Ben S Bernanke: The Chinese economy - progress and challenges
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the Chinese Academy of Social Sciences, Beijing, 15 December 2006.
* * *
The emergence of China as a global economic power is one of the most important developments of
recent decades. For the past twenty years, the Chinese economy has achieved a growth rate
averaging nearly 10 percent per year, resulting in a quintupling of output per person. In overall size,
China's economy today ranks as the fourth largest in the world in terms of gross domestic product
(GDP) at current exchange rates and the second largest when adjustments are made for the
differences in the domestic purchasing power of national currencies. This strong economic
performance has resulted in improved living standards for the Chinese people. By some estimates,
about 200 million Chinese have been brought out of poverty since the reforms began in 1978.1
Moreover, by 2004 life expectancy at birth in China had reached seventy-one years, the infant
mortality rate had fallen to 26 per 1,000 live births, and the literacy rate of those aged fifteen or above
had reached 90 percent.2 These are remarkable accomplishments.
Nonetheless, by most measures China remains a developing nation.3 In particular, although life in
some urban centers is typical of a modern, affluent society, average household incomes and
consumption remain quite low in rural and inland areas. Thus, China faces the double challenge of
sustaining a high and stable overall rate of economic growth while stimulating economic development
in parts of the country that have shared less fully in the economic boom. In my remarks today, I would
like to offer a few thoughts on how China can continue to prosper and promote the economic welfare
of its people.
Economic progress: markets and productivity
Economists agree that the most important determinant of living standards in a country is the average
level of productivity, or output per worker. On this score as well, China's record in recent decades is
excellent. Between 1978, when the Open Door policy reforms began, and 1989, output per employed
person in China grew vigorously, at an estimated average rate of about 6-1/2 percent per year.
However, from 1990 to 2005, productivity grew at an even more impressive rate of 9 percent per
year.4
Many factors have contributed to this strong productivity performance, including high rates of capital
investment, increasing openness to trade, and a strengthening of the educational system.5 However,
in my view, the single most important cause of the ongoing expansion in productivity is that China has
moved, gradually but steadily, away from central planning and toward a greater reliance on markets. In
1978, almost no prices in China were determined by the market, and most production was controlled
or directed by the state. Since then, the government has reduced its direct intervention in the economy
and scaled back state-owned enterprises, in the process allowing more scope for market forces. By
1999, according to one estimate, about 95 percent of retail business, together with more than 80
percent of trade in agricultural commodities and producer goods, was conducted at market-determined
prices.6
Substantial experience has shown that modern economies, including those in early stages of
development, are too complex to be managed effectively on a centralized basis. Prices set in free and
competitive markets serve several critical functions, among them aggregating disparate information
about supply and demand conditions and the relative scarcities of specific goods and services;
directing resources to their most productive uses; and providing incentives to engage in cost reduction,
innovation, and entrepreneurial activities.
A free market for labor is particularly critical for sustained economic development. China has made
substantial progress in this area over the past few decades, most notably by reducing barriers to the
movement of workers among regions, sectors, and firms and by allowing greater flexibility in the
determination of employment and wages.7 Indeed, the ongoing movement of workers from relatively
low-productivity, low-wage jobs in agriculture to higher-productivity, higher-wage jobs in manufacturing
and services has been a significant source of Chinese economic growth. The decline in the share of
the population in rural areas, from more than 80 percent in 1970 to less than 60 percent in 2005,
indicates the scale of the movement of labor out of agriculture in recent decades.
Despite these shifts, differences in labor productivity among sectors remain large. For example, in
2005, estimated output per worker in agriculture and related sectors was about $800, whereas in
industries such as manufacturing, utilities, and mining, output per worker was about $5,900, more than
seven times as much.8 Moreover, a considerable portion of China's labor force (specifically, in
agriculture and in inefficient state-owned enterprises) remains underutilized. Thus, substantial
additional gains in productivity for the economy as a whole might be realized through the further
reallocation of the labor force to more productive and growing sectors. In particular, small- and
medium-sized enterprises are emerging as an engine of job creation in China - as they are in the
United States - even as they promote innovation and help to create a more dynamic and diversified
economy. The government can support the process of reallocating labor to more productive uses by
continuing to reduce barriers to labor mobility, helping workers obtain the education and training they
need to be productive in new occupations, and encouraging entrepreneurship and small-business
development.
As significant as the reallocation of labor among sectors has been, more of the improvement in
productivity in recent years has resulted from increasing efficiencies within the major sectors rather
than from the reallocation of resources between sectors. Here again, markets and competition have
played a vital role. In particular, the opening of the economy to international trade and investment,
which has accelerated since China's accession to the World Trade Organization in 2001, has done
much to harness market forces in the service of the country's development. Exposure to the
competition of the global marketplace has forced Chinese producers - alone or in partnership with
foreign firms - to increase their efficiency and improve the quality of their output. Notably,
globally-engaged firms (or their affiliates) operating in China have helped to foster productivity growth
in the country by introducing new technologies and managerial techniques, as well as by enhancing
domestic competition.
Although the expansion of the market-based portion of the economy has yielded impressive results,
further gains could be achieved by allowing still greater scope for market forces. The energy sector
presents one such opportunity. As you know, China's appetite for energy has grown rapidly: China's
consumption of oil has risen by more than 50 percent since 2000, and the International Energy
Agency estimates that Chinese oil usage has increased by about 400,000 barrels per day in 2006,
representing nearly half of this year's growth in world oil demand. This rapid expansion in energy use
reflects both overall economic growth and a relatively energy-intensive pattern of development.
Greater use of market pricing in the energy sector, including the elimination of remaining price controls
on fuels and the liberalization of electricity prices, would support cleaner, sustainable economic growth
by promoting more-efficient use of energy by households and firms and by encouraging the
development of new energy supplies.9
Significant benefits could also be obtained by allowing a larger role for market forces in guiding
investment decisions. China's economic growth owes much to the extraordinary share of GDP that is
devoted to investment in new capital, such as factories, equipment, and office buildings, which is partly
financed by a very large amount of business saving.10 However, the rapid pace of investment growth
raises concerns about whether new capital is being deployed in the most productive ways. In
particular, some analysts have questioned whether China is getting an adequate return on its
investment. For example, from 1990 to 2001, fixed investment as a share of GDP in China averaged
about 33 percent, and the economy grew at an annual rate of 10 percent. Between 2001 and 2005,
fixed investment's share of GDP rose to about 40 percent, but the economy's average growth rate
remained about the same, suggesting a lower return to the more recent investment. Comparisons can
also be drawn to the rapid development phases of other Asian countries, such as South Korea and
Japan. Average annual growth was between 9 and 10 percent in South Korea during the 1982-91
period and in Japan during the 1955-70 period; but for both countries during the relevant years
investment's share of GDP was about 30 percent, lower than it is in China today. In a few Chinese
industries, heavy investments have continued even as signs of excess capacity have begun to appear
- another possible indication of capital misallocation. An example is the steel industry, in which excess
capacity appears to have tripled between 2002 and 2005 to reach more than 115 million metric tons.11
Allowing competitive financial markets to play a larger role in the allocation of capital would likely
increase the returns to investment and reduce the risk that uneconomic investments could exacerbate
the problem of nonperforming loans and contribute to future financial instability. Basing investment
decisions on market signals also takes better account of the costs of inputs complementary to capital,
such as labor (relatively abundant in China) and energy (relatively scarce).12
China has taken initial steps toward a greater reliance on markets for determining the allocation of
investment - for example, by authorizing and beginning to liberalize the stock market. China has also
strengthened its banking system by improving supervision, confronting the enormous problem of
nonperforming loans, allowing domestic institutions to partner with foreign banks, and increasing the
use of market-based criteria in bank lending. These trends are positive; however, a great deal more
remains to be done, including broadening the range of financial instruments available to savers and
borrowers; taking further steps to ensure that credit evaluation and extension are based on sound
economic criteria; increasing competition in banking and finance; improving credit availability for
consumers and smaller firms; removing the remaining controls on interest rates; and eliminating the
use of quantitative and administrative measures to influence the amount and composition of capital
investment. Finally, capital markets require an appropriate institutional foundation to function
effectively: Well-defined property rights (including intellectual property rights), transparent accounting
standards, good corporate governance, effective supervisory oversight of banks and markets, the
consistent enforcement of contracts, and rules that allow for orderly bankruptcy proceedings for
unprofitable firms all help to support efficient investment. China has made progress in developing
these critical institutions, but continued focus on these areas would provide large economic benefits in
the long run.
Macroeconomic policy
Moving from microeconomics to macroeconomics, I believe that China could benefit by improving its
tools for managing the economy - notably, monetary and fiscal policies. Effective use of
macroeconomic policy tools can help achieve low and stable inflation and increase economic stability
by moderating the effects on growth of temporary fluctuations in global or domestic demand. Stable
economic conditions reduce an important source of risk and consequently promote innovation and
growth. As a central banker, I will focus my remarks on the development of monetary policy.13
The People's Bank of China (PBOC), the nation's central bank, is capable and well-respected around
the world. However, monetary policy can work well only to the extent that financial markets are
sufficiently developed to allow the monetary authorities' interest-rate decisions to affect economic
activity in a reasonably predictable way. The development of a reliable "monetary transmission
mechanism" is thus another reason to reform and strengthen China's banks and financial markets.
The more interest-sensitive that borrowing and investment decisions are, the more monetary policy
can affect investment and aggregate demand without the need for quantitative controls. Moreover,
when funds are allocated on market principles, only those projects with an expected risk-adjusted
return that is higher than the relevant market rate of interest will be undertaken. Thus, for example, if
the central bank raises interest rates, the market will ensure that the resulting slowing of investment
will be borne by the least promising projects, without the need for officials to make such judgments.
The effectiveness of monetary policy would also be enhanced by greater flexibility in the exchange
rate. To maintain the current close link of the renminbi (RMB) to the dollar in the presence of capital
inflows (arising from China's trade surplus or from foreign purchases of RMB-denominated assets),
the PBOC must intervene in the exchange market to buy dollars with RMB. Increases in the domestic
money supply will result unless the central bank offsets the effects of these purchases on the money
supply by selling bonds to investors, primarily commercial banks, in exchange for RMB - a procedure
commonly referred to as "sterilization." If dollar purchases by the central bank were not routinely
sterilized, the money supply might increase more than desired, possibly leading to an overheating of
the economy and inflation.
To date the PBOC has been largely successful in its sterilization operations, but if it continues to use
this strategy it will eventually encounter problems. If the exchange rate and the domestic interest rate
are maintained near their current levels, the incentives for capital inflows - and thus the need for
continued intervention and sterilization - will remain undiminished. Accordingly, the value of
outstanding sterilization bonds will continue to grow rapidly. These bonds could substitute for other
assets that might be held by banks and private investors, potentially interfering with the growth and
development of private financial markets. Further, the perception that the RMB is undervalued (a point
to which I will return) has fueled additional capital inflows, as investors expect to earn capital gains
when the RMB ultimately appreciates. However, these speculative inflows only increase the need for
exchange-market intervention and sterilization.
In the longer term, the continued growth and modernization of the Chinese economy will require a
substantial loosening of current restrictions on the flow of financial capital into and out of the country.
However, if fluctuations in the value of the RMB remain limited within a narrow range, permitting
substantial capital mobility would almost entirely eliminate the PBOC's capacity to use monetary policy
to stabilize the domestic economy, as any excess of Chinese over dollar interest rates, for example,
would trigger large capital inflows. Further appreciation of the RMB, combined with a wider trading
band and with the ultimate goal of a market-determined exchange rate, would allow an effective and
independent monetary policy and thereby help to enhance China's future growth and stability.
From an institutional perspective, China may find - as many countries have done - that granting
greater autonomy to the central bank, by insulating it to a degree from short-term political concerns,
increases its ability to ensure price stability and support stable growth. Of course, central banks must
remain accountable to governments over the longer term.
Trade, capital flows, and the transition to domestically-led growth
A central component of China's development strategy has been its openness to trade and capital
inflows. For example, the value of goods exports and imports currently equals about two-thirds of
China's GDP, a high level for a country of China's geographic size. China's accession to the World
Trade Organization (WTO) has been particularly effective in stimulating trade: Since joining the WTO
in 2001, China has seen the dollar value of its exports grow at an average rate of about 30 percent per
year, compared with annual growth of about 12-1/2 percent over the five years before gaining WTO
membership. China currently accounts for about 7-1/2 percent of world exports, up from 1-1/2 percent
in 1985. About half of China's trade is so-called processing trade; that is, components and materials
are imported (mostly from other Asian countries), processing or assembly is done in China, and the
finished product is re-exported. Much economic research has shown that openness to trade promotes
growth.14 Trade supports growth not only through the classical principle of comparative advantage, but
also through the effects of trade on the intensity of market competition, transfers of technology and
knowledge, and other factors.
China has also proved successful in attracting capital inflows, particularly foreign direct investment
(FDI). The flow of FDI into China increased from about $2 billion in 1986 to $72 billion in 2005, making
the country the third largest recipient of FDI in the world, after the United Kingdom and the United
States.15 FDI benefits China's development by bringing with it new technologies, products, and
business methods.16 The flow of foreign investments in Chinese securities has also increased
significantly, reaching $22 billion in 2005.
As you know, China today is running substantial trade and current account surpluses. These external
surpluses are caused in part by China's remarkably high saving rate.17 Because China's national
saving rate is even higher than its rate of domestic investment, the country has excess funds to lend in
the global capital market; it follows from the balance-of-payments accounts that China's net lending
abroad (or its acquisition of foreign assets) equals the country's current account surplus. A large
portion of this lending finances foreigners' purchases of Chinese net exports (the trade surplus). High
household saving and the corresponding low level of consumption in China contribute to the trade
surplus by depressing the demand for imports and by forcing domestic firms to look abroad for
markets.
Together with the large trade and current account deficits of the United States, the Chinese external
surpluses are contributing to the current pattern of global imbalances, which many economists and
policymakers have argued are unsustainable in the long run. The Chinese leadership has recognized
the importance of encouraging imports and achieving greater balance in China's international trade,
having recently included these objectives in the Five-Year Plan for 2006-2010. In my view, not only
would China's achieving smaller external balances contribute to global financial stability, it would also
be in China's economic interest.
Although China's extensive participation in the global trading and financial systems has been
invaluable for the country's development, the ultimate purpose of economic growth is to improve living
standards at home. Today, about half of China's GDP is devoted to investment and to producing net
exports for the rest of the world, and thus only the remaining half is available for consumption,
including government consumption. In particular, household consumption in China last year was only
38 percent of GDP, down from 45 percent in 2001. In comparison, household consumption was about
60 percent of GDP in India in 2004, according to the most recent available data. China's low share of
consumption in GDP is, of course, the counterpart of its high national saving rate.
Policies aimed at increasing household consumption would clearly benefit the Chinese people, notably
by improving standards of living and allowing the fruits of economic development to be shared more
widely. Such policies, by reducing saving and increasing imports, would also serve to reduce China's
current account and trade surpluses.18 Putting greater reliance on domestic demand rather than net
exports to drive growth would also decrease China's vulnerability to fluctuations in global demand.
How can China direct a greater share of its output to domestic consumption? Again, increased
flexibility in the exchange rate could help. As the Chinese trade surplus has continued to widen, many
analysts have concluded that the RMB is undervalued.19 Indeed, the situation has likely worsened
recently; because of the RMB's link to the dollar, its trade-weighted effective real exchange rate has
fallen about 10 percent over the past five years.20 Allowing the RMB to strengthen would make imports
of consumer goods (as well as capital goods) into China less expensive. Greater scope for market
forces to determine the value of the RMB would also reduce an important distortion in the Chinese
economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that
focus on exporting rather than producing for the domestic market. A decrease in this effective subsidy
would induce more firms to gear production toward the home market, benefiting domestic consumers
and firms. Reducing the implicit subsidy to exports could increase long-term financial stability as well:
If China invests too heavily in export industries whose economic viability depends on undervaluation of
the exchange rate, a future appreciation of the RMB could lead to excess capacity in those industries,
resulting in low returns and an increase in nonperforming loans.
Although more flexibility in the exchange rate would be helpful, the most direct and probably the most
effective way to reduce the external surpluses and increase the welfare of Chinese households is to
take measures to reduce domestic saving relative to domestic investment.21 Why is domestic saving
so high at present? The high saving rate of households, even very poor households, likely reflects the
relatively thin "social safety net" in China. For example, only about 14 percent of the population is
covered by health insurance, and pension plans (which, in any case, replace only about 20 percent of
pre-retirement earnings) apply to only about 16 percent of the economically active population.22
Combined expenditures by the central government and local governments on education, health,
pensions and relief, and social security amount to only about 4 percent of GDP, lower than most other
countries at similar income levels. In the absence of a stronger social safety net, Chinese households
save at high rates to protect themselves against risks such as unexpected medical expenses and
poverty in old age.
A sustained program of expanding social services has the potential for reducing saving and raising
living standards in China and, at the same time, moderating China's external surpluses. In particular,
increased government spending on health, education, and other types of social services would raise
both household consumption and government consumption, and thus reduce national saving. As one
means of helping to fund the increase in social expenditures, state-owned enterprises could be
required to pay larger dividends to the government, a measure which I understand to be currently
under consideration. Financial reforms that increase the access of households to mortgages, private
insurance, and other forms of consumer finance would also support higher rates of consumption.
As I have noted, the Chinese leadership has made reducing the trade and current account surpluses
an important policy objective. Further, recognizing that achieving these goals would be greatly
facilitated by increases in consumption and in the social safety net, the government has instituted or
proposed various reductions in taxes and increases in social spending. The government has also
announced an effort to raise living standards in rural and inland areas. Obviously, it is too early to
judge the success of these initiatives. However, these efforts are constructive and deserving of
support.
Conclusion
As I have discussed today, China has made remarkable economic progress since the reforms began
in 1978. Greater use of markets, together with expanding trade and capital flows, has helped to
increase growth in output and productivity, which in turn has increased living standards significantly. A
still-greater reliance on markets, particularly for allocating capital investment, would contribute to a
continuation of strong economic growth. Further development of macroeconomic policy tools would
also support healthy growth by keeping inflation low and by increasing economic stability.
China also faces some significant risks and imbalances. The principal risk arises from the likelihood
that capital is not being allocated as efficiently as possible, the result of an undervalued exchange rate
and of capital markets that, despite positive steps, remain distorted and underdeveloped. Misallocated
capital will not pay the highest possible returns, leading potentially to slower growth and future
financial stress. In addition, monetary policy may be constrained by the lack of a reliable monetary
transmission mechanism and by the relative inflexibility of the exchange rate, which inhibit the central
bank's ability to keep inflation low and to stabilize the economy.
The principal imbalance lies in the composition of Chinese GDP, which is heavily tilted toward
investment and net exports and away from domestic consumption and government provision of social
services. A better balance would improve the welfare of the Chinese people (by increasing
consumption and social services) and would increase global financial stability (by reducing China's
current account and trade surpluses). The Chinese government has undertaken to reduce this
imbalance by taking measures to expand domestic demand, especially household consumption, and I
hope that these efforts will be successful.
China's development and its opening up to the global economy have also benefited the United States
in many ways. China is now the second-largest source of U.S. imports; these imports boost U.S. real
incomes by allowing U.S. households to purchase consumption goods and U.S. firms to purchase
intermediate inputs at lower cost. China is also a growing market for investment and exports by U.S.
firms. Since China joined the WTO, U.S. exports to China have more than doubled. As China develops
further, its households and firms will demand a greater variety of goods and services, enhancing
opportunities for producers in industrial countries, including the United States. At the same time, trade
- with all its benefits - does displace some workers and firms as patterns of production and
consumption change. The policy challenge for the United States is to help those who are adversely
affected by trade while preserving the broad gains that openness to trade provides for the economy as
a whole.
The economic relationship between China and the United States is of extraordinary importance, and
both countries have much to gain from interactions with each other. Serious challenges exist as well,
requiring both countries to address such areas as energy, the environment, intellectual property rights,
and global imbalances. Regarding global imbalances, I have discussed means by which China can
reduce its contribution to the imbalances while encouraging domestic consumption. The United States
must also do its part, in particular by increasing its own rate of national saving and by avoiding
protectionism. With greater integration come greater interdependence and greater responsibility. I
hope that our countries will work together in a spirit of cooperation to address these shared
challenges.
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