Lucas Papademos: China and the European Union - global economic
challenges and policy responses
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the
Hamburg Summit: "China meets Europe", Hamburg, 11 September 2008.
* * *
I. Introduction
Dear Lord Mayor Von Beust, Excellencies, Ladies and Gentlemen,
It is a privilege and pleasure for me to be in Hamburg today to address this distinguished
audience on some important and topical policy issues concerning the rapidly growing
economic relations between China and Europe. The Free and Hanseatic City of Hamburg
provides an ideal stage for addressing these issues. Hamburg's history as a great port and
trading metropolis bears testimony to how openness to commerce and exchange generates
growth and prosperity. Still today, Hamburg is the second-largest port in Europe, and ranks
ninth in the world. It is thus not surprising that China is Hamburg's most important and fastest
growing trade partner, accounting for more than one third of total shipments. Hamburg is,
therefore, one of the most vital points where Europe meets China.
Today, I would like to discuss the economic relations between the European Union and
China in the context of the major policy challenges being faced by both our economies in an
environment of increasing global interdependence. I will examine, in particular, the role of
economic reforms and monetary policy in addressing the challenges stemming from the
marked slowdown in global economic growth and the persistently high inflation, and will
assess their effects for the China-EU economic relationship. Let me start with a brief review
of key features of the bilateral trade between the EU and China and related policy issues.
II. The trade dimension of the China-EU economic relationship
Trade between the 27 members of the European Union and China has expanded at an
impressive pace, especially since China joined the World Trade Organisation (WTO) at the
end of 2001. China has indeed become the second largest trading partner of the EU since
2005, while it was ranking fourth in 1999. From China's perspective, the relative importance
of the EU in total trade has grown even more impressively: the EU is now the first trading
partner of China, having overtaken both the United States and Japan since 2005. Increasing
trade with China has clearly implied major benefits for Europe. Our economy has benefited,
at least over a certain period of time, from the favourable impact on inflation resulting through
various channels from the lower cost of imported manufactured and intermediate goods.
Moreover, increased competition has provided a further stimulus for the introduction of
structural reforms to enhance the efficiency and flexibility of the European economy.
So, why do we Europeans occasionally express concern about the expanding trade and,
more generally, the economic ties between the EU and China? I think that there are many
bad and some good reasons. The main reason, in my view, is that Europe can not yet reap
the full potential benefits of free trade owing to certain "asymmetries" characterising the
EUChina trade relationship. Let me first illustrate this with some figures. While China is the EU's
main import partner, it is only its fourth largest export partner. In 2007, the value of EU
imports from China was 231 billion euro, almost four times higher than the imports from
Japan. The EU's exports to China amounted to almost 72 billion euro, that is, less than one
third of the imports from China. The EU currently exports more to Switzerland, a country with
only 7.5 million inhabitants, than to China! As a result of this asymmetry, the EU's trade
deficit with China was 160 billion euro in 2007, accounting for 86% of the EU total trade
deficit. To put it differently, the total trade deficit of the EU of 186 billion euro very much
reflects the sizeable imbalance in the European-Chinese trade.
There are several explanations for the EU-China trade imbalance. A significant part of it is, of
course, the natural outcome of market forces. For instance, the large Chinese trade
surpluses in the textiles and IT sectors can be explained by China's competitive advantage
and specialisation in labour-intensive production. In addition, due to its increasing role as an
"assembling hub", China has become an export platform in Asia, meaning that several goods
that were previously exported directly from other Asian countries are now exported from
China. At the same time, while Europe has a comparative advantage in the production of
high value-added goods, such as pharmaceuticals and machinery, we do not observe
significant surpluses in the trade of any of these products.
Why does Europe not export more of the products where it has a comparative advantage to
China? And, more generally, what other factors can explain the observed asymmetries in the
EU-China economic relationship? One possible explanation is that European firms are not
able to successfully export high-tech goods to China due to difficulties in accessing its
domestic market. According to the European Commission, non-tariff barriers in China are
indeed estimated to result in a loss of European exports estimated at 20 billion euro, or 30%
of total trade.1 Another likely reason relates to the exchange rate between the euro and the
Chinese renminbi. While the bilateral exchange rate is only one factor affecting the growing
trade deficit, it is difficult to argue that it has had a negligible impact over the years 2002-07:
in that period, the Chinese trade surplus with the euro area almost tripled while the Chinese
renminbi depreciated vis-à-vis the euro by a cumulative 30%. In 2008, however, the renminbi
has so far appreciated against the euro by 9.4%, a welcome development for the balancing
of our trade relationship.
III. Global economic challenges, structural reforms and monetary policy
responses
More generally, the observed "asymmetries" characterising the EU-China economic
relationship reflect to a large extent differences in the structure and functioning of markets in
the two areas as well as differences in the economic and monetary policies pursued. The
latter are partly a consequence of differences in domestic economic circumstances and of
differences in the policy responses to the global economic challenges.
At the present juncture, China and Europe face three main common challenges, albeit to
varying degrees: first, a marked slowdown of the global economy and a deteriorating
economic outlook; second, persistently high inflation over a prolonged period of time, as a
result of past increases in oil and food prices as well as of rising underlying domestic
inflationary pressures; and, third, continuing tensions in global financial markets that have
intensified in recent months.
The magnitude and nature of the economic challenges being faced domestically varies
across countries and economic areas. In advanced industrial economies, including the euro
area economy, the deceleration of economic growth has turned out to be more marked and
abrupt than previously expected. At the same time, the pace of economic activity in many
emerging market economies has so far remained relatively strong, although it is moderating.
Nevertheless, the further weakening of economic activity in most advanced industrial
economies is progressively having spill-over effects, through trade and financial markets, on
emerging market economies. The hypothesis of decoupling of the growth performance of
advanced and emerging economies is increasingly being tested across the globe. The
notable exception is China which continues to experience robust growth, only moderately
lower than the growth of 11.5% recorded in 2007.
To address these multiple challenges, policy instruments must be used in an effective and
consistent way. Effectiveness requires to choose the appropriate policy instrument that can
materially contribute to the achievement of an objective in a sustained manner. Consistency
requires using the available instruments in a way that is mutually reinforcing. The effective
and consistent use of policy instruments should produce outcomes that have a durable
overall positive impact on economic performance. Let me elaborate on these propositions by
examining the appropriate policy responses to the global economic challenges we face in the
euro area and in China, and by assessing their effects on the EU-China economic
relationship.
Policy responses in the euro area
In the euro area, although the slowdown of the economy is mainly the consequence of the
impact of the significant past increases in oil and other commodity prices and of the direct
and indirect effects of the ongoing financial turmoil, the growth performance of its economy
over the medium and longer run will fundamentally depend on the implementation of further
reforms that can raise trend productivity growth, by increasing investment in innovation and
education, and raising the utilisation of labour, by enhancing the flexibility and adaptability of
labour markets. Such reforms will simultaneously contribute to the moderation of unit labour
cost growth and to the more efficient response of both product and labour markets to the
adverse shocks buffeting the European economies. As a result, the adjustment of the
economy will be facilitated and its shock-absorption capacity strengthened. Moreover, the
international competitiveness of the euro area will increase and this will help to reduce some
of the asymmetries characterising the China-EU relationship.
The question that some will raise is whether such reforms should or can be implemented
during a period of heightened uncertainty and reduced consumer confidence. My answer is
that if they are properly designed, adequately explained and effectively introduced, such
reforms can also help boost confidence in the performance and prospects of the euro area
economy, particularly in some of its member states that have experienced a substantial
cumulative erosion of competitiveness over the past years.
Fiscal policy in the euro area can play a stabilising role during the current slowdown
automatically, because our tax systems incorporate stronger income-stabilising mechanisms
than is the case in other advanced industrial economies. At the same time, budgetary
policies for 2009 and beyond should reflect and fully respect existing policy commitments.
The implementation of fiscal policies that aim at sound fiscal positions over the medium-term
will contribute to containing inflationary pressures and will enhance the functioning of the
automatic stabilisers that can mitigate the impact of shocks over the economic cycle.
What is the role of the ECB in addressing the unfavourable combination of persistently high
inflation, weakening economic growth and continuing tensions in the financial markets? The
objective of the single European monetary policy is unambiguously clear. The overriding
goal, in accordance with our mandate, is to preserve price stability over the medium term.
The stance of monetary policy must ensure that the high inflation we have been experiencing
over a prolonged period of time does not get embedded into medium and longer-term
inflation expectations, which should be kept firmly anchored to price stability. Broad-based
second-round effects from higher energy and other commodity prices on price and
wagesetting should be avoided. In order to address these upside risks to price stability, the
Governing Council raised the key ECB interest rates by 25 basis points in early July. We
believe that the current monetary policy stance will contribute to achieving our objective. We
will continue to monitor very closely all developments in the period ahead and will do what is
necessary to preserve price stability in the euro area over the medium term.
At the same time, the ECB will continue to manage liquidity in the interbank money market in
order to ensure that the very short-term money market rate remains close to the ECB's main
policy rate, as required for the efficient implementation of monetary policy, and to alleviate
the persisting pressures in the term money markets, so as to mitigate the impact of the
financial turmoil on the banking system and the broader economy. Over the past year, the
ECB money market operations have effectively contributed to containing risks to the euro
area's financial stability without changing the stance of monetary policy - as defined by the
key ECB interest rates - which remained firmly geared towards the price stability objective.
Moreover, although the ECB supplied large amounts of liquidity to the banking system to
offset or contain the impact of disturbances to the money market, the injection of additional
liquidity was temporary. As a result, the overall amount of bank reserves - central bank
money- in the economy has not been augmented, but only the intertemporal allocation and
the maturity structure of the central bank funds provided has been affected.
Last week, we announced certain changes in the operational risk framework (collateral
framework) of the Eurosystem's money market operations. These changes did not alter the
key elements of this framework - as they did not affect the range of eligible counterparties or
the range of eligible collateral - but they did refine some of the framework's features so as to
better contain certain potential risks in the light of changing financial market developments
and practices. The changes introduced, which will be effective as of 1 February 2009, aim at
striking a balance between preserving the stabilising features of the collateral framework and
mitigating risks which could be faced by the Eurosystem in an environment of protracted
financial market tensions.
Policy responses in China
Let me now turn to China and focus on two policy issues that are particularly relevant to the
global economic challenges we face and to the strengthening of the EU-China economic
relationship. A bright spot in the clouded global economic environment is the continuing
resilience of China's growth. Indeed, the latest consensus forecasts project very strong GDP
growth of 9.9% in 2008 and 9.2% in 2009, only moderately lower than the economic
expansion of 11.5% in 2007. The remarkably robust growth outlook of the Chinese economy
is however surrounded by uncertainty in the light of the sharp slowdown in most advanced
industrial economies and the declining pace of economic activity in a number of emerging
market economies.
At the same time, inflation pressures in China intensified in late 2007 and early 2008.
Although headline inflation declined in recent months, average annual CPI inflation is
forecast2 to be 6.9% in 2008, about 2 percentage points higher than the average annual
inflation rate in the previous year and the inflation target set at the beginning of 2008.
Moreover, the rise in underlying inflationary pressure is more visible in nominal wage growth,
which according to some estimates was above 18% in the second quarter of this year, after
having reached a peak of over 19% in the first quarter. If wage developments are indicative
of domestic underlying inflationary pressures, a key issue is how China will contain
potentially significant inflation risks which could undermine the sustainability of its
extraordinary growth performance. A second important issue is the implication of the
combination of fast growth and rising inflation in China for the global inflation prospects, both
because of potential effects on the prices of its exports and, especially, because of the large
share of the growth in the demand for commodities by China in the growth of total global
demand for commodities.3
These two issues are intimately linked because the sustainability of growth depends on
establishing an environment of low inflation, of price stability. Moreover, to "maintain the
stability of the value of the currency and thereby promote economic growth" requires the
preservation of domestic price level stability. To secure these goals, monetary policy has to
be fully geared towards achieving the internal price stability objective, as is the case in the
euro area. But to successfully achieve price stability requires allowing for greater exchange
rate flexibility, since pegging the exchange rate vis-à-vis another currency or a basket or
currencies, or tightly managing the exchange rate, effectively limits the room of manoeuvre
for monetary policy. These arguments underscore the importance of the steps that have
been taken by the Chinese authorities since the exchange rate reform in July 2005: they
have formally delinked from the hard peg against the US dollar, allowed an appreciation of
the renminbi in effective terms, promoted the development of the local foreign exchange
market, and set up a policy framework that has the potential to deliver even greater
exchange rate flexibility. As a result of these measures, the renminbi has appreciated by
almost 17% in real and around 15% in nominal effective terms. These developments are
welcome and should be praised since they contribute to the achievement of external and
internal stability. But are these steps sufficient in the light of the global and domestic
challenges we all face?
In July 2008, the Chinese authorities have emphasised at the highest political level that the
central policy objective is "to maintain steady, comparatively fast growth while fighting
inflation".4 The continued emphasis on fighting inflation is especially significant during this
period of still strong underlying inflationary pressure. But as a central banker, I would like to
add that to win the battle against inflation in any country requires enhancing the room for
manoeuvre for monetary policy and the effectiveness of the monetary policy instruments.
This would imply allowing for greater exchange rate flexibility, as the continuing substantial
foreign exchange inflows and the persistent current account surpluses of China keep
augmenting domestic monetary liquidity and increase the costs of sterilisation operations.
Moreover, it would require greater reliance on indirect means of monetary control, notably
the use of the interest rates as an instrument to better manage liquidity in the money market
and influence aggregate demand more effectively. To this end, structural changes are
necessary to enhance the functioning of the interbank money market and, more generally, to
promote the development of the financial system. Our colleagues at the People's Bank of
China are fully aware of the importance of such reforms and have been taking pertinent
measures to strengthen the effectiveness of monetary policy instruments in fighting the battle
against inflation.
Two questions are often asked concerning two perceived trade-offs that may be faced by
central banks and economic authorities: First, the potential trade-off between fast, sustained
growth and inflation, and, second, the potential trade-off between exchange rate stability and
internal price stability. These issues have also been debated extensively and intensively in
China in recent years. Let me say that the European experience, as well as the evidence
from other advanced as well as emerging market economies, clearly demonstrates that there
is no stable trade-off between growth and inflation that can be effectively exploited by
policymakers. Containing inflationary pressures and preserving price stability over the medium
term is the best contribution that monetary authorities can make to achieving the objective of
sustainable growth. The pace of durable growth can only be strengthened through structural
reforms that can increase the economy's efficiency and productive potential. On this front, we
Europeans have made a lot of progress in recent years, but much more remains to be done.
With regard to the concerns that have been expressed about the potentially adverse effects
of currency appreciation on export performance and the pace of economic growth in China,
let me point to the lessons of history. It provides rich evidence from many countries which
adjusted their economy successfully to a stronger currency and became more prosperous as
the domestic currency appreciated and internal price stability was secured. Germany's
economic history over the past sixty years offers the best example. It demonstrates the
benefits associated with the transition from a fixed exchange rate pegged to the US dollar, to
a fixed but adjustable exchange rate, to the eventual adoption of a free float of the Deutsche
Mark that allowed for greater monetary policy autonomy. This autonomy was essential for
pursuing the primary objective of domestic price stability in Germany in the face of external
price shocks without hampering - and indeed even helping to strengthen - its overall
competitiveness performance over the medium and longer run. But there are also other
success stories of achieving price stability without sacrificing competitiveness among
emerging market economies, which, notwithstanding significant appreciation of their real
effective exchange rates, have experienced stronger non-inflationary growth that was
instrumental in securing those countries' competitiveness and keeping up export growth.
IV. Concluding remarks
The world economy is navigating through heavy seas at the moment. Both China and the
European Union are confronted with a number of common challenges as well as specific
domestic concerns. In order to address these in an effective and consistent manner, all
available policy tools need to be used in an appropriate way. This requires continued
progress in implementing the necessary reforms. I think it is fair to say that we all have our
homework to do - though the focus of these efforts naturally differs. In Europe, it means,
inter alia, focusing on labour and product market reforms, in order to enhance the growth
potential of our economies; in China, it means, inter alia, reforms in financial markets and the
banking sector, in order to improve financial intermediation and monetary control. As I
highlighted in my remarks, one of the common challenges that we all face is the high
inflationary pressure affecting the global economy. To master this challenge, it is essential to
use monetary policy in an effective and determined manner. The global phenomenon of
inflation is perceived in many countries or economic areas as the consequence of an
"external" shock. This harbours the risk, if this shock is accommodated, that it will result in
sustained inflationary pressure with adverse effects for growth in these countries and
beyond. Therefore, concerted efforts by monetary authorities worldwide are needed to fight
global inflation. Finally, the combination of stability-oriented monetary policies and continued
structural reforms would also help to address some of the asymmetries I referred to earlier
and thus further strengthen the bilateral economic relations between Europe and China.
Thank you very much for your attention.