Martin Wolf

East and west are in it together

Size matters. If we look only at China’s average level of development, we see a country with much the same standard of living as Thailand. If we look only at China’s size, we see what is already the world’s second largest economy, biggest exporter (if members of the European Union are treated as separate economies), second largest importer and holder of the largest stock of foreign currency reserves.

China’s leaders are, naturally and rightly, focused on sustaining stability and achieving prosperity. The rest of the world is, no less naturally and rightly, wondering how China will exercise its growing power and responsibility.

So far, despite the difficulties, the adjustment to China’s rise has been remarkably successful, particularly if one considers the gulf in culture, history and political systems between China and incumbent powers. The Chinese economy has proved outstandingly dynamic and increasingly market-driven. The west, in turn, has accommodated itself to China’s rise. That was the wise thing to do.

Contrast, for example, the devastating impact of US protectionism and the “great depression” of the interwar years with the increasingly open Chinese economy of the last three decades and the successful response of Chinese Keynesianism to the challenges of the recent “great recession”. Consider, too, China’s entry into the World Trade Organisation and the world’s impressive ability to adjust to the rapid rise in China’s trade from just 4 per cent of the world’s total a decade ago to 10 per cent today.

Both China, then, and the west have much to be proud about. Yet this does not mean that everything has gone smoothly. On the contrary, both sides have made sizeable mistakes in managing their economic interactions over the past decade.

China, for example, allowed an extraordinary surge in exports and the current account surplus to mask the development of an increasingly unbalanced domestic economy. Chinese household consumption collapsed from an already very low share of 46 per cent of gross domestic product in 2000 to a mere 35 per cent in 2008, while gross fixed capital formation jumped from 34 per cent in 2000 to 41 per cent in 2008 and 45 per cent in 2009.

Partly as a result of its decision to suppress the appreciation of the exchange rate, China emerged as the world’s largest surplus country, with a current account surplus peaking at over 10 per cent of GDP and foreign currency reserves of close to 50 per cent of GDP. These were foolish investments, made as a result of foolish policies. It is absurd for China’s leaders to complain about China’s consequent (and unnecessary) vulnerability to US fiscal policy.

Meanwhile, the US and a number of other western countries allowed the supply of cheap foreign savings, partly from China, to help stimulate a huge surge in household debt, consumption, residential construction and financial sector leverage. While the excess savings of the emerging world were not the principal cause of the financial crisis, they were surely a contributory factor.

Fortunately, most of what needs to be done to achieve a better balanced and less unstable world economy is strongly in the economic interests of both sides. This is becoming ever more obvious as China struggles with inflationary pressure and the lagged effect of the surge in credit growth used to cope with the downturn in exports during the crisis.

It is also evident that a large real appreciation of the Chinese exchange rate is both inevitable and a way of facilitating a shift in the economy towards greater reliance on domestic consumption. A far higher nominal exchange rate would surely be a better way to achieving such a real appreciation than higher inflation.

This rebalancing is, however, merely one element in the agenda, as China grapples with the challenges of achieving rapid, widely shared and environmentally sustainable growth and the rest of the world learns to adjust to its growing impact. In seeking to address these challenges, China and its partners need to remember two over-riding considerations.

First, the political and economic consequences of a breakdown in relations between China and the west would be catastrophic. At best, it would be impossible to sustain prosperity and manage the many shared challenges created by the pressure of humanity on the world’s limited resources. At worst, it could mean war.

Second, it is vastly important to strengthen the legitimacy and effectiveness of global governance. China may view these structures as a western invention, if not an alien imposition. But they remain the best way to manage a world in which no one country – even ones as powerful as the US or as potentially powerful as China – can achieve what it wants for its own people on its own.

What, then, is the economic agenda that both sides need to tackle? This is well known: maintaining open trade; securing balance of payments adjustment; reforming the international monetary system; managing the global commons; and containing potential conflicts over access to natural resources.

As China’s president Hu Jintao visits US president Barack Obama this week, both will be aware of how much lies on their shoulders.

Both countries have strong suspicion of the other. Both dislike constraints on their freedom to act. Both find some aspects of the other’s behaviour intolerable. Yet both must also be aware that what lies ahead of their countries is a long and intense relationship. Technology and economics have made the world smaller than ever before. China’s development is putting to an end the period of unquestioned western supremacy. East and west must co-operate, or perish.

Martin Wolf is chief economics commentator of the Financial Times.

This post is also available in: Chinese (Simplified)

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