Carolyn Wilkins: China's great transition - what it means for Canada
Remarks by Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, to the
Greater Vancouver Board of Trade, Vancouver, British Columbia, 5 April 2016.
* * *
I'd like to thank Mark Kruger and Gurnain Pasricha for their help in preparing this speech.
Introduction
If I were to ask everyone here what the value of the Canadian dollar is these days, I expect
you'd assume I meant relative to the US dollar. And you'd probably get the value bang on.
This is understandable: the United States is our biggest trading partner, and most
Canadians, especially business people like you, are well aware of the links between our two
economies.
Now, if I were to ask you about the exchange rate between the Canadian dollar and the
Chinese renminbi, the answers probably wouldn't be as accurate. This makes sense too: it's
not a number you often come across, even if you're reading news stories about China's
slowing growth and financial volatility.
Yet, China is Canada's second-largest trading partner and accounts for 17 per cent of the
world economy.1 More than 400 Canadian companies have a foothold there. They are in
sectors as diverse as life sciences, aerospace and information technology. China's currency
is on the way to becoming a global reserve currency. A decade from now, our children may
convert Canadian dollars into renminbi as easily as we do now for US dollars.
We pay very close attention to China at the Bank of Canada because of its growing
importance to our country's economic and financial well-being. Today, I want to share with
you some of what we've learned by studying how China's economy and financial system
have evolved, and to discuss the opportunities and challenges that lie ahead.
This is relevant to all regions of Canada, especially here in Vancouver, our gateway to Asia.
It's a real pleasure to be here, and I'd like to thank the Greater Vancouver Board of Trade for
the invitation.
In my remarks, I will walk you through four points that frame our thinking on China:
(i) China's rise on the world stage has been exceptional, even disruptive, and
beneficial for the global economy and Canada.
(ii) The slowing of China's growth to a more sustainable pace is not only inevitable, it's
also desirable.
(iii) History teaches us that this type of transition is difficult to manage, takes time and is
very likely to be uneven.
(iv) Canada is not immune to the risks China poses to the global economy, but we're
well positioned to manage them.
A giant awakens
China's market reforms of the 1980s and its accession to the World Trade Organization
(WTO) in 2001 marked the beginning of a remarkable transformation that has been felt
around the world.
For China, the process has been overwhelmingly positive, even though it has entailed some
stresses, particularly environmental ones. Its economy has more than tripled in size. More
than a quarter of a billion Chinese people have been lifted out of poverty, in what has been
the largest migration of rural workers to cities in history.2 Life expectancy has increased by
nearly three years. And China is hosting the G20 this year, just one example of its growing
presence on the world stage.
China's transformation has also yielded benefits for the global economy. It's true that China
and other emerging markets have presented stiff competition to exporters around the globe,
including in Canada. We see the result in the declining proportion of people working in
manufacturing industries in advanced economies, which has been difficult for many. And it
likely contributed to the buildup of imbalances in the global financial system ahead of the
financial crisis in 2008.3 Yet, China's expansion also helped drive global trade to record
highs. This means that exporters have been selling into a bigger market. At the same time,
businesses and households have benefited from lower prices for many goods.4
China's growth has also meant better prices for the resources Canada sells. China has
become the world's second-largest consumer of oil, with its demand doubling over the past
15 years.5 It now buys half of the world's output of base metals, compared with less than
20 per cent in 2001.
This has helped make Canada richer. China's increased demand for commodities
contributed to the big improvement in Canada's terms of trade - the price of our exports
relative to that of our imports - between 2001 and 2008. Our terms of trade has fallen over
the past couple of years, in part because of slowing growth in China, but it remains just over
10 per cent higher than it was when China joined the WTO.
It's hard to overstate how quickly the economic links between our two countries have
developed. Two-way trade between Canada and China increased more than fivefold over the
past decade and a half, and our exports to that country now exceed $20 billion a year. British
Columbia has seized this opportunity; for example, China bought just under one-third of the
province's exports of forestry products last year, compared with only 4 per cent in 2001.
Our governments have also worked to encourage trade and investment through accords,
trade missions and other agreements with China.6 And the growth in foreign direct
investment in both directions speaks to the deep links that have been formed.7
On the financial side, the Bank of Canada signed a $30 billion Canadian dollar/renminbi
bilateral swap arrangement with the People's Bank of China in 2014. This paved the way for
2
R. Garnaut, L. Song and C. Fang, "Reform and China's Long-Term Growth and Development," in Deepening
Reform for China's Long-Term Growth and Development (Canberra: ANU Press, 2014): 3-25.
3
B. S. Bernanke, "International Capital Flows and the Returns to Safe Assets in the United States 2003-2007,"
Banque de France, Financial Stability Review, no. 15 (February 2011): 13-26.
4
L. Morel, "The Direct Effect of China on Canadian Consumer Prices: An Empirical Assessment," Staff
Discussion Paper No. 2007-10, Bank of Canada, 2007; M. Francis, "The Effect of China on Global Prices,"
Bank of Canada Review (Autumn 2007): 13-25.
5
According to the International Energy Agency, China's oil consumption rose to 10.6 million barrels per day in
2014, from 4.6 million barrels per day in 2000.
6
Examples include the Canada-China Foreign Investment Promotion and Protection Agreement, the Joint
Declaration on Canada-China Clean Technology Cooperation, and the memorandum of understanding aimed
at increasing British Columbia's lumber exports to China. For more information, see
http://www.international.gc.ca/trade-agreements-accords-commerciaux/agr-acc/fipa-apie/china-chine.aspx?
lang=eng, http://news.gc.ca/web/article-en.do?nid=1036379, and
https://news.gov.bc.ca/stories/china-and-bcsign-wood-frame-mou.
7
China's investments in Canada reached $25 billion in 2014, 115 times more than they were in 2001.
Meanwhile, Canadian investments in China rose by a factor of 10 during the same period, to $7 billion.
the opening last year of the Canadian Renminbi Trading Hub, which will make it easier for
our companies to use renminbi in business transactions. Canadian financial institutions are
active in China, and, just a few months ago, British Columbia became one of the first
governments to issue Panda bonds in China.
Slower - but steady - wins the race
Let me turn to my second point. While China's economic growth has had an overall positive
impact on the Canadian economy, that growth is slowing. It's slowing to a more sustainable
pace, and this is not only inevitable, it's desirable.
The Chinese economy expanded by a little less than 7 per cent last year. That sounds fast
relative to advanced economies, but it's the slowest pace for China in 25 years and down
from the double-digit numbers of a few years ago.
The slowdown is natural. The economic strategy that the Chinese have pursued over the
past 15 years cannot continue indefinitely. The strategy is simple: add more workers and
more capital to increase the economy's potential to produce goods, and then sell those
goods in global markets.
This has run its course, for a couple of reasons. First, demographic forces are no longer in
China's favour - the working-age population is projected to shrink by about 5 per cent by
2030.8 Second, China's reliance on investment is not sustainable - it was 46 per cent of
GDP in 2014, compared with 25 per cent for other emerging-market and developing
economies and 20 per cent for advanced economies.9
The strong investment policy is increasingly creating redundant or unproductive capital in
China, which may boost growth in the short run but also increases the odds of painful
economic adjustments in the future.
A critical question is where growth in China is likely to settle if the transition is successful.
Bank of Canada researchers judge that China has the potential to grow at an annual rate of
around 6 per cent, on average, over the next 15 years.10 At that pace, it takes less than
12 years for the economy to double in size.
To understand how such growth is possible, recall that China's GDP per capita is still only
one-fifth of what it is in the United States. This means China still has a lot of room to catch up
by adopting existing advanced technologies. As part of this process, the share of agricultural
workers in China will continue to shrink, to the benefit of more productive sectors.
With Chinese incomes rising, education levels should follow suit and boost productivity.
These improvements in human capital could potentially more than make up for the decline in
the working-age population.11
One implication for Canada is that China's demand for commodities should remain high and
grow from a higher base, even if the country's economic growth is slower and less reliant on
natural resources.
Solving the Chinese puzzle
My third point is that history shows that the transition to the next stage of development is
difficult to manage, takes time and is quite likely to be uneven.
If China is to achieve its potential to grow, it will have to avoid what economists call the
"middle-income trap," in which developing countries that seem destined to join the club of
advanced economies suddenly see their growth stagnate for many years.12
Chinese authorities recognize that their specific challenge is to shift from an economy fuelled
by investment to one supported by domestic consumption. Another is to boost productivity.
To meet these challenges and to achieve the economy's potential, Chinese authorities are
working to fit a number of pieces together - much like a Chinese puzzle. There are many
pieces, but let me mention three.
Comprehensive social safety net
The first one is outside the purview of central banking but crucial to achieving the rotation of
demand toward consumption. I'm talking about a comprehensive social safety net. In
advanced economies that have a public pension system, unemployment insurance and
healthcare, risks are pooled, and people can spend more of their income because there is
relatively less need to save for a rainy day. That's why people in developed countries save
an average of around 5 cents of every dollar they earn. Contrast this with China, where
urban households currently save nearly 40 cents out of every dollar earned.
Chinese workers and capital will also need to adjust as the composition of the economy
shifts out of state-owned sectors like coal and steel, toward more productive sectors like high
value-added services.13 This will be a lengthy transition, in part because many people will
need to relocate to different regions and perhaps even be retrained.
China has taken steps in the right direction, bringing in pension reforms, higher healthcare
spending and reforms to the household registration system that will give migrant workers
access to basic services in smaller Chinese cities. China also made raising the level of social
protection a priority in its new Five-Year Plan.
Solid monetary policy framework
The second piece, which is very relevant to central bankers, is a solid monetary policy
framework to provide the foundation for sustainable growth. China faces what is known in
international economics as the "policy trilemma."14 No country can sustainably maintain all of
the following three policies: (i) a fixed exchange rate, (ii) independent monetary policy and
(iii) free international capital flows. It's the classic case of "you can't have it all."
Resolving this trilemma won't be easy, and it takes time. No one knows this better than
Canada. We successfully confronted the trilemma and then later adopted inflation targeting
in 1991, which was the perfect complement to a floating exchange rate and free capital flows.
This monetary policy framework has served us well for the past quarter century.
But we should remember that it took us several decades, and a number of policy reversals
and missteps, to reach this point. History buffs will recall that Canada let markets determine
the value of the Canadian dollar in 1950, then went back to a fixed exchange rate in 1962
and finally adopted a floating exchange rate in 1970.15 Yet we still lacked a robust monetary
anchor and this contributed to a period of very high inflation that lasted through the
early 1980s. The lesson for us is that orienting monetary policy toward achieving low and
stable inflation can lead to better economic outcomes.16
China only recently moved from pegging the renminbi to the US dollar to maintaining its
stability against a basket of currencies. This has increased the variability of the renminbi/US$
exchange rate and allows for exchange rate movements that could facilitate deep structural
adjustments. Certainly, in Canada, we've seen that our floating exchange rate supports
structural adjustments, like the reorientation toward the non-resource sector under way
today. My colleague Deputy Governor Lynn Patterson gave a speech about this last week - I
recommend it to anyone who wants to learn more about this transition.17
That said, if Chinese authorities gear monetary policy toward supporting the exchange rate,
there may be trade-offs with pursuing domestic objectives. Moreover, the appropriate level of
the basket itself changes over time, leading to speculative flows if the target level is not
adjusted on a timely basis.
Chinese authorities have committed to further liberalizing the capital account. Loosening
restrictions on international flows, if managed well and at the right time, could help China's
transition.18 Liberalizing the capital account would help to complete markets and expand
access to market financing within China.
That said, liberalizing the capital account is one of the most difficult challenges that
developing economies face. Take the Asian Crisis as an example: countries liberalized their
capital accounts before their financial systems were ready and suffered a currency crisis in
1997 that set their development back a few years. One of the lessons is the need for
welldeveloped and resilient financial markets to allow for the pricing of risks and to accommodate
large financial flows. This episode also illustrates that a lack of market-determined exchange
rate flexibility can encourage excessive unhedged foreign currency borrowing. Hedging
raises the cost of foreign borrowing and would have limited excessive exposures.
Financial stability
Financial stability is the last piece of the puzzle I'll mention. There are some points of
concern here. In the aftermath of the global financial crisis, China embarked on a massive
expansion of credit to support domestic demand.19 China's overall debt has grown much
faster than the economy, now reaching some 285 per cent of GDP. Around 60 per cent of
this is in the non-financial corporate sector, mainly state-owned enterprises. This sector is
where a lot of the excess capital and non-performing loans may reside.20
15
J. Powell, A History of the Canadian Dollar (Ottawa: Bank of Canada, 2005).
16
M. Parkin, "Mounting Evidence: Findings from Natural Experiments in Inflation Targeting," E-Brief, C.D. Howe
Institute, 31 March 2016.
17
L. Patterson, "Adjusting to the Fall in Commodity Prices: One Step at a Time" (speech to the Edmonton
Chamber of Commerce, Edmonton, Alberta, 30 March 2016).
18
These benefits are discussed in greater detail in Kruger and Pasricha (forthcoming).
19
The Bank for International Settlements (BIS), which conducts a worldwide assessment of financial sectors
every quarter, identified China as a vulnerable financial system, as measured by three out of the four early
warning indicators used. See Bank for International Settlements, BIS Quarterly Review, September 2015.
20
Data are from the Institute of International Finance's Emerging Market Debt Monitor.
There are other worries too, such as potential under-reporting of non-performing loans in the
banking sector and the strong growth in lending and other financial activity by entities that
may be lightly regulated.21
That is why Chinese authorities are working to strengthen regulation and oversight. For
instance, they have improved the transparency of the country's debt, which should make it
easier to spot problems before they spiral out of control. Local governments, for example, are
now required to borrow by issuing bonds for new projects rather than by using opaque
financing vehicles. Moreover, China is a net international creditor - of about US$1.7 trillion -
which insulates it, to some extent, from the decisions of international investors.
The People's Bank of China has so far been able to manage downward pressures on the
renminbi that have come with capital outflows. An estimated US$600 billion left China last
year.22 Some of the capital outflows have been Chinese corporations paying down foreign
currency debt, which is a good thing. The People's Bank of China still has around US$3
trillion in reserves. There is concern in markets that, if capital account pressures were to
continue, the central bank may have to either lower its target range for the currency or
introduce more-stringent capital controls. Chinese authorities are focusing on more proactive
communications and reforms to foster trust in their financial system.
Canada has a stake in China's future
This brings me to my final point. Canada is not immune to the risks that China's transition
poses to the global economy. It is nonetheless well positioned to manage them.
At the Bank of Canada, we've been thinking through what a shock from China would mean
for our economy.23
Canada would be affected mainly through lower commodity prices and slower trade. Direct
financial spillovers would likely be relatively small because our banks have little direct
exposure to China. What's more, the US and European banks that our banks do business
with have strengthened their balance sheets since the financial crisis. That said, uncertainty
about China's prospects has had a surprisingly large effect on investor confidence in recent
months, so this could be an important channel.
To get a rough idea of how important the trade and commodity price channels could be, our
staff conducted simulations using our economic models. They looked at what would be the
effect on the Canadian economy if GDP growth in China were 1 percentage point lower than
our baseline projection. They found that Canadian GDP would be 0.1 percentage point lower
than it would have been otherwise. To give some perspective, if the same shock occurred in
the US, the effect on our GDP would be six times greater.
The effects of a shock from China would also depend on a number of other factors our
models don't capture well, such as what parts of the Chinese economy were growing more
slowly and how severely global financial markets were impaired. A significant depreciation of
the renminbi, especially if it were sudden, could be disruptive to the global financial system,
with implications for Canada. It would also depend on the progress the Canadian economy
has made in its own adjustment to the drop in commodity prices that we've seen in the past
two years.
Canadian financial institutions have the capital and liquidity in place to handle adverse
shocks like this. Stress tests conducted by the International Monetary Fund and Canadian
authorities in 2013 showed that our banks can withstand a larger shock than even those we
saw during the 2008 financial crisis or the recessions of the 1990s and 1980s.24
Conclusion
Ladies and gentlemen, let me conclude with a quote that dates back two centuries and that is
attributed to Napoleon. He is reported to have said about China: « Ici repose un géant
endormi, laissez-le dormir, car quand il s'éveillera, il étonnera le monde. » It means, "Here
lies a sleeping giant, let him sleep, for when he wakes, he will shake up the world."
This was prescient.China's integration into the world economy has been nothing short of
extraordinary.
As China's economy continues to mature, its growth is slowing to a more sustainable pace.
This is desirable. China has the potential to grow at a healthy pace over the longer run, but
the transition will take time and there is uncertainty about whether this potential will be fully
achieved. That means China may go through some periods of economic and financial
volatility.
The Bank of Canada will continue to watch developments in China closely, given its
importance to the global economy and Canada. China's transition poses risks, and Canada
is well positioned to manage them. At the same time, lower prices for oil and other
commodities mean that Canada is going through its own complex adjustment.
In March, the Bank of Canada left the policy interest rate unchanged, since the economy was
evolving broadly in line with our expectations set out in our January Monetary Policy Report.
Next week, we will update our projection and take into account all that has happened since
January, including the measures announced in the federal budget.
And if you're still wondering about the exchange rate and have resisted googling it, the
answer is around five renminbi per Canadian dollar.