Tuesday, April 29, 2008

From the People's Daily
The Olympics organizers held a "swearing in ceremony" for the security forces involved in Olympics security. Of course, you would expect Zhou Yongkang to show up and oversee the ceremony. Besides description of the event with "high flying flags"....etc, this article is also very revealing of the organization of Olympic security.

1. Zhou Yongkang, the secretary of the CC Law and Politics Committee, probably also heads some kind of leading group on Olympics security.

2. Members likely include PS of Beijing Liu Qi, Minister of Public Security Meng Jianzhu, Vice Minister of Public Security and, yes, head of the anti FLG office Liu Jing, and finally head of the Beijing public security department Ma Zhenchuan. This is a very experienced team, which will think of most of the contingencies. Also, I don't expect this group to have a "limp hand" when it comes to cracking down.

3. The actual day-to-day coordination and command is directed by an organization called the Coordination Team on Olympic Safety and Security Work (奥运会安全保卫工作协调小组), headed by Liu Jing (once again--one can call him the CCP regime's hit man, in a sense).

4. This organization will coordinate activities and responses of the normal police, special police, people's armed police, chemical warfare units (of the PLA presumably), central guard units of the PLA, volunteer security personnel, and private security.

I would be interested in knowing how private security is incorporated into this effort, and who is contributing private security. Anyway, I expect to see someone every 10 meters or so all over Beijing. For those out there who want to unfurl a protest banner or two, Zhou Yongkang promised even more "overly hard measures" (更加过硬的措施) to deal with such events; be warned!

2008年04月30日07:30 来源:人民网-《人民日报》

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Veteran World Banker and current professor at SAIS penned this remarkable essay for China Brief. It covers all the basic points on contemporary inflation. He notes that it has been a miracle that China managed to expand money supply so quickly without generating serious inflation. That was indeed a miracle and was the topic of my book: Factions and Finance in China.

The Long Term Risks of China's Inflation Problem

By Pieter Bottelier
China’s tolerance of inflation has a low threshold because of the risks it poses to social and political stability. That is why the government and the people have been worried about a steep rise in the consumer price index (CPI) since the first half of 2007. Is this the beginning of a new and potentially dangerous inflation cycle? Earlier cycles were often associated with severe social hardship and political turmoil. The Tiananmen disaster on June 4, 1989, might have been prevented if the high inflation of those days had not brought so many additional demonstrators to the Square frightening the leadership. Older political leaders remember that the Communists’ defeat of the Nationalists in the Chinese civil war of 1945-1949 was greatly assisted by the run-away inflation of those years, which sharply reduced the popularity of Chiang Kai-shek’s Republic of China (ROC) government.

What is driving current inflation in China and what are the prospects?

In the economic arena, the greatest challenge facing China’s leadership at the present time is a new round of consumer price inflation. It started in the first half of 2007. The consumer price index (CPI) rose by 8.7 percent year over year (yoy) in February 2008, the steepest increase in over a decade. The index ebbed to 8.3 percent (yoy) in March. For the first quarter of 2008 as a whole the index was 8 percent (yoy) [1]. The current inflationary cycle is different in origin from the previous one (1992-1995), which was triggered by endogenous excessive credit expansion and economic “overheating” [2]. The present cycle was ignited by domestic supply disruptions in the food sector—mainly pigs and poultry—and reinforced by sharp international price increases for oil, coal, soy beans, grains and metals. The combined effect was to drive up the price of many food items, especially pork, poultry, eggs, vegetable oil and dairy products. CPI inflation received an extra jolt in the early months of 2008 from the worst-ever transportation and power supply disruptions caused by severe snowstorms. The non-food CPI has remained surprisingly modest so far (at least through March - Chart 1 in PDF), but there are some troubling signs that inflation may become more pervasive—for example, the producer price index (PPI) for industrial goods rose to 8 percent in March.

Although China’s growth rate accelerated from 10.1 percent in 2004 to 11.9 percent in 2007 [3], this was mainly due to an increase in net external demand (trade surplus), not domestic demand, as was the case in the earlier inflation cycle. Although growth was extremely high, domestic monetary expansion in 2007 was relatively moderate and the margin of loanable funds in the banking system [4] actually contracted due to the aggressive sterilization of excess bank liquidity by China’s central bank. Tight liquidity in the banking system drove up short-term inter-bank rates and increased their volatility in 2007. It is therefore hard to argue that the recent CPI increases are due to an “overheated” economy, as was the case in 1992-3.

Although China’s rising import demand for soy beans, oil, coal, metals and other commodities has undoubtedly contributed to the global commodity price increases of recent years, for economic planners in Beijing, such price increases have to be seen as exogenous [5]. In principle, China should not aim to reduce global commodity prices by deliberately slowing down domestic demand, unless a slow down is necessitated by domestic policy requirements. When inflation is driven by exogenous factors beyond the government’s control, as has essentially been the case since early 2007, a further tightening of monetary policy may have perverse effects: it could reduce employment and slow growth without necessarily reducing inflation. Yet, the government is understandably concerned that a prolonged period of relatively high CPI inflation may generate inflation expectations, which could trigger new inflation dynamics that are even harder to control.

In this context it is important to draw attention to the fact that China’s broad money supply (M2) as a percentage of GDP—around 160 percent since 2004—is exceptionally high by international standards. Moreover, China’s M2 (cash + time deposits + demand deposits) is becoming increasingly liquid [6] as a result of a gradual shift of household deposits from savings accounts to checking accounts or demand deposits (Chart 2 in PDF). This shift has been going on for some years, reflecting a growing need for larger cash balances to pay for consumer durables and down payments for mortgage loans. In recent years the shift accelerated, presumably because deposit rates were lower than inflation for most of the period since the middle of 2004 (Chart 3 in PDF). Negative real deposit rates made it unattractive to keep money in savings accounts. China’s high M2/GDP ratio combined with the increasing liquidity of household deposits, points to the existence of serious excess liquidity in the economy. Until now this excess liquidity has mainly expressed itself in asset price inflation, not in CPI inflation, but that may change. Excess liquidity does not necessarily trigger CPI inflation, but it facilitates it when expectations take over as the driving factor, which is precisely what the Chinese government is worried about.

The government faces serious dilemmas in how to deal with the current CPI inflation, and thus far Beijing seems to be pursuing a set of right measures: a relatively tight monetary policy while refraining from additional tightening; an increased supply of basic food items from government stocks and imports; and froze some basic food prices on the expectation that the supply disruptions that sparked CPI inflation are temporary. Maintaining price controls and delaying upward price adjustments for energy, however, is a double-edged sword. Faster appreciation of the RMB, as implemented since December 2007, will help on the margin to counter domestic inflation, but it will force accelerated adjustment in low-margin export industries.

A new situation would arise if and when inflation becomes more widespread and extend beyond food into producer goods, general consumer goods and wages. There are some early indications that that may happen [7]. Should those indications persist, China will have to tighten monetary policy. That said, there is still reason to expect that domestic food prices will stabilize later in 2008 of their own accord. The situation is complex and hard to read, and the room for policy mistakes through over-reaction or under-reaction is ample.

During the past 15 years, China’s economy has become closely integrated into the global economy. China cannot avoid the consequences as inflation also reappeared on the global scene. The golden age of low inflation—which was associated with intensive globalization during the past 15 years—seems to have come to an end. The next 15 years may well see higher global inflation because of rapidly rising demand in the developing world and supply constraints in minerals (oil, gas, metals) and grains. There is also a serious risk of rising protectionism, which would contribute to global inflation. The latter can be prevented if nations stick to both the letter and the spirit of the WTO Charter. Given its sharply increased weight in international trade and strong domestic economy, China is now in a unique position to play a pro-active role in promoting multilateral trade liberalization through the Doha Round. Unfortunately, it has shied away from playing such a role until now.

Negative real deposit rates can have perverse economic effects.

In the current inflationary cycle, China has been reluctant to increase domestic deposit rates sufficiently to make them positive in real terms, which would encourage long-term savings deposits and thus reduce the liquidity of M2. This may reflect the government’s belief that current CPI inflation is driven by temporary domestic supply-side factors and temporary international price hikes beyond its control. It may also reflect a concern that higher domestic interest rates would: (1) adversely affect the profitability of state enterprises and (2) attract additional hot money inflows, which would require even more sterilization of excess liquidity in the banking system. The first concern should be resisted on the ground that capital is so cheap in China that it has contributed to overinvestment in manufacturing and other economic imbalances. The second concern does not seem to be well-founded; because China’s capital account remains largely closed, the transaction costs of bringing large amounts of speculative capital into the country tend to be high. In light of this, it seems unlikely that hot money inflows are strongly influenced by relatively modest adjustments in domestic interest rates or, for that matter, the nominal exchange rate. In China’s case, it seems more likely that hot money inflows are primarily driven by large anticipated asset price increases—real estate or shares. An appreciating exchange rate and higher interest rates add relatively little to the large profits that can be earned in bullish asset markets.

The experience with previous inflationary cycles in China confirms that negative real deposit rates can be harmful to the financial system by driving financial intermediation underground [8] and by increasing the liquidity of M2, which facilitates inflation. It is in China’s interest to raise deposit rates to make the positive in real terms. Since current CPI inflation in China is primarily driven by exogenous and temporary domestic supply-side factors, an attractive alternative to nominal deposit rate increases would be to index them to current inflation, as was done during the inflation cycles of the late 1980s and early 1990s. Indexation would avoid the need to lower nominal rates when inflation begins to fall.

What is the risk of asset price bubbles in China?

Another potentially dangerous risk to China's economic stability, the bubble on China’s stock market—fueled by excess liquidity in the hands of the public and enterprises—has subsided, in part because of government intervention. Between October 2007 and the middle of April 2008, the Shanghai Composite Index fell by almost 50 percent. A new bubble may develop, of course, but it is likely that the government will again intervene should that happen. The risk of a national housing price bubble, as developed in the United States from 2002, seems remote in China. There may be local bubbles, but at the national level average urban housing prices have been rising more slowly than personal incomes—making houses on average more affordable. In some large cities, such as Shenzhen in Guangdong, housing prices have actually been falling for some time.

China’s government makes effective use of markets for development, but it is definitely not guilty of “market fundamentalism” [9]. It believes that the state is responsible for controlling potentially dangerous asset price bubbles. Both the national and local governments have intervened with various administrative measures to deflate local real estate price bubbles [10]. The national government intervened in the share price bubble that developed in 2006 and 2007 by: (1) increasing transaction costs though a raise in the stamp duty, (2) increasing the supply of tradable shares in state enterprises, (3) raising the ceiling on amounts that can be invested abroad, and (4) high-level public warnings against price bubbles. It must be expected, however, that controlling asset prices bubbles will become more difficult in China as the economic system liberalizes and the direct influence of the state on economic processes shrinks.

What explains China’s high M2/GDP ratio and what are the prospects for reducing excess liquidity in the economy?

Looking at China’s development since the start of Deng Xiaoping’s reforms in the late 1970s, it is remarkable how modest inflation has actually been on average, especially in light of the super fast growth of money supply relative to GDP for most of that period. The M2/GDP ratio rose from about 0.59 to over 1.6, one of the highest such ratios in the world. This clearly reflects two things: China’s high savings rate and the scarcity of alternative assets available for investment. For most of the reform period Chinese households were essentially limited to domestic bank accounts for the investment of their savings. From around 2004 China’s M2/GDP ratio appears to have leveled off at a little over 1.6. The main explanation for the rapid increase in M2 with surprisingly low inflation on average is the gradual monetization of China’s economy, including the monetization of state subsidies for housing, energy, consumer goods and many services. This monetization process has yielded significant unplanned financial benefits for China’s government in the form of seigniorage [11]—the nearest thing to free money. As most subsidies have now been monetized—while credit cards and electronic payments systems reduce the need for transaction money—China’s exceptionally high M2/GDP ratio may be expected fall in the years ahead. This combined with the development of domestic capital markets and gradual relaxation of restrictions on private capital outflows should reduce excess liquidity in the economy and make it easier to control inflation. Since China’s transition from plan to market is incomplete, effective inflation control in China requires not only appropriate short-term monetary policy, but also long-term institutional development aimed at developing domestic capital markets, freeing interest rates, liberalizing the capital account and flexibilizing the exchange rate regime.


1. China calculates its monthly CPI (and other price indices) as the percentage change over the same period 12 months earlier, not the preceding month as is the practice in most countries. Similarly, China’s quarterly CPI is calculated as the change over the same quarter one year earlier. This often leads to confusion when international comparisons are made. For example, China’s CPI of 8.3 percent for March actually represents a price decline of 2.4 percent relative to February.
2. Economic “overheating” refers to a situation where demand exceeds supply in many sectors of the economy simultaneously.
3. The government’s estimate of GDP growth in 2007 was adjusted from 11.4 to 11.9 percent in April 2008.
4. Defined here as total bank deposits minus loans outstanding, minus minimum reserve requirement at the central bank.
5. The sharp price increases for rice, oil and other internationally traded commodities in recent months may also reflect the effects of speculation related to excess liquidity in pockets of the international financial system.
6. The terms liquid and liquidity refer to the ease with which the market value of an asset can be converted into cash or to the supply of liquid funds in the economy, depending on the context.
7. For example, the producer price index for industrial products jumped 8 percent in March after having been low and stable for many months. In addition, in some parts of the manufacturing sector wages are rising faster than productivity, which increases unit labor costs.
8. For obvious reasons, there are no official statistics on underground financial intermediation in China, but anecdotal evidence suggests that it has become a very important factor in certain parts of the country in recent years.
9. The term is sometimes used to refer to a blind faith or ideological belief in the power of markets to correct their own excesses.
10. For example, when it became concerned that local real estate prices were rising too fast, the Shanghai municipal government intervened by raising the minimum down payment on new mortgages and by requiring that first mortgages were fully paid off before second mortgages could be applied for.
11. Seigniorage is the difference between the nominal value of new money printed (or coined) and the cost of printing (or minting).

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Saturday, April 19, 2008

Here is more discussion between my friend Josh Goldstein, currently in Beijing on leave from USC, and myself. Again, please chime in with comments. I am far from the leading authority on this issue.

Josh: It seems he's saying there are two fairly distinct policy choices: pegging the RMB and low domestic spending. It seems that you are saying these two are strongly linked: that increasing domestic spending would be directly linked to currency
revaluation. So why is that? Because it would be increasing production and construction even more and also throwing even more money into the economy and all that would lead to even more inflation somehow? Is that money that would
be spent RMB or dollars or both, and does that matter (would converting China's dollar holdings back into RMB, if that is what domestic spending requires, raise the RMB value vs. the dollar?) Please elaborate, or is the domestic spending issue distinct from the revaluation issue (as he presents it)

Me: When there is revaluation, Chinese people's purchasing power in the world goes up. This may not lead to more domestic spending (since purchasing power for non-tradable is the same), but may prompt Chinese to buy more imported goods and travel more abroad. This is a reason why the US Congress wants China to revaluate. A nominal appreciation of the RMB would decrease demand for RMB and lessen inflationary pressure. Again, I am not sure if I agree with Fallows that this leads to more inflation. In fact, the causal arrow is the reverse: if there is high domestic inflation, China's real purchasing power increases given fixed exchange rates. Think about it this way: suppose that RMB to dollar is fixed at 8 to 1, but due to inflation, everyone in China now gets paid 10% more in salary. Within China, a Chinese wouldn't be able to buy more because of inflation, but since the exchange rate is fixed, you can buy more stuff overseas because you now have 10% more RMB.

Josh: Even so, the explanation he provides seems rather vague: I get the logic of something like: more sewage treatment plants etc. would raise the costs on goods (like paper, plastic etc.) and make poor farmers even that much more economically distressed. I suppose that is somewhat true. But I'm not sure I follow the logic about why building beneficial infrastructure for the poor (clinics, schools, whatever else you spend 1.4 tril on) hurts them so much. Why would such things cause inflation? And these folks don't buy lots of stuff anyway, and in many many areas depend on migrant workers in the city for their case...workers who MIGHT get higher wages because the cost of living in the city would also go up with inflation (I say might cause it doesn't always work that way, like over the past 5 years, migrant labor earnings haven't kept up with inflation). His vagueness here makes me think you are right...but how exactly domestic spending as he's describing and currency revaluation are linked is unclear to me.

Me: Here, I think Fallows is talking about two different things that may or may not be linked with each other. First, revaluation would make Chinese goods less competitive, thus decreasing the number of manufacturing jobs. This may be bad for the income of farmers, especially those households with migrant workers. Second, if the central government spends more money on welfare, farmers may have it so good that they have fewer incentive to travel to cities to work. This would drive up labor costs in China on top of the revaluation. It is true that if the government uses its foreign exchange reserve (1.5 trillion) directly on domestic spending (like hospitals...etc.) it would have an inflationary effect. Much of the 1.5 trillion in the fx reserve has been "sterilized" meaning that bonds were issued to make sure the domestic money supply does not increase due to this surplus. If you turn around and use this money in the domestic economy, domestic money supply would increase once again. Fallow, however, is making a straw man because inflation would happen regardless of what the central government uses the fx reserve on domestically. It would be inflationary if Beijing used the fx reserve to build a stadium.

Josh: About the private property issue...I think I disagree with you...I think it would be real bad. Peasants having land has been pretty much the backbone and engine of this economy (both before and even more so after the 78 divide) and China is
not ready (I don't think), to get rid of it...not in places like Shaanxi, or even Sichuan and Henan. But you should talk to my friend Shi Yaojiang about it...he's the rural survey guy and he's convinced that with property up for grabs local party
strongmen would make a killing and decimate communities in short order. And finally, there is at this very moment a global food crisis...food markets are unstable, prices are skyrocketing, and food markets are due to become much more unstable (and higher priced) in the coming years, so I'm not sure it is irrational to keep farmers on their land and avoid detaching hundreds of millions of folks from their safety (or in many places basic everyday) food supply.

Me: Yes, this is the Chinese government thinking now. But farming in China is extremely unproductive now because of the prevalence of small scale farming, which may make sense in some places. However, in other places, China would produce much more if farms were consolidated and farmers instead went to the cities to work for factories. If the government can come up with a credible rural welfare scheme, which is in the works now, I would argue that farm consolidation wouldn't be so bad (look at the US, we went through this painful but ultimately beneficial process).

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Friday, April 18, 2008

The Fallows article got our readers' attention, and some good questions were sent in. Here, I address them briefly in a new post.

Anantha: Is there a possibility that authoritatrian/semi-authoritarian prefer FDI/Export-led growth to domestically led growth because it could eventually grow into a threat to their political authority? Is there thereoetical or empirical literature on this? Could this also be a factor in the CCP's economic policy choices?

Me: Well, you could be right in the case of encouraging so much FDI. The regime knows that foreign investors are only interested in making money and that they would move if the conditions weren't right. In contrast, domestic businesses engaged in both the domestic and export markets may have a larger stake in trying to change the system in order to improve profits. China's foreign exchange limits also make domestic investment abroad difficult, especially for smaller firms. I don't think this is a deliberate strategy, but the outcome certainly certainly encourages FDI. The best treatment of this issue is Huang Yasheng's Selling China (Cambridge University Press), which systematically lays out Chinese policy biases in favor of FDI.

Anonymous: I don't know if the food reserve is so irrational in today's world. Both Clinton and Obama are so anti free trade, at least in rhetoric. and they're from the economically most powerful market in the world. Think about it. 21st century doesn't necessarily mean a free market century, especially when so many ppl in the west are so wary about China.

Me: True, food security is never completely irrational policy, and China still worries about the threat of famine. Nonetheless, unless you believe in the collapse of the global commodities market, one can hedge against price threat by buying futures contracts which guarantee food delivery at a certain price. True, I think China should maintain control over major food conglomerates (like China Grain) so that they can go out to the world market to buy future deliverables. Granted, with export limitation that some countries are now imposing on their own farmers, food prices will be driven up some more. However, I think this situation will right itself in a couple of years as US and Canadian farmers catch up with the high profit that can be made from increased production.

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Wednesday, April 16, 2008

My good friend Josh sent me this article written by veteran Asia watcher James Fallows dissecting China's foreign exchange reserve. He is right; it is basically a transfer of purchasing power from the Chinese people to the government and to the American people. I would say that this statement "And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem" is not quite right. Of course, when you lift everyone's purchasing power by revaluation, the rich benefit disproportionately, but you also free up capital flow, so the rich will likely spread their spending around the world rather than just in China. If the RMB is worth twice as much, it would drive up the prices of nice townhouses in San Francisco, but also nice houses in Dalian. But for the poor, China will be more able to import food from abroad, decreasing the rate at which food prices increase. The people who will be really screwed are the farmers, who are generally much less productive than their counterparts abroad. If they have to compete with cheap import, they would be jobless. But then you say, they can work in factories, thus continuing the advantage of Chinese manufacturing. But, farmers currently CANNOT sell their land and go work in a factory since they don't own the land. Why not? Well, I think besides fear of instability, it is China's continuing wish to preserve food security, which is pretty irrational in today's world.

Atlantic Monthly
January, 2008
The Chinese are subsidizing the American way of life. Are we playing them for suckers—or are they playing us?

by James Fallows
The $1.4 Trillion Question

S tephen Schwarzman may think he has image problems in America. He is the co-founder and CEO of the Blackstone Group, and he threw himself a $3 million party for his 60th birthday last spring, shortly before making many hundreds of millions of dollars in his company’s IPO and finding clever ways to avoid paying taxes. That’s nothing compared with the way he looks in China. Here, he and his company are surprisingly well known, thanks to blogs, newspapers, and talk-show references. In America, Schwarzman’s perceived offense is greed—a sin we readily forgive and forget. In China, the suspicion is that he has somehow hoodwinked ordinary Chinese people out of their hard-earned cash.

Last June, China’s Blackstone investment was hailed in the American press as a sign of canny sophistication. It seemed just the kind of thing the U.S. government had in mind when it hammered China to use its new wealth as a “responsible stakeholder” among nations. By putting $3 billion of China’s national savings into the initial public offering of America’s best-known private-equity firm, the Chinese government allied itself with a big-time Western firm without raising political fears by trying to buy operating control (it bought only 8 percent of Blackstone’s shares, and nonvoting shares at that). The contrast with the Japanese and Saudis, who in their nouveau-riche phase roused irritation and envy with their showy purchases of Western brand names and landmark properties, was plain.

Six months later, it didn’t look so canny, at least not financially. China’s Blackstone holdings lost, on paper, about $1 billion, during a time when the composite index of the Shanghai Stock Exchange was soaring. At two different universities where I’ve spoken recently, students have pointed out that Schwarzman was a major Republican donor. A student at Fudan University knew a detail I didn’t: that in 2007 President Bush attended a Republican National Committee fund-raiser at Schwarzman’s apartment in Manhattan (think what he would have made of the fact that Schwarzman, who was one year behind Bush at Yale, had been a fellow member of Skull and Bones). Wasn’t the whole scheme a way to take money from the Chinese people and give it to the president’s crony?

The Blackstone case is titillating in its personal detail, but it is also an unusually clear and personalized symptom of a deeper, less publicized, and potentially much more destructive tension in U.S.–China relations. It’s not just Stephen Schwarzman’s company that the laobaixing, the ordinary Chinese masses, have been subsidizing. It’s everyone in the United States.

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. But because of political tensions in both countries, and because of the huge and growing size of the imbalance, the arrangement now shows signs of cracking apart.

In an article two and a half years ago (“Countdown to a Meltdown,” July/August 2005), I described an imagined future in which a real-estate crash and shakiness in the U.S. credit markets led to panic by Chinese and other foreign investors, with unpleasant effects for years to come. The real world has recently had inklings of similar concerns. In the past six months, relative nobodies in China’s establishment were able to cause brief panics in the foreign-exchange markets merely by hinting that China might stop supplying so much money to the United States. In August, an economic researcher named He Fan, who works at the Chinese Academy of Social Sciences and did part of his doctoral research at Harvard, suggested in an op-ed piece in China Daily that if the U.S. dollar kept collapsing in value, China might move some of its holdings into stronger currencies. This was presented not as a threat but as a statement of the obvious, like saying that during a market panic, lots of people sell. The column quickly provoked alarmist stories in Europe and America suggesting that China was considering the “nuclear option”—unloading its dollars.

A few months later, a veteran Communist Party politician named Cheng Siwei suggested essentially the same thing He Fan had. Cheng, in his mid-70s, was trained as a chemical engineer and has no official role in setting Chinese economic policy. But within hours of his speech, a flurry of trading forced the dollar to what was then its lowest level against the euro and other currencies. The headline in the South China Morning Post the next day was: “Officials’ Words Shrivel U.S. Dollar.” Expressing amazement at the markets’ response, Carl Weinberg, chief economist at the High Frequency Economics advisory group, said, “This would be kind of like Congressman Charlie Rangel giving a speech telling the Fed to hike or cut interest rates.” (Cheng, like Rangel, is known for colorful comments—but he is less powerful, since Rangel after all chairs the House Ways and Means Committee.) In the following weeks, phrases like “run on the dollar” and “collapse of confidence” showed up more and more frequently in financial newsletters. The nervousness only increased when someone who does have influence, Chinese Premier Wen Jiabao, said last November, “We are worried about how to preserve the value” of China’s dollar holdings.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

The dollar’s value has been high for many years—unnaturally high, in large part because of the implicit bargain with the Chinese. Living standards in China, while rising rapidly, have by the same logic been unnaturally low. To understand why this situation probably can’t go on, and what might replace it—via a dollar crash or some other event—let’s consider how this curious balance of power arose and how it works.

Why a poor country has so much money

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion, according to Edwin Truman of the Peterson Institute for International Economics in Washington. Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world. (In second place is Japan, whose economy is, at official exchange rates, nearly twice as large as China’s but which has only two-thirds the foreign assets; the next-largest after that are the United Arab Emirates and Russia.) China’s U.S. dollar assets probably account for about 70 percent of its foreign holdings, according to the latest analyses by Brad Setser, a former Treasury Department economist now with the Council on Foreign Relations; the rest are mainly in euros, plus some yen. Most of China’s U.S. investments are in conservative, low-yield instruments like Treasury notes and federal-agency bonds, rather than showier Blackstone-style bets. Because notes and bonds backed by the U.S. government are considered the safest investments in the world, they pay lower interest than corporate bonds, and for the past two years their annual interest payments of 4 to 5 percent have barely matched the 5-to-6-percent decline in the U.S. dollar’s value versus the RMB.

Americans sometimes debate (though not often) whether in principle it is good to rely so heavily on money controlled by a foreign government. The debate has never been more relevant, because America has never before been so deeply in debt to one country. Meanwhile, the Chinese are having a debate of their own—about whether the deal makes sense for them. Certainly China’s officials are aware that their stock purchases prop up 401(k) values, their money-market holdings keep down American interest rates, and their bond purchases do the same thing—plus allow our government to spend money without raising taxes.

“From a distance, this, to say the least, is strange,” Lawrence Summers, the former treasury secretary and president of Harvard, told me last year in Shanghai. He was referring to the oddity that a country with so many of its own needs still unmet would let “this $1 trillion go to a mature, old, rich place from a young, dynamic place.”

It’s more than strange. Some Chinese people are rich, but China as a whole is unbelievably short on many of the things that qualify countries as fully developed. Shanghai has about the same climate as Washington, D.C.—and its public schools have no heating. (Go to a classroom when it’s cold, and you’ll see 40 children, all in their winter jackets, their breath forming clouds in the air.) Beijing is more like Boston. On winter nights, thousands of people mass along the curbsides of major thoroughfares, enduring long waits and fighting their way onto hopelessly overcrowded public buses that then spend hours stuck on jammed roads. And these are the showcase cities! In rural Gansu province, I have seen schools where 18 junior-high-school girls share a single dormitory room, sleeping shoulder to shoulder, sardine-style.

Better schools, more-abundant parks, better health care, cleaner air and water, better sewers in the cities—you name it, and if it isn’t in some way connected to the factory-export economy, China hasn’t got it, or not enough. This is true at the personal level, too. The average cash income for workers in a big factory is about $160 per month. On the farm, it’s a small fraction of that. Most people in China feel they are moving up, but from a very low starting point.

So why is China shipping its money to America? An economist would describe the oddity by saying that China has by far the highest national savings in the world. This sounds admirable, but when taken to an extreme—as in China—it indicates an economy out of sync with the rest of the world, and one that is deliberately keeping its own people’s living standards lower than they could be. For comparison, India’s savings rate is about 25 percent, which in effect means that India’s people consume 75 percent of what they collectively produce. (Reminder from Ec 101: The savings rate is the net share of national output either exported or saved and invested for consumption in the future. Effectively, it’s what your own people produce but don’t use.) For Korea and Japan, the savings rate is typically from the high 20s to the mid-30s. Recently, America’s has at times been below zero, which means that it consumes, via imports, more than it makes.

China’s savings rate is a staggering 50 percent, which is probably unprecedented in any country in peacetime. This doesn’t mean that the average family is saving half of its earnings—though the personal savings rate in China is also very high. Much of China’s national income is “saved” almost invisibly and kept in the form of foreign assets. Until now, most Chinese have willingly put up with this, because the economy has been growing so fast that even a suppressed level of consumption makes most people richer year by year.

But saying that China has a high savings rate describes the situation without explaining it. Why should the Communist Party of China countenance a policy that takes so much wealth from the world’s poor, in their own country, and gives it to the United States? To add to the mystery, why should China be content to put so many of its holdings into dollars, knowing that the dollar is virtually guaranteed to keep losing value against the RMB? And how long can its people tolerate being denied so much of their earnings, when they and their country need so much? The Chinese government did not explicitly set out to tighten the belt on its population while offering cheap money to American homeowners. But the fact that it does results directly from explicit choices it has made—two in particular. Both arise from crucial controls the government maintains over an economy that in many other ways has become wide open. The situation may be easiest to explain by following a U.S. dollar on its journey from a customer’s hand in America to a factory in China and back again to the T-note auction in the United States.

Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.

With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.

The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.

And thus our dollar comes back home. Spent at CVS, passed to Oral-B, paid to the factory in southern China, traded for RMB at the Shenzhen bank, “surrendered” to the PBOC, passed to SAFE for investment, and then bid at auction for Treasury notes, it is ready to be reinjected into the U.S. money supply and spent again—ideally on Chinese-made goods.

At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.

One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. The obvious reason for doing this is to keep Chinese-made products cheap, so Chinese factories will stay busy. This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. And there are numerous less obvious reasons. The very act of managing a currency’s value may be a more important distorting factor than the exact rate at which it is set. As for the rate—the subject of much U.S. lecturing—given the huge difference in living standards between China and the United States, even a big rise in the RMB’s value would leave China with a price advantage over manufacturers elsewhere. (If the RMB doubled against the dollar, a factory worker might go from earning $160 per month to $320—not enough to send many jobs back to America, though enough to hurt China’s export economy.) Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could).

These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. The result, while very complicated, is to keep the buying power earned through China’s exports out of the hands of Chinese consumers as a whole. Individual Chinese people have certainly gotten their hands on a lot of buying power, notably the billionaire entrepreneurs who have attracted the world’s attention (see “Mr. Zhang Builds His Dream Town,” March 2007). But when it comes to amassing international reserves, what matters is that China as a whole spends so little of what it earns, even as some Chinese people spend a lot.

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The government doesn’t want to let the market set the value of the RMB, because it thinks that would disrupt the constant growth and the course it has carefully and expensively set for the factory-export economy. In the short run, it worries that the RMB’s value against the dollar and the euro would soar, pricing some factories in “expensive” places such as Shanghai out of business. In the long run, it views an unstable currency as a nuisance in itself, since currency fluctuation makes everything about business with the outside world more complicated. Companies have a harder time predicting overseas revenues, negotiating contracts, luring foreign investors, or predicting the costs of fuel, component parts, and other imported goods.

And the government doesn’t want to increase domestic spending dramatically, because it fears that improving average living conditions could paradoxically intensify the rich-poor tensions that are China’s major social problem. The country is already covered with bulldozers, wrecking balls, and construction cranes, all to keep the manufacturing machine steaming ahead. Trying to build anything more at the moment—sewage-treatment plants, for a start, which would mean a better life for its own people, or smokestack scrubbers and related “clean” technology, which would start to address the world pollution for which China is increasingly held responsible—would likely just drive prices up, intensifying inflation and thus reducing the already minimal purchasing power of most workers. Food prices have been rising so fast that they have led to riots. In November, a large Carre­four grocery in Chong­qing offered a limited-time sale of vegetable oil, at 20 percent (11 RMB, or $1.48) off the normal price per bottle. Three people were killed and 31 injured in a stampede toward the shelves.

This is the bargain China has made—rather, the one its leaders have imposed on its people. They’ll keep creating new factory jobs, and thus reduce China’s own social tensions and create opportunities for its rural poor. The Chinese will live better year by year, though not as well as they could. And they’ll be protected from the risk of potentially catastrophic hyperinflation, which might undo what the nation’s decades of growth have built. In exchange, the government will hold much of the nation’s wealth in paper assets in the United States, thereby preventing a run on the dollar, shoring up relations between China and America, and sluicing enough cash back into Americans’ hands to let the spending go on.

The Chinese public is beginning to be aware that its government is sitting on a lot of money—money not being spent to help China directly, money not doing so well in Blackstone-style foreign investments, money invested in the ever-falling U.S. dollar. Chinese bloggers and press commentators have begun making a connection between the billions of dollars the country is sending away and the domestic needs the country has not addressed. There is more and more pressure to show that the return on foreign investments is worth China’s sacrifice—and more and more potential backlash against bets that don’t pay off. (While the Chinese government need not stand for popular election, it generally tries to reduce sources of popular discontent when it can.) The public is beginning to behave like the demanding client of an investment adviser: it wants better returns, with fewer risks.

This is the challenge facing Lou Jiwei and Gao Xiqing, who will play a larger role in the U.S. economy than Americans are accustomed to from foreigners. Lou, a longtime Communist Party official in his late 50s, is the chairman of the new China Investment Corporation, which is supposed to find creative ways to increase returns on at least $200 billion of China’s foreign assets. He is influential within the party but has little international experience. Thus the financial world’s attention has turned to Gao Xiqing, who is the CIC’s general manager.

Twenty years ago, after graduating from Duke Law School, Gao was the first Chinese citizen to pass the New York State Bar Exam. He returned to China in 1988, after several years as an associate at the New York law firm Mudge, Rose (Richard Nixon’s old firm) to teach securities law and help develop China’s newly established stock markets. By local standards, he is hip. At an economics conference in Beijing in December, other Chinese speakers wore boxy dark suits. Gao, looking fit in his mid-50s, wore a tweed jacket and black turtleneck, an Ironman-style multifunction sports watch on his wrist.

Under Lou and Gao, the CIC started with a bang with Blackstone—the wrong kind of bang. Now, many people suggest, it may be chastened enough to take a more careful approach. Indeed, that was the message it sent late last year, with news that its next round of investments would be in China’s own banks, to shore up some with credit problems. And it looks to be studying aggressive but careful ways to manage huge sums. About the time the CIC was making the Blackstone deal, its leadership and staff undertook a crash course in modern financial markets. They hired the international consulting firm McKinsey to prepare confidential reports about the way they should organize themselves and the investment principles they should apply. They hired Booz Allen Hamilton to prepare similar reports, so they could compare the two. Yet another consulting firm, Towers Perrin, provided advice, especially about staffing and pay. The CIC leaders commissioned studies of other large state-run investment funds—in Norway, Singapore, the Gulf States, Alaska—to see which approaches worked and which didn’t. They were fascinated by the way America’s richest universities managed their endowments, and ordered multiple copies of Pioneering Portfolio Management, by David Swensen, who as Yale’s chief investment officer has guided its endowment to sustained and rapid growth. Last summer, teams from the CIC made long study visits to Yale and Duke universities, among others.

Gao Xiqing and other CIC officials have avoided discussing their plans publicly. “If you tell people ahead of time what you’re going to do—well, you just can’t operate that way in a market system,” he said at his Beijing appearance. “What I can say is, we’ll play by the international rules, and we’ll be responsible investors.” Gao emphasized several times how much the CIC had to learn: “We’re the new kids on the block. Because of media attention, there is huge pressure on us—we’re already under water now.” The words “under water” were in natural-sounding English, and clearly referred to Blackstone.

Others familiar with the CIC say that its officials are coming to appreciate the unusual problems they will face. For instance: any investment group needs to be responsible to outside supervisors, and the trick for the CIC will be to make itself accountable to Communist Party leadership without becoming a mere conduit for favored investment choices by party bosses. How can it attract the best talent? Does it want to staff up quickly, to match its quickly mounting assets, by bidding for financial managers on the world market—where many of the candidates are high-priced, not fluent in Chinese, and reluctant to move to Beijing? Or can it afford to take the time to home-grow its own staff?

While the CIC is figuring out its own future, outsiders are trying to figure out the CIC—and also SAFE, which will continue handling many of China’s assets. As far as anyone can tell, the starting point for both is risk avoidance. No more Blackstones. No more CNOOC-Unocals. (In 2005, the Chinese state oil firm CNOOC attempted to buy U.S.–based Unocal. It withdrew the offer in the face of intense political opposition to the deal in America.) One person involved with the CIC said that its officials had seen recent Lou Dobbs broadcasts criticizing “Communist China” and were “shellshocked” about the political resentment their investments might encounter in the United States. For all these reasons the Chinese leadership, as another person put it, “has a strong preference to follow someone else’s lead, not in an imitative way” but as an unobtrusive minority partner wherever possible. It will follow the lead of others for now, that is, while the CIC takes its first steps as a gigantic international financial investor.

The latest analyses by Brad Setser suggest that despite all the talk about abandoning the dollar, China is still putting about as large a share of its money into dollars as ever, somewhere between 65 and 70 percent of its foreign earnings. “Politically, the last thing they want is to signal a loss of faith in the dollar,” Andy Rothman, of the financial firm CLSA, told me; that would lead to a surge in the RMB, which would hurt Chinese exporters, not to mention the damage it would cause to China’s vast existing dollar assets.

The problem is that these and other foreign observers must guess at China’s aims, rather than knowing for sure. As Rothman put it, “The opaqueness about intentions and goals is always the issue.” The mini-panics last year took hold precisely because no one could be sure that SAFE was not about to change course.

The uncertainty arises in part from the limited track record of China’s new financial leadership. As one American financier pointed out to me: “The man in charge of the whole thing”—Lou Jiwei—“has never bought a share of stock, never bought a car, never bought a house.” Another foreign financier said, after meeting some CIC staffers, “By Chinese terms, these are very sophisticated people.” But, he went on to say, in a professional sense none of them had lived through the financial crises of the last generation: the U.S. market crash of 1987, the “Asian flu” of the late 1990s, the collapse of the Internet bubble soon afterward. The Chinese economy was affected by all these upheavals, but the likes of Gao Xiqing were not fully exposed to their lessons, sheltered as they were within Chinese institutions.

Foreign observers also suggest that, even after exposure to the Lou Dobbs clips, the Chinese financial leadership may not yet fully grasp how suspicious other countries are likely to be of China’s financial intentions, for reasons both fair and unfair. The unfair reason is all-purpose nervousness about any new rising power. “They need to understand, and they don’t, that everything they do will be seen as political,” a financier with extensive experience in both China and America told me. “Whatever they buy, whatever they say, whatever they do will be seen as China Inc.”

The fair reason for concern is, again, the transparency problem. Twice in the past year, China has in nonfinancial ways demonstrated the ripples that a nontransparent policy creates. Last January, its military intentionally shot down one of its own satellites, filling orbital paths with debris. The exercise greatly alarmed the U.S. military, because of what seemed to be an implied threat to America’s crucial space sensors. For several days, the Chinese government said nothing at all about the test, and nearly a year later, foreign analysts still debate whether it was a deliberate provocation, the result of a misunderstanding, or a freelance effort by the military. In November, China denied a U.S. Navy aircraft carrier, the Kitty Hawk, routine permission to dock in Hong Kong for Thanksgiving, even though many Navy families had gone there for a reunion. In each case, the most ominous aspect is that outsiders could not really be sure what the Chinese leadership had in mind. Were these deliberate taunts or shows of strength? The results of factional feuding within the leadership? Simple miscalculations? In the absence of clear official explanations no one really knew, and many assumed the worst.

So it could be with finance, unless China becomes as transparent as it is rich. Chinese officials say they will move in that direction, but they’re in no hurry. Last fall, Edwin Truman prepared a good-governance scorecard for dozens of “sovereign wealth” funds—government-run investment funds like SAFE and the CIC. He compared funds from Singapore, Korea, Norway, and elsewhere, ranking them on governing structure, openness, and similar qualities. China’s funds ended up in the lower third of his list—better-run than Iran’s, Sudan’s, or Algeria’s, but worse than Mexico’s, Russia’s, or Kuwait’s. China received no points in the “governance” category and half a point out of a possible 12 for “transparency and accountability.”

Foreigners (ordinary Chinese too, for that matter) can’t be sure about the mixture of political and strictly economic motives behind future investment decisions the Chinese might make. When China’s president, Hu Jintao, visited Seattle two years ago, he announced a large purchase of Boeing aircraft. When France’s new president, Nicolas Sarkozy, visited China late last year, Hu announced an even larger purchase of Airbuses. Every Chinese order for an airplane is a political as well as commercial decision. Brad Setser says that the Chinese government probably believed that it would get “credit” for the Blackstone purchase in whatever negotiations came up next with the United States, in the same way it would get credit for choosing Boeing. This is another twist to the Kremlinology of trying to discern China’s investment strategy.

Where the money goes, other kinds of power follow. Just ask Mikhail Gorbachev, as he reflects on the role bankruptcy played in bringing down the Soviet empire. While Japan’s great wealth has not yet made it a major diplomatic actor, and China has so far shied from, rather than seized, opportunities to influence events outside its immediate realm, time and money could change that. China’s military is too weak to challenge the U.S. directly even in the Taiwan Straits, let alone anyplace else. That, too, could change.

A Balance of Terror

Let’s take these fears about a rich, strong China to their logical extreme. The U.S. and Chinese governments are always disagreeing—about trade, foreign policy, the environment. Someday the disagreement could be severe. Taiwan, Tibet, North Korea, Iran—the possibilities are many, though Taiwan always heads the list. Perhaps a crackdown within China. Perhaps another accident, like the U.S. bombing of China’s embassy in Belgrade nine years ago, which everyone in China still believes was intentional and which no prudent American ever mentions here.

Whatever the provocation, China would consider its levers and weapons and find one stronger than all the rest—one no other country in the world can wield. Without China’s billion dollars a day, the United States could not keep its economy stable or spare the dollar from collapse.

Would the Chinese use that weapon? The reasonable answer is no, because they would wound themselves grievously, too. Their years of national savings are held in the same dollars that would be ruined; in a panic, they’d get only a small share out before the value fell. Besides, their factories depend on customers with dollars to spend.

But that “reassuring” answer is actually frightening. Lawrence Summers calls today’s arrangement “the balance of financial terror,” and says that it is flawed in the same way that the “mutually assured destruction” of the Cold War era was. That doctrine held that neither the United States nor the Soviet Union would dare use its nuclear weapons against the other, since it would be destroyed in return. With allowances for hyperbole, something similar applies to the dollar standoff. China can’t afford to stop feeding dollars to Americans, because China’s own dollar holdings would be devastated if it did. As long as that logic holds, the system works. As soon as it doesn’t, we have a big problem.

What might poke a giant hole in that logic? Not necessarily a titanic struggle over the future of Taiwan. A simple mistake, for one thing. Another speech by Cheng Siwei—perhaps in response to a provocation by Lou Dobbs. A rumor that the oil economies are moving out of dollars for good, setting their prices in euros. Leaked suggestions that the Chinese government is hoping to buy Intel, leading to angry denunciations on the Capitol floor, leading to news that the Chinese will sit out the next Treasury auction. As many world tragedies have been caused by miscalculation as by malice.

Or pent-up political tensions, on all sides. China’s lopsided growth—ahead in exports, behind in schooling, the environment, and everything else—makes the country socially less stable as it grows richer. Meanwhile, its expansion disrupts industries and provokes tensions in the rest of the world. The billions of dollars China pumps into the United States each week strangely seem to make it harder rather than easier for Americans to face their own structural problems. One day, something snaps. Suppose the CIC makes another bad bet—not another Blackstone but another WorldCom, with billions of dollars of Chinese people’s assets irretrievably wiped out. They will need someone to blame, and Americans, for their part, are already primed to blame China back.

So, the shock comes. Does it inevitably cause a cataclysm? No one can know until it’s too late. The important question to ask about the U.S.–China relationship, the economist Eswar Prasad, of Cornell, recently wrote in a paper about financial imbalances, is whether it has “enough flexibility to withstand and recover from large shocks, either internal or external.” He suggested that the contained tensions were so great that the answer could be no.

Today’s American system values upheaval; it’s been a while since we’ve seen too much of it. But Americans who lived through the Depression knew the pain real disruption can bring. Today’s Chinese, looking back on their country’s last century, know, too. With a lack of tragic imagination, Americans have drifted into an arrangement that is comfortable while it lasts, and could last for a while more. But not much longer.

Years ago, the Chinese might have averted today’s pressures by choosing a slower and more balanced approach to growth. If they had it to do over again, I suspect they would in fact choose just the same path—they have gained so much, including the assets they can use to do what they have left undone, whenever the government chooses to spend them. The same is not true, I suspect, for the United States, which might have chosen a very different path: less reliance on China’s subsidies, more reliance on paying as we go. But it’s a little late for those thoughts now. What’s left is to prepare for what we find at the end of the path we have taken.

Dear Prof. Shih:

That was a wonderful article you posted (from James Fallows). I have a genuine question (not a rhetorical one):

Is there a possibility that authoritatrian/semi-authoritarian prefer FDI/Export-led growth to domestically led growth because it could eventually grow into a threat to their political authority?

Is there thereoetical or empirical literature on this?

Could this also be a factor in the CCP's economic policy choices?
I don't know if the food reserve is so irrational in today's world. Both Clinton and Obama are so anti free trade, at least in rhetoric. and they're from the economically most powerful market in the world. Think about it. 21st century doesn't necessarily mean a free market century, especially when so many ppl in the west are so wary about China.
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Friday, April 11, 2008

Well, talk about princeling love-fests. They made a big deal out of the 100th birthday of Wang Zhen, a close protege of Deng Xiaoping. It was attended by Wang's surviving family, including former CITIC Chairman Wang Jun. It was presided by Xi Jinping. The interesting history behind this is that Xi Zhongxun, Xi's dad, once harshly criticized Wang Zhen for implementing land reform in Uighur and Kazakh areas of Xinjiang without any special consideration. Wang was demoted because of elder Xi's action. I think Xi junior's speech may be a way to make nice with Wang's family and Deng's family, and perhaps even endorse the "Wang Zhen" way of managing minority affairs! Actually, the Wang Zhen way is the current policy anyway!

(2008年4月11日) 习近平

2008年04月12日04:59 来源:人民网-《人民日报》
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  王震同志出生于湖南省浏阳县一个农民家庭。在上世纪20年代的大革命洪流中,他开始接触进步思想和中国共产党的组织,并在工人运动中迅速成长起来。1927年1月加入中国共产主义青年团,同年5月转为中国共产党党员。大革命失败后,他毅然投身武装反抗国民党反动派的斗争,参加了湘赣苏区的创建工作,先后任红军湘东独立一师团政治委员、师政治委员、师党委书记,红八军师政治委员、军政治部主任、代理军长,中共湘赣省委委员,省军区代理司令员。在湘赣苏区斗争中,王震同志英勇善战,曾获三等红星奖章。他坚决执行毛泽东同志关于纠正肃反扩大化的指示和粉碎敌人“围剿”的战略战术原则,尽力保护同志,抵制 “左”倾军事路线造成的影响。1934年7月起,王震同志先后任红六军团军政委员会委员、政治委员,在任弼时同志领导下,为执行中央红军长征先遣队的任务,与军团长肖克同志一起率部西征。同年10月与红二军团会师。此后,王震同志任中共湘鄂川黔省委委员、中央军委分会委员、代理军区司令员。1935年11月,为摆脱国民党重兵“围剿”,红二、红六军团主动转移,继续长征,于1936年7月初在四川甘孜地区与红四方面军胜利会师。其后,红二、红六军团与红32军组成红二方面军,王震同志与任弼时、贺龙、关向应等同志一道坚决反对和抵制张国焘分裂红军、分裂党的行径,坚决执行党中央北上抗日的正确方针。1936年10月,共同北上的红二方面军和红四方面军,在甘肃与红一方面军会合,胜利实现了红军三大主力在西北地区的大会师。














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Well, the Chen Liangyu verdict is out. They only indicted him for 300,000 in bribes. Frankly, I know cases of much more junior officials who have taken much, much more. Unlike the Chen Xitong case, where Chen really did not take much, Chen and his family probably took much more. They didn't investigate the case thoroughly because that would involve Huang Ju's family, so Chen only gets busted for a small slice of what he took. His family gets to keep much of what remains, socked away in a Swiss bank. I am sure his sentence will be commuted in a few years, and he will be able to live out a quiet life in the suburbs of Shanghai....such is life in the CCP!

The New York Times
April 12, 2008
Ex-Party Boss in China Gets 18 Years

BEIJING - The former Communist Party boss of Shanghai, Chen Liangyu, was sentenced on Friday to 18 years in prison for taking bribes and abusing power.

Mr. Chen, who before his arrest in late 2006 was also a member of China's ruling Politburo, is the highest ranking government official to be stripped of power here in over a decade.

His sentence was handed down Friday at the No. 2 Intermediate People's Court in the northern city of Tianjin, where he had recently been on trial.

Prosecutors accused Mr. Chen, 62, of helping siphon hundreds of millions of dollars out of the city's pension fund, and also of enriching himself, friends and relatives through shady financial and real estate deals beginning as early as 1988.

Government auditors said they discovered that about $4.8 billion had been illegally taken out of the city's social security fund while Mr. Chen was serving in various government posts in Shanghai.

The pension fund scandal rocked Shanghai in late 2006 and early 2007, leading to the arrests of a group of powerful politicians and businessmen, including Zhang Rongkun, once one of the country's wealthiest men.

Mr. Zhang, 39, was sentenced earlier this month to 19 years in prison for stock manipulation, financial fraud and his role in the city pension fund scandal.

Prosecutors said Mr. Chen had helped Mr. Zhang acquire land and other holdings by illegally lending him money from the city's pension fund.

During a closed-door trial, Mr. Chen admitted that he was "partially responsible" for some of the pension fund fraud but pleaded not guilty, according to the state-run news media.

The sentencing comes at a time when China is struggling to cope with a growing number of corruption scandals among its officials. When a government Web site went public last December, welcoming tips on corruption, it was bombarded with so many hits that it crashed.

In recent years, Beijing has been vowing to get tough on corruption, which some leaders believe could be a threat to the ruling Communist Party.

Still, the Chen Liangyu case is unusual because few members of the country's ruling Politburo face legal troubles, even when there is some evidence of corruption, unless there are sharp political conflicts or a ferocious power struggle with more powerful leaders.

Before his fall, Mr. Chen was considered part of a group of powerful Shanghai politicians who were close to China's former paramount leader, Jiang Zemin, who led Shanghai and later became president, stepping down in 2003.

The members of the Shanghai group were frequently at odds with the policies of their immediate successors as the country's new leaders, President Hu Jintao and Prime Minister Wen Jiabao, according to people close to the leadership.

Rumors of Mr. Chen's downfall had circulated in China as early as 2005. He was detained in September 2006, after Beijing sent a team of inspectors to Shanghai to investigate fraud there.

Last October, Mr. Chen was stripped of his Communist Party post. At the time of his arrest, he was one of the country's most powerful politicians, and had served in various city posts, including vice mayor, mayor and Shanghai party secretary, the highest position.

The government said he was guilty of accepting about $300,000 in bribes, according to the state-run news media.

On Friday, in announcing his prison sentence, the government said it had confiscated about $45,000 worth of his personal belongings.

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Wednesday, April 02, 2008

Dear Readers,

Just when you think that things are getting boring after the NPC, something strange happens. Apparently, Jiang Zemin has penned an essay on energy at the main journal of his alma mater Jiaotong Daxue (email me if you have trouble downloading it). It seems relatively mundane-- calling for comprehensive planning and an emphasis on renewable and conservation....etc., except for the fact that it was published. Why is it being published at this particular moment, when the energy bureaucracy is undergoing restructuring?? A couple of interesting points:

1. It calls for long term and comprehensive planning for energy policy, which implies that he may have supported keeping energy within the NDRC to facilitate long term planning. If so, this is a clear case of retirees intervening in policy.

2. At the end, he thanks several "comrades," all leading figures in the energy field, starting with Ma Fucai. Being born in 1957, this article may be Jiang's blessing for Ma to head the new energy bureau. I guess we'll see. The other coauthors of this article include vice head of the State Council Research Office Ning Jizhe and a couple of NDRC energy experts Zhou Dadi and Han Wenke. Any insights into these guys would be appreciated.

Anyway, I just find this whole thing very, very strange. Jiang was never known to be an energy expert, but all of the sudden, there is this long, fairly detailed essay outlining China's energy future. What is happening here?

The news is a bit slow on the uptake but nonetheless v interesting!


Sue Anne
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