Vítor Constâncio: Economic reforms - European and Chinese challenges
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at The
Hamburg Summit: "China meets Europe", Hamburg, 25 November 2010.
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Introduction
Relations between China and Europe are currently closer than ever before. This is ultimately
a result of the growing interdependence between these two partners and the ensuing need to
address common policy challenges through cooperation in today's global environment.
The strength of the economic links between China and Europe is undeniable. In my capacity
as a euro area central banker, let me provide some evidence pertaining to this vast region of
Europe, which in around one month's time will span 17 different countries. The euro area is,
alongside the United States, the main destination for Chinese exports, with an export share
of 15% in 2008. But it is equally impressive - when looking, in turn, at euro area exports -
that euro area exports to China tripled between 2000 and 2009, at a time when the share of
the United States in total euro area exports was decreasing from 17% to 12%. The pace of
this development has been particularly striking during the financial crisis: China's share of
total euro area exports rose from 3.8% to 6.2% between the first quarter of 2007 and the
second quarter of this year, increasing by an extraordinary 70% since the first quarter of
2009. It is also interesting to note that Chinese foreign direct investment in the euro area,
while still at a relatively low level, has shown consistently strong growth since 2004. The
people of Europe have now become used to the idea of some of their firms being owned by
companies located in China.
It is therefore no surprise that our countries have significant shared interests. The point I
would like to make today is that our common strategic concerns pertain not only to the
continuance of a bilateral and global free trade environment, but also to the pursuit of
domestic models in terms of growth and economic governance that prove sustainable and do
not exacerbate macroeconomic or financial stability vulnerabilities over time. This would
place the close relationship between our two economies on a solid footing in the long term.
Such relations must, in turn, be seen against the broader, multilateral background of the
upgrading of the G20 in response to the financial crisis, which has been crucial in further
involving all systemically important countries, including China, in international policy
cooperation. In particular, the G20 Framework for Strong, Sustainable and Balanced Growth
is a promising means of fostering collective action at the global level. If this goal is to be
achieved, the ECB considers it vital that all G20 members fully live up to the commitments
made within the Framework.
Against this backdrop, I will first discuss the policy challenges currently confronting euro area
authorities and the responses that are being adopted. I will then talk about those factors
which - both in my understanding and, as far as I can see, in the view of the Chinese
authorities - make the pursuit of economic reforms a central objective in China, too.
1. Euro area
There has recently been a tendency among commentators to regard Economic and
Monetary Union (EMU) as being in need of far-reaching reform. This view has been
encouraged by the emergence of tensions in certain euro area sovereign debt markets in
2010, which has caused some observers to reappraise the prospects for the single currency.
These criticisms stem from three challenges currently facing the euro area:

first, the excessive debts and deficits in a number of member countries;

second, the considerable divergence across the euro area in terms of
competitiveness and member countries' sizeable current account imbalances;

third, the challenge of preventing and managing crises, given the lack of a clear euro
area framework for this purpose.
These challenges refocus attention on certain indispensable aspects of what it means to be
part of a single currency area.
The challenge of excessive public debts and deficits serves as a reminder of the need for
countries in EMU to pursue sustainable fiscal policies. Fiscal sustainability is a must in a
union with a centralised monetary policy, but decentralised fiscal policies, and a central bank
which - for very good reasons - is prohibited by the Treaty on the Functioning of the
European Union from engaging in the monetary financing of public deficits. Moreover, fiscal
policy has to be geared towards maintaining domestic demand in line with sustainable
growth and price stability.
The challenge of intra-euro area imbalances underscores the importance of countries
keeping nominal price and cost developments in line with those of the euro area as a whole.
Otherwise, losses in competitiveness will ensue which cannot be offset by the exchange rate
or the single monetary policy, which by definition can only be geared towards price stability in
the euro area as a whole. This also underscores the importance of avoiding unsustainable
current account imbalances, which imply vulnerabilities such as excessive credit growth or
dependence on external financing.
The challenge of preventing and managing crises draws attention to the need for euro area
countries to genuinely treat their economic policies as a "matter of common concern" - as
they are obliged to by the Treaty - and exercise effective peer pressure. Intrusive mutual
surveillance is a necessary precondition for participation in a highly integrated economic and
financial area. As we have seen this year, a failure in terms of surveillance can quickly result
in a crisis in a member country which - no matter how small the country - spills over to the
rest of the area via cross-border holdings of that country's sovereign debt and more general
confidence effects.
While these challenges are genuine and serious, I do not agree with the conclusions that
some commentators have drawn. Such criticisms overlook two very important aspects of the
euro area that tell a different story about its resilience.

First, the euro has been successful, in its first 12 years, in many important areas
which do not require reforms. The euro has brought stability, with inflation averaging
1.98% and inflation expectations remaining solidly anchored. The euro has
facilitated economic integration, with financial integration increasing by around
25-30% in those EU countries that first adopted the euro and trade integration
increasing by an average of 5-10% since 1999. Those countries that have remained
more competitive have benefited significantly in terms of trade in view of the
absence of exchange rate fluctuation. The advent of the euro has also been
associated with the stronger correlation of business cycles and a reduction in the
dispersion of annual inflation rates and real GDP growth rates across euro area
countries. Indeed, nowadays such dispersion is comparable to the dispersion seen
across the various US states. And the euro has established itself as the second
international currency. Given these achievements, it would be distressing to imagine
a world without the euro. What would have happened to individual euro area
economies during the deepest economic and financial crisis in decades?

Second, the major efforts that are already being made to address the root causes of
the euro area's challenges are sometimes overlooked. Euro area countries are
currently leading the way in prioritising a swift return to fiscal consolidation, which
will have important confidence effects. The IMF currently predicts that the euro
area's aggregate fiscal deficit will be 5.1% of GDP next year. This compares with
That said, there are still areas of that reformed governance framework where the ECB would
like to see further progress. We would like to see greater automaticity in the implementation
of fiscal surveillance procedures. We would also like to see stronger sanctions, such as
financial sanctions, under the macroeconomic surveillance procedure. This procedure should
concentrate firmly on euro area countries experiencing sustained competitiveness losses and
large current account deficits. It should be based on transparent and effective trigger
mechanisms and give its assessments and recommendations a high degree of publicity at all
stages of the surveillance process.
The euro area is undeniably facing many challenges. But these challenges do not invalidate
our achievements to date or the steps that are being taken to reform economic governance
and address them at the source. I am confident that euro area authorities will do whatever is
necessary to steer the single currency through its current difficulties, ensuring its future
stability.
2. China
Turning to China, I very much welcome the fact that the Chinese authorities have placed the
gradual rebalancing of growth at the heart of their policy objectives. The 12th five-year plan,
due to be finalised in March next year, testifies to these efforts, which should not be seen in
isolation, but as part of the broader efforts made by systemically relevant G20 members with
a view to rebalancing their economies. In Pittsburgh last year, G20 members with significant
external deficits pledged to implement policies to support private saving and/or embark on
fiscal consolidation, while members with significant external surpluses committed themselves
to strengthening their domestic sources of growth, as well as allowing greater flexibility in
their exchange rate policies, as decided in Toronto. One year later, in Seoul a few days ago,
G20 leaders pledged to "pursue the full range of policies conducive to reduc[ing] excessive
imbalances", the "timely identification" of which will be facilitated by "indicative guidelines to
be agreed by [...] Finance Ministers and Central Bank Governors" in the first half of 2011.
It is against this backdrop that we have to look at the Chinese growth model. This model
began three decades ago, when the country embarked upon a courageous process of
reforms, and relies upon a large pool of domestic savings and cheap labour, with growth
being driven mainly by investment and low-cost exports. In this context, China's
macroeconomic policy framework is built on three mutually consistent pillars: a managed
exchange rate; a closed capital account; and the pursuit of some degree of monetary policy
autonomy, mainly via administrative measures.
The achievements of this model over the past three decades are unquestionable. First,
China's output has grown by an average of around 10% per year since those economic
reforms began in 1978, with the economy showing remarkable resilience even during the
recent global financial crisis. In terms of levels, China's GDP now accounts for less than 40%
of US GDP in market exchange rate terms, but around two-thirds of it in terms of purchasing
power parity. Looking ahead, some observers expect China to surpass the United States as
the world's largest economy as early as 2020.
Strong and sustained economic growth has fuelled an eightfold rise in per capita income.
And as a result, the poverty rate - the percentage of the population that has an income of
less than USD 1.25 per day - has declined to less than 16%, down from 85% when the
reforms began. In other words, China has managed to lift more than 600 million people out of
poverty in the last three decades.
China's export development is equally outstanding. It has increased its world market share
from less than 1% in 1980 to 8% today, and in 2009 it dethroned Germany as the world's
largest exporter.
However, the apparent successes and resilience of the Chinese economic model do not
necessarily mean that this model will prove equally sustainable over, say, the next 15 years.
Indeed, it is interesting to note that some of the major long-term factors that have been
driving China's strong economic performance may reach a turning point in the not too distant
future. These are (i) the continuous growth of demand for Chinese exports, (ii) favourable
demographic developments, and (iii) the sustained accumulation of physical capital. As
regards the first factor, it seems unlikely that China's export growth can continue to
persistently exceed 15% per year, given projected domestic demand trends in advanced
economies. Also, historical experience with export-led economies suggests that there are
limits to the process of gaining market share. The turning point on the demographic side
looks to be further off, but is even more critical. China's dependency ratio - the ratio of
people of non-working age to people of working age - is expected to start rising again by
2015 at the latest. This means that the number of people who cannot save and can only
consume - the youngest and oldest sections of the population - will increase. This, coupled
with the progressive drying-up of labour supply from the agricultural sector, will reduce the
saving rate and the resulting domestic funding of investment. It will probably also bring about
wage increases that impinge upon the cost competitiveness of Chinese exports. Finally,
historical experience with industrialised economies also tells us that the marginal return on
capital diminishes as countries grow richer and accumulate more capital per worker. This
means that in China a transition is needed from an economy driven by growth in factor inputs
to one driven by efficiency and productivity improvements.
The declines in these long-term structural factors are a fundamental reason why economic
reforms are also very important in China, even if in the short run these developments may
not result in immediate challenges to the long-standing economic model. The Chinese
authorities have, however, identified other, partly related developments - the emergence of
domestic and external imbalances - as key factors calling for more urgent reforms.
First, the share of private consumption in GDP has declined further. In the first nine months
of 2010 the contribution made by consumption to GDP growth fell to 34%, down from the pre
crisis average of 39%, while the contribution of investment picked up to stand at 59%
(against a pre-crisis average of 49%). Second, overcapacity in some segments of the
economy and the limited efficiency of capital - especially in the public sector - have been
additional sources of concern. More than half of the RMB 4 trillion stimulus enacted during
the financial crisis has resulted in investment in public infrastructure, which has further
increased the already sizeable role played by the public sector in the economy. Third, the
share of the service sector in GDP has remained small. Given that the service sector is
considered to be the most labour-intensive of the three major sectors, its underdevelopment
has had negative implications for overall employment. Fourth, income inequality has been on
the rise. Average urban income is now three times higher than average rural income. And the
income gap between urban households with high incomes and those with low incomes has
also been increasing.
Of course, given the complexity of the structural reforms involved, China cannot become a
consumption economy overnight. This will take time. And for this very reason it is important
to start now in order to ensure that the transition process is as smooth as possible.
However, the benefits of these structural reforms could be substantial. To give you an idea of
just how substantial, I would like to quote a recent study by the Asian Development Bank1. It
estimates that without policy reforms China's real annual GDP growth will slow to an average
of 5.5% for the period 2010-30 as a result of less favourable developments in the structural
factors I have just described, namely export demand, demographics and capital
accumulation. According to the findings of the ADB study, policy improvements in areas such
as education, research and property rights could instead increase GDP growth by at least
1 percentage point over that period.
Chinese measures to achieve more balanced growth have also included, over the past five
years, very important exchange rate reforms. Both in July 2005 and in June 2010, the ECB
and other euro area authorities publicly welcomed China's moves towards a more flexible
exchange rate regime. The potential for exchange rate adjustment implied by these decisions
needs to be further exploited. Given the importance of China's role in the global economy,
further flexibility of the renminbi would be another element conducive to more balanced
growth. Greater exchange rate flexibility could help in achieving the objective of improving
economic efficiency and market-based resource allocation. It would allow greater control
over domestic monetary policy and help to adjust the policy stance in line with GDP growth in
a timely manner in order to prevent the emergence of inflationary and asset price pressures.
* * * * *
In conclusion, I would like to emphasise once again that, given the global nature of the
challenges at stake, all major economies should do their part by striving to implement the
policy measures collectively agreed in order to rebalance global growth patterns.
Multilateral cooperation is not the easiest way forward. However, in the absence of
cooperative policy action, the pain that purely market-driven adjustment would bring about in
the transition phase could prove too severe for us to simply dismiss this course of action
today.
Given their size and importance, Europe and China both have a key role to play in the global
resolution of the crisis. It is important to understand that a stronger, more sustainable and
balanced global economy - which is in all our interests - can only be achieved if policy
makers from all countries work together.
We still cannot be sure that the G20 Framework will be implemented effectively. It is
therefore paramount that the systemically most relevant countries fully live up to the
commitments made in Pittsburgh, Toronto and Seoul.