems will be important. So the various problems involving population, including intergenerational problems and interegional problems, are going to be extremely important as long-term issues.
Next, let me talk about social and political problems. As I mentioned earlier, China is supported by rapid economic development, and it is a fact that in the present situation the degree of satisfaction among the general population is quite high. However, as I said just now, it is also a fact that dissatisfaction is arising in various ways, especially in rural areas, and the spectacular spread of the Internet with the arrival of the information society deserves special attention. This means that hundreds of millions of people are now beginning to share information. They are all coming into contact with the same information. However, although they are sharing information, naturally doubts also arise as to whether they are properly sharing in other areas, such as material affluence or political and social power. This is a natural result of globalization, and the phenomenon is beginning to occur in China as well. I think that it will become even more conspicuous in the future. Inevitably the people’s discontent with the various inequities in society, the rampant corruption in the government and business circles, and excessive regulations will grow, and indeed there are already signs of this happening. In other words, ordinary people are naturally going to react against inequities, corruption, and regulation.

Such social problems are certainly not limited to China; they are occurring now in almost every country around the world. In China’s case, however, the government faces an especially difficult and important task, because the problems must be tackled within the process of qualitative change from a planned economy to a market economy and from a developing economy to a developed economy.

And in China’s case, I think there is one more extremely difficult issue. That is to say, in the end communism failed. Although communism originally was an economic and political theory, however, it went beyond that and had a certain ethical character as well in terms of equality and the basic rights of workers. Communism failed, but it did possess an unmistakable kind of ethics. Some people will not agree with me, but I think that while the reforms of Deng Xiaoping made a major contribution in the sense of bringing about a historical change in the Chinese economy, at the same time his reforms undoubtedly killed off communism, including its ethical side. Accordingly, people like me who have a great respect for China and an affection for the country are extremely worried about one aspect of present-day China. That is, while there clearly is a tremendous momentum toward material affluence, there also seems to be a kind of social distortion in the form of spiritual poverty.

Next I would like to speak about the other part of today’s theme, which is what the Chinese economy means for Japan. It goes without saying that for Japan, relations with China are the most important bilateral relationship alongside its relations with the United States. Furthermore, I would like to emphasize that Japan-China relations are the longest bilateral relationship in the world. Relations between these two countries have continued for more than 1,500 years. During this time there have been various incidents, and to be frank, it is a fact that there was an extremely unfortunate period in bilateral relations from the second half of the nineteenth century when things did not go smoothly. However, it is not my role to speak here about political relations between Japan and China. I will focus on economic ties. At present the scale of economic relations between Japan and China is extremely large and, moreover, deep. This is evident from the statistics. For example, two-way trade, that is, exports and imports, amounts to $200 billion, and China is Japan’s largest trading partner. Direct investment from Japan to China already reaches $55 billion, and at present there are nearly 40,000 Japanese companies operating in China, directly and indirectly employing nearly 10 million Chinese and paying \50 billion in taxes to the Chinese government.

There is no need to repeat that economic relations between Japan and China are close, but it also goes without saying that stable and firm economic relations between these two countries are crucially important for Asia as a whole as well. Over the next few decades I think that East Asia will be the most dynamic region in the world economy and will develop into one large regional factory, and within this process cooperative relations between the Japanese and Chinese economies will be extremely important. Inevitably the Japanese and Chinese economies will become competitors and rivals in various areas. There will be the problem of energy and the processing of primary products, the problem of the expansion of export markets, and competition over various technological developments. Competitive and rival relations in various fields will be unavoidable.

At present the Japanese economy is more than double the size of the Chinese economy, and more than 20 times the size in per capita terms. But if the Chinese economy continues the present high growth rates over the next few decades, it is possible that the time will come when the Chinese economy surpasses the Japanese economy in terms of both overall size and per capita scale.

I do not think that either the Japanese economy or the Chinese economy will achieve an unquestionably hegemonic or leadership position in Asia in the foreseeable future. Accordingly, I believe it is important---for the two countries themselves, for Asia, and in turn for the world as a whole---for Japan and China to maintain an economic policy of competition and coexistence, of rivalry but definitely not hostility.

QUESTIONS AND ANSWERS

Q:I think this is closely related to Japan-China relations, but I would like to ask about the relationship between Japan and India. The government of Prime Minister Shinzo Abe has said that it wants to promote Japan-India relations. Could you comment on the strategy of the Abe government behind this move? And what is your opinion about Abe’s desire to promote these relations?
My second question is about the bubble economy. Comparing the state of Japanese banks at that time and Chinese banks at present, how serious is the problem in China now?
A:First of all, regarding the question about India, I am not a member of the government now, so I cannot speak on behalf of the government about its policies. But I would like to give you my personal opinion instead. In the past few years Japanese companies have come to adopt a “China plus one” policy. This is a strategy of dispersing the risks involved in investment rather than concentrating them too much in a single country. In this case, as you know, the “plus one” countries are places like India and Vietnam. For Japanese companies, there has not been the slightest change in the fact that China is the most important market in Asia. However, in terms of spreading the risk, place names like India are being cited as well. I think that the government’s policy has a similar feature. Considering India’s economic scale and development potential, I think it can be predicted that in 10 or 20 years’ time India will be playing an extremely important role in Asia. Accordingly, it is a natural diplomatic policy for Japan to think beforehand about properly building relations with such a country. At present, however, relations between Japan and China are without doubt much more important than those between Japan and India.
Regarding your second question, the assets of Japanese banks worsened rapidly and greatly after the collapse of the bubble. At the worst time, I think that nonperforming loans probably accounted for 20 percent of the loan assets of Japanese banks. In monetary terms, that is \100 trillion out of outstanding loans of \500 trillion. After that, as you know, following a period of painful adjustments that lasted for an extremely long time, including the injection of public funds by the government and the write-off of bad loans by the banks, the situation sharply improved from 2003. At present the ratio of nonperforming loans to the total assets of Japanese banks has dropped to less than 2 percent. As for the asset quality of Chinese banks, and the corresponding figures in China’s case for the ratios of 20 percent and 2 percent that I just cited for Japanese banks, to be quite honest, I do not know. As you know, overseas analysts and others have announced various opinions about the quality of Chinese bank assets. Among them, there are some extremely pessimistic views. For example, some people say that the ratio of nonperforming loans in China’s state-owned banks is higher than 20 percent. According to announcements sometimes made by the Chinese authorities, for individual banks the bad loan ratio is extremely low at 2 percent. The main reason for the obscurity is that information disclosure is simply too inadequate. So I just do not know about the content and quality of Chinese bank assets. If anyone does know, I would love to hear.
As you know, recently Chinese banks have been going private and getting listed. If this happens, then naturally there will be information disclosure and analysis of the balance sheets of the banks, and, I hope, an accurate picture of the nonperforming loans will come into view.

Q:As you said, the water, energy, and employment problems in China are becoming more and more serious, and we hear talk about the “China risk.” Among the Japanese, some people say that Japanese investment should be shifted to other places, such as Southeast Asia and India. Do you think Japan should increase its investment in China or decrease it?
A:Considering the potential of the Chinese economy, naturally I think that Japanese companies should further increase their investment in China. Actually, the largest destination of direct investment from Japan is still the United States. China is the main destination in Asia, but from a worldwide point of view, Japanese investment is still concentrated to a considerable extent in North America. I think it would be only natural for investment in China to increase further. However, since investments involves considering both the opportunities and the risks, naturally it is necessary for Japanese companies to have sharp eyes.

Q:I am very glad to have been able to hear your talk. Speaking at an international student meeting at Princeton University 15 years ago, you said that young Japanese now must have the ability to express themselves in English, so I became an English-language journalist!
I have two questions. First, you said that the dependence on exports and the weak renminbi will exert an adverse impact in the future. What do you think would be an appropriate level for the renminbi? And second, what is your forecast for the yen-dollar exchange value about six months from now? At present the advancing weakness of the yen is drawing criticism from various countries, so please tell us your prediction.
A:Since it is a fact that the trade deficit between China and the United States is in the region of $120 billion to $130 billion a year, I think it cannot be denied that the value of the renminbi to the dollar, at least on the foreign exchange market, is too low. The problem is, what should be done to improve the trade imbalance between China and the United States? And what role should the renminbi-dollar exchange rate play in this respect? I think this is a separate matter. As you probably know, some American politicians and scholars, such as Senator Charles Schumer and people like Fred Bergsten, say that in order to solve the trade balance between China and the United States, the value of the renminbi against the dollar must be raised 20 percent or 25 percent. In practice, however, such a large revaluation of the renminbi cannot be implemented. If it were, I think the result would be enormous economic confusion. The answer, I believe, is to build a setup whereby the value of the renminbi is decided more by actual supply-and-demand conditions in the market.
On this matter, actually, there is absolutely no difference of opinion between China and the United States. People’s Bank of China Governor Zhou Xiaochuan and US Treasury Secretary Henry Paulson are saying the same thing. Governor Zhou says that the system reform in July of last year was extremely important, and I completely agree with him. However, as I stated earlier, he also says that changes after that must be moderate. Paulson would probably say that the changes should be faster, so the problem is one of different timing. As I explained earlier, the People’s Bank of China does not have final authority over exchange rates, so it is wrong to place all the blame on the People’s Bank. In reality, the problem of the value of the renminbi is an extremely political one, and I am not in a position to make any further comments on the matter.
Regarding the yen-dollar exchange rate, as you know, there are various factors at work. As a result, as you can see, the yen-dollar exchange rate recently has been virtually a fixed one, hovering in a stable manner between \115 and \120 to the dollar. Your question was about the outlook for the next six months. I think that the biggest factor that we must pay attention to is the movement of interest rate policies in Japan and the United States. In both countries interest rate policy is now entering a rather delicate phase. In the United States, the federal fund rate is 5.25 percent. There are three possibilities for the next few months: the rate will remain at this level; or inflation in America will become dangerous, and the rate will be further raised; or, conversely, the US economy stagnates more than expected, and the rate is lowered. At the present point in time nobody, including Federal Reserve Board Chairman Ben Bernanke, knows what will happen. In Japan, meanwhile, Bank of Japan Governor Toshihiko Fukui wants to normalize the interest rate situation as quickly as possible. That is to say, he wants to raise the rate from the current level of 0.25 percent. However, the Japanese economy is in a rather delicate situation. The figures for gross domestic product in the third quarter, announced the day before yesterday, were positive, but the situation is unstable, with domestic demand and especially household consumption not expanding. There is also doubt about whether plant and equipment investment is going to remain brisk from now on. It is uncertain, therefore, whether the lively conditions will continue enough to justify an interest rate hike, or whether the Japanese economy will experience a slight slump or downturn. The government naturally has its eyes on next year’s House of Councillors election, so it wants to avoid any economic slowdown. Monetary policy is the prerogative of the Bank of Japan, but I think that without doubt the government hopes that the Bank of Japan will continue the easy-money situation as much as possible.
Accordingly, the main interest of the market in the immediate future will be whether the Bank of Japan raises interest rates or does not raise them before the end of the year. The reason is that, as I just explained, the interest rate situation in the United States is quite open. So will Japanese interest rates rise or not rise in these circumstances? And as a result, will the gap between Japanese and US interest rates shrink, or not shrink, or widen? Here also, there are three possible scenarios. These interest rate trends will probably exert a major impact on the yen-dollar exchange rate over the next six months.
If I might venture to give my own personal opinion, in the case of US interest rates, I think that the present level of 5.25 percent will continue for a while, probably for a few months. In the case of Japanese interest rates, I think there is a fifty-fifty possibility of a rise by the end of the year. So the most likely scenario is that the interest rate gap between Japan and the United States will shrink a little or will not shrink at all. Accordingly, I think there is quite a strong possibility that the yen-dollar exchange rate will remain in the present range of \115 to \120. I would add, however, that I have been involved in international finance work for around 50 years, and the extremely clear conclusion that I have gained as a result is that exchange rates are quite unpredictable.
(FPCJ is the responsibility for the wording.)

* Given on November 16, 2006, at the Foreign Press Center/Japan. This paper is reserved for internal use; any reproduction or quotation is forbidden without prior permission from the FPCJ. 　
©FPCJ 2006