Citation: 91 Foreign Aff. 173 2012

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Response

The Great China Debate

Will Beijing Rule the World?

The Wobbly DragonDEREK SCISSORS

Arvind Subramanian claims that Chinawill unquestionably replace the UnitedStates as the dominant global power in thenext two decades ("The Inevitable Super-power," September/October 2011). He isright that if the U.S. economy continueson its current trajectory, the United Stateswill not be able to maintain its position ofglobal leadership. But he is far too bullishon China. Subramanian overlooks Chinesepolicies that will complicate the country'seconomic rise and ignores the possibilitythat Chinese growth will simply stop. Andhe uses a definition of "dominance" thatbears little resemblance to the U.S.-stylepreeminence he sees China assuming.

Consider how Subramanian measuresChina's growing power. He cites the abilityof Beijing to convince African countriesto recognize it instead of Taipei, but out-muscling Taiwan diplomatically is hardly asign of global leadership. He sees the easewith which China undervalues the yuanby pegging it to the dollar as proof of the

country's strength, but hiding behind aforeign currency is not a sign of economicmight. He forecasts that China in 2030 willhave an economy that is one-third largerthan the United States', yet he admits thatit will remain only half as wealthy. Theseare notable trends, to be sure, but not onesthat indicate China will attain anythingclose to the position the United States hasheld over the past 6o years.

The biggest flaw in Subramanian's indexof dominance is the importance he assignsto China's status as a net creditor. Based onthis alone, he is prepared to say that China'seconomic strength is already comparable tothat of the United States. But China's credi-tor status does not make up for the fact thatits economy is presently less than half thesize of the United States' and its people arebarely one-tenth as wealthy as Americans.

Creditor status is also a misleadingmetric by which to judge China because itis usually used to describe financially openeconomies, and China is largely closed.Countries with open economies can investtheir money in many places. Beijing,because it cannot spend its foreign reservesat home, is forced to keep buying U.S.Treasury bonds.

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Subramanian and His Critic

China's creditor status arises largelyfrom its weaknesses, not its strengths.The country's $3.2 trillion worth of foreigncurrency holdings represents an imbalancebetween investment and consumption.Instead of loaning money to rich coun-tries, China should be importing capitalin order to speed its domestic develop-ment and meet its sizable needs, startingwith properly capitalized pension andfinancial systems.

China's financial books are strictly di-vided, with huge assets in foreign currency(primarily dollars) on one side and hugeliabilities in local currency on the other.Local governments have incurred highdebts by spending heavily on programssuch as railroad expansion and by borrow-ing to fund the 2009 stimulus (which camemostly from local, not national, governmentcoffers). Beijing should be paying downthis debt and addressing other domesticshortfalls with its mountain of foreigncurrency, but it cannot do so under itspresent balance-of-payments rules, whichare designed to keep foreign currency in thehands of the national monetary authorities.Due to a closed capital account, domesticholders cannot send money overseas, andforeign currency can be converted to yuanonly through the state financial system.

The Chinese government has not letmoney flow freely because doing sowould undermine its control of domesticinterest rates, reducing its ability to in-fluence economic cycles, and it wouldexpose the domestic banking sector todevastating competition. If domesticentities were allowed to send moneyabroad, hundreds of billions of dollarswould flee the country for financialinstitutions that operate commercially,unlike Chinese banks. Such a stark fear

of competition does not suggest acountry ready to exert dominance any-time soon.

Lastly, Subramanian inflates China'sfinancial influence over the United States,forgetting that influence in a buyer-sellerrelationship is determined not by what-if scenarios but by who has better alter-natives. The United States has alreadydiversified away from Chinese debt byhaving the Federal Reserve flood theU.S. financial system with liquidity. Thisis hardly ideal, but it has driven down theChinese share of U.S. debt while keepinginterest rates historically low. In contrast,Beijing, despite its best efforts to diversify,still holds 70 percent of its foreign currencyreserves in dollars. The reason is simple:those reserves are so large and growingso quickly that there is no alternative.The United States needs China to keepU.S. interest rates below historic norms;China needs the United States to maintainits entire balance-of-payments system.

Even if Subramanian acknowledgesthat China's lopsided financial systemis holding the country back now, heassumes that Beijing will soon rewriteits balance-of-payments rules and be-come an open economy. This assumptionunderestimates the Communist Party'santipathy to change. In fact, the principaladvocate for such reforms has beenWashington, which hopes to encourageChina's transformation from an invest-ment-led to a consumption-led economy.Such a transition would undermineChina's net creditor status-what Sub-ramanian sees as its main claim todominance. But implementing marketreforms would also allow China to keepgrowing at its blistering pace and sur-pass the United States in GDP. If China

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insists on maintaining governmentcontrol over development, on the otherhand, its long-term growth prospectswill be dim.

Salvatore Babones ("The MiddlingKingdom," September/October 2011)warns against drawing conclusions aboutChina's trajectory by simply projectingits growth rates forward. Indeed, it isentirely possible that Chinese GDP growthwill simply stop. Growth depends onland, labor, capital, and innovation. Chinahas depleted its ecology, its labor surpluswill soon begin to erode, and vast over-spending has driven down the return oncapital-all discouraging trends from thestandpoint of growth.

As for innovation, Subramanian praisesChina's growing technology sector andits ability to absorb new advances. Buta true economic leader must create, notabsorb, and Beijing's favoritism towardlarge state firms will hinder innovation.Moreover, the quality of the Chinesehigher-education system is poor andnot necessarily improving. A no-growthscenario is a genuine danger-just askthe Japanese.

By underemphasizing or ignoringChina's various weaknesses, Subramanianunderestimates the United States' abilityto influence the competition with China.That said, his criticisms of the UnitedStates are valid; indeed, his baselineprediction of U.S. growth at 2.5 percentannually may be too optimistic. Crippledby debt, the United States faces a periodof stagnation. If the overall economyremains sluggish, a lack of import growthwill cause trade to lag and further reducethe United States' global influence.

Still, the Chinese dragon will not flyforward indefinitely, as Subramanian

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Subramanian and His Critic

suggests; it may even crash. For theforeseeable future, China will not attainthe kind of dominance the United Stateshas long held. The world should notexpect to crown a new global leaderbut prepare for the absence of one.

DEREK SCISSORS is ResearchFellowin Economics at the Asian Studies Centerof the Heritage Foundation andAdjunctProfessor ofEconomics at George WashingtonUniversity.

Subramanian RepliesDerek Scissors argues that my articleprematurely heralds the rise of Chinaand overstates the dominance that it willachieve. Above all, he takes issue withthe importance I give to China's status asa net creditor and disputes my assessmentof the country's prospects for growthand reform.

For starters, Scissors is simply wrongto claim that my characterization ofChina's economic might is driven by itsstatus as a net creditor. In the index Idesigned to measure economic domi-nance, I give net creditor status a weightof just five percent; the size of a coun-try's economy and the amount it tradesaccount for the rest. I argue not thatChina's dominance in 2030 will dependon the country's remaining a creditornation but rather that it will mostlystem from China's economy and tradeoutpacing those of the United Statesby nearly 50 percent.

That said, history is replete withexamples of countries whose status ascreditors has given them great power.After World War II, for example, the

United States used its position as Europe'smajor creditor to design the rules of theInternational Monetary Fund, which,not coincidentally, favored the UnitedStates. Today, Europe is assiduouslycourting the world's new major creditor,China, in the hope that Beijing will putup the money for an EU bailout fund. Ifit does, it will surely use this leverage toshape the rules of international financeand trade.

Scissors also argues that China'screditor status reflects an underlyingweakness because it is caused by "animbalance between investment andconsumption." But China's creditorstatus is the result of a strategy that hasdelivered humanity's most dramaticeconomic transformation in the shortestperiod of time, posting unprecedentedrates of growth and consumption. Thatis hardly a sign of weakness.

Still, it is true that this strategy hasdistorted the economy, especially theprices of capital and foreign exchange.Keeping these prices artificially low willcertainly entail future costs. Moreover,when China's exchange rate reverts tonormal levels, its hoard of foreign reserveswill lose value in terms of yuan. But whetherthese future costs will prove catastrophicfor China, as Scissors contends, dependson the country's prospects for growth,since rapid growth makes all problemsmanageable.

On this issue, Scissors alleges that Iam being too bullish; I would argue thathe is being far too pessimistic. My centralgrowth forecast assumes that China willgrow at a rate of seven percent over thenext two decades, about 40 percent slowerthan its current growth rate of 10. 5 per-cent. This is a conservative estimate.

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The Great China Debate

Plenty of countries at China's level ofeconomic development have posted thatkind of growth. And as long as China'sstandard of living remains lower thanthose of Western countries, its wages willstay low. This will continue to makeChina an attractive destination for in-vestments and exports and will spurmore growth. For this reason, Scissors'Japan analogy is misleading: at the timeof its slowdown in the 199os, Japan hadalready achieved Western standards ofliving and exhausted its catch-up possi-bilities. China, by contrast, has a GDP

per capita that is only about 20-25 percentof the United States', which means Chinawill remain internationally competitivefor the foreseeable future.

Scissors nonetheless insists that China'sgrowth could soon stop because theCommunist Party will resist makingnecessary financial reforms. But China'spolicymakers know that delivering steadygrowth, which their legitimacy hingeson, will require reform. And althoughgrowth could always be derailed by de-velopments overseas (such as a Europeancrisis), China has shown that it can ablycounteract such problems. In 2008, whenthe financial crisis caused Chinese exportsto collapse, Beijing implemented a mam-moth stimulus package to offset the shockin a way that few other countries could.As this suggests, China still has boththe political will and the fiscal ability tograpple with problems as they arise.

Finally, Scissors argues that Chinawill not be able to exercise economicdominance in the way that the UnitedStates has so long as it lacks the abilityto create technology. True, innovation can

give a country a unique kind of influenceby inspiring others to want what it wants.

As long as China remains politicallyclosed, with a state-dominated economyand a lackluster technology sector, it can-not hope to attain this kind of dominance.

But my article focuses on a differentkind of dominance: the ability to getothers to do what you want or to preventthem from forcing you to do what youdo not want. With its large and rapidlygrowing economy, China already wieldssuch power. Consider, for example, howChina's depressed exchange rate hurtseconomies from the United States toBangladesh. Yet despite protests fromacross the world, Beijing continues todo what it wants. If that's not dominance,what is?O

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