China recently surged past Japan to become the world’s second-largest economy, while Western economies--including many of those in Europe--are still struggling to recover from the financial crisis. This imbalance between high- and low-growth economies is increasingly shaping the global distribution of power.

To celebrate the opening of Carnegie Europe’s new offices, Jessica T. Mathews, president of the Carnegie Endowment for International Peace, and Fabrice Pothier, director of Carnegie Europe, hosted a debate on China’s role in the changing economic order and the implications of the growing global economic imbalance. Carnegie’s Yukon Huang, Minxin Pei, and Michael Pettis spoke. The debate was moderated by the Financial Times’ Philip Stephens.

China’s Economy and Development Model

  • Volatile Economy: Heavily reliant on its export surplus, the Chinese economy was hit hard when international trade contracted following the economic crisis, Pettis explained. Chinese growth in the last quarter of 2008 and the first quarter of 2009 may have shrunk to as little as zero, contrasting sharply to the double-digit quarterly growth figures of a year earlier.
  • Expanded Investment: The collapse in growth that resulted from the crisis brought with it the potential for a very rapid rise in unemployment. To protect against this possibility, Pettis continued, Beijing significantly increased its domestic investment, with bank credit officially expanding by 31 percent of GDP in 2009, which generated significant growth.
  • Household Consumption: China lags behind the East Asian average in consumption, a potential engine of economic growth. Beijing’s growth relies too heavily on investment and external trade, Pettis explained; balancing the economy would require greater domestic consumption. To raise consumption, China would need to dramatically raise the value of its currency as well as raise wages, household incomes, and interest rates. But moving too quickly could send the country’s exporters and employers into bankruptcy. Realistically, Pettis concluded, China will need eight to ten years to rebalance its economy.
  • China’s Development Model: The reason that consumption has remained low in China, Pettis continued, stems from the country’s development model. While the model has been very successful at generating growth at first, Pettis warned that it inevitably runs into constraints. The model’s central characteristic is using household income to generate additional productive capacity. China does this in three ways:
    • Undervalued Currency: An undervalued currency leads to higher costs for imports, which in turn reduces the real value of household income. This ultimately benefits the export sector, and acts as a transfer of income from the household sector to the export sector.
    • Wage/ Productivity Differential: In the past decade, wages have been growing more slowly than productivity in China. This results in another transfer of wealth, this time from the household sector to the employment sector.
    • Financial Repression: In China, the vast majority of household savings take the form of bank deposits, while the vast majority of corporate financing takes the form of bank loans. More than 90 percent of all capital raised by Chinese companies is in the form of bank loans rather than bond or equity issues.  This amounts to another transfer from the household sector to favored borrowers.

Lack of Long-term Vision

Similarly to Japan in the 1980s, China is a great economic power, but one that does not have a clear idea about its future, Pei explained. For thirty years China underwent a period of reform. For the first twenty of these years, China’s progress was driven by two crucial ideas that received wide support both at home and abroad: Reforming its socialist economy and opening to the outside world. Over the past decade, however, China’s economy has grown rapidly, while no new ideas for the direction the country should take in the future have emerged. This absence of a clearly defined long-term vision underpins the growing discrepancy between Beijing’s perception of itself and the world’s perception of China, which is itself the source of much friction between China and the rest of the world.

Friction between China and the Global Community

  • Political Friction: Political friction, Huang argued, arises from the fact that China’s conceptions of democracy and human rights differ from those of the West. The lack of transparency in China’s political system, Pei added, contributes to uncertainty and misunderstandings between China and the West. However, Pei concluded, the problem does not come from China alone. The West also has profound reservations about China’s role on the international stage, and has consequently adopted a fundamentally contradictory position where it seeks broader global engagement from China, but does not wish Beijing to start acting like a traditional great power.
  • Economic Friction: Economic friction, Huang argued, arises because China’s global power affects both commodity and financial markets, which threatens to change global power dynamic and has the potential to change the structure of global governance.   

Areas of Conflict between Europe and China

Huang identified four areas in which the EU and China’s interests currently intersect and which could lead to problems:

  • Growth Agenda: China wants to avoid falling into the so-called ‘middle-income trap’ like the countries in Latin America, where over the past ten to fifteen years no country has progressed from middle- to high-income status. It wants to become a high-income country by developing a knowledge-based, technology-intensive economy. This brings China into direct conflict with European hi-tech companies that wish to have a greater global presence.
  • Sustainability: China is currently the world’s largest polluter in terms of hydrocarbons. Beijing sees global environmental standards as appropriate for developed countries, but not for developing ones like China. This puts its interests in direct conflict with the West.
  • Trade Imbalances: China’s growing trade imbalances are creating friction with the United States and increasingly leading to tension with Europe. The West’s exclusive focus on the exchange rate as a potential solution to this problem is misguided and will only exacerbate tensions.
  • Global Interests: China’s economic rise is also making the Chinese political and security apparatus feel more confident. Beijing therefore feels it can be more aggressive on its core interests than it has been in the past, leading to tension in the political and security arena.

Potential Collaboration between Europe and China

  • Collaboration in a Tri-Polar World: China’s rise is creating a world with three distinct poles of power: North America, Europe, and Asia (including China). In this context, Huang argued, there are numerous opportunities for Europe to strengthen its relationship with China by focusing on shared interests over competing ones:
    • High-End Goods: A significant amount of the luxury goods that China imports come from Europe. Europe can create a niche market in this area and learn from the U.S. example that China can become a profit center.
    • Environment: The market for collaboration between the EU and China on environmental technology is significant, particularly given that Europe’s experience managing environmental issues far exceeds that of the United States.
  • Shared Interests: Europe, Huang concluded, should not see China as a strategic partner on its core interests; there are too many differences between the two. Rather, if Europe recognizes China as a legitimate global stakeholder, and engages it on a basis of shared interests, it can play a role in China’s future development rivaling that of the United States.