Strategic Priorities : China's Reforms and the Reshaping of the Global Order 9781623200527, 9781623200374

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Strategic Priorities: China’s Reforms and the Reshaping of the Global Order

Yifan Hu

Singapore • Hong Kong • Beijing • Honolulu

Published by Enrich Professional Publishing, Inc. Davies Pacific Center, 841 Bishop Street, Suite 208 Honolulu, HI, 96813 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 2/F, Rays Industrial Building, 71 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Hai Dian Zhong Jie, Haidian District, Beijing, China Singapore Office: 16L, Enterprise Road, Singapore 627660 English edition © 2014 by Enrich Professional Publishing (S) Private Limited Edited by Glenn Griffith and Phoebe Poon All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. 978-1-62320-037-4 ISBN (Hardback) 978-1-62320-052-7 ISBN (ebook) This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally minded publisher focusing on the economic and financial developments that have revolutionized new China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate and engaging information on China. Printed in Hong Kong with woodfree paper from Japan

Contents Acknowledgements .................................................................................... vii Economic Leverage: China’s Priorities for the Future

Economic Leverage, the Key to a Rising China’s ............................. 3 New Foreign Affairs Strategy



What to Expect When Expecting: ....................................................... 41 Policy Reforms to Bring the Birth of China’s Future



Strategy to Promote the Renminbi as ................................................ 79 a World Reserve Currency



Diffusing the Ticking Time Bomb: China’s Pension System .......... 109



China’s Local Government Debt: Save for a Rainy Day ................. 143



Is China a Real Superpower? .............................................................. 151



Evolution or Extinction: Amid Rising Labor Costs, ........................ 169 What Is the Future for China’s Labor Bonus?



Shale Gas: Powering China’s Future? ................................................ 183

Looking for the New Sources of Growth: China and the Global Order

Looking for the New Sources of Growth .......................................... 197



Global Impact of the U.S. QE Exit ...................................................... 235



Japan’s Stimulus Policy of Brinkmanship ......................................... 247

Investment Strategy amid a Global Currency War .......................... 257



Reshoring of U.S. Manufacturing: A Ripple or ................................ 275 a Tide Approaching China?



How Weighty Are BRICS? ................................................................... 289



China’s Long-Term Strategy in Africa ............................................... 299



ASEAN: A Rising Hot Destination for ............................................... 305 China’s Outbound Investment



What Is at Stake with Cybersecurity? ................................................ 313

About Haitong International ..................................................................... 323

Acknowledgements I would like to take this opportunity to express my deepest appreciation to my colleagues and friends at Haitong International who helped me with

this project. I thank them for their enthusiasm and commitment to my book.

I would especially like to give my thanks to my colleague, Alexis Garatti,

for his incredible input and effort in the completion of book. Without his contributions, this project would never have been accomplished.

I would like to give my thanks to the following institutions: the Institute

of Financing and Banking of the Chinese Academy of Social Sciences, the

Research Institute of the China Securities Regulatory Commission, the

Peterson Institute for International Economics, the Faculty of Business and

Economics of the University of Hong Kong, Georgetown University, Renmin University of China, and Zhejiang University.

I would also like to express my special appreciation of my family because

without their strong support the publication of this book would have been impossible.

Last but not the least, I would like to give my thanks to my editors at

Enrich Professional Publishing, Mr. Glenn Griffith and Ms. Phoebe Poon, for their hard work, dedication, and professionalism.

Yifan Hu

November 2, 2013

vii

ECONOMIC LEVERAGE: CHINA’S PRIORITIES FOR THE FUTURE

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

A Rising China Calling for a New EconomicFocused Diplomatic Strategy Economic rise translates into political power Over the past three decades, China’s growth has been a wonder to behold. The average year-over-year growth rate for the period of 1980 to 2012 was 9.9%, a stunning pace. As of the end of 2012, the nominal GDP had grown roughly to 27 times its 1980 value. Today, China’s GDP ranks second in

the world, below only the United States. The catching-up process has been impressive as China successively overtook Germany in 2007 and Japan in 2010. The weight of Chinese GDP was close to 15% of the world GDP in

2010, compared to less than 5% in 1990. Furthermore, China has managed to maintain robust growth through the 2007–2009 Global Financial Crisis

and ongoing European Sovereign Debt Crisis, while many economies

suffered significant economic malaise if not outright recessions. Based on

our assumption of growth rates at 7% year-over-year and 2% for China and the United States over next 10 years, together with the possibility of 10% to 15% appreciation of the renminbi, China will likely replace the United States to become the number one economy in the world by 2023.

China’s exports have been on a track of continuous rapid growth,

representing 11% of world exports today from only 1.1% in 1982, higher

than the 8% weights of the United States and of the Eurozone. Meanwhile, China’s imports have shown an upward trend, registering at 10.1% of world total imports today, compared to the 12.7% of the United States and 11.6% of the Eurozone. China has built up a large pool of foreign exchange reserves

totaling USD3.5 trillion by the first half of 2013, the highest in the world, accounting for over a third of the world reserves. China has therefore become the largest creditor of developed economies.

Backed by rising economic power with the promotion of a “go out”

strategy, outbound investment of China amounted to USD87.8 billion in 2012, representing 6.3% of total global foreign direct investments (FDIs) in that year and being the second runner-up after the United States and Japan.

China’s cumulative outbound investment has surged in recent years, reaching

USD5.3 trillion in 2012, about 18 times the level of 2002. The proportion of

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

the investment overseas accounted for 6.4% of the GDP in 2012, up from 2.5% in 2000.

All of these factors allow China to have a louder voice and more bargaining

power in international affairs, showing that China’s economic power has been gradually shifting into political power. China has accumulated more

voting power in most international institutions, and played an increasingly significant stabilizing role after the Global Financial Crisis and during the ongoing European Sovereign Debt Crisis.

A call for a new strategy for foreign affairs China’s rising economic and political power and its transition from different stages of development mean that its foreign affairs approach has to be redefined. Noninterventionist in the recent past, the stance of Chinese foreign

policy has become progressively awkward. China’s increasing influence and growing interests overseas requires a higher degree of intervention and protection.

The history of the United States presents a good example of the

transformation in foreign policy associated with the emergence of a superpower. Contemplating the initial policy of isolation and the subsequent

historical evolution of the Monroe Doctrine in the United States is a way to understand how a country’s foreign policy changes with levels of economic

development and with scales of assets overseas during a country’s rise to the level of a superpower.

At the early stages of its economic development, during which it had

a weak presence outside and poor military forces, the United States had adopted a neutral and isolationist foreign policy. In parallel with a stronger

presence and investments abroad, the Monroe Doctrine, applied from 1823, transformed this U.S. foreign policy into a more assertive, though still

defensive, policy. At its core, the Monroe Doctrine aimed at discouraging

European colonization of North and South America. The Monroe Doctrine

was a foreign policy declaration that any future aggression by European powers in the Americas would be perceived as a threat to the United States;

in essence, it was an expectation that the European powers would stay away from the Americas, in exchange for the United States not interfering with

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

European politics and existing colonies. This phase of U.S. foreign policy

development perhaps similarly reflected China’s attitude in the last several decades; with relatively limited foreign interests, the focus was mainly to protect domestic interests.

At the turn of the 20th century, the United States was gradually rising

to superpower status. The Monroe Doctrine was amended in a more interventionist manner by the Roosevelt Corollary in 1904, along with

increasing U.S. interests overseas. Foreign investments from the United

States increased to over 5% of GDP at that time (similar to China’s ratio today). This was seen by many as the United States’ departure from the

previously defensive stance towards a more aggressive declaration of regional hegemony. From intervention in case of instability in America, the

U.S. strategy became implicitly preemptive with the containment strategy, justifying the deployment of foreign affairs resources and possibly military

interventions to protect U.S. national interests. Defensive at its creation, this

doctrine therefore became more and more assertive with the rising power of the United States at the world level. It is interesting to note that, similar

to China’s current economic status, the United States had just completed its transition from an agricultural to an industrialized country with a strong

manufacturing infrastructure in place at that time, with GDP per capita at

roughly USD4,000 to USD5,000 and outbound investment at about 5% of GDP.

With China’s rise to a superpower status and with increasing interests

abroad, it has become increasingly important and urgent for China to

establish a new foreign affairs strategy to face the challenges and seize the

opportunities brought by its new status in a new international structure and environment.

A New Diplomatic Strategy Leveraging Economic Power Suitable for a Rising Superpower China has gradually become a rising economic and political power worldwide, while other developed countries have struggled to regain growth momentum

6

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

following the Global Financial Crisis and during the ongoing European Sovereign Debt Crisis. Still in the process of developing its economy, China has been abruptly thrust into the spotlight as a superpower by recent events,

and this rapid rise has drawn concern from the Western countries as well as

its neighboring countries. With China’s rise to a superpower and increasing

interests abroad, together with concerns and fears of both Western and neighboring countries, it has become increasingly important and urgent for China to establish a new foreign affairs strategy to face the new challenges

and opportunities for its new status in a new international structure and environment. Communication is equally important as the new foreign

strategy, especially in a context of a “trust deficit” between China and the rest of the world. China would benefit from improving communication to

promote cooperation and diplomacy, which could be done through a variety of methods, both official and nonofficial.

China has become the second largest economy in the world through its

past three decades of unparalleled fast growth, and is seeking to walk the path that took the United States a century to do in the next three decades, in

transitioning from a manufacturing society to a more consumption-orientated society with higher labor productivity through technological development. China’s rise and transition from different stages of development will mean

that the focus for managing foreign affairs will change over time as well. China’s “no intervention” foreign policy for the past decades has appeared

increasingly awkward in dealing with international affairs due to its rising

power as well as increasing investments and interests overseas. At varying

stages of economic development, there will be different agendas and views for policymakers. In the course of China’s rise to a superpower status,

China will have both increasing influence and interests worldwide, and, consequently, there will be a need for notable changes in foreign policy direction in the next 30 years.

Despite military force, economic power will play an increasingly

important role in international affairs. Tackling unemployment and boosting growth have increasingly become the winning tickets for politicians in the

power struggle process of most economies; therefore countries that can help drive global growth and produce positive spillover effects are the kings of the game. China is a superpower on the rise, with vast amounts of still untapped

7

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

potential for further growth, implying a good timing and opportunity for China to play economic cards strategically in maneuvering a new win-win

scope of diplomatic relationships. In doing so, China first needs to identify its dynamic position in the global competitiveness pyramid, and then establish strategic relationships with major economies accordingly.

Global competitiveness pyramid

U.S.

Germany Japan Some developed economies Small Asian Dragons (Korea, Singapore) BRICS (China, Russia, India, China, South Africa)

Transitional economies

Based on the definition by the World Economic Forum, competitiveness

is composed of three main categories: (1) basic requirements including institutions, infrastructure, macroeconomic environment, healthcare, and

primary education; (2) efficiency enhancers including higher education and training, goods market efficiency, labor market efficiency; (3) financial market development, technological readiness, and market size, and innovation and business sophistication. Our pyramid is a ranking of the current competitiveness of several countries in the international system. Currently, the United States ranks at the top, and is likely to remain in that

8

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

spot for at least the next several decades. Despite the recent Global Financial

Crisis, the United States remains at Tier 1, as it is one of the highest GDP per capita countries in the world, has high value added, and is still the largest national economy in the world in nominal terms by a good margin. In the

next tier, Japan and Germany are developed economies with traditionally

high competitiveness, but are currently facing significant socioeconomic

issues. Following Japan and Germany are countries such as the four Little Asian Dragons including South Korea, Singapore, Hong Kong, and Taiwan.

The four Asian Dragons have become either financial centers or hubs for technological innovation in Asia.

China is in Tier 4 along with other BRICS such as Russia and India, as it

still has lower efficiency and competitiveness relative to the economies listed

in the first three tiers. As it begins to evolve towards increasingly valueadded manufacturing and services, as institutional arrangements have

improved, as urbanization continues, and as innovation and technological

improvements are more encouraged, China will move up from Tier 4 to Tier

3 in competitiveness. It is vital for China to properly manage relations with the upper tiers and within its tier in the process of rising. In this paper we

focus on China-U.S., China-Europe, China-Russia, China-Japan, and the China-emerging neighbor ties over the next several decades.

New strategic China-U.S. relations The Sino-U.S. relationship is arguably the most important bilateral relationship in the world, and it is tightly bound by economic ties and increasing cultural ties. This relationship frequently undergoes tensions due to a variety of economic and political issues, and is likely to continue to do so

in the future. Especially following the Global Financial Crisis and during the ongoing European Sovereign Debt Crisis, China has suddenly been thrust towards the forefront of the discussion as a potential superpower. There have been increasing discussions of a G2 world, where the United States and

China are the two superpowers in the international system to bail out the

global economy. As the two largest national economies in the world, these countries are set to play the primary roles in shaping the global economy in the decades to come.

9

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

As a rising economic and military power, China is a concern for Western

countries, especially the United States, as evidenced by President Obama’s push for reallocating military resources to the Asia-Pacific region, a move

known as the “pivot strategy.” A U.S. Department of Defense assessment report covering U.S. military interests, named Sustaining U.S Global Leadership: Priorities for 21st Century Defense was announced on January 6, 2012. In this report, the United States linked its economic and security interests closely to regional development ranging from the Western Pacific Area and Eastern

Asia to the Indian Ocean and Southern Asia. It is evident that the redirection

of the U.S. military strategy focuses much more on China than other powers in this region.

The China-U.S. bilateral relationship is unfolding with an interesting

dynamic. One way to describe it would be a pair of wary Siamese twins

that do not trust each other but are nonetheless irrevocably joined together;

both countries deal with mutual distrust despite growing increasingly

interdependent economically. From the U.S. perspective, they would like to have further cooperation while hedging against the risk that China will

develop along a different path from what they would prefer; the United States would obviously prefer China’s rise to benefit both parties in a complementary manner, rather than having China’s rise be at the expense

of American prosperity and security. Consequently, they have continued to try to strengthen cooperation and trade ties, while at the same time hedging against risk by adopting a policy of containment, where the United States

has increased its influence and presence in countries surrounding China in a

physical and economic buffer. The two channels where the United States is particularly containing China are from a naval perspective, where the United States has a presence in maritime shipping routes that China must go through

to reach open waters, and in terms of energy commodities. The United

States is also linking up with India, a regional competitor with many similar characteristics to China, which may be to hedge against China’s power in the region. China can respond to this policy of containment by attempting

to strengthen ties with neighbors; as a driver of economic growth, and due

to geographical proximity, China has an advantage over the United States in securing stronger ties with countries in Asia.

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

The U.S. and Chinese economies are largely complementary and

have great potential to work together to strengthen economic ties, reform economic structures, and contribute to global regulation. The potential of

economic cooperation could encompass the following areas: strengthening

trade relationships, promoting common strategic sectors, rebalancing

domestic economies, coordinating for an optimal policy mix at a global level, and collaborating at a financial level.

Strengthening trade relations China’s largest trade partner is the United States, and the United States’ second largest trade partner is China. The Chinese and U.S. economies are

mostly complementary and have intertwined deeply with each other. The

United States has greatly benefited from China’s cheap products as well

as low-cost financing for the past years, and will continue to be better off as long as China can keep acting as the driver of world growth. However,

the potential of trade between China and the United States remains largely

untapped. Sino-U.S. trade can be developed via four different channels: to reduce the level of protectionism, to lift restrictions on high-tech products,

to develop trade in intermediate products, to participate in free trade agreements, and to reduce trade protectionism.

To reduce the level of protectionism The Global Trade Alert has initiated an inventory of protectionist measures

taken since November 2008. It appears clearly that China is at the top of the

list of the countries targeted by the U.S. administration. The same is true for the United States relative to the Chinese administration. The issue has

been discussed in recent summits, as both countries have expressed their

willingness to reduce protectionism, which is still on an upward trend. They both advocated free and fair trade. In this context, the limitation of

protectionist measures, amid a lower level of growth for the two countries,

should contribute to the increase of their potential of growth. There is a

mutual interest in reducing the level of protectionism between the two countries.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Commercially harming measures taken by the United States, since November 2008 25 20 15 10

Brazil

Belgium

Austria

Australia

Japan

Germany

Vietnam

India

Canada

Mexico

0

China

5

Sources: Global Trade Alert; Haitong International.

Commercially harming measures taken by China, since November 2008 45 40 35 30 25 20 15 10

Sources: Global Trade Alert; Haitong International.

12

Thailand

Russia

Sweden

Spain

U.K.

Italy

France

Netherlands

Germany

Japan

0

U.S.

5

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

To lift restrictions on high-tech products The solution for narrowing the large trade gap of the two countries should come from a rise in U.S. exports to China rather than a fall in China’s exports

to the United States. To achieve Obama’s ambition to double exports in five

years, the United States’ self-interest is to lift certain constraints on exports of high technology itself or high-tech products as well as promote services

exports. In his 2013 and 2012 visits to the United States, President Xi Jinping reiterated China’s wish to see trade restrictions be progressively removed. The current export restriction list in the United States includes about 2,400 different products in nine categories. They range from nuclear, biotechnology,

electronics, information security, sensors, and lasers, navigation and

avionics, marine, to propulsion systems. A gradual strategy pursued step by step and product by product would probably be the best approach for the two countries to obtain concrete steps toward barrier removals. The best way

to progress in this area consists of developing joint programs of research, focusing on the commercial exploitation of the different technologies, developing relations with the historical partners of the United States, and keeping an open mind for both sides.

The U.S. administration has recently toughened the tone of its accusation

of China for cyber espionage. The White House estimates the cost of cyber

theft to be between USD250 billion to USD1 trillion per year. In the coming

months, the U.S. Congress could vote for a legislative arsenal allowing the identification of companies and countries practicing hacking and cyber espionage, and the blockage of imports of products benefitting from

these activities. Chinese products are already the main victims of the U.S. administration regarding the value of goods seized for intellectual property rights violations.

To develop trade in intermediate products Another way to improve trade relations can be explored at the level of

intermediate products such as machinery. The United States is in a process

of reindustrialization and has at its disposal a large accumulation of knowhow, illustrated by the global domination of companies like Caterpillar

13

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

and General Electric (GE). Developing exchanges in this domain would contribute to modernizing the capital of production in China, and reducing

U.S. trade deficit. The concrete steps to take for doing that are not obvious, as China is catching up quickly and other partners in the world offer the same degree of technology as the United States. However, the targeting of

intermediate sectors would be much more promising in terms of developing

the exchanges. Traditional industries and raw materials depend too much on price competitiveness and therefore remain hampered by the currency issue. Cutting-edge sectors are too sensitive, and therefore are subject to different

kinds of protectionism. The highest potential of progress in trade between

China and the United States therefore has to be found in intermediate industries, i.e., machinery, manufacturing, energy, infrastructure, food

processing, electronics, electricity, chemical industry, car and motor parts, and so on.

To participate in free trade agreements China signed a free trade agreement with ASEAN countries (Brunei, Burma,

Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand, and Vietnam) in 2002, reducing its tariffs on 90% of imported products. The

pace of multilateral and bilateral trade agreements implicating China and

other Asia Pacific countries has recently accelerated as U.S. presence in this area increased. The Trans-Pacific Partnership (TPP) represents a free trade agreement between 12 nations, the United States (negotiating), Australia

(negotiating), Brunei (signatory), Canada (negotiating), Chile (signatory),

Japan (negotiating), Malaysia (negotiating), Mexico (negotiating), New Zealand (signatory), Peru (negotiating), Singapore (signatory), and Vietnam

(negotiating). This area represents 40% of world trade. This agreement has

been criticized for being favorable to corporations over workers and being particularly harsh on intellectual property rights, which could represent an

obstacle to the diffusion of cheap medicine toward poorer countries. The

participation of the United States in this agreement, in addition to other bilateral free trade agreements in the Asia Pacific region (Thailand, New

Zealand, Indonesia, Malaysia, and Taiwan), aim also to impose norms

of trade in this area. The implementation of different kinds of norms, as

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

also envisaged in the European Union (EU) or U.S. free trade areas, on

the environment, intellectual property rights, and health care, among other topics, could be used as protectionist tools by the United States and other countries against China or as instruments of geostrategy. In this “containment” race, an involuntary harmonization of norms will happen, leading to a reinforcement of trade.

Promoting common strategic sectors Both China and the United States have identified strategic sectors to

develop in the medium term. China’s 12th Five-Year Guideline and Obama’s industrial policies after the Global Financial Crisis have quite a few overlapping highlights reflecting great potential to cooperate between the

two superpowers. These industries are related to health care, new energy, IT, and infrastructure.

Healthcare The two economies face a similar challenge of an aging population with the

necessity of controlling healthcare costs. The protection of seniors has to be

improved in the two countries. Given these priorities, the access to cheaper Chinese products and transfers of technologies between the two countries

would be in their mutual interest. Therefore, freeing access to local markets represents a necessity to make this virtuous circle happen.

New energy Cooperation between the United States and China is well advanced in this area. The Chinese and American sides agreed on different programs related

to smart power grids, large-scale wind power development, and distributed energy including natural gas, shale gas, and biojet fuel. The dispute on solar

panels between China on the one side and the United States and Europe on the other side is currently intensifying but will not hamper a broad cooperation on the environment and energy production, as reflected by the agreement on hydrofluorocarbons.

15

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

IT The two countries have similar directions that develop household access to new technologies related to information and communications. To achieve

this goal, China needs to further open its market and the United States needs to transfer its technology and high-tech products.

Infrastructure This includes not only construction projects but also urban engineering,

commuter transportation, waste disposal, and so on. This is an area in which the exchange of expertise would be positive for both countries.

Agriculture The United States is the world’s largest exporter of agricultural products

and China is its biggest customer. President Xi was present when Chinese

Agriculture Minister Han Changfu and U.S. Agriculture Secretary Tom Vilsack signed a five-year partnership plan on food security, food safety,

and sustainable agriculture in February 2012. This sector is one of the most promising regarding Sino-U.S. relations.

Cultural goods and multimedia The progress observed in China on intellectual property rights and the large

Chinese investments in the U.S. entertainment industry signaled a strong

development of trade between the two countries in this sector. Dalian Wanda

Group acquired in 2012 the theater operator AMC Entertainment for USD2.6

billion. A survey of the law firm Manatt, Phelps & Phillips shows that more than 100 American and Chinese professionals of this industry expect

a significant increase in the number of mergers and acquisitions between

the two countries. The emergence of the middle class in China and the corresponding needs in terms of entertainment production, as well as a deep and modern market in the United States is attractive for investors of the two countries.

16

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

Financial activities The rise of the middle class in China represents another opportunity

of development for the U.S. financial industry. The supply of services

in commercial banking, payment processing (credit cards), investment banking, and insurance products will continue to register high growth in the

coming years. In parallel with the progressive opening of the Chinese capital

account, U.S. exports of financial services and direct investments in China

will continue to top the performances of Western countries. Symmetrically, Chinese banks will assume a growing role in the United States as a presence in the most developed and deepest financial market in the world is a necessity

for accessing U.S. dollar–denominated assets, liquidities, and expertise. The difficulties of European banks in this sector represent an opportunity for Chinese financial institutions to win market shares.

Rebalancing domestic economies Both China and the United States are facing great challenges in rebalancing

their domestic economies. Leaders of the two countries have committed to

rebalance domestic economies. In other words, China is to transform into

a domestic consumption–oriented economy, while the United States is to move toward reindustrialization with lower leverage. The United States and

China have complementary goals and can make joint efforts to reduce their domestic imbalance, using trade and investments:

• Coordinate the China-U.S. policy mix. The U.S. government has recently

tightened its fiscal policy, while China’s fiscal policy remains supportive of the domestic economy. This global policy mix should contribute to the

reduction of U.S. trade deficit and at the same time foster consumption in China. A coordination of economic policies could be envisaged with the engagement on an expansionary consumer-oriented policy in China coupled with a restrictive bias of the fiscal policy in the United States

• The reduction of imbalances could find some solutions at the level of monetary policies, in particular via coordinating the exchange rate policy of the two countries. The United States has progressively softened the tone

of its rhetoric on the degree of appreciation of the renminbi, which keeps

17

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

a gradual trend of appreciation. This equilibrium has to be preserved by the two countries as it lowers the price of imported products in China

and therefore fosters domestic consumption, while it contributes to the reduction of U.S. trade deficit.

• Trade policies have also to be coordinated. U.S. restrictions on high-tech exports could be lifted.

• China and the United States could envisage a coordinated action to

influence the level of domestic saving rates, considered too high in China

but too low in the United States. The two countries could work toward programs of cooperation in healthcare. A reduction of healthcare costs could contribute to the lowering of Chinese household saving rates. To increase the saving rate in the United States would probably consist

of elevating healthcare costs via a diminution of government support,

which is a necessity for the stabilization of debt. Programs of cooperation could also be developed on aging issues.

• The opening of the capital account in China will also reduce the two countries’ imbalances as real exchange rate variations will adjust more closely to the state of macroeconomic fundamentals. The role of exchange

rate as a shock absorber and corrector of global disequilibrium will be reinforced.

Coordinating for an optimal policy mix at a global level The potential and reality of cooperation between China and the United States has been increasingly strong in addressing issues in their bilateral relationship. Their room for cooperation in global affairs is also huge, not only for the long term but also for short-term urgent issues, such as how to

stabilize the world economy amid great uncertainty. The stimulus policies implemented in a coordinated manner by China and the United States after the Global Financial Crisis were the main contributions to global recovery. Today, the Chinese policy is still well adapted to the current situation at a global

level, characterized by higher risks and an increasing global unemployment

rate. The Chinese central government pursues the implementation of major infrastructure investment projects focusing on affordable housing, water

conservancy in rural areas, emissions reduction, and energy saving. This

18

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

policy is contributing to the stabilization of the world demand and as well

as the increase of the potential of the global economy. On the American side, the progressive transition toward an austerity policy represents another

central element for the stabilization of world demand. Such support from the Chinese and American governments compensates the negative shock on world activity originating in the austerity policy of Eurozone countries.

Collaborating at a financial level China and the United States have a high incentive to collaborate at a financial level. All the segments of Chinese financial markets have registered a strong

growth albeit representing a transition model in terms of liberalization

(see the table from the World Economic Forum below, which establishes

a classification of financial models). On the U.S. side, the progression of

financial activities has recently decelerated in a context of restructuring in the aftermath of the 2007–2009 Global Financial Crisis. China has the momentum and the United States more expertise. There is a strategic

interest in collaborating for these two countries at a financial level as both expertise and momentum contribute to the stability of a financial system. The World Economic Forum survey on the development of financial systems shows indeed that China reaches a higher degree of stability thanks in part

to a sound level of growth and a lower frequency of crisis. It shows that

the liberalization of the Chinese financial system has to keep its pace of progressive implementation. The following sectors are the areas in which the development of trade and partnerships are the most promising:

• Insurance industry. The penetration rates of life insurance and non–life insurance products are significantly lower in China. There is a strong

potential to develop insurance products, which is consistent with the development of consumption. With a higher degree of protection,

Chinese households will be more inclined to consume. The subscription to such products would not represent an increase of the saving rate given the high level of liquidities and deposits.

• Payment processing is a sensitive issue given the content of high

technology of these activities. China’s credit card market will open up to international operators in the coming years.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

• Securitization. The United States is a world leader in terms of securitization. The high level of private credit in China (120% of GDP) could give the

occasion to cooperate in this area for freeing some assets from the balance

sheet of Chinese banks. According to the World Economic Forum, China is at around the 50th rank in terms of Tier 1 ratio at 9.7%, compared to 12% for the United States.

• Money market. China has one of the highest M2/GDP ratios at 170% of GDP, compared to 60% for the United States. At the same time,

money market products have a low penetration rate. This configuration highlights a high potential of trade and collaboration in this segment.

• Interest rate derivatives (swaps and options) and foreign exchange

derivatives (swaps and options) have also a low penetration rate in China. The U.S. expertise could be useful in this area.

• The cooperation in financial activities between the United States and

China must give the priority to a strong cooperation at the level of supervisory and regulatory activities.

The financial collaboration between China and the United States can also

extend to currency issues and public debt issues. The two countries could be interested in both promoting the internationalization of the renminbi

as it could make it appreciate further and contribute to the reduction of global imbalances. The gains linked to the promotion of the renminbi

as a reserve currency could be significant as it would lower the negative impact of a renminbi block of countries manipulating their currency to not suffer from China’s competitiveness, and it would produce net positive gains of seigniorage via a higher capacity to issue debt internationally. The

diversification of international reserves to the profit of the renminbi would

also diminish the global risk related to the U.S. public debt. China expects the

United States to clarify its plan of fiscal consolidation to get some reassurance regarding the stability of Treasury securities value. The transition toward a

model of growth less dependent on exports and investment would also be facilitated by the internationalization of the renminbi.

20

21

4.03

4.00

3.58

3.31

3.18

3.16

3.05

Nigeria

Romania

Venezuela

Ghana

Argentina

Ukraine

Kenya

Vietnam

Egypt

Pakistan

India

Morocco

Bangladesh

Russia

Poland

Kazakhstan

Brazil

Mexico

Saudi Arabia

Advancing financial markets

Source: World Economic Forum.

4.47

4.89

Slovak Republic

Columbia

4.89

Czech Republic

4.52

4.96

Peru

Indonesia

5.17

Tanzania

Early-stage financial markets

Conservative

3.26

3.92

4.03

4.12

4.33

4.37

4.38

4.42

4.51

4.98

5.19

6.32

3.37 3.29

Turkey

4.06

4.20

4.23

4.56

4.58

Hungary

Philippines

South Korea

Bahrain

Thailand

Panama

4.99

5.06

China Finland

5.12

5.25

5.40

5.53

5.86

South Africa

Kuwait

Malaysia

Chile

UAE

Transition

2.85 2.14

Greece

3.57

3.66

3.73

4.31

4.35

4.62

4.73

4.94

4.97

5.02

5.13

5.69

6.06

Portugal

Spain

Ireland

Italy

U.K.

France

Austria

Belgium

Netherlands

Sweden

Denmark

Germany

Norway

Switzerland

European

4.04

4.41

U.S. Jordan

4.83

4.93

5.26

5.42

5.51

5.69

Israel

Japan

Canada

Australia

Hong Kong

Singapore

NonEuropean

Liberal

Classification of countries by degree of financial sector liberalization with financial stability score

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

New strategic China-Europe relations China and Europe have developed strong relations over time, now being the largest trade partners of each other. The ongoing European Sovereign

Debt Crisis offers opportunities for China to assist Europe in a time of need and thus strengthen ties for the future. Investment from China into Europe

is likely to accelerate in the years to come, and investors seeking to enter

Europe should target their investments in industrial or specific clusters rather than by country borders.

Points strengthening China-Europe relations A number of elements make the relations between Europe and China easier than the relationship with the United States:

• The unilateralism of the United States is off-putting to both China and Europe.

• Unlike the United States, Europe does not have a containment strategy for China.

• The relations are purely commercial, and are less influenced by military issues.

• The Taiwan and Japan situations do not have any impact on EuropeChina relations.

• Political and military powers are fragmented in Europe, and so in contrast with the United States, each European country approaches relations with China from a less dominant position and is encouraged to cooperate.

• There is a competition between the United States and Europe for penetrating the Chinese market.

• There is a common view between China and Europe on the necessity of a strong regulation of the market.

• The current account is broadly balanced in the Eurozone, meaning less incentive to accuse China of currency manipulation.

• The United States and Europe are strongly opposed in trade disputes, as they broadly have the same structure of specialization.

• China and the Eurozone are committed to the existence of the euro currency, and more broadly to the emergence of new global currencies

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

to counterbalance the privileges linked to the U.S. dollar, and for the purpose of diversifying their foreign exchange reserve portfolio.

• Joint projects with Europe can bring new opportunities in Africa.

Europe remains a major trade partner of China As a main trade partner of China, Europe de facto represents a highly

strategic partner. Chinese exports toward Europe include machinery, mechanical appliances electric equipment, and textile products, while China imports from Europe are mainly machinery, mechanical appliances, electric

equipment, vehicles, aircraft, vessels, and associated transport equipment.

Potential possibilities for relaxing export constraints in Europe could further promote the two countries’ trade relations.

Despite long-term trade relations and the large trade volume, trade

frictions between these two regions have increased recently. Note that the

European Commission opened an investigation in early 2012 on alleged subsidies from the Chinese government to Huawei Technologies and ZTE, telecommunications equipment companies which have rapidly caught up

with European competitors such as Nokia and Alcatel. This dispute could have larger political consequences, as it is related to sensitive sectors, and it

is the first time the European Commission, rather than private companies, has taken the initiative in the lawsuit. European countries have become

more assertive regarding the trade policy of China after the Global Financial Crisis, and blamed their trade deficit with China as the cause of their current difficulties. Their trade balance deficit with China reached EUR156 billion

in 2011, compared to EUR49 billion in 2000. The European Commission

also criticized the rare-earth hoarding strategy of China, as well as the lack of openness of the Chinese public market to foreign companies. The unilateral decision of European authorities to tax all airlines, including

foreign ones, on greenhouse gas emissions on flights within the European territory has also strained the relations between China and Europe. China

has expressed its strong opposition to EU tariff initiatives regarding Chinese telecommunications products and duties on Chinese solar panels. This harshening of trade relations seems paradoxical in a context of higher financial needs within Europe, where Europe asks for more and more help

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

from China. The best strategy for China is to avoid direct confrontations with

the European Commission, while obtaining concessions by negotiating with each individual country where national priorities and common interests will incite governments to adopt a more consensual approach.

China’s role in stabilizing the world economy during the European Sovereign Debt Crisis China has backed the Eurozone during its sovereign debt crisis through investing in government bonds of periphery countries such as USD6 billion in Spanish bonds in 2011, as well as in infrastructures such as harbor

infrastructures in Greece, and the electricity grid and energy company in

Portugal. China was also actively involved in developing joint projects such as the agreement between China Petrochemical and Repsol, Spain’s largest

oil company, to expand oil exploration in Latin America. Both Spain and Portugal have significant strategic holdings in Latin America and Africa, two continents where China wants to expand. The Chinese government also

mentioned the possibility of investing in the European Financial Stability

Facility or European Stability Mechanism via the International Monetary

Fund (IMF) to provide direct support to the rescue packages. China has a strategic interest in stabilizing the Eurozone, as sharp depreciations of the

euro could lead to a significant decline of competitiveness, especially in relation to products coming from Germany. Besides this short-term interest, extending a hand during the crisis could provide a boost to diplomatic relations in the future.

China’s investment in Europe to accelerate Right now may be a good time to invest in Europe, notably in different kinds

of infrastructures. In doing so, the Chinese government or companies have to avoid emanating an image of “vulture” capitalism. We present below the most competitive sectors for the most significant countries:

• Germany: cars, motors, pharmaceuticals, machinery, electronics, banking

industry, aeronautical industry, biotechnologies, links with Eastern Europe

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

• France: all infrastructure (roads, harbors, energy), tourism, food processing, aeronautical industry, water industry, pharmaceuticals, banking industry, luxury industry, energy in particular nuclear energy, links with Africa

• United Kingdom: finance, cars and auto parts, telecommunications, pharmaceuticals, energy, links with the Commonwealth

• Italy: tourism infrastructure, food processing industry, agriculture, cars and motor parts, luxury industry, links with North Africa

• Spain: tourism infrastructure, communications, food processing, cars

and motor parts, agriculture products, green energy, links with South America

• Portugal: tourism infrastructure, food processing, energy, links with South America

• Netherlands: harbor infrastructure, energy, electricity, electronics, chemical industry, information and communications technology

• Greece: tourism industry, harbors, oil refineries, food processing, nonferrous metals

• Ireland: advantageous tax regime making the location of units of production ideal in Europe

Besides these traditional sectors, the European banking industry is worth

special attention. The European banks suffer from undercapitalization, as the capital needed is estimated at EUR117 billion by the European Banks Authority at the end of 2011. This amount is probably significantly higher

today. It has been estimated between EUR300 billion and EUR400 billion.

The first strategy for Chinese investors would consist of investing in newly issued capital by European banks. However, the current distrust of the

market could make these operations uncertain. European banks will reduce their international presence, notably in the most capital consuming areas, such as the financing of big infrastructure projects or activities of global

players such as airlines or energy companies. Some large Chinese banks have already begun to win market shares in these activities.

New strategic China-Russia relations The fact that Xi Jinping chose Moscow as his first foreign capital visit after

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

becoming the president of China is an indication of the strategic importance

of Sino-Russian ties, and the strength of the bilateral relationship in recent

years. Besides geostrategic issues, the last summit between China and

Russia was the occasion to announce an agreement between Russia’s stateowned energy company Rosneft and the Chinese government, planning a tripling of oil supplies to China in return for a USD2 billion loan. The two

countries also progressed on a gas pipeline project. The relations between China and Russia have significantly improved since the beginning of 2000,

a thaw embodied by the signature of the Treaty of Good-Neighborliness

and Friendly Cooperation. This treaty plans cooperation in numerous areas related to national integrity and sovereignty, economic and social

development, cooperation in international institutions, military know-how, science and technology, energy resources, transport, nuclear energy, finance,

aerospace and aviation, IT, fight against criminality and terrorism, and cultural exchanges, among others.

Energy issue at the heart of China-Russia relations According to the International Energy Agency, China’s share of Russia’s total earnings from fossil fuel exports is to grow to 20% in 2035 from 2% in

2010. A pipeline between Russia and China was built up at the end of 2011,

allowing for direct exports of oil from Russia to China for the first time in history. China has recently become the most important oil importer in the world, while Russia has one of the most significant oil reserves in the world. At the same time, cheap Chinese manufacturing products are welcomed

by Russia. Given the complementary strategies of both countries as well

as common interests in defending against the U.S. policy of containment, the two countries have strong motivations and potential for cooperation. Energy is the most promising sector, including a variety of fields such as

oil, natural gas, hydroelectricity, coal, and nuclear know-how. Note that the Russian fiscal position fluctuates heavily with energy prices; if energy prices go down, pressures on the government budget will intensify as tax revenues from energy falls. The support for the social welfare system, and therefore

the probability for the Russian government to be reelected, depends heavily on energy prices. Therefore the best strategy for both countries is to set

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

up a long-term contract on energy imports, which could bring stability of prices to Russia and secure the long-term energy supply for China. China and Russia announced in September of 2013 the signature of a gas supply

agreement. This agreement will allow for the export of gas from Russia to China via the eastern pipeline for more than a decade. Negotiations on this

agreement lasted more than 10 years and there was probably a breakthrough at the level of price discussions. They also announced further cooperation in aviation, military, and energy sectors, accompanied with a significant increase of cross-border FDI.

Similar economic and political background, and comparable structures China and Russia share a common economic and political background, and a similar structure in many fields. The countries used to be allies in the

Cold War, and it is not impossible for them to build upon old alliances and improve relations as they continue to develop and grow.

• A central power still plays an important role in both economies. Both countries have shifted from a centralized to a more market-oriented

economy, but the central government retains the dominant role in defining strategic sectors and fixing economic priorities. The strength

of the governments’ roles makes it easier for the two governments to coordinate their economic policies, in the field of infrastructure projects in particular.

• Both governments have common interests in increasing the weight of consumption in their economies. From this perspective, promoting

tourism and setting up a free trade zone between the two countries could be attractive to both. The Shanghai Cooperation Organization including China, Kazakhstan, Kyrgyzstan, Russia, and Tajikistan (Uzbekistan,

Mongolia, Pakistan, Iran, and India are still in the observer seats) represents the most promising framework for organizing this free trade

agreement. It would counterbalance the U.S. presence in Asia Pacific via the Trans-Pacific Partnership.

• Both countries have strong state entities, conglomerates, or monopolies. In such a context, it would be particularly beneficial to identify potential

27

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

strategic partnerships between dominant players to reach a global

leadership position. Infrastructure projects with a global dimension

related to energy could offer opportunities for cooperation. The aircraft industry, healthcare, or waste disposal could be developed in a joint manner.

• The common needs to improve social protection explain the interest

of the two countries to develop joint programs related to healthcare, infrastructure, equipment, education and research.

• Both countries have a common policy of foreign exchange reserve

accumulation. Given their significant positioning on the U.S. dollar and common view on the necessity to negate U.S. containment, China and Russia have spoken in one voice in many fields. Coordination of their

monetary policy could be improved with currency-swap arrangements and joint interventions in the foreign exchange market. China and Russia have also signed an agreement on a bilateral local currency settlement system in the renminbi or the ruble.

• Russia has a strong defense and aerospace industry. Cooperation in these sectors will be difficult for security reasons. However, a large number of

Russian companies benefit from the government’s investment decisions. In this context, China’s interest would reside in investing in defenserelated companies and developing trade relations with them on high-end machinery equipment and IT.

The BRICS potential China and Russia have found the opportunity to speak in one voice on global issues at the BRICS summits, representing an alternative way of multilateralism. They push for less dependence on United States–dominated international institutions, and for the emerging world to play a larger role.

According to different estimates, the BRICS economies have the potential to overtake the joint economies of the United States and Eurozone in the

coming decades. Despite occasional disagreements, the potential to find converging views in the future could increase. The main issues covered by BRICS are the following:

28

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

• Request more voting power in international institutions such as the IMF and the World Bank

• Announce their intention to create a BRICS bank in order to compete with the World Bank and bring aid to the emerging world (The creation

of a BRICS development bank was announced during the BRICS summit of Durban in South Africa in March 2013, which will aim to reduce the reliance of BRICS countries on western financial institutions)

• Favor lowering the influence of the U.S. dollar at the global level

• Favor rebalancing global economies

• Share similar views on military issues to an extent

In September of 2013, the BRICS countries decided to continue the Durban

process and create a USD100 billion common pool of foreign exchange

reserves to combat the excess volatility of exchange rates amid growing

capital outflows from the emerging areas. China will contribute USD41 billion, Brazil, India, and Russia USD18 billion, and South Africa USD5 billion. They also further defined their project of creating a development

bank with an endowment of USD50 billion of capital. The bank is expected to be established by 2015.

New strategic China-Japan relations The China-Japan relationship is one of the most complex bilateral

relationships in Asia. Due to brutal historical conflict, this relationship has a strained nature weighing on it independent of any current issues, and this

is a disadvantage right off the bat. The recent tension caused by conflicts over the Diaoyu Islands is a symptom of this distrust rooted in historical

reasons. It is likely that political and diplomatic ties will take a long time to fully mend, and the bilateral relationship will likely remain tense until

China’s ascension to superpower status is complete, and Japan no longer views China as a competitor but rather a neighboring superpower.

Despite political and historical tensions, China and Japan can benefit

economically from further cooperation. In the mid-1990s, Japan was one of China’s largest trade partners, and this has gradually diminished as Japan

experienced stagnation and China increased trade elsewhere. Japan in

particular is at a crossroad. The nation is mired in debt, and the past two

29

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

decades of stagnation have illustrated its lack of growth drivers. Japan for the better part of the last century has been fairly strongly aligned with

Western powers, which led it to a fast rise. Now, it has a chance to realign itself with Asia, currently the world’s biggest driver of growth. If Japan faces a choice of being “Asia’s Japan” or a “Western Japan,” China should give it every chance to choose the former.

As the two largest economies in Asia by a large margin, there is room

for increased cooperation, particularly in areas such as technology transfer, renewable energy, and mutual investment. Technology transition might be

in fields such as automobile parts, waste disposal, and pharmaceuticals, where Japan has primarily moved on to higher value-added industries

while China is still in the process of climbing up the value-added ladder. Renewable energy is also an area for cooperation, as Japan is advanced in renewable energy technology, while China has abundant cash from foreign

reserves. Finally, as far as mutual investment goes, while Japan is one of

the largest investors in China (primarily taking advantage of China’s cheap labor and manufacturing infrastructure), there is a negligible amount of investment from China into Japan, and this can be increased to bolster their

economic cooperation. Furthermore, traditionally Japan has viewed China as an offshore factory for its products, and with China transitioning towards a domestic consumption–driven society, there is further opportunity for

Japanese investment aimed at China’s consumers rather than simply at its cheap labor.

China and Japan have complementary fields to work together, mainly

the following:

• There is a complementary nature of trade between the two countries. China imports materials and semifinished products, and then plays

the role of an assembler. In contrast, Japan is a supplier of parts and components, with limited assembly processes domestically. Due to different areas of comparative advantage, China and Japan can benefit significantly from bilateral trade.

• There is significant Japanese FDI into China, taking advantage of the

low-cost labor force in China, but Chinese FDI into Japan is negligible.

This is due to the Japanese market being relatively closed, with numerous administrative and tax obstacles for foreign investors. Reducing

30

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

administrative and legal barriers could give a boost to Chinese FDI in Japan, supporting investment and employment.

• The establishment of joint ventures between China and Japan can be highly profitable as a way for China to acquire the know-how of Japanese firms linked to quality control and management policies. Concepts such

as just-in-time (JIT, boosting efficiency by delivering materials as they are needed), kaizen (continuous improvement), kanban (a scheduling system determining what, when, and how much to produce), and quality circles (enlisting the aid of employees of the company for improving quality) could be valuable for improving aspects of the Chinese corporate sector.

• Japan has already gone through population aging. China can learn from the structure of the Japanese pension system and social safety net, to prepare for the turning point of 2020, when the share of working-age

population in total population will decline. One particularly interesting area for collaboration is automation, which was largely developed in

Japan. Collaboration between China and Japan in robotics and all forms of automation can improve China’s industry and also assist in tackling the issue of aging.

• There is a common need in both Japan and China to support consumption. The development of tourism and the establishment of free trade agreements represent long-term solutions. Japan expressed its willingness in 2012 to join a trilateral free trade agreement with China and South Korea.

• The geographic proximity of the countries encourages collaboration on environmental issues and the creation of technology clusters.

New strategic China-emerging neighbor relations China’s emerging neighbor countries are in a catching-up process, like

China 20 to 30 years ago. Referencing our global competitiveness pyramid,

most of these countries are located in the Tier 4 or 5 of the pyramid. These countries were often viewed as China’s competitors in the field of low valueadded manufacturing products, but there is increasing room for cooperation between them and China when China begins to move up the value-added

ladder. Emerging neighbor countries are already becoming increasingly

31

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

important for China, evidenced by their increasing share in China’s total trade in recent years.

The relationships between China and its emerging neighbors are important

on several levels. First, intracountry trade in the region has remained strong

despite the Global Financial Crisis. Regional trade agreements could provide both parties with more access to export markets. The ASEAN China Free

Trade Agreement (ACFTA), effective in 2010, is an example of this. It has helped lowered tariffs between China and the ASEAN countries by over

90%. Under the agreement, the average tariff rate of China’s goods imports from ASEAN countries is lowered to 0.1% from 9.5%. The reduction of tariffs and removal of trade barriers are the best ways to develop trade relations in the region. This policy will also divert some trade from the United States and

other countries, benefiting members of the ACFTA. In addition to increases

in trade flows between them, such agreements could foster intra-industry trade, promote the specialization and concentration of activities, encourage

technology transfer, and increase productivity. This approach can develop infant industries at the regional level.

Second, there will be increasing room for cooperation in production

and investment when China starts to move up the value-added ladder in a transition toward a domestic consumption–oriented economy. As the

relocation of low value-added production to the emerging neighbors is to happen sooner or later, instead of letting it happen spontaneously at the

private level, a good strategy for China is to guide an “orderly” transfer of some production capacity to emerging neighbors that have good relations

with China. This model could be particularly effective in China’s case, as it has both a huge resource base and market, and thus can offer and control both

upstream and downstream flows. Together with matching investment, this

“orderly” transfer could help local economies’ development on one hand,

and on the other hand create an economic dependence on China, which would motivate these economies’ willingness to keep strong economic and

political ties with China. Smooth relationships with neighbors could provide China with more freedom to focus on its own growth and on big global

scenarios. To incentivize countries to improve ties with China, China could

start this process with friendly neighboring countries such as Thailand, Nepal, and Pakistan, and then extend the process to strategically important neighboring economies.

32

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

Last but not least, China can further improve relations with

neighboring emerging countries through accelerating the pace of renminbi

internationalization, especially for use in cross-border trade. Currently, this is already a process in motion, as ASEAN countries among others are able to settle portions of trade using the renminbi. China has also signed currency-

swap agreements with several neighboring countries. By accelerating the

process, China can strengthen the renminbi’s position, and aim to have it

become the reserve currency of the regional bloc, thus extending ties and expanding its influence.

Third, it is currently good timing for China to become a regional leader, as

it will help neutralize the containment strategy of the United States. Similar to the strong ties of North American countries under U.S. leadership, China

could benefit greatly from playing a more active leadership role in dealing with regional affairs and promoting regional growth.

China’s strategic role in international organizations Over the next several decades as China continues to rise to superpower

status, it will be particularly important for China to focus on improving ties with large countries as well as to increase its participation and influence in

international organizations such as the IMF, World Bank, and the United Nations (UN). Failing to manage these strategic relations tactfully could

increase tension between China and key global players, and ultimately hinder China’s rise. China has increased its efforts to improve international relations with large countries and expand its roles and stakes in international organizations.

China and the IMF and World Bank: The insider-outsider approach After the Global Financial Crisis, due to its contribution towards stabilizing

the global economy, China’s voting power at the World Bank increased to 4.42% in April 2010, up from 2.77% previously, becoming the third largest contributor. Similarly, China’s voting rights at the IMF are expected to increase to 6.07% in the coming years from the current 3.81%.

33

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The Global Financial Crisis and European Sovereign Debt Crisis provide

good opportunities for cash-rich emerging countries like China to exert their

influence in these international organizations traditionally dominated by the

United States and Europe. China’s strategy at the international institutions can be emphasized in a threefold manner:

• China could gradually gain influence via higher capital contribution and

more high-quality Chinese staff, while it continues to accept the rules set by Western powers. China could penetrate institutions recognized by major competitors, and progressively gain influence once inside. This is

the best way to withstand the U.S. containment strategy and a good way to win more support among international partners.

• Chinese representatives at these institutions need to move away from the

old ideologies, and introduce more flexible measures via implementing

more pressure on developed economies and suggesting new forms of regulation.

• China could set up alternative institutions and structures outside the IMF and World Bank to regulate the world in a bilateral and multilateral manner. For example, China substituted for the World Bank in helping

Chad in 2008, and replaced the IMF and the United States in different aid programs for Cambodia in 2008 and 2010. China recently bypassed the

IMF in terms of the size of its financial assistance for Africa. China has also made large efforts to promote regional trade and monetary liaisons. For example, China has played an important role in the establishment of the free trade zone ACFTA in 2010, the regional reserve fund among ASEAN+3 (ASEAN plus China, Japan, and Korea) in 2009, and various

currency-swap agreements with neighboring countries after the Global Financial Crisis.

China and the UN: A growing role in peacekeeping China has increased its contribution to the UN in terms of peacekeeping

operations in the recent years. China is a member of the Permanent Security

Council, and continues to play a fundamental role in international conflicts and counterbalancing the influence of North Atlantic Treaty Organization (NATO) countries. Increasing participation in UN operations has not altered

34

Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

the independence of China, as the Chinese authorities discuss on a case-bycase basis whether or not to participate in the UN operations. China could

benefit significantly from its operations at the UN. Benefits can include

conducting joint military operations with other leading nations for the modernization of the People’s Liberation Army, improving China’s image,

raising influence in Africa, and counterbalancing the policy of excolonialist countries in unstable countries.

Effective Communication to Narrow “Trust Deficit” Communication is equally important as strategy in international affairs,

especially for a rising power like China facing great challenges on how to communicate its intentions to the other countries in the system. As a country

grows in power at an alarming pace, it is natural for the established powers

and neighboring countries to feel a degree of apprehension and question

whether or not the rising superpower will pose a threat to the national interests of any given country. In turn, China’s historical experience, where it was often attacked whenever it became weak, motivates China to continue

to build up its strength. This creates what can be described as a “trust deficit” between China and many other countries in the world.

The trust deficit is mainly caused by the differences in China’s cultural

and political background when compared with the backgrounds of other leading countries. Another reason is that the recent financial crisis dragged down major developed economies such as Europe, while China maintained strong growth; as China rises while others shrink, they will not only be

nervous but also likely bitter, which explains why many politicians and media sources in other countries use China as a scapegoat. Finally, distrust is

a vicious circle, where a lack of trust leads to actions and communication that further breeds distrust. As a result, a failure to address the issue will result in the trust deficit growing wider.

Communication should therefore play an important role in alleviating the

trust deficit along with the rise of China. Improving China’s communication

strategy, particularly through advocating the school of thought of complex

35

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

interdependence and reemphasizing China’s peaceful history, would go

a long way toward smoothing the transition to superpower status. China would benefit from improving communication to promote cooperation

and diplomacy through a variety of methods, both official and nonofficial, including promoting cultural bridging to narrow trust deficit; establishing

open, smooth, and regular official communication platforms; and promoting multilayer grassroots communication channels.

Promote cultural bridging to narrow trust deficit Currently there is a trust deficit that is widened in China’s case by a lack of mutual understanding, and a cultural disconnect between China and the rest

of the world. This is not to say China is anywhere near the era of isolation. The days of China being “five to ten years behind the trend” are fast disappearing

as the increasingly wealthy population, aided by the spread of the Internet

culture, is more and more in tune with global trends. However, the cultural transfer seems to be largely one way, mainly with foreign cultures permeating

in China rather than Chinese culture spreading across the world. This is

a strange phenomenon for a country with the world’s largest population; neighboring Asian countries such as Japan and South Korea have a larger

cultural permeation in the world, despite only having a fraction of China’s

population. Due to basic human psychology, we are predisposed to be more wary of individuals that are different from ourselves; consequently, cultural bridging will help China appear less “foreign” and narrow the trust deficit.

Cultural bridging can take place across a variety of forms. Historically,

cultural bridging often took place through the actual physical migration of individuals; for instance, a former colony such as Hong Kong is heavily

steeped in British culture after occupation, while culture-specific locales such as Chinatowns, Little Tokyos, and Korea towns all over the world are imprinted with Asian cultures, largely due to migration. In this respect,

China is strong with numerous individuals studying and working overseas,

and can further increase its influence in this arena by hiring more foreigners to work in Chinese companies as well as continuing to provide ample opportunities for foreign exchange students.

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

However, in the late 20th and early 21st century, media became the

predominant tool for cultural dispersion. Particularly successful countries such as the United States and Japan were able to spread their cultural

influences over the world by exporting various forms of cultural media such as pop music, Hollywood movies, and Japanese animation. While it would be

a stretch to say that all individuals are familiar with American and Japanese culture due to media, the reach of these cultural mediums is significantly

wider than any Chinese media. Currently, the influence of Chinese media forms worldwide is negligible.

Some major moves last year [2012], including the decision of Chinese

media groups to engage in joint ventures with American media firms such as DreamWorks and Disney, as well as decisions to purchase AMC, America’s largest movie theater chain, are steps towards cultural bridging. These

actions can sow the seeds for two-way cultural exchange, if not eventual

cultural integration. It would be beneficial to continue and expand on actions of this nature; fostering similarities in culture will help reduce the amount of distrust between China and other countries.

Establish open, smooth, and regular official communication platforms It is important for China to establish a more consistent and open platform to smooth communication. Improving what is currently a suboptimal communication channel can help alleviate a lot of the distrust and friction in international relations, across a variety of issues. Along with cultural

bridging, establishing an open, smooth, and regular official communication platform can foster mutual understanding and trust in various fields including trade and military.

In terms of trade, China’s trade with its large partners is greatly

complementary and benefits both sides. China has made great efforts in improving transparency in trade and flexibility in its currency; however,

without an effective, efficient, and consistent communication platform the progress is not fully seen nor understood by its counterparties. Consequently,

the counterparties assume there is neither enough progress nor clear efforts

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

on the part of China. The U.S. side sometimes indeed does not understand

constraints on the Chinese side, according to the report by Brookings Institution. Communication therefore could help build up good faith for both sides.

In terms of military affairs, where the current communication strategy

often comes across as fairly heavy handed, there is a degree of distrust from

the international community stemming from how China has communicated

on key issues such as the South China Sea and increasing military expenditure. China can benefit from engaging in deep discussions with countries such as the United States and neighboring nations about core security interests and military principles. If accommodations can be reached to assure mutual restraint and provide every country with a reasonable degree of assurance that their security is not threatened, trust can be significantly deepened.

Besides trade and military, there are a variety of other issues that can be

addressed via smoother communication. The report by Brookings Institution

also gives several insights on areas for improvement in particular for the Sino-U.S. relationship. In sum, domestically, China can address popular sentiment by detailing the importance of international relations as a whole, as well as outlining the positive aspects of individual bilateral relationships, particularly with the United States. Internationally, China can seek to engage in more multilateral dialogues, where the presence of multiple parties can

prevent discussions from becoming confrontational, with two parties on different sides. Finally, China can discuss a broader spectrum of issues

ranging from economic to political with other countries, and set some of

the norms, rules, and expectations for acceptable practices. By improving communication with other countries, it will be easier for China to implement their broader strategy successfully.

Promote multilayer grassroots communication channels Communication can be approached using a multilayer structure. Currently,

a lot of the communication is taking place through government channels, either directly from government communiqués or through governmentsponsored think tanks. Consequently, communication coming from China

may sometimes have a “sterile” feel, and comes from similar angles.

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Economic Leverage, the Key to a Rising China’s New Foreign Affairs Strategy

Additionally, purely governmental communication often leads to a deficiency

of sincere communication, as it is often driven by set agendas and limited by restrictions; opening up more grassroots avenues for communication can help alleviate this problem.

Expanding China’s communication structure to create more layers can

add depth and different perspectives to China’s communication strategy. This also allows for different areas of focus; think tanks can communicate more on economic issues, while the government may focus more on political

and diplomatic issues, and nongovernmental organizations (NGOs) on other issues such as environmental and social concerns. Multiple layers

can augment rather than fragment China’s communication strategy, and opening up more layers can bring valuable new perspectives and ideas to Chinese society.

Japan is a good example of a country successfully exercising this

strategy. Japan started the process in the 1970s along with its surge of

economic power, and exponentially escalated it in the 1980s and 1990s. For example, Japan’s NGOs expanded to over 200 in the 1990s from 20 in the 1970s. Japan’s government encouraged think tanks such as the Japan

Center for International Exchange (dedicated to strengthening Japan’s role

in international networks of dialogue and cooperation), and NGOs such as the Association for Aid and Relief, Japan to change the nation’s image across

the globe. Besides its own think tanks and NGOs, the Japanese government

provided significant funds to international organizations such as the World

Bank and IMF, and encouraged Japanese companies to build up strong connections with influential American think tanks and NGOs, especially to promote trade and business. Japan’s expansion of international influence was in line with its rise to an economic superpower, and was in part due to

the international expectations that they should begin to shoulder more of an active role in the international system. China will be approaching a similar scenario over the coming years, and could preemptively set up a think tank

and NGO infrastructure, as well as gradually establish links with influential think tanks and NGOs overseas. If Japan was able to successfully change

its international reputation despite a significantly more aggressive history, it stands to reason that China can also make improvements on its international

image. It is necessary for the Chinese government to encourage and support

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

these groups if China decides to adjust its communication strategy to a multilayer structure.

“An Iron Fist in a Velvet Glove” A farsighted new foreign affairs strategy together with effective

communication will greatly benefit China on its way to becoming a bone fide superpower. Approaching international affairs tactfully and pragmatically while sticking to the bottom line can be expressed as an “iron fist in a

velvet glove” strategy. This presents a gentle, pleasing outer demeanor while encompassing a stronger core. This is to say, even if China’s bottom line issues dictate that the message must be harsh, deftly communicating with other countries will improve relations or at the very least not strain

them as much as a stiff, unyielding interaction would. The United States is

arguably the country that has mastered this idea of the “iron fist in a velvet

glove” the most, able to pursue its own agenda but still claim a mantle of righteousness. Particularly on issues that are likely to strain relations, such as trade or territorial disputes, it could be beneficial for China to organize

its communication in a multidimensional manner, being rigid when the situation calls for it, but flexible when there is room for negotiation.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

President Xi Jinping and Premier Li Keqiang took office after the conclusion of the National People’s Congress. With this leadership transition taking

place, China is preparing for a new era of leadership. Following China’s leadership transition, we expect an investment boom especially in the field of infrastructure investments such as railways, expressways, subways,

airports, and ports. We forecast this boom backed by supportive policies from the government is likely to bring another “Golden Decade” for China’s economy, implying 5% to 8% annual GDP growth for the next 10 years.

While the new outlook for the next several years may be optimistic, there

is a pressing need for reforms in China, and serious issues must be addressed

if China is to maintain its growth thereafter. From this perspective, the upcoming Golden Decade is not only a Golden Decade for growth, but also

for reforms, as reforms will be easier to push and implement during times of considerable growth. The new leaders taking office heralds various reforms to come over the years ahead.

China’s reforms are entering deep waters after 30 years’ experience of

“crossing the river by touching the stones.” It is a consensus that China has no

choice but to continue marching forward; however, there are great differences

of opinions on how to do so, for example, which routes it should take, how

to juggle short- and long-term concerns, and how to balance gains and risks. The choice of reform routes and policy mix now will have a fundamental influence on China’s economy and society for the future decade.

There are great expectations for reforms from the public as the new

leadership enters office. They have significantly different backgrounds, education, and experience from the previous leaders. Xi and Li grew up in

the era of the of the “reeducation reform” and saw firsthand the hardships

of the populace. Xi and Li and their fellow peers obtained higher education on social sciences such as economics, law, and history, compared with the

previous generations which were more science and engineering focused or

had military backgrounds. Xi and Li are seen as having particularly broader global perspectives, having travelled extensively, and benefited from useful learning experiences abroad, such as in Xi’s Iowa trip in 1985 and Li’s one-year study in Harvard. The new leadership has already brought a

noticeable culture change to the administration over the last several months,

from the much publicized party meeting protocol changes to the fight

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

against corruption. They take over an economy that has risen to the status of the world’s second largest economy, a rising superpower with immense potential, but also far from a finished or flawless product.

China faces numerous challenges in the years ahead, and many reforms

will be necessary to keep the country competitive and to reach its maximum potential. Several of the overarching goals include transitioning the economy

toward a domestic consumption–driven model of growth, addressing demographic issues, implementing an effective tax system, and gradually liberalizing and developing the financial markets. China’s “visible hand” of the government will be paramount in implementing these reforms. There will first be an acclimation process for the new leadership which will likely

span the next several years, during which their focus will be on laying a foundation, gaining further experience, and establishing a new status quo. As entrenched interest groups as well as bureaucracy in general will create impediments to pushing certain difficult reforms, certain reforms will require significant time and effort to implement.

Over the Xi administration’s first term, the new leadership is likely to

continue with the various reforms which have a solid foundation to build on,

or expand upon the reforms which are already in place, rather than pursue the most difficult and politically sensitive reforms unless there is a high level of time sensitivity and immediate saliency for the particular issue at hand.

For said urgently needed reforms, we expect China’s leadership to address

difficult issues accordingly. The Xi administration is likely to implement the following reforms at their first term: fiscal and tax reforms, financial reforms, population and income reforms, and environment-related reforms.

Fiscal and Tax Reforms On a nationwide scale, China’s government debt would appear to be relatively under control, compared to many other countries; the International

Monetary Fund reported China’s government debt to GDP at around 25%, far lower than many countries with debt levels over 100% of GDP. Furthermore,

China has benefited from a sustained trade surplus, and has the world’s largest foreign reserves, enough to buy the global supply of gold twice over.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

However, these facts do not reflect the dire situation of local government finances in China, which has stirred up significant concern in recent years.

One of the major concerns is regarding local government finances,

between their sources of funding and their expenditures. While local governments incur the lion’s share of expenditure in China, they have

traditionally collected about half of the tax revenue, which has created a disparity historically. In 2012, the share of the central government in total tax

revenue was 47.8%, compared to local governments at 52.2%. However, local governments accounted for 63.7% of spending; this gap means that local

governments must utilize other sources of finance to make up the difference.

China: Tax revenue breakdown (%) (%) 100 90 80 70 60 50 40 30 20 10 0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Central as % of total revenue

Local as % of total revenue

Sources: CEIC Data; Haitong International.

China: Government expenditure breakdown (%) (%) 100 90 80 70 60 50 40 30 20 10 0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Central as % of total expenditure

Local as % of total expenditure

Sources: CEIC Data; Haitong International.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

Local governments’ dependence on land sales for revenue to fund

infrastructure projects and other expenditures has been increasingly a

concern over the past several years. According to Ministry of Finance data, in 2012 land sales accounted for CNY2.69 trillion, down from 2011’s CNY3.15

trillion but still at very elevated levels; this accounted for 26.8% of total local government revenue, and 78.6% of local governments’ nontax revenue of CNY3.42 trillion. Compared to the local government tax revenue of CNY6.11

trillion in 2012, this is still at elevated levels. With slowdown in the real estate sector under continuous tightening policies, sustainability of the local fiscal position has become an increasing concern.

Reforms to address rising local government fiscal difficulties Issue local government bonds for local financing There are three primary methods for local governments to obtain funding,

including fiscal revenue, property proceeds from land sales and usage agreements, and local government financing platforms. Due to the disparity

between tax revenue and expenditures, there is a need for local governments to utilize nontax revenue sources of finance, which often leads to overreliance

on unsustainable sources of funding. Furthermore, as local government

leaders are incentivized to first and foremost boost the level of GDP growth, they are often compelled to push high quantities of investment, which is the

fastest way to push growth; this process also vastly increases the government expenditure.

Local governments were compelled to rely even more on nonfiscal

revenue sources of funding as expenditures climbed without an equivalent

boost of fiscal revenues, particularly following the mandated stimulus in

2009. For example, we can see that between 2007 and 2011, land sales rapidly grew, both in absolute value as well as in proportion to local governments’

total revenue. The year 2012 saw increasing tightening measures on the property sector to control prices, which also had the impact of reducing

local governments’ proceeds from property sales. However, as expenditures continued to rise, local governments had to rely on other financing methods, namely local government financing platforms. There was rising concern at

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

the end of the year surrounding these alternate sources of finance; at the end of 2012, China placed restrictions on local governments on conducting

certain financing activities, including using public assets as loan guarantees or by forcing government employees and other individuals to purchase wealth management and trust products.

According to statistics from the National Audit Office, local government

financing platforms had an outstanding balance of CNY10.7 trillion owed at the end of 2010, with CNY1.8 trillion coming due in 2012. The previous

viewpoint was that due to local governments assuming responsibility for the financing platforms, these “platform loans” were a safe asset. The two major growing concerns are that these local government financing platforms

carry with them high risks for default, and that the scale of local government financing platforms is growing too large. These concerns have been magnified in light of developments in 2012.

For example, local governments issued a high quantity of city investment

bonds in 2012 on the interbank market to raise finances. City investment bonds have played an important role in local government financing for infrastructure projects, including the projects approved last year [2012] by

the National Development and Reform Commission in May and September. According to China Central Depository & Clearing Company data, in 2012,

there was CNY636.8 billion of city investment bonds issued on the interbank market. This is compared with the Ministry of Finance–backed local

government bonds, which registered at a lower CNY250 billion. In other

words, about CNY1 trillion local government–related bonds in total were issued in 2012. There are increasing market concerns on potential default

of large local government debts due to continuous policy tightening on real

estate and weak recovery of the economy. The unclearly identified ultimate borrowers of these debts intensify these concerns.

One of the long-term solutions is to issue local government bonds for

government financing. Currently, local governments are not allowed to issue bonds directly, but instead are required to apply to the central government,

which issues bonds on their behalf via the Ministry of Finance; there is a

strict quota on these bond issuances every year. In March, the State Council approved an expansion of the Ministry of Finance–backed local government

bond quota to CNY350 billion for 2013. According to data from the China

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

Central Depository & Clearing Company, there was a quota of CNY250

billion set for local government bond issuance in 2012, and CNY200 billion per annum between 2009 and 2011. However, even given this expanded quota, it is nonetheless only a drop in the bucket when comparing to the size

of local governments’ expenses, and this forces local governments to seek out costlier or unsustainable sources of finance to fund infrastructure projects and other expenditures. Another financing channel for local governments is to issue city investment bonds, which were started in 2012. These bonds

do not have clearly defined ultimate uses for the funds and have created

increasing concerns for investors. We expect the new central government

will gradually allow local governments to issue bonds directly based on needs and capacity for the coming years. In this way, the responsibility and liabilities of the local government debt are clearly disclosed, which facilitates fast growth of the local government bond market.

We believe China would benefit from eventually allowing local

governments to issue their bonds directly, despite the risk of a debt bubble. A pilot program allowing this was launched in November 2011 but

ultimately discontinued on concerns of mounting local government debt potentially creating risk to the financial system. We view this as a necessary

step for long-term development, not only as a short-term solution for local

government financing but also for creating a long-term market mechanism for fundraising.

Before establishing a reliable and transparent local government bond

market, local governments need to clear up the current financing platforms.

Firstly, there is a need to clean up bad assets such as nonperforming loans and city investment bonds; a method to achieve this may be via forming

asset management companies to assume the bad assets, and/or selling bad assets to existing asset management companies. This is similar to

when China set up the four giant asset management firms of Huarong, Cinda, Great Wall, and Orient Asset Management in 1999 for removing an

approximate CNY1.4 trillion of bad loans from state-owned banks. The sale of bad assets will enable local governments to raise funds using otherwise

dormant holdings, the proceeds of which could be used to finance various investment activities. Furthermore, it would also improve the levels of transparency by providing clarity on the quality of assets the government

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

holds. Secondly, local governments can also sell various assets that are under

their control to raise funds. Privatizing certain functions such as toll roads or other government-owned assets may be a method to not only raise funds for the local government, but also facilitate a privatization process in China, where many aspects of the economy are still dominated by the government.

There are a number of prerequisites tied to the development of China’s

local government bonds, including a need for cleaning up the city investment bonds, and consolidating the various financing platforms that are currently

utilized. As mentioned above, these can be cleaned up via asset management companies.

There is also a need to establish technical infrastructure, such as a credible

and transparent credit-rating system to enable investors to clearly evaluate

investment risk, and facilitate a market-pricing mechanism; furthermore, this will also generally increase the efficiency of the market, lowering

costs for both lenders and borrowers. The development of the derivatives

markets would also facilitate the process; for example, according to an announcement by China Securities Regulatory Commission Chairman Guo

Shuqing in January [2013], China will launch a government bond futures market soon, with a goal of improving liquidity and price discovery for the bond market. Government bond futures and other derivatives will allow for more sophisticated investing, enabling individuals to hedge and speculate to greater effectiveness.

Local governments must also be incentivized to take responsibility for

the bonds that are issued. Currently, there is little consequence to refinancing,

with the government negotiating “payback adjustments” with banks, and taking out new loans to pay back maturing debt with minimal short-term

ramifications. The implicit central government guarantee of its debt may lead to ballooning and out-of-control debt if not brought under control, and is not sustainable in the long run.

Furthermore, local governments need to provide the public with more

accurate information regarding their spending plans, namely what they will do with the proceeds raised from bond issuances. This will improve

transparency in the long term, and be beneficial for the health of public finances. Increased use of government bonds will also have the benefit of improving transparency via having a higher share of their funding sources from regulated sources, rather than from opaque financing vehicles.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

Rebalance local expenditure to closer reflect tax revenue breakdown As discussed, there is a notable disparity between the central government and local government revenues and expenditures. In addition to illustrating the current plight of local governments needing to seek out other sources of

finance, this also shows a need in the medium to long term to rebalance, either

in terms of tax revenue breakdown, or in terms of government expenditures. As we can see from the table below, local government expenditures are

composed of the bulk of government spending on categories such as general

public service, public security, science and technology, and social security,

and in sum, local governments have significantly outspent the central government.

China: Expenditure by central and local governments, 2012 (CNY billion) Expenditure

Central

General public service

Local

133.0

1,170.2

33.2

0.1

National defense

650.6

21.1

Public security

188.0

592.8

Education

378.2

2,014.1

Science and Technology

229.1

224.2

Diplomacy

Culture, physical education, and media

49.5

207.5

Social security and employment

575.4

1,200.0

Medical and healthcare

204.8

717.1

Environmental protection

199.8

290.0

Others

1,836.4

4,281.8

Total

4,478.1

10,718.8

Sources: CEIC Data; Haitong Internationl.

Due to China’s tax revenue split, the government may choose to

rebalance expenditures more toward central government spending. In our

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

view, there are several areas where the spending can be reoriented towards

central government–led spending; this is particularly the case for public goods which can be seen as national resources:

• Public security. Though these functions are often run at a local level,

services such as law enforcement, and emergency services such as fire

departments and emergency medical services are important for the stability of the country at a national level; consequently, increasing central government spending on public security is reasonable.

• Education spending. While local investment in education is natural to

boost a region’s competitiveness, it is also in the central government’s

interest to boost education spending, particularly in underdeveloped areas, to utilize and develop human capital. Spending can include investment in training and the construction of schools, among others.

• Environmental protection. Though it may be more apparent on a regional

scale, the environment is a national concern, and protecting resources for future generations should be a major focus.

• Maintenance of public services, utilities, waste disposal, and sanitation functions

• Medical and healthcare — facilitating training of medical professionals to accommodate for aging population

If altering the tax revenue breakdown proves to be difficult in the short

run, shifting expenditures toward the central government may also be a method of alleviating the local government debt burden.

Property tax reforms China’s real estate market has been booming over the past years, and has raised significant concerns of a housing bubble, causing the government to

tighten restrictions on the sector in 2010 to try and cool down the market and rein in prices. The government has done this by encouraging increased

housing supply and implementing purchase restrictions to quell speculation. However, without a property tax being implemented, there is still no

downside for investors to buy and hold property, beyond depreciation and an inherent risk that the property price falls. Implementing a property tax

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

will make it more costly to hold property, and serve to stabilize the housing market, reduce the amount of idle land resources, as well as lower the income inequality gap.

After unleashing the earlier policy “bullets,” one of the remaining tools

left is property tax reform. While this is no “golden bullet” to solve the issues in the housing market, it is nonetheless an important step that is likely to

be pursued by the government. A property tax will also have the benefit of wealth redistribution in China, which will contribute toward alleviating the inequality problem.

Starting on January 27, 2011, China implemented a pilot scheme in

Shanghai and Chongqing to levy annual taxes on high-end apartments. Some of the features from Shanghai’s reforms are listed below:

• Two tax rates for properties, 0.4% and 0.6%, with 0.6% charged for properties valued at two times or above the average price, and 0.4% for anything less

• Properties purchased previously have been exempted from property tax

• Focus on limiting secondary-property purchases; for city residents, purchases of secondary properties (properties that are not used as the

family’s primary location of residence) will be taxed, only if the average floor area per family member is more than 60 m2

• All new property purchases for nonresidents will be taxed, but the tax on the first property can be refunded following three years of working in Shanghai

• The tax base is 70% of transaction price at the time of purchase, and later will switch to home evaluation prices at an undisclosed date

Some of the features from Chongqing’s reforms are listed below:

• Three tax rates of 0.5%, 1%, and 1.2%, with 0.5% levied on properties less

than three times the average price, 1% on properties between three times to four times the average price, and 1.2% on properties exceeding four times the average price

• More focused on higher-end property; taxation is designated for all villas, as well as apartments priced more than two times the average price of newly built homes, which limits the affected population

• First 180 m2 for a villa and first 100 m2 for high-end apartments are exempted from tax for primary residences.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

• Nonresidents will have second purchased property taxed at 0.5%, regardless of property size.

• Plan to switch tax base to home evaluation prices rather than purchase prices in three to five years.

Overall, while these pilots have been seen as a step in the right direction,

there were several flaws observed during the pilots:

• Narrow scope, with a very limited number of properties being taxed

• Limited impact on property prices, as low tax rates and a lack of collection efficiency led to minimal deterrence for speculators

• Legal issues, with questionable legal right to collect tax in China

Recently, there has been a significant amount of discussion about

expanding this pilot, particularly at the end of 2012 and in early January 2013, when various government sources discussed the merits of expanding the property tax. In the first half of 2012, the Ministry of Housing and Urban-Rural Development accelerated the development of the individual housing information system in key cities, addressing one of the key technical

prerequisites for property tax implementation. By June 2012, 40 major cities

had completed setting up the information system, compared to an ultimate target of covering 500 prefecture-level cities.

However, soon after, there were concerns raised on the viability of

expanding the pilots in the short term, including a comment by exiting Premier

Wen Jiabao that implementing property tax reform may be a “medium- to

long-term” prospect, as well as discussions of postponing expanding pilot cities due to the “general complexity” of the housing market, a lack of clarity

regarding property rights, and technical issues. We still hold the view that

property tax reforms are still a likely short-term reform. Local governments

also have incentives to collect property tax, as it is another source of income for local governments, and would reduce the reliance on land sales as a form of revenue.

A State Council meeting in February [2013] outlined five major objectives

regarding property reforms:

• To establish a property price control target and to improve the

accountability system for the stability of housing prices, outlining the responsible bodies

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

• To curb speculative purchases of housing, encouraging differentiated mortgage treatments and the expansion of property tax trial cities

• To increase the supply of ordinary commodity housing and land

• To accelerate planning and construction for affordable housing projects

• To strengthen market supervision on sales and intermediaries, and set up an information infrastructure

As evidenced by the objectives from the State Council meeting, the tone

coming from the leadership is that the primary focuses continue to be the

stabilization of prices and stifling speculation. While it serves both functions,

the primary motivation of the property tax currently lies in providing another

mechanism for influencing property prices via discouraging speculative investment in property, rather than as a method of income redistribution.

There are several considerations with regard to the implementation of a

property tax:

• Legal issues may arise. As China’s land system operates off a “land lease” rather than a “land sale” system, ownership remains the property of the

state, while people only have a “right of use.” There is a legal question on whether or not property tax could be levied if the individuals do not own the land in question, and as they already pay significant duties and

fees in housing purchases. Moreover, similar to income tax, a property tax is a new tax in the national tax category, so the decision should be

made by the Communist Party of China and written into law; and tax

rates should be applied nationwide. The current differentials in tax rates and exemptions across regions may introduce many potential arguments in the future.

• Various technical problems may emerge, requiring significant planning to address. Some of the issues include:

• A comprehensive information system needs to be well developed. If a property tax is to be implemented, with a tax base reflecting home

evaluation prices, accurate and up-to-date information on property

ownership and valuation will need to be assembled. Significant efforts will be needed, although China’s Ministry of Housing and UrbanRural Development has accelerated efforts to develop an information system for individual property ownership in 60 key cities.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

• A fair valuation on property needs to be established. It is of questionable administrative practicality to determine property

valuation on a case-by-case basis, but also quite inaccurate and

inequitable to set a generalized valuation. Fair and accurate valuation requires significant manpower. Major concerns include (1) whether

valuation should be based on purchase or current market prices; (2)

whether valuation should be based on bare-shell or fully decorated prices, especially given that units sold in China are bare-shell; (3)

whether valuation should be different for state-owned or individualowned housing, given the generally large subsidies behind most

state-owned housing; (4) how to estimate depreciations. Concerns and confusion remain, although the authorities claim training

courses on property valuation have been offered to officials from 30 provinces since the second half of 2012.

• An effective enforcement system needs to be established. Unlike income tax that corporations could directly deduct from wages, property tax

collection needs significant manpower and efforts on issues such as who will be responsible for tax collection and assessment, how frequently

values will be reassessed, which categories will be exempt, how tax collection will vary (if at all) between domestic and foreign entities, whether or not rebates will be given, and so on. Furthermore, there is a question of what will be the penalty if taxes cannot be paid.

In our view, the property tax will be collected despite legal and technical

difficulties for the coming months. It will start with certain experimental

cities, especially cities like Hangzhou (which has leading housing prices) being very likely chosen in the first batch. Like other gradual reforms, property tax reform will spread to the whole country after issues emerging in the experimental cities are discussed and solved. We expect the following features for the coming pilots.

• Annual taxes likely to range between 0.5% and 2% per annum. At

present, the taxes are set at 0.4%/0.6% and 0.5%–1.2% in the pilot zones in Shanghai and Chongqing, respectively. Considering property tax is

a continuous tax, any rates above 2% could be a fairly high burden to households.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

• Property tax likely to be levied on future purchases rather than made

retroactive. The primary policy goal of a property tax is to stabilize the housing market, and this aim can still be achieved mainly by levying the

tax on future transactions. By doing so, China can avoid strong resistance which would be invoked in a retroactive taxation of properties.

• Progressive tax rates on multiple property ownership. As the government

does not seek to discourage first-time buyers, the property tax levied is likely to be more heavily tilted towards owners of multiple properties, to further discourage speculation. This tax is likely to be progressive, with each further property purchase raising rates of tax paid.

• Different rates based on region. Property is likely to be taxed at different

rates depending on region, based on a multitude of factors, such as the

need to control property prices, the affordability of housing, and GDP per capita.

• More transparent government expenditures required. A specific

account should be created at the local level for property tax revenues and expenditures. The property tax revenues should mainly be used

to develop local infrastructure and affordable housing. Therefore, local governments need to publicize their budget plans in advance and disclose fund expenditure afterwards.

Lowering tax burdens China has the highest tax rates in the world. According to the estimate of the World Bank, the overall corporate tax for Beijing and Shanghai is 73.9%, compared to 52% in Tokyo, 46.2% in New York, 35.7% in London, 24.4% in Hong Kong, and 23.2% in Singapore. China’s revenue tax is 5%, compared

to the world average of 1%. China’s income tax is up to 45% for individuals with incomes over CNY100,000 without any deductions, compared to the highest tax brackets of 35% in the United States and 16% in Hong Kong.

As a result, China’s fiscal revenues have grown by 19.2% year-over-year on

average over the past decade, much faster than an average of 10% of GDP growth for the past decade. With low public debt, China’s government has great leeway to reduce tax burdens to provide more room for Chinese firms, especially small and medium-sized enterprises (SMEs), to excel.

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• Value-added tax (VAT) reforms to expand nationwide. China is currently in the process of transitioning from the business tax toward the VAT, which will alleviate the tax burdens on companies. According to the State

Administration of Taxation, the business tax is levied on the transportation industry, building industry, and finance and insurance industries, mostly at rates of 3% or 5% of revenue. If in line with the current VAT rates levied on select industries already, these could instead be charged at a basic rate

of 17% or a lower tax rate of 13% on value added, with 0% for export

goods, which would serve to reduce the tax burden on companies. A pilot program was implemented in Shanghai on January 1, 2012, with 11% and 6% VAT rates on transportation and services industries, respectively, and was estimated to have saved companies over CNY17 billion in taxes through October 2012. Further expansion of the VAT reforms to

additional industries and cities will reduce the tax burdens and improve

competitiveness. The implementation of a VAT system will also allow for larger structural reforms in developing related industries, by providing tax incentives to encourage the development of certain sectors.

• Various targeted measures to aid SMEs or new emerging sectors such as high-tech, high-end machinery equipment, and new energy. More

measures are expected to be announced to support these firms at both the state and local levels.

• Continuous income tax reforms to be implemented for the coming years.

This includes raising taxable income benchmarks, lowering income

taxes, allowing tax deductions on education/housing purchases, and postponing taxes on financial products.

Financial Reforms The opening up of China’s financial markets has been a gradual process, as China went from being a largely closed market to its current state of gradual

liberalization. The new leadership will continue financial reforms, mainly focusing on four main overarching categories: diversification of financing

sources, capital market liberalization, internationalization of the renminbi, and interest rate liberalization.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

Diversification of financing sources Diversify the sources of finance from two angles: diversifying financial assets on one hand and diversifying the financing structure on the other.

Banks in China continue to take the dominant role in the financial system.

According to Bloomberg, Chinese banks hold over 90% of the total financial assets, compared to approximately 45% to 55% in the United States; Chinese

insurance and securities in total account for only 10%, while they account for approximately half the assets of financial institutions in the United States.

In terms of the financing structure, self-raised capital and domestic loans

combine to reach approximately 80% of China’s sources of finance, implying

the weak role of direct financing and an underdeveloped capital market. In the United States, we can see a more balanced financing structure; a rough

breakdown of financing sources for firms in the United States shows equity issuance accounting for 14% to 20%, loan financing at 38% to 42%, selffinancing at approximately 30%, and other sources of finance at 9% to 13%.

The development of alternate sources of financing is critical for

China’s continuous growth, with special emphasis on the following fields: establishing a comprehensive and mature bond market; promoting the

insurance market and a pension system; energizing stock market and deepening reforms; and the development of non–bank loan lending sources and regulation enhancement.

Establishing a comprehensive and mature bond market China’s bond market has expanded over 10 times in size over the past decade,

with a total market capitalization of CNY24.4 trillion by 2012. Despite its rapid growth in absolute value, the Chinese bond market accounted for only 46.3% of GDP in 2012, compared to that of 243.1% of U.S. GDP.

Developing the bond market will bring various benefits. It will not

only widen financing sources and provide more investment channels

for households, but also facilitate interest rate liberalization. It is a wide consensus that bond market development should be a priority for financial reforms, and major policies are likely to be focused on the following fields:

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• Integrate the segmented bond markets, and combine regulatory

roles to a single regulatory body. Currently, there are three primary

regulatory bodies regulating China’s bond market: the People’s Bank of China oversees the interbank market, the China Securities Regulatory

Commission oversees the stock market, and the National Development and Reform Commission is in charge of syndicated debts sponsored by

China’s Bank of Development. The interbank bonds have grown the fastest to account for over 90% of bonds in China in the past five years of

development. A unified regulatory body will streamline bond issuance procedures and better monitor the associated risks.

• Relax the restrictions on bond issuance. Significant restrictions on bond

issuers have handicapped the development of the bond market. Windows should be gradually opened for non-listed firms, for SMEs, and for local

governments. More players will be attracted to the market once the pool is enlarged.

• Foster independent and reputable credit-rating agencies to provide evaluations of creditworthiness. Currently there are four major creditrating agencies in China. They are China Chengxin International (a joint

venture with Fitch and the International Finance Corporation), China

Lianhe, Dagong Global (partnered with Moody’s), and Shanghai Far East. A common critique of Chinese credit-rating agencies is that they are more prone to “qualitative analysis” than their Western peers, which is to say

they evaluate other factors that may not appear in the financial data. On one hand, this may better reflect certain aspects of the Chinese business environment, where connections and implicit or explicit government

support can count for an enormous portion. On the other hand, this

system is ripe for abuse; as qualitative analyses are by nature subjective, there can be no way of determining if any particular rating was made in

good faith or tampered with. The partnerships that two of China’s top four credit-rating agencies have with international credit agencies help lend some credibility to them.

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Promoting insurance market and pension system development and reforms China’s insurance market is an area of growth, with an increasingly wealthy and also aging population providing steady demand over the long term. As

of the end of 2011, the insurance sector in China had a size of over CNY6 trillion, with the life insurance sector accounting for CNY4 trillion of this. China’s pension system in total accounted for approximately CNY3.2 trillion in 2010. China’s pension system and insurance market together combined

to account for 19.4% of GDP, with the pension system registering at 7.9% of GDP in 2010.

In comparison, just the pension system alone in other countries often

accounts for a much higher proportion of GDP. China’s pension system size

was a startlingly low proportion of its GDP, especially when compared with countries such as the United States, United Kingdom, and Australia, where

the pension system assets are near or exceeding 100% of GDP, and even when compared with other Asian territories such as Japan and Hong Kong at 57%

and 34%, respectively, in 2011. According to the World Economic Forum, a ratio of 50% or more indicates that a country is “reasonably well prepared,”

while a ratio below 25% marks “room for improvements.” China’s pension system has a long way to go, and significant challenges are ahead.

The expansion of the insurance sector and pension system is beneficial

on various levels. On one level, similar to the development of the bond and equity markets, this will also increase the depth of the financial system at

large. On another level, insurance and pension funds also bring an element

of stability to the financial system, as typically they are long-term investment

methods. Besides promoting the bond market, the insurance market and pension system should be another primary focus among financial reforms for the new leadership.

Expand the insurance sector and pension system The insurance sector has been expanding at a robust pace, growing to over

CNY6 trillion (USD966 billion) in size by the end of 2011, almost six times

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that in 2003. However, the size of China’s insurance sector remains under a fifth of the U.S. insurance industry, despite China’s huge population

being over four times the size of the United States’ population. More policy attention is expected to be placed on developing the insurance sector to bring it more in line with global averages in terms of penetration, density, and market size. In particular, we view that life and health insurance are

areas with strong potential for growth due to the aging population, with

products for individuals, groups, and bancassurance as the channels for

insurance products. China’s life insurance market is still in the very early

stages of development; as China boasts the world’s largest population, there is enormous potential for further development.

The development of the pension system is important in order to build

the national societal safety net, which will be beneficial not only to societal stability, but also to encourage additional consumption. As outlined earlier,

China’s pension system is still small in relative size to its GDP, with a ratio of 7.9% at the end of 2010, far below the benchmark of 50% for “reasonably well prepared” as defined by the World Economic Forum.

Improve investment returns of pension funds and insurance companies through better-managed investment schemes Improve investment returns of pension funds and insurance companies

through better-managed investment schemes. One of the major concerns for pension investments are that they provide both low and volatile returns;

combined, these factors lead to high potential risk and questionable longterm sustainability. The bulk of the funds are managed by local governments, which hold the vast majority (over 90%) of their assets in deposits and the

rest in government debt, and achieve very low returns. The National Social

Security Fund (averaging a 9.17% year-over-year return from 2001 to 2010) and private sector funds achieve better but very volatile returns, as they are heavily dependent on equity investments, which account for about a

third of its assets, much higher than the average international level. The major cause of the problems is their poor management and less balanced

and diversified investment schemes. With high levels of risk in the current

pension system, rather than a national buffer, the pension system has become

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an area for concern with a rapidly aging population. China should develop

better management of the pension system investments, and diversify the investments to address the poor returns.

China can learn from other successful pension funds in the world, which

have less stringent restrictions and thus allow fund managers to diversify

risk and pursue higher returns. For example, Sweden’s pension system

was split into various funds which had different targets and strategies; an example of their largest fund, the Sweden AP1 fund, illustrates that their

exposure in 2010 was 58% in equities (32% in North America, Europe, and the

Pacific, 16% in Sweden, and 10% in emerging markets), 32% in fixed income investments, 8% in alternative investments, and 2% in cash. This is a more

diverse and aggressive investment scheme than China’s, and it allows the pension system to target higher returns while at the same time diversifying regional and asset class specific risks.

Implement preferential tax policies for tax deferral This means that individuals can invest up to a certain amount into pensions without incurring taxes until the proceeds are withdrawn. Deferring taxes

will encourage investors to invest in related insurance products, which

will serve to develop the insurance sector, and also promote savings for contingency and retirement. On January 24, 2013, a preliminary agreement

was announced outlining a pilot in Shanghai for a tax-deferred pension plan, marking an early step in this process. In this plan, employers are given an

option to invest up to CNY1,000 per month per employee in commercial

pensions and be exempt from income taxes, with CNY700 of this going into a commercial pension investment product, and the remaining CNY300 into an

enterprise annuity. This will encourage companies to invest in commercial pension products.

Energizing stock market and deepening reforms China’s domestic stock markets have burgeoned over the past decade,

and took off especially since 2006. The market cap in March 2013 equaled approximately USD3.2 trillion, up from a mere USD400 billion at the end of

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2002. This value places it below the United States (USD18.4 trillion), Japan (USD3.9 trillion), the United Kingdom (USD3.4 trillion), and Hong Kong

(USD3.4 trillion), as the fifth largest national stock market. This trend of

rapid development will continue. Currently, there are 2,506 listed firms in China and 6,019 in the United States. Assuming China is to continue the pace

of initial public offering (IPO) of the past decade, that is, an average of 200 to 300 firms listed per year, it will take about a decade for China to surpass the United States and become the largest stock market in the world.

In 2012, China implemented various stock market reforms, continuing

the progress made in recent years. These measures included a mandatory

dividend payout, a bonus allocation scheme urging listed companies to share profits with the investors, a market exit scheme requesting unqualified

listed companies to be delisted, and IPO rule reforms aimed at improving the accuracy of information available for investors and setting a more reasonable IPO price. At the same time, the China Securities Regulatory Commission gradually loosened restrictions on security houses and funds,

and encouraged more innovation on products, markets, and platforms. As the new leadership takes office, stock market reforms will continue mainly via encouraging innovation, enhancing risk management and strengthening transparency and supervision.

Besides the exchange market, the over-the-counter (OTC) market is to be

continually fostered. A “New Third Board” was created as a place for small

high-tech companies to transfer shares and raise funds; this concept was

initiated in 2006, and was officially launched in January 2013. The 2012 data

showed that this market is still very small in scale, with only 200 companies

being traded on the New Third Board and average funding per firm only equaling a relatively paltry CNY33.8 million. Going forward, the third board

market is expected to be expanded rapidly at regional levels first, and then

interconnected with fine supervision to become a good compliment to the main board.

China’s authorities will also continue to promote China’s integration with

the international capital market. Besides more creative cross-board products

such as the Qualified Foreign Institutional Investor (QFII) and Qualified Domestic Institutional Investor (QDII) schemes, an international board for

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foreign companies to get listed in China is another channel. We expect the

international board set to be launched on the Shanghai Stock Exchange to come out in the next year or two despite persistent delays due to various

regulatory and technical reasons. Quite a few foreign companies have

shown their interest publicly in participating in the potential international

board, including the Hongkong and Shanghai Banking Corporation (HSBC), Standard Charter, Unilever, Coca-Cola, and Cheung Kong Holdings, among others.

Development of non–bank loan lending sources and regulation enhancement There is also a need to develop other sources of lending beyond traditional

lending, which is particularly important as the process of interest rate liberalization will impact banks’ profitability, and as non-bank lending will

also reduce the financial sector’s overdependence on banks. This process has

been in place over the past decade; looking at China’s historical aggregate

financing statistics, bank loans had accounted for 92% of total social financing in 2002, as opposed to just 52% in 2012.

Nonbank loans, including trust loans, entrusted loans, leasing, financing,

and derivative financial instruments, are commonly called “shadow banks” that will continue to be expanded in the upcoming years, as part of a long-term

goal of diversifying the available loan sources. Reducing the overreliance on bank lending will ultimately promote a healthier and more efficient financial

system. However, on the other hand, the rapid growth of shadow banks has aroused concerns, as the estimated size of this sector reached approximately CNY30 trillion by 2012.

It is important that regulation is established for these alternate sources of

financing, to minimize the potential risks they could impose on the system. During the 2013 National Banking Regulatory Conference on January 14, the China Banking Regulatory Commission set a goal to “severely regulate the

design, sales, and allocation of funds of financial products,” emphasizing the importance of preventing and mitigating risks. The listed areas for focus

included “credit default risks, corporate risks, and external risks.” The

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commission also outlined an intention to set up firewalls to prevent risks

from private financing and illegal fundraising spreading to the banking system.

Capital market liberalization and internationalization of the renminbi Capital market liberalization is one of the next steps of the evolution of

China’s financial system as it becomes increasingly integrated with global markets. The process of the internationalization of the renminbi in particular has been a major focus over the last several years. The internationalization

of the renminbi is likely to promote the development of an international financial center in Mainland China. We can summarize the evolution of

this internationalization in three phases, of which China is currently in the process of transitioning from Phase 1 to 2; we view the completion of this transition as only a matter of time.

1. Phase 1: The early stage of renminbi internationalization can be characterized by an easing of policy controlling capital flows, trade flows, and direct investment flows.

2. Phase 2: The advanced stage of renminbi internationalization can be

characterized by the free circulation of capital flows, meaning a total

liberalization of the capital account, also meaning unconditional renminbi convertibility.

3. Phase 3: The most advanced stage of renminbi internationalization would be embodied by a stature of world reserve currency for the renminbi, an active and stable renminbi offshore market, as well as a profound and well-developed international financial center in Shanghai.

Tight controls on capital flow, such as the limits on currency exchange,

restrict the ability of investors and companies to transfer capital in and out

of China. Renminbi repatriation channels have also been developed, with the expansion of Renminbi Qualified Foreign Institutional Investor (RQFII)– facilitating investment in equities and bonds, as well as the introduction of cross-border renminbi lending. These factors lead to freer circulation of the

renminbi, which is an important step in the currency internationalization

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process. We view the following as some of the likely policy goals in the coming years:

Programs such as QFII, RQFII, and QDII to be rapidly developed Currently, there are 201 QFII members, with a size of USD43.54 billion, with 66 members added and the quota expanded by USD20.1 billion in 2012.

There are also 24 RQFII members, and the quota was expanded by CNY50

billion in 2012. These programs are set to be expanded dramatically in the

near future in size and scope. It was announced on February 25, 2013 that the restrictions on RQFII investments in A-shares would be lifted, reversing a previous restriction that forced RQFII participants to hold onto a 2:8 ratio of stocks to bonds.

Former China Securities Regulatory Commission Chairman Guo Shuqing

stated during the Asian Financial Forum on January 14, 2013 that the QFII2 and RQFII quota may be expanded to 10 times the current level. According

to Guo’s later comments, there is a target of expanding foreign holdings

of the stock market to 16%. Historical examples from Taiwan and Korea have shown with increasing foreign ownership rising beyond 10%, equity

markets have exhibited a higher index number, but a lower price/earnings (P/E) ratio (from a P/E of 40 to 20 in Taiwan, from 25 to 15 in Korea), as well

as a lower market turnover, due to longer-term investments. This indicates

that the expansion of foreign holdings will reduce speculation and improve stability. In early March, the RQFII program was expanded to allow foreign investors to access a broader range of investment goods, from just bonds and A-share exchange-traded funds (ETFs) to individual stocks, mutual funds,

interbank bonds, index futures, warrants, and any other products approved by the regulator.

Furthermore, according to a People’s Bank of China statement on January

11, there is a high likelihood that the QDII2 policy will be released later

on in the year. This should further expand upon the quota of QDII, which accounted for CNY85.58 billion between 107 institutions at the end of 2012. These programs’ quotas are likely to continue to expand in the short term, until China is ready for full capital account convertibility.

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Offshore renminbi market to expand in scale and scope Dim sum bonds, real estate investment trusts (REITs), currency futures,

and equity derivatives have all been developed for the Hong Kong offshore

market since 2011. Renminbi-denominated savings accounts also grew more prominent in the last several years; by the end of January 2013, renminbi

deposits in Hong Kong registered at CNY624 billion, or 9.1% of total

deposits. The offshore market in Hong Kong in particular has expanded significantly over the past several years with more investment products, such as dim sum bonds, REITs, currency futures, and equity derivatives, and

is growing in size, with renminbi deposits of CNY571 billion near the end of 2012, up tenfold from CNY56 billion in 2008. This scope is likely to continue

to increase rapidly in the short term as China pushes the internationalization of the renminbi.

Additionally, London and Singapore may be cities for the development

of further offshore renminbi centers, and both cities have made their bids to

do so. Furthermore, Taiwan also has ambitions to become another offshore renminbi clearing and settlement center, and made significant progress in

2012 via setting up a clearing mechanism directly between the renminbi and the New Taiwan dollar.

Exchange rate liberalization to continue The government doubled the renminbi’s daily trading band in April 2012, which had little de facto impact but was nonetheless a symbolic step towards

liberalization. Chinese officials have been quoted as setting 2015 as a target

for making the renminbi convertible, while others set 2020 as the target. The renminbi has reached a state of two-way fluctuation, rather than a simple single-direction appreciation, giving room for further liberalization. And a boom in the offshore renminbi market in Hong Kong will facilate a more

market-decided exchange rate, which could inversely affect the level of renminbi rates in the Mainland.

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Renminbi repatriation to be developed As cross-border capital flow controls are loosened, channels for the

repatriation of the renminbi will expand. Currently, this is mostly through the RQFII program, which allows for investment in the Mainland bond and equity markets, as well as via cross-border lending. Newer channels

for renminbi repatriation may also be developed in the near future, such as

the Renminbi Qualified Foreign Limited Partner (RQFLP) program which allows foreign fund managers to raise offshore renminbi and invest these funds in private equity funds set up on the Mainland.

Cross-border clearing systems to be enhanced and integrated with the international system The renminbi has been increasingly used internationally over the past

several years. At the end of 2012, renminbi-denominated cross-border trade settlement accounted for CNY2.94 trillion, up 41% year-over-year, and accounted for approximately 12% of China’s total trade in 2012. The system

currently in place is called the China International Payment System, and has been criticized as relatively lacking in efficiency, security, and stability, as a

significant portion of the processing is done manually. Improving the clearing systems are important to minimizing the costs associated with the current

payment system, which boosts transaction costs due to its inefficiencies. Comments from central bank officials indicate that enhancements of the

system would be targeted at bringing it in line with international standards, and making it compatible with the Society for Worldwide Interbank Financial Telecommunication (SWIFT), and that the development of a new clearing system would likely take several years to implement.

Currency-swap schemes to be expanded Currency-swap deals of approximately CNY1.7 trillion were completed since

2006, with agreements in place with over 20 countries. China has established tight money links after the Global Financial Crisis with ASEAN and East Asian

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countries such as Korea, Singapore, Hong Kong, Malaysia, and Indonesia; as well as commodity-rich countries such as Brazil, Argentina, Russia,

Australia, and New Zealand. Renminbi-swap contracts not only facilitate trade settlement in the currency but also promote confidence in holding the currency, which is paving a concrete way for renminbi internationalization and the renminbi as a world reserve currency.

Interest rate liberalization Mismatched interest rates are a major factor causing overinvestment in China. China’s current lending and deposit rates are still controlled by the People’s

Bank of China, which sets a benchmark rate and offers banks a small amount of leeway from which they can deviate. On one hand, the guaranteed spread ensures banks a good profit margin giving them less incentives to provide diversified products and services or better manage risks; on the other hand,

the inflexible rates lead to low investment costs for state-owned firms while SMEs face a shortage of financing. Interest rate liberalization, a goal long pursued by China, will be on the agenda in Xi’s first term, with renewed efforts to make China’s interest rates more responsive to market forces.

Some progress has been made. In 2012, China took a step toward interest

rate liberalization by expanding the band which allowed banks to deviate

from the benchmark, to 10% for deposit rates and 20% for loan rates. The Qianhai region of the pilot financial program announced in 2012 may also

be an opportunity for promoting the long-term integration of the offshore and onshore interest rates for the renminbi. The Qianhai region started its

first cross-border renminbi loan program this January [2013], with a quota of CNY2 billion. The interest rates on loans with one-to-four year terms

registered at an annualized rate of 4.3% to 4.5%, lower than the rates on the

Mainland of 6%, but higher than the level of the 4% prime rates in Hong Kong.

Population and Income Reforms Two of the greatest long-term challenges that China faces are dealing with an aging population, and dealing with income inequality. Both issues are

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coming to important junctures and the future is murky. China is currently approaching what is described as a “mature” age distribution structure, and

will soon face the problem of a rapidly aging population. According to the United Nations, China’s working-age population ratio will peak sometime between this year [2013] and 2015, and be on a steady decline from that point

forward. According to CEIC Data, at the end of 2011, 16.5% of the population was aged between 0 and 14, 74.4% of the population was aged 14 to 65, and

9.1% of the population was aged above 65; the share of the population aged above 65 has risen from just under 7% at the turn of the millennium, and is set to rise even faster in the upcoming years.

Furthermore, income inequality is also a mounting concern, which could

be even further exacerbated upon slowing economic growth. China’s Gini

coefficient (where a score of 1 means total inequality, and a score of 0 means total equality) is officially reported at 0.474 for 2012, but most scholars estimate this to be significantly higher; for example, a recent survey done by

the Southwest University of Finance and Economics in Chengdu estimated

the Gini coefficient at 0.61 in 2010 — shockingly high. The recommended

level for the Gini coefficient is a level below 0.4, with the global average roughly around 0.44. These factors illustrate China’s need to address the

issue. Public anger has been simmering over inequality, particularly over

shows of extravagance from elected officials, leading to the new leadership

engaging in a campaign to cut down on corruption. Reforms to address these

long-term issues have quite a high degree of importance, if not immediate urgency, due to the huge ramifications of leaving them unchanged. It is our view that the new leadership will take strides in this direction during their first term in office.

Income reforms To address the problems of inequality among other issues, income reforms are likely to be pushed from two aspects. First, there is an urgent need to

increase household income in both absolute value and relative share of GDP. Second, tax and other reforms are needed to ensure better income distribution to households. Several necessary reforms are critical in this context, namely, income-doubling reform, tax reforms, and reforms on social transfers.

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Income-doubling reform China’s household income has increased greatly for the past decades; however, its share of GDP has decreased continuously. That is to say, household income

grew slower than those of enterprises and the government, which has driven

the share of household income to decrease by about one percentage point every year in the past decade. In other words, households have become relatively poorer despite the rise in nominal income, which makes it even harder to enhance the role of consumption in the GDP structure.

The “Income-Doubling Reform” addressed at the 18th National Congress

of the Communist Party of China last November [2012] indicated a goal

of doubling per capita income for both urban and rural citizens by 2020. This is a good step towards the track of raising disposable income levels. However, the government will have to consider some critical points before

such a plan is a success. This includes considering that a rise in real income is more meaningful than nominal income, and household income’s relative share of GDP is more critical than its absolute value in transformation; thus the reform should be a systematic reform requiring many related reforms to make it effective.

Japan’s “Income-Doubling Plan” during their “Golden Sixties,” which is

widely seen as an enormous success, is a good lesson for China, as China’s current state of economic development is similar to Japan’s in that era. Japan announced the Income-Doubling Plan in December 1960, with an original

target of doubling real income within 10 years. Japan had achieved this feat by 1967, several years ahead of schedule.

There were some overarching features of Japan’s plan beyond the

basic goal of doubling real income, including raising wages and cutting

taxes, pushing efficiency enhancements, and raising crop prices to aid the

agricultural sector, that China can learn from when attempting to achieve its goal:

• Emphasize balancing economic development with societal harmony. This included improving household living conditions, providing attention to

addressing the difficult issues of inequality, and balancing the gains from economic growth between the urban and rural areas.

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• Narrow the competitiveness gap between large enterprises and SMEs. This is a major concern in China, just as it was for Japan at the time.

Larger state-owned enterprises in China enjoy significant benefits, from simply economies of scale to easier and cheaper access to credit, and often build upon these competitive advantages to marginalize competitors.

• Emphasize the upgrading of infrastructure as a priority of the government.

This is a feature that is in line with China’s recent actions, as the National

Development and Reform Commission and other government bodies encourage various infrastructure projects.

• Improve the competitiveness of corporations and individuals via investing in technology and training. This is an area where China has a lot of room for progress. Currently, China’s innovation in technology is

still lacking, and its labor productivity is still very low compared to most major developed economies.

Tax reforms to increase the household income share of GDP One of the important reasons for a fall in the household income share of GDP comes from high personal income tax in China. China has one of the highest income tax rates in the world with tax rates ranging from 3% to 45%. Tax is an

efficient tool in the first-round wealth distribution that can boost household

disposable income. China’s current personal income tax system imposes significant burdens on households, with relatively high tax rates, fairly low income brackets for taxation, and a lack of deductibles. Addressing these

issues would lead to more disposable income for households, and promote consumption.

• Personal income tax reforms:

• Lower tax rates on personal income tax. This would directly reduce tax burden and raise the disposable income of most households.

• Adjust tax brackets. Adjusting the tax brackets more leniently, via

eliminating the tax on the bottom income earners and by reducing the

burden on the middle class would also free more disposable income for households.

• Introduce tax deductions. Currently, China lacks a sophisticated tax

deduction system, particularly on the individual level. Introducing

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

deductions for married couples, care for children and the elderly,

depreciation, self-education, and housing purchase interest payments, among other deductions would also bring welcome relief for citizens and boost disposable income.

• Levy additional taxes to balance out the loss of tax revenue from personal

income tax reforms (Several tax reforms were proposed in the 1996 9th

Five Year Plan, but were never implemented):

• Social security tax. Currently there is no social security tax, but social

security contributions are mandatory between a band with limits of 60% to 300% of the average wage of the city.

• Inheritance and gift tax. At the moment there is also no inheritance or

gift tax in China. This means that there is no redistribution of wealth on the estate of the deceased, and this exacerbates the inequality problem.

Government and social transfers to narrow income inequality Tax reforms are generally difficult to push due to existing interest groups; therefore government transfers need to play a more important role in the second round of wealth distribution to narrow income inequality.

In China, the level of social transfers as a proportion of nominal GDP

was 6.5% in 2009, far below the Organization for Economic Cooperation

and Development (OECD)’s average of 22.1% and the U.S. average of 19.4% that year. While the OECD average is buoyed by many developed European economies with high social transfers, China also remained behind the likes of countries such as Turkey, South Korea, and Mexico, which registered transfers as a percentage of GDP of 12.8%, 9.4%, and 8.2%, respectively,

in 2009. In 2012, the OECD average slid slightly to 21.7%, but it was still

significantly higher than China’s transfers. This means that relative to other countries around the world, Chinese citizens receive less money back

from their government, and thus this is not a help in narrowing the income inequality gap.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

Social transfers, 2012 Country China France Germany Greece Italy Japan Korea Mexico Spain Turkey U.K. U.S. OECD average

% of GDP 6.5 32.1 26.3 23.1 28.1 22.4 9.3 8.2 26.3 12.8 23.9 19.4 21.7

Sources: OECD; CEIC Data; Haitong International. Note: China, Japan, Mexico, and Turkey data is from 2009.

One-Child Policy at a juncture for review and revision China introduced the One-Child Policy as early as 1980 to control the population boom. The One-Child Policy will likely leave a mixed legacy in China. On one hand, the policy fulfilled the vital role of reining in population

growth; on the other hand, it also created the impending aging problem

among other issues, and drew much criticism as a violation of civil rights.

When the policy was launched, China’s government claimed that the policy

could be revised 30 years later if its fast population growth could slow down to a reasonable rate.

Several factors contribute to the argument that now is indeed the time

to revise the policy. Currently, China’s official figures indicate that China’s

fertility rates are at 1.8 per woman, with fertility rates in big cities such as Beijing and Shanghai at levels below 1.0 child per woman; furthermore, the

United Nations and some scholars estimate that the rate is only about 1.4

to 1.5. According to the United Nations, a rate of around 2.0 is required for healthy generation evolution and to avoid a population decrease. If China

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

follows a similar pattern to developed nations, the fertility rate will continue

to drop as the process of industrialization is complete, and as urbanization rates, wealth, and education levels rise. This means that the One-Child

Policy may not only become less useful for population stabilization, but may become detrimental to the demographic mix.

Several major consequences come to mind when considering the negative

effects from the One-Child Policy:

• The labor pool will shrink as the working-age population declines. Aging will reduce one of China’s greatest competitive advantages, namely

its plentiful pool of low-cost labor. The working-age population will

decrease, which is one of the factors that should raise labor costs and reduce China’s competitiveness in low-cost industries.

• A “4–2–1” structure has emerged as a consequence of low fertility. As

those adults who came from multi-child families only have a single child, this results in what is called a “4–2–1” structure, where each generation grows increasingly smaller and becomes responsible for the wellbeing of a greater number of older relatives. This results in a staggering burden for

many individuals. This will also increase the burden on public healthcare and pension systems, with more dependents claiming benefits, and as

the average lifespan increases, the average claimant will be receiving benefits for a longer time.

An abrupt abolition of the One-Child Policy is highly unlikely in the

short term, as such an abrupt drastic change would be uncharacteristic of the

Chinese government and could have dangerous ramifications. Instead, we anticipate that the changes may be more incremental. We view the following as some of the possible changes that the government may make:

• Pilot regions are likely to be chosen to test the effects of policy changes. Any policy changes, rather than being implemented abruptly on a

nationwide level, are likely to be implemented in specific regions first. Previous talks had regions of Dongbei and Zhejiang as possible pilot

zones, with a mix of urban and rural areas to gauge the impact on each of these zones.

• Gradually ease the age guidelines for childbirth. While it is unlikely that

the government will explicitly encourage childbirth for various ages, it is likely that there will be less discouragement for childbirth at an earlier age.

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

• Gradually ease the age gap guidelines for having two children. Families

eligible for a second child are currently required to wait five years before having the second child; this gap can be shortened or altogether removed.

• Gradually allow couples with one spouse from a single-child family to

have a second child. Currently, only in the case where both spouses are from single-child households will the family be allowed to have two children.

• Gradually lift the restriction on rural residents. Currently, rural residents

are allowed to have a second child if the first child is female or born with a disability. This could be further eased to allow a second child with no restrictions.

• Allow but not encourage having a second child, and restrictions to remain on third child.

Once the One-Child Policy is eased, what is known as the “two-high”

group (high-education and high-salary) will be more willing to have a second

child, while less affluent households are likely to hesitate, given the high life

pressures and high costs of raising children. According to a grassroots survey in Shanghai, about 50% of families will consider having a second child. In

sum, easing the One-Child Policy will not only prevent the population from falling into an even deeper aging crisis, but will also rebalance the population

structure to avoid falling into a severe demographic distortion of a “4–2–1” structure.

However, as population policies can have long-lasting and enormous

consequences, a great deal of caution should be taken when altering policies. It is likely that in any of the possible policy actions, the government will

take gradual steps and be conservative in its policy making; rather than

encouraging the population to have more children like in decades past, it will only loosen restrictions on it.

Environment-Related Reforms China’s environment has unfortunately been a victim of the rapid economic expansion over the past three decades. While pollution has been a growing

problem over the past several years, the recent concerns over air quality in

Beijing with the high quantities of PM2.5 particles, the most dangerous size

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

of inhalable particles that can enter the human bloodstream, have captured global headlines and sparked significant outrage domestically. Exposure to PM2.5 can contribute to cardiovascular, cerebrovascular, and respiratory diseases, as well as greater cancer risks, all leading to a significantly higher mortality rate.

At the start of 2013, 74 cities in China began monitoring real-time air

quality, providing PM2.5 data. In January 2013, we can observe that the

official PM2.5 levels in cities were far above the World Health Organization

(WHO) recommended maximum level of below 25, with Beijing’s average at 161.9 µg/m3, Chengdu’s at 212.9 µg/m3, Shanghai’s at 118.5 µg/m³,

and Guangzhou’s at 80.0 µg/m3. While these levels improved slightly in

February, they remained near or above triple the WHO recommended maximum levels; in the 74 cities sampled, the monthly average was 85 µg/

m3, while the highest daily average was 232 µg/m3, down from 130 µg/

m3 and 336 µg/m3, respectively. According to a recent study by Harvard University, an increase of 10 micrograms of PM2.5 per cubic meter shows a

14% increased risk for death, and a 26% increased risk for cardiovascular and lung cancer mortality.

Air pollution is not the only issue in China. Water pollution has

aroused serious concerns. Industrial accidents, irresponsible waste disposal procedures, and household pollution have led to significant water pollution

of rivers, lakes, and oceans. The Ministry of Environmental Protection has linked water pollution to the spread of cancer in certain regions. Soil erosion

is another worry that has been plaguing China for the past several decades. Food security of the nation is also a key concern and it will be for some years to come.

China’s GDP rapid growth model for the past decades at the cost of its

environment and resources has become increasing unsustainable. Despite

the growth rate, the quality of GDP growth with an emphasis on green growth is the key for sustainable development. Addressing environmental concerns will undoubtedly be costly, and more stringent environmental standards will be reflected by a lower GDP growth. Various organizations

including the International Fund for China’s Environment and Dale W. Jorgenson Associates have estimated the cost to clean up pollution in China

to be about 2% to 4% of GDP per year. While this may be undesirable in

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What to Expect When Expecting: Policy Reforms to Bring the Birth of China’s Future

the short run, it is ultimately more important to China to focus on the longterm quality of growth. In the big picture, preserving the environment is absolutely essential for the long-term welfare of the country and its people,

and preserving China’s environment will be of growing importance to the

new leadership. It is important to note that environmental challenges will take a long time and great effort to achieve, but with the current dangerous levels of pollution, the process needs to be accelerated as soon as possible.

With growing environmental awareness, the new leadership will be

pressured to continue to take actions to improve the situation. China will

continue to shift its focus more towards the quality of growth including a greater focus on environmental issues; making environmental protection

part of the performance evaluations of local governments will support these efforts. Major measures could include the following:

• Invest in cleaning up pollution. For example, the Ministry of Environmental Protection pledged investments of CNY350 billion to construct 13,369 projects to control emissions and reduce PM2.5.

• Further develop and encourage cleaner energy sources and energy

efficient products. Studies have shown PM2.5 is most prevalent in the combustion of coal, which accounts for about 70% of energy

contribution in China. A long-term goal would be to wean China off its coal dependency, and promote cleaner energy sources such as natural

gas, shale gas, wind power, solar power, and nuclear power. On the other hand, the government could address emissions by encouraging cleaner consumer and industrial products, ranging from automobiles to appliances; a possible method to kill two birds with one stone would

be to launch subsidies for energy-efficient appliances and automobiles,

which would not only bolster consumption but also reduce China’s carbon footprint over the long term.

• Levy resource taxes, environmental taxes, and “sin taxes” to encourage

sustainable behavior. Several of these reforms are already in progress, and we expect the pace of these reforms to escalate over the next several years.

• Expand resource tax reforms. China currently taxes crude oil, natural

gas, coal, other non-medal ores, ferrous ores, nonferrous ores, and salt. China is already in the process of revamping the resource tax

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

system from a traditional taxation-on-volume system, where taxes are levied on the quantity of resources harvested, towards a taxationon-value system, where taxes are levied based on the value of the

resources to better reflect changes in commodity prices and create

a dynamic rather than static tax rate. In December 2012, 12 western

provinces switched to this method for taxing crude oil and natural gas. This is likely to be expanded to cover other commodities and reach other provinces.

• Create emissions taxes. Though China has long discussed a carbon tax, this has yet to be implemented. This is currently planned to

be addressed by 2015, but may be implemented earlier given the

seriousness of the issue, by creating a carbon trading market to improve energy efficiency.

• Increase “sin taxes” to discourage unhealthy behavior and raise additional revenue. China’s current “sin taxes,” including taxes on

tobacco in particular (at just 36% or 56% depending on the brand), are set at among the world’s lowest levels. With rising health awareness, raising these taxes to more suitable levels would increase revenue as well as promote public health.

Structural Reforms and Transitions China’s short and medium future still looks bright, but serious structural reforms are necessary. With the new leadership entering office, there are high

hopes for reform, but this will be an acclimation process. Many of the reforms

are already in progress, have solid foundations for reform already in place,

or are scheduled to be reviewed. In the coming decade, there will be many opportunities and challenges ahead for China. In a period of transition and

tumult, with the global economy still removed from its precrisis dynamism, the spotlight now shines upon China’s new leadership, and whether or not

they can seize the reins to the world’s second largest economy and lead it to a brighter future.

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Strategy to Promote the Renminbi as a World Reserve Currency

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The offshore renminbi market and internationalization of the renminbi

are topics that have been increasingly discussed by scholars, financial

professionals, and policymakers. The Chinese government has aggressively promoted Hong Kong as a critical offshore renminbi (CNH) market since the first personal renminbi banking service was launched in Hong Kong in

2004. The pace of CNH market development has accelerated from 2007, as evidenced by the increasing levels of trade settlement in the renminbi and the creation of multiple financial products such as bonds issued by foreign

enterprises, sovereign bonds, dim sum bonds issued by Chinese enterprises, and exchange-traded funds of Mainland China–listed stocks denominated in the renminbi. The CNH market today offers a large spectrum of products,

from the most traditional ones, such as trade settlement and deposit services, to the most advanced ones, such as derivatives products. By the end of 2012,

the CNY deposits outstanding and CNY loans outstanding reached CNY603 billion and CNY79 billion, respectively, up from CNY588.5 billion and

CNY31 billion in 2011. The trade settlement in 2012 was also up to CNY2.63 trillion, growing by 37% year-over-year from 2011. CNY bonds were up to

CNY175.8 billion, compared to CNY152 billion in 2011. Besides Hong Kong, London, Singapore, and Taiwan are fighting to become renminbi offshore centers.

Three Phases of Renminbi Offshore Markets and Renminbi Internationalization Renminbi internationalization is related to the currency’s convertibility and

capital market control, while a renminbi offshore market is a market facilitating the development of renminbi-denominated financial products outside Mainland China. A renminbi offshore market starts up with the initiation of

and develops along with deepening renminbi internationalization, but will gradually operate independently of renminbi internationalization. We can summarize this evolution in three phases:

1. Phase 1: The early stage of renminbi internationalization can be

characterized by an easing of the policies controlling capital flows, trade flows, and direct investment flows. It was accompanied by a quickly

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Strategy to Promote the Renminbi as a World Reserve Currency

growing renminbi offshore market and the establishment of Shanghai as an international financial center in Mainland China.

2. Phase 2: The advanced stage of renminbi internationalization can be

characterized by the free circulation of capital flows, meaning the total

liberalization of the capital account, and also meaning unconditional renminbi convertibility. Once this stage is achieved, the renminbi offshore market will have matured (possibly starting to gradually decline from

its peak), while the Shanghai international financial center could still undergo strong development.

3. Phase 3: The most advanced stage of renminbi internationalization would

be embodied by a status of world reserve currency for the renminbi, an active and stable renminbi offshore market, as well as a profound and well-developed international financial center in Shanghai.

Moving from one phase to another represents an approach of tactical or

strategic dimension, regarding both the development of the offshore market and the process of internationalization. Moving from Phase 1 to Phase 2 has

a tactical dimension as it deals with technical issues or difficulties, all of them

being solvable with manageable risks. In the Chinese case, the completion of Phase 2 is only a matter of time.

Moving from Phase 2 to Phase 3 has a strategic dimension, representing a

leap which may not necessarily be achieved. It is also an issue of willingness from both international society and the Chinese government. On one hand,

international society should be willing to accept the renminbi as a world currency in trade and official reserves. On the other hand, China should have the willingness to allow the renminbi to become part of world currency reserves, indicating new rights and responsibilities. It would have huge

consequences in terms of the conduct of monetary policy and attractiveness

of the domestic economy for global flows of liquidity. Phase 3 is a stage beyond full control but it requires a strong willingness of official bodies.

If China desires to reach Phase 2 only, the renminbi offshore market will

be a short-lived market existing at most for 5 to 10 years, and it will gradually fade out when Shanghai becomes a real international financial center. If

China desires to continue expanding the internationalization of its currency to Phase 3 after the termination of Phase 2, the Chinese government has to

get well prepared. An early strategy is a must. Japan was often characterized

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as a “trade giant but a currency coward,” as the country missed the chance

to promote the yen during the golden age of its economy in the 1970s and 1980s. China significantly lagged other countries regarding the degree of

internationalization of its currency. The currency distribution in foreign

exchange transactions, the percentage of world payment denominated in a currency, and the percentage of world reserves held in a certain currency represent the best indicators of such internationalization.

Currencies used in world payments vs. trade, 2010 (% of total) 40 30 20

Payment

EUR

USD

GBP

JPY

AUD

CAD

CHF

HKD

SEK

SGD

THB

NOK

DKK

HUF

MXN

RUB

0

CNY

10

Trade

Sources: Society for Worldwide Interbank Financial Telecommunication; World Trade Organization.

Indicators of currency internationalization (%)

Share of world trade Share of world GDP (PPP) Share of global cross-border deposits Share of international debt outstanding Share of global FX transactions Share of global reserves

EUR

USD

JPY

GBP

CHF

14.5 14.6

12.3 19.7

5.6 5.8

3.3 2.9

1.3 0.4

Others/ unallocated 62.9 56.5

22.5

59.2

2.1

—

—

16.2

31.4

45.8

5.8

7.4

3.6

6.1

39.1

84.9

19.0

12.9

6.4

37.8

14.5

33.9

2.1

2.2

0.1

47.3

Sources: European Central Bank; Shahin Vallée, “The Internationalization Path of the Renminbi” (Bruegel Working Paper 2012/05, March 2012).

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Strategy to Promote the Renminbi as a World Reserve Currency

This report analyzes the fundamental steps which led to the dominance

of the U.S. dollar, and discusses the pros and cons of a world reserve currency using the U.S. dollar, Japanese yen, and euro as case studies. The capacity of the United States to get rid of the exchange rate channel of its economic policy has been a fundamental factor in the domination of the U.S. dollar. In the renminbi case, developing a regional renminbi bloc could represent an efficient intermediate target before reaching a status of world reserve

currency, as sacrificing the exchange rate channel of the economic policy would be premature and too costly.

U.S. Dollar’s Quick Accession to World Reserve Currency Status Both spontaneous and policy-driven factors contributed to the establishment

of the current dominant role of the U.S. dollar. To identify the factors which allow a currency to achieve internationalization, we consider the cases of the

U.S. dollar and other competing currencies. It is traditionally said that the

U.S. dollar overtook the British pound as the dominant international currency just after World War II due to the economic and commercial weakening of

the British Empire. This consensual approach underlines the very long time needed for internationalizing a currency and insists on network externalities,

which corresponds to the lower incentives to change a currency for financing and settling trade once its domination is well established. In fact, recent studies show that the rise of the U.S. dollar was much quicker than generally

thought, that network externalities are not the only determinant, and that the

role of economic policy is very important regarding the internationalization of a currency. Once we have identified the factors which contributed to

the internationalization of the U.S. dollar, we will consider the cases of the

Japanese yen, the German deutsche mark, and the European Union’s euro and explain why their internationalization has not been totally achieved and did not allow them to compete with the U.S. dollar as a world reserve currency.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

U.S. dollar experience: Exchange rate channel of economic policy was not essential The U.S. dollar’s experience of internationalization is interesting when looking to understand the factors behind its emergence as a world reserve

currency. We first examine this at the level of trade financing and settlement, then at the level of the international bond market, and finally at the level

of the foreign exchange reserve function. At these three levels, the growing

economic power of the United States and the progressive weakening of European countries have admittedly played decisive roles, but political factors have also been decisive via the monetary policy, fiscal policy, and reforms of the financial market.

Regarding the trade settlement and financing function, Barry Eichengreen

and Marc Flandreau in “The Rise and Fall of the Dollar, or When Did the Dollar Replace Sterling as the Leading International Currency?” (European

Review of Economic History 13[3] [2009]) reached the following conclusions related to the competition between the U.S. dollar and the British pound to become the dominant currency in the 20th century:

• The internationalization of the U.S. dollar was much quicker than was generally thought. It was accomplished as soon as the 1920s. This

suggests that the internationalization process of a currency can be very rapid and can take less than 10 years.

• The network effects linked to the British pound were important but they

did not block the accession of the U.S. dollar to a status of world reserve currency, leading to a bipolarization of the international monetary system.

It shows that the domination of the global currency is not established

once and for all, and shows the possibility of a multipolar system of international currencies.

• The economic weakening of Great Britain after World Wars I and II was not the only factor explaining the progressive decline of its currency. The

inconsistency between its monetary and exchange rate policies explained this weakening.

• The interventions of the U.S. government and the U.S. Federal Reserve were decisive in the promotion of the U.S. dollar as a world reserve

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Strategy to Promote the Renminbi as a World Reserve Currency

currency. Financial liberalization led to the creation of bankers’

acceptances, a financial product backed by a trade recognition of debt,

which had only been offered by London before. This financial innovation and its propagation via the establishment of foreign branches of U.S.

banks have been decisive in internationalizing the U.S. dollar. The Fed also played an active role in accepting these bankers’ acceptances in its monetary operations, playing the role of market-maker for them.

Implicitly, in ensuring the international liquidity of these products, the

Fed made the sacrifice of the exchange rate channel of its economic policy

as it implied an international provisioning of the U.S. dollar independent of domestic conditions. Regarding the weight of the U.S. dollar in the international bond market, the process was the same. The internationalization

of the U.S. dollar was much quicker than commonly believed. As early as

the beginning of the 1930s, the U.S. dollar reached a dominant status in global foreign public debt. Recent studies show that the size of the economy,

declining in the U.K. case, was the main factor explaining the decline of the British pound. However, the growing size of the economy was not the main

factor explaining the rise of the U.S. dollar. The deepening of the financial market and the credibility of the framework regulating it were the most

important factors in convincing foreign governments to issue debt in the

U.S. dollar. We have to underline the fact that the development of financial activities in the 1920s took place in a context of strong gains of productivity

linked to fundamental innovations in transport, communications, and energy (electricity) sectors. This context, favorable to the emergence of a new industry

to the detriment of more traditional activities, contributed to, besides the

weakening of European economies, the lowering of the dependency of the United States on price competitiveness. As reflected by the strong influence of

bankers regarding the creation of the Federal Reserve in 1913, the influence of bankers on politicians was also very important during that period. All these

factors, which reflect a lower interest in defending traditional industries and therefore preserving price-competitiveness, were probably fundamental to the rise of the U.S. dollar to a status of world reserve currency.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Global foreign public debt (% of total foreign public debt) 90 80 70 60 50 40 30 20

GBP

USD

Gold

1944

1942

1940

1938

1936

1934

1932

1930

1928

1926

1924

1922

1920

1918

1916

0

1914

10

Other

Sources: Livia Chitu, Barry Eichengreen, and Arnaud J. Mehl, “When Did the Dollar Overtake Sterling as the Leading International Currency? Evidence from the Bond Markets” (NBER Working Paper No. 18097, May 2012); Haitong International.

The emergence of the U.S. dollar as an official foreign exchange reserve

was also very quick. Eichengreen and Flandreau identified 1924 as the year

when the U.S. dollar overtook the British pound as the dominant official reserve currency, but not after World War II as was commonly estimated. The United States maintained this domination in the 1920s due to the doubts

on the capacity of the Bank of England to assure the convertibility in gold

of its currency. In the 1930s, the British pound regained its top position, contradicting again the notion of inertia in the status of a dominant currency.

Mainly political factors explained this comeback of the pound after both

the United Kingdom and the United States abandoned the gold standard in

1933. The study of Eichengreen and Flandreau therefore shows that it is both

a challenge for a currency to acquire and keep a dominant position. Besides the economic strength and depth of the financial market, the political factor plays once again a decisive role.

Jeffrey Frankel also examines the rise of the dollar and the lessons

to be taken for the renminbi, in his “Historical Precedents for the

Internationalization of the RMB” written for a workshop organized by

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Strategy to Promote the Renminbi as a World Reserve Currency

the Council on Foreign Relations and the China Development Research Foundation. He underlines the fact that despite being more powerful in terms of the size of the economy, the United States had no dominant role

at the beginning of the 20th century in terms of currency due to the lack of a deep, liquid, and open financial market, the absence of a credible central

bank, and doubts on the reliability of the dollar. Once a central bank was

created in 1913, the internationalization of the dollar followed quickly. After World War I, the United States shifted from a global debtor status to a global creditor status. This is another important criterion for a currency to reach

an international status. After 1945, the U.S. dollar became the only money convertible into gold and this became the basis of the Bretton Woods system.

Lessons from the German deutsche mark and Japanese yen The rise of the deutsche mark and the yen was due to the growing economic weight of Germany and Japan. These two export-based economies took a higher share of world trade during the 1980s and 1990s in parallel

with periods of instability in the United States. This corresponded with

an increasing share of the yen and deutsche mark in international and official foreign exchange reserves. However, this rise did not result from a political impulse. Both governments were reluctant to see an appreciation

of their currencies and a stronger demand for it as their economies were, and still are, based on the performance of exports. Consequently they

never promoted the internationalization of their currencies and never challenged the U.S. dollar as a world reserve currency. Moreover, the size

and liquidity of their financial markets had no comparison with that of the United States. From 1990 onward, both countries entered a phase of low growth due to a climate of austerity in Europe and due to the long-

lasting effects of the housing bubble burst in Japan. The interruption of

this era of a very high level of growth in the 1990s put an end to their processes of currency internationalization. The Japanese economy never really recovered from the credit crisis, and lately liberalized its financial system; Germany gave up its currency hegemony in favor of the euro, which was created in 1999.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Lessons from the euro From the beginning of its creation, the euro had strong potential. The Eurozone has a similar economic weight as the United States, and a very

deep, liquid, and open financial market. The European Central Bank is a credible institution, and there is a political will to internationalize the currency to counterbalance the privileges of the United States linked to its

dominant currency. In the first years following its creation, a catching-up process favorable to the euro was indeed at work at the level of official

foreign exchange reserves. This process continued very progressively

until 2010. Since the trigger of the European Sovereign Debt Crisis, and even before, this catching-up process has been interrupted. The context of

the crisis has given a status of safe haven to the U.S. dollar. The market for U.S. Treasuries remains one of the most important and liquid markets, therefore providing a considerable advantage to the U.S. dollar. The euro

internationalization is limited by the fragmentation of the bond market. The lack of homogeneity in the market of European government bonds

and the absence of European government bonds represent significant obstacles to the further internationalization of the euro. The doubts on the

stability of the public debt of the periphery, the absence of mechanisms of redistribution inside the Eurozone between the weakest countries and the core countries, the absence of any bank union, and the fragmentation

of political power have definitely represented an obstacle to the further internationalization of the euro. Doubts on the sustainability of the euro project persist in the market.

Privileges and constraints linked to the status of a world reserve currency Historically, the status of international reserve currency has both produced benefits and costs for the United States. We first consider the advantages

linked to this status, which essentially deal with a higher degree of protection against balance-of-payment crises and a form of international seigniorage.

We then detail the constraints, which mainly weigh on the conduct of the monetary policy.

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Strategy to Promote the Renminbi as a World Reserve Currency

The “exorbitant” privileges of the U.S. dollar Following the remarks of Giscard d’Estaing, a former French president, the U.S. dollar is often presented as having “an exorbitant privilege.” The

status of world reserve currency indeed provides many advantages to the beneficiary country:

• The status of international reserve currency naturally protects against balance-of-payment crises, as the beneficiary country purchases imports

in its own currency. The United States has indeed never been penalized by

the accumulation of structural and large trade account deficits. Countries not benefitting from this status and exposed to large external deficits can

see their currency suddenly depreciate, which increases further the price

of imports (therefore reinforcing the accumulation of external imbalance) as well as the weight of external debt. A default on the external debt, periods of recession and austerity, and disorderly movements of prices

and interest rates represent the most frequent outcome of such a situation, as was typically observed in Southeast Asia at the end of the 1990s. The capacity to issue debt in the currency, in which most of the trade is denominated, markedly increases the degree of protection of the country benefitting from the international reserve currency status against

potential balance of payment crises. At a microeconomic level, it reduces hedging costs linked to potentially adverse fluctuations of exchange rates for importers and exporters.

• The benefits of an international reserve currency also relate to so-called international seigniorage revenues. Seigniorage basically represents the difference between the cost of production of a currency (its printing

cost) and its face value, the amounts of goods it is allowed to acquire. Seigniorage is in fact a tax on inflation, the owner of the note or coin

not asking the issuer of the currency for a compensation offsetting its

depreciated purchasing power during a period of positive growth of prices. These seigniorage revenues are obviously related to the capacity

to create money and the capacity of the government to be funded by the injection of new liquidities. Once a currency has an international

dimension, this seigniorage becomes more important, as the government

has a higher capacity to purchase international goods, and faces lower

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

funding costs for its debt amid strong demand for the national currency. In

the case of the U.S. dollar, several authors have mentioned the exorbitant

privileges of the dollar and lower funding costs for the federal and local governments as well as for the economy as a whole. The structurally strong demand for U.S. dollar–denominated assets allowed a cheap

financing of the private and public sectors despite the accumulation of public and trade deficits.

• The dominant position of the U.S. dollar gave a leadership status to U.S.

monetary policy, with the countries using “satellite” currencies implicitly

fixing their monetary policy in response to the Fed’s decisions. John Connally, the Treasury Secretary of President Nixon, famously said that

“the dollar is our currency, but your problem” to a group of European officials. This leadership position provides a considerable advantage in

leading negotiations between central banks when coordinated actions are required at a global level.

• After World War II, as the heart of the Gold Exchange Standard, the U.S.

dollar acquired a dimension of a global public good necessary for the

reconstruction and stability of the world. In such a context, the United States has markedly extended its political influence in impacting the shape and functioning of international organizations. Regarding this

criterion, the benefits of a world reserve currency are not only limited to the United States but are broad based, providing stability to the

international monetary system and contributing to the reinforcement of global trade.

• The status of reserve currency provides a significant advantage to

domestic banks as foreign investors are interested in accessing U.S. dollar liquidities and U.S. assets. The access to U.S. depositors and to

refinancing operations of the Fed gives a comparative advantage to U.S. banks in terms of liquidity. In such a context, it becomes easier for these institutions to sell their products or finance international projects.

• The U.S. dollar provides a natural protection against large fluctuations

in commodity prices. International importers face a twofold risk, both at the level of oil prices and at the level of U.S. dollar fluctuations as most of the commodity prices are denominated in the U.S. dollar. U.S. importers therefore face a lower level of risk, reducing the cost of their

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Strategy to Promote the Renminbi as a World Reserve Currency

protection against adverse fluctuations of commodity prices. Moreover, oil producers (or producers of other commodities) generally modify their

prices when the U.S. dollar fluctuates to stabilize their margins. There

is therefore a stabilizing factor in the strategy of commodity exporters regarding the fluctuation of the U.S. dollar.

A weaker exchange rate channel caused by hegemony The monetary policy has generally four channels of transmission for

stabilizing growth and inflation: the interest rate channel (to modify the level of official rates in order to modify the position of the yield curve), the credit channel (to modify the level of banks’ required reserves or refinancing costs), the exchange rate channel (direct or indirect interventions on the foreign

exchange market), and the wealth channel (to target wealth effects linked to stock performances). The status of world reserve currency has significantly weakened the exchange rate channel of U.S. economic policy in a fourfold manner as follows:

Postwar U.S. dollar stability progressively reduced U.S. competitiveness The status of world reserve currency led to a structural over-appreciation of the U.S. dollar and hampered the country’s competitiveness. The period of

dollar shortage lasted until 1958 and was characterized by the accumulation

of huge trade surpluses in the United States and large deficits in Europe.

Outside the United States, all economic actors were highly interested in

holding dollar assets, due to the lack of confidence in currencies of countries which were seen as being highly fragile. Most of the European economies and

Japan had fixed their exchange rate to the U.S. dollar as there was no trust in economies still under reconstruction. This fixity in the parity of exchange rates, despite higher gains of productivity in Europe and in Japan linked

to the reconstruction, led to a rapid deterioration of U.S. competitiveness.

The United States provided the world with dollar liquidities and contributed to the reconstruction, developed aid programs such as the Marshall Plan,

and deliberately led a policy creating deficits. From 1958 onward, the

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

United States built up increasing trade deficits and progressively saw

its reserves in gold diminish. The “interest equalization tax” voted on in 1963 in the United States aimed at reducing the outflow of capital and the diminution of gold reserves. Paradoxically, it contributed to the increase of

the internationalization of the U.S. dollar, as U.S. banks, to bypass the law, set up a large number of branches in foreign countries and facilitated the rapid development of Eurodollars.

U.S. dollar became a source of inflationary instability in the 1970s and 1980s In 1971, the U.S. dollar was no longer convertible with gold, a consequence of a long erosion of U.S. competitiveness. The Nixon shock of 1971 led to a rapid depreciation of the U.S. dollar. This depreciation accentuated the impact

of inflationary shocks. The accumulation of deficits and periods of strong inflation damaged the U.S. dollar’s credibility as a store of value. Foreign

central banks tried to limit the depreciation of the U.S. dollar as it hampered the competitiveness of their countries. In the absence of sterilization of

their intervention, they contributed to the increase of the global amount of liquidities, reinforcing world inflationary pressures. President Carter also

embarked in 1976 on a policy targeting a depreciation of the U.S. dollar, leading to the same reaction from foreign central banks, and creating a new wave of inflationary pressures. Finally, after undergoing the devastating

effects of overly high levels of inflation, all the developed economies implemented a tightening of their monetary policy and reformed the status

of their central bank to gain credibility. The Volcker policy implemented

at the beginning of the 1980s led to a sharp appreciation of the U.S. dollar, which significantly penalized the level of growth. The conclusion on this period is that the status of world reserve currency reduced the efficiency of the exchange rate channel of the U.S. economic policy as foreign central

banks acted to reduce the depreciation of the U.S. dollar. The United States, confronted with the increasing competitiveness of Japan and Germany, could not use this instrument for fostering growth. It contributed to the

maintenance of the U.S. monetary policy in an overly expansionary stance and nurtured global inflationary pressures.

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Strategy to Promote the Renminbi as a World Reserve Currency

World reserve currency status contributed to inflation since 1990 U.S. authorities were regularly accused of neglecting the stability of the

U.S. currency in certain periods: 1977 to 1979, 1985 to 1988, 1993 to 1995, and 2002 to 2008. This instability explains the decline of the U.S. dollar in international foreign exchange reserves from 1977 onward and the rise

during this period of currencies such as the deutsche mark and the yen.

However, these two currencies never reached a real status of world reserve

currency as their export-based model of growth could not afford such a position. Despite the creation of the euro, the U.S. dollar has steadily

represented more than 60% of the total foreign exchange reserves. As an

indicator of strong demand for U.S. dollar–denominated assets, and as an illustration of the U.S. dollar’s over-appreciation during this period, we only need to highlight the path of the United States’ current deficit, which

increased from a neutral position at the beginning of the 1980s to more than

3% of GDP on average from 1990 until today. This over-appreciation of the U.S. dollar, more recently triggered by the reserve accumulation strategy of

emerging countries, has structurally hampered the competitiveness of the

United States and weakened the contribution of external factors to U.S. GDP growth. This situation has repeatedly incited the U.S. monetary policy to

be overly expansionary on the domestic side. Alan Greenspan’s policy was rightfully accused of being overly expansionary, nurturing the high-tech and housing bubbles. Ben Bernanke’s current monetary policy can also be judged as being overly expansionary and it will potentially create new bubbles.

This time, the status of international currency represents a constraint on the monetary policy, which is exaggeratedly expansionary to compensate for the structural weakness of external factors’ contribution to growth. A roundtrip process or repatriation of U.S. dollar liquidities, with foreign-owned

U.S. dollar liquidities flowing back into the United States, has also played

a destabilizing role in nurturing the subprime bubble. In other words, the world reserve currency status contributed to inflating bubbles due to an

overly expansionary monetary policy or due to destabilizing financial flows.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

U.S. current account balance (% of GDP) 2

2

0

0

﹣2

﹣2

﹣4

﹣4

﹣6

60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11

﹣6

Sources: Thomson Reuters Datastream; Haitong International.

Moral hazard risk linked to the stabilization of public debt The “benign neglect” policy of the United States was observable not only at

the level of the monetary policy but also at the level of the fiscal policy. The U.S. government, facing a constant and structural demand from international

investors for U.S. Treasury securities, has accumulated a level of public debt which is not sustainable anymore. Moreover, the increasing share of foreign

investors in the structure of this debt ownership have markedly increased the external pressure on the United States and constrained this country to envisage drastic waves of fiscal consolidation in the coming years. Moral hazard comportment of governments benefiting from the advantages of an international currency status represents a major risk.

What kind of lessons can be learned from the U.S. dollar’s rise to

become a world reserve currency? Besides the traditional argument of

a growing economic power, we identify the fact that at each stage of its internationalization, the U.S. dollar’s history reflected a neglect of the exchange rate channel of the economic policy:

1. During the 1920s, enormous gains of productivity, a political class

favorable to the development of financial activities, and the growing

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Strategy to Promote the Renminbi as a World Reserve Currency

dependency of Europe on the United States made price competitiveness a lower concern and therefore facilitated the internationalization of the U.S. dollar.

2. The British pound and U.S. dollar coexisted until the end of World War

II as dominant international currencies. After World War II, the U.S. dollar was the only currency convertible with gold. During that time,

and in parallel with the organization of the Marshall Plan, the U.S. dollar acquired a status of global public good necessary for the reconstruction

of a new world organization. The status of public good of the U.S. dollar took the priority on domestic considerations of competitiveness in the aftermath of the war.

3. From this period until today, the status of international currency of the U.S. dollar has been regularly a constraint for the conduct of the monetary

policy as it contributed to increasing the impact of inflationary shocks during the 1970s and 1980s, and inflating bubbles from 1990 until today.

The U.S. dollar experience clearly shows that a status of reserve currency

can weaken the exchange rate channel of the economic policy for several reasons:

• The over-appreciation of the currency limits the potential positive effects of a depreciation that the central bank could target for supporting growth.

• The opening of the capital account gives birth to destabilizing financial

flows. The monetary policy is therefore more constrained for stabilizing their impact.

• Foreign central banks implement strategies for depreciating their

currency relative to the U.S. dollar, which therefore reduces the efficiency of the Fed exchange rate tools.

• The external constraints linked to the status of reserve currency create

incentives for the central bank to lead an overly expansionary policy, potentially creating several bubbles.

• The seigniorage benefits create moral hazard strategies for the fiscal policy.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Strategies to Promote the Renminbi as a World Reserve Currency The previous analysis highlights two main lessons. First, the status of world reserve currency may significantly weaken the exchange rate channel of the

economic policy. Second, the accession to the status of reserve currency is a source of large imbalances. From the first lesson we can recommend a threestep process for renminbi accession to world reserve currency status, which

will be inevitable, progressive, and politically driven. From the second lesson, linked to potential imbalances accompanying the internationalization of the renminbi, we can identify new priorities for the industrial, monetary, fiscal, and social policies.

Three-step strategy to solve the weakening exchange rate channel brought by the world reserve currency status The over-appreciation of the currency represents a significant risk for the

Chinese economy still relying on the dynamism of exports. We see that the existence of a renminbi bloc and the context of a currency war have

already constrained and weakened this economic policy tool. Preserving

the exchange rate channel of the economic policy will allow for reducing the risk of imbalanced accumulation. This channel has to be progressively neutralized for promoting the further internationalization of the renminbi.

Existing constraint: The existence of a regional renminbi bloc The experience of the U.S. dollar showed that the weakness of the exchange rate

channel of the U.S. economic policy allowed for a quick internationalization and rapid accession to the status of world reserve currency. At the same

time, this sacrifice was a real handicap for the United States in terms of competitiveness and created significant imbalance. An excessively high

demand for a currency can lead to a structural over-appreciation of it,

damaging the competitiveness of a country in the long term. The potential of growth can be negatively impacted as a result of this structural lack of price

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Strategy to Promote the Renminbi as a World Reserve Currency

competitiveness. This is particularly important for China, where exports broadly represent 30% of GDP. As a dominant and growingly integrated

world economy, China will inevitably face the possibility of becoming a world reserve currency, requiring the implementation of a careful strategy to promote the renminbi.

The experiences of the U.S. dollar, Japanese yen, and German deutsche

mark show that any dominant economy faces, sooner or later, a process of

internationalization of its currency and has to develop a strategy regarding the status of reserve currency. The process of the internationalization of

the renminbi is probably much more advanced than generally thought. For now, no real official peg exists to take the renminbi as a basis of a fixed

parity. However, several studies have already identified a renminbi bloc. According to Arvind Subramanian and Martin Kessler (“The Renminbi Bloc is Here: Asia Down, Rest of the World to Go?” [Peterson Institute for

International Economics Working Paper 12-19, October 2012]), the renminbi has increasingly become a reference currency for East Asia, where 7 out of

10 economies have seen the comovement of their currency with the renminbi to increase and even surpass their comovement with the U.S. dollar (40% higher) or the euro. In my view, currencies of South Korea, Indonesia,

Malaysia, the Philippines, Taiwan, Singapore, and Thailand more closely

track the renminbi than the U.S. dollar. This means that their central banks

unofficially intervene on the foreign exchange market for avoiding a too sharp variation of the parity between their currency and the renminbi, in order to not suffer from unfavorable movements, which would damage their

competitiveness with a major trade partner. These higher comovements of their currency with the renminbi can also reflect the natural effects of

higher economic integration due to the intensification of trade exchanges

with China. This hidden form of currency peg or manipulation represents a risk for China. It hampers the efficiency of the exchange rate channel of the Chinese economic policy. The current currency war represents another major obstacle to the efficiency of this economic tool. The continuing reliance

of the Chinese economy on exports, the existence of a renminbi bloc, and the context of a currency war indicate that the preservation of the exchange rate channel of the Chinese economic policy is an urgent matter.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Progressive accession to world reserve currency status needed China’s economy presents several features, which, in contrast to the U.S. case, show that the accession to the status of reserve currency will be progressive: • The U.S. dollar has still a dominant role and this domination has been

reinforced after the weakening of the euro following the European

Sovereign Debt Crisis. The recent succession of major crises has reaffirmed the role of U.S. dollar–denominated assets as a global safe haven.

• The U.S. economy remains the biggest and most innovative economy.

• The Chinese economy still heavily relies on the performance of its exports.

It cannot afford an overly quick internationalization or appreciation of its currency.

• The exchange rate channel of the People’s Bank of China remains a central element of its policy in managing growth and inflation.

• A quick accession to the status of world reserve currency for the renminbi

would mean a wave of distrust in the U.S. dollar, an event against which major central banks would intervene. In particular, the People’s Bank of China and the Bank of Japan have no interest in seeing the value of their reserves, largely invested in U.S. dollar assets, abruptly lose their value.

The three stages of reform We present here an agenda to optimally promote the renminbi’s accession to

the status of world reserve currency and optimally manage the progressive

weakening of China’s exchange rate channel of economic policy in the short term, medium term, and long term.

Short term: Cautiously preserve the exchange rate channel and progressively open the capital account In the short term, the exchange rate channel of the Chinese economic policy

has to be preserved with a cautious and progressive opening of the capital account.

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Strategy to Promote the Renminbi as a World Reserve Currency

The internationalization of the renminbi already constrains China’s

monetary policy. The People’s Bank of China recently organized reverse repos of significant size. The injection of liquidity into the money market has

a primary goal of easing monetary conditions to support credit and growth. Besides that, we can observe that these large injections of liquidity were not

followed by significant downward movements of the repo rate. The absence of significant movements in the repo rates means that the liquidities injected

by the People’s Bank of China have probably been offset by liquidities flowing out of the system. The recent outflow of capital from China could

be associated with this outflow of liquidity. Generally, when the People’s Bank of China wants to control the path of the renminbi for slowing its

appreciation or reaching depreciation, it builds up foreign exchange reserves in purchasing foreign securities. This purchase means an injection of liquidity into the banking system. So this accumulation of reserves is generally

accompanied with repo operations, which allow for the mopping up of the

injected liquidity and controlling thereafter of the inflation risk. Recently, probably the inverse phenomenon happened. To avoid an overly sharp depreciation of the renminbi, linked to the outflow of capital, the People’s

Bank of China had to sell foreign securities and therefore reduce the liquidity in the banking system. For compensating these liquidities drying up, the

People’s Bank of China had to reorganize reverse repos, not increasing the

liquidity but maintaining the level of liquidity, as reflected in the stability of the repo rate. We have here a clear illustration of a phenomenon linked to a

growingly free circulation of capital and to the emergence of new obstacles in the transmission of the exchange rate policy. In such a context, to prematurely open the capital account would represent another constraint as a potential

over-appreciation of the renminbi could reduce the overall competitiveness of Chinese exports. In the current context of currency war, the opening of the

capital account represents another source of risk and another potential for

over-appreciation. A certain control of capital flows and interventions on the

foreign exchange market are still required to avoid an overly high drag on Chinese exports.

This promotion of open market operations, equivalent to the

harmonization of the money market with global models, undoubtedly

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

represents another step favorable to the internationalization of the currency for three reasons:

• The increasingly market-based functioning of the money market and the

reduction of money market volatility will reassure international investors on their capacity to quickly and efficiently manage renminbi liquidities.

• The extensive use of open market operations represents a higher degree of independency for the People’s Bank of China as these decisions do not

require the approval of the administration. However, the administration will keep control over the most important tools. This is not a disadvantage, as we have seen that the outright purchase of Treasury securities by Western banks in extreme cases probably led to a diminution of their independence.

• In the very long term, the adoption of an inflation target could represent

another way to harmonize the monetary policy with the rest of the world.

The perspective of stable inflation means a lower probability of currency depreciation and therefore reinforces the potential of this currency for becoming a world reserve currency.

The structures promoting the renminbi as a world reserve currency

can be developed. We define structures of renminbi internationalization as all the initiatives consisting of developing renminbi offshore centers, promoting the international presence of Chinese banks, and organizing new

swap arrangements with other central banks. In particular, in a context of weakening of Western banks, Chinese banks have to take this opportunity

to rapidly expand their role in intermediation and investment banking. The development of these infrastructures contributes to the internationalization of the renminbi without endangering the stability of the economy with an

overly quick opening of the capital account. The recent reforms adopted by the People’s Bank of China represent an important contribution to the

reinforcement of these structures. As a significant step aiming to harmonize its method of functioning with other major central banks, the People’s Bank of China has recently announced a reform of the ways it intervenes in the

monetary market, setting up a more market-oriented interest rate system. The People’s Bank of China will use short-term operations for injecting or

withdrawing liquidity twice a week into the monetary market via 12 major lenders. The People’s Bank of China still has control over lending rates and

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Strategy to Promote the Renminbi as a World Reserve Currency

controls the quantity of money in circulation via the reserve requirement ratio. From now on, and as evidenced by its recent interventions, it will more extensively and frequently use open market operations to guide the

monetary policy. These operations could have a bigger and quicker impact than the traditional tools of the reserve requirement ratio and lending rates.

The promotion of open market operations also targets a lower volatility of money-market rates. The People’s Bank of China will announce the details

of these biweekly open-market operations later and things will converge progressively toward reference market-based Libor rates.

Medium term: Neutralize the exchange rate channel In the medium term, the exchange rate channel has to be neutralized via the

regional diffusion of the renminbi as an invoice and settlement currency, as well as the promotion of service activities, nontradable goods, and high-tech and high-quality products.

The main function of an international currency consists of invoicing the

merchandise and currency trades (billing of exports and imports, foreign

exchange market, and central bank swaps). Given the growing weight of

China in international trade, and its status as the world’s second biggest

economy, there is a natural process to make the renminbi an international currency. However, we have to underline that only 8% to 9% of China’s trade is currently settled in the renminbi, while 6% of China’s exports are currently invoiced in the renminbi, and 13% of its imports. The trade of

goods between industrialized economies is predominantly invoiced in the

exporter’s currency, mainly due to the bargaining power of the exporter. There is therefore still a large potential for the renminbi as a world reserve

currency, given the weight of China’s economy in the world and this low

share of renminbi denomination in Chinese trade. In this domain, the main advantages of an international currency relate to higher bargaining powers

for national producers and lower hedging costs attached to imported or exported goods.

However, one should be cautious in estimating this potential of

internationalization linked to trade and the rapidity of this process. The invoicing of merchandise trade is generally marked by a high degree of

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

inertia, where dominant currencies remain dominant as long as no major

events disrupt their hegemony. Conventions prevail; oil and other organized commodity markets function with the U.S. dollar, and transactional networks

evolve slowly because there is a cost to leave them as long as they remain important. One good example of this network effect is the experience of the direct yuan/yen convertibility. Direct daily turnover between the yuan and

the yen is close to CNY5 billion (USD63 million), compared with a daily turnover of the U.S. dollar and yen of USD145.4 billion. One of the reason is that yuan/yen trading is still more expensive than the two-step trading

consisting of the yuan/dollar and dollar/yen combinations. The cumulated

bid-ask spreads of this combination are lower than the bid-ask spreads of the yuan/yen trading. To progress in terms of invoicing, Chinese authorities will have to incite exporters to denominate their products in the renminbi,

especially in new products or new markets where China can aim to be a

leader, develop swap arrangements with other central banks to foster trading in the renminbi, reduce the exchange risks linked to the differences between

the domestic and offshore markets of the renminbi, and develop the supply of hedging products linked to the renminbi.

The existence of the renminbi bloc with the low diffusion of the

renminbi as an invoice currency represents a major risk as diminishing price competitiveness means a relocation of activities in countries actively stabilizing their currency against the renminbi and benefiting from unfair

price competitiveness. Promoting the usage of the renminbi with neighbor

countries would represent the best way to neutralize this unfair competition. To envisage a currency union with neighbor countries would represent a

more ambitious solution. The regionalization of the renminbi is a necessity

for reducing the negative effects linked to the existence of a currency bloc, which represents the manipulation of exchange rates from trade partners.

Another way for avoiding the negative effects of exchange rate manipulations consists of reducing the sensitiveness to the price competiveness of the

economy in developing the weight of service activities, nontradable goods,

and high-tech and high-quality goods. They are less price sensitive and more resistant to adverse exchange rate fluctuations.

Promoting the diffusion of the renminbi regionally can represent a safe

way toward the status of reserve currency. The fact that the bulk of countries

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Strategy to Promote the Renminbi as a World Reserve Currency

in Southeast Asia actively stabilize their exchange rate comparatively to the

renminbi means that they build up large amounts of renminbi. A reserve currency is held primarily by governments or official bodies as a foreign

exchange reserve, i.e., assets or deposits denominated in foreign currencies. The reserve currency has therefore to preserve the value of assets owned

by official investors. By extension, international reserve currencies also

refer to the most popular currencies in which international investors, both private and public, hold their assets. The U.S. dollar represents more than

60% of global official reserves, and the euro close to 24%. The two major

currencies represent therefore around 85% of the world amount of official

reserves. Such domination is of course related to the size of their economy and their weight in international trade, but it is also to the depth, maturity,

and liquidity of their financial markets. The broad acceptance of a currency as a store-of-value asset reduces the probability of speculative attacks by international investors. It also implies responsibilities at the level of public

debt management, as evidenced by the pressures exerted by countries such as China on the United States for reining in their public accounts. A high

global demand for the renminbi as a reserve instrument could lead to its

overvaluation as in the case of the U.S. dollar, which would damage the competitiveness of China.

Long term: Create a framework to counteract destabilizing financial flows In the long term, the full abandonment of foreign exchange interventions will be synonymous with a free circulation of capital, requiring the preparation

of a framework dedicated to the smoothing of negative effects linked to destabilizing financial flows.

When a currency has reached the status of world reserve currency,

it means that the capital account is perfectly convertible and the national currency evolves in a free float. This is related to the “impossible trinity”

theory of Robert A. Mundell and Marcus J. Fleming: the impossibility of

having at the same time the fixity of the exchange rate, the independence of the monetary policy, and the free circulation of capital. The world reserve

currency status of the renminbi would possibly mean a certain loss of

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

control by the People’s Bank of China either on its exchange rate policy or

regarding the conduct of domestic monetary policy. Once its currency is

internationalized, a country can be exposed to higher volatility in exchange

rates. The associated free circulation of capital can expose a country to large waves of distrust or gains of confidence, leading to sharp depreciation of the currency or large appreciation of it. In the first case, the country could be exposed to increasing inflationary products via the increasing prices of

imported goods. A sharp depreciation of the currency would also increase the difficulties of the government or the corporate sector in repaying their debt denominated in foreign currencies. In the second case, the appreciation

of the currency could penalize the export performances of the country and its growth performances, a problem well known by the Bank of Japan, which has to intervene regularly on the foreign exchange market to counterbalance

the appreciation of the yen linked to its safe haven status. In all the cases, we

can see that the exchange rate channel of the monetary policy is constrained by international pressures. The People’s Bank of China would also have to intervene at a global level in coordination with other central banks for

avoiding shortages of renminbi liquidity. Swap arrangements already exist

with numerous countries in Southeast Asia, and also with Argentina, New Zealand, Australia, the United Arab Emirates, Pakistan, and Turkey.

An insufficient supply of financial products, the lack of depth in the

financial markets, and the restrictions on the circulation of capital represent obstacles to the accession of the renminbi to the status of world reserve

currency. The lack of supply of Chinese government bonds and the lack of securitization activities in this country probably represents the main obstacles. The issuance of foreign debt with the national currency in the

domestic economy could also represent a higher level of risk in the sense that any significant default could endanger the stability of the financial system as a whole. More generally, the internationalization of a currency is accompanied by an internationalization of the banking system, which

becomes more integrated with the global financial system. This higher integration exposes a country to a larger extent to systemic and global shocks

in the financial industry. The three major currency areas have all faced a major financial crisis following the strong development of the financial market and its internationalization. China will probably have to reinforce the regulation of its markets to avoid such a pitfall.

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Strategy to Promote the Renminbi as a World Reserve Currency

Financial depth, end of 2010 (% of regional GDP) 500 450 400 350 300 250 200 150 100

CEE and CIS

Latin America

Other Asia

Middle East and Africa

India

China

Other developped

Western Europe

Japan

0

U.S.

50

Nonsecuritized loans outstanding

Securitized loans outstanding

Nonfinancial corporate bonds outstanding

Financial institutions bonds outstanding

Public debt outstanding

Stock market capitalization

Source: McKinsey Global Institute.

Structural preparations against imbalances brought by the world reserve currency status Following the experience of the U.S. dollar in its accession to the status of

world reserve currency, there could be four categories of imbalances, each of which would require advance economic policies.

Industrial policy: Reduce sensitivity to price competitiveness Industrial policy has to combat the loss of competitiveness associated with

the over-appreciation of the currency once the status of reserve currency

is reached in order to avoid the accumulation of trade deficits in the case

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

of the U.S. dollar. The status of a reserve currency is more adapted to an economy where consumption or service activities have a dominant position, as the over-appreciation of the currency is favorable to the domestic demand via lower import prices. Besides, service activities are more isolated from

international competition. An over-appreciation of the currency will therefore have less damaging effects in an economy where service activities represent

a large share of GDP. The accession to the status of international currency for

the renminbi has therefore to be put in parallel with the structural reforms

of China’s economy targeted by the new administration. The targeted promotion of consumption and service activities are consistent with the progressive accession of the renminbi to a status of world reserve currency.

China’s government also has to promote the technological content

of Chinese products via the support of R&D activities, encourage the

development of services and nontradable goods, and increase the average quality of products. These orientations are in line with the objectives

of the new administration and will reduce China’s dependence on price competitiveness. It should therefore lower the impact of renminbi appreciation in its process of internationalization.

Fiscal policy: Avoid the accumulation of public debt Fiscal policy has to be vigilant and must not misuse the seigniorage benefits linked to the status of foreign reserve currency in accumulating public debt

as the status of world reserve currency fosters moral hazard strategies. The structural demand for U.S. dollar–denominated assets has encouraged the U.S. government to increase the level of public debt due to particularly favorable funding conditions. The global supply of Chinese bonds has to be promoted, but it also has to be carefully monitored as the inflow of hot money could be destabilizing. In this regard, the reining in of local government debt,

its access to the bond market, and monitoring as targeted by the current U.S. administration seems to be a necessity.

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Strategy to Promote the Renminbi as a World Reserve Currency

Monetary policy: Prevent the formation of bubbles Monetary policy has to monitor and prevent the formation of bubbles

inherent with the weakening of the external performances of the economy. Institutional reforms are necessary over the long term for keeping control

of financial activities, especially capital repatriation movements, which can be destabilizing for the whole economy. We have seen that the weakening of the exchange rate channel could incite the central bank to implement an

overly expansionary monetary policy. To avoid such a pitfall, the status of the People’s Bank of China probably has to be reformed to feature both a higher degree of transparency as well as a greater consideration to market mechanisms in the determination of interest rates. The supervision of financial markets has to be reinforced.

Social policy: Organize the sharing of gains Social policy must be prepared to face increasing inequalities linked to the

opening of the capital account via organizing the sharing of gains. The fight against the increase of inequalities becomes more difficult as the opening

of the capital account and the attraction of foreign capital imply a low level of tax and therefore a low capacity of redistribution. The free circulation of

capital will be favorable to a minority, and at the same time generate new fiscal revenue. The reduction of inequalities represents a clear priority for the current government of China.

Eventual World Reserve Currency Status for the Renminbi The lessons learned from the experiences of the U.S. dollar as a world reserve currency, as well as the three stages of reform outlined earlier, are

the milestones on the road to world reserve currency status for the Chinese renminbi. Advance economic policies could lessen the structural imbalances which may occur during the rise of the renminbi to world reserve currency status.

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Diffusing the Ticking Time Bomb: China’s Pension System

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Most of the world’s major economies are currently facing significant

challenges related to the aging of their populations. They are engaged in

reforms of their pension systems with a goal of not overloading the active population with supplementary taxes or social transfers or putting at risk

the public finances of the aging population. China does not differ in that point but presents a set of specific characteristics which are fundamental to understanding the pension issues in the country. China has a younger

population than member countries of the Organization for Economic Development and Cooperation (OECD), but converges rapidly toward those countries in terms of aging due to demographic factors linked to the One-

Child Policy. It means the transition of the pension system, a process that has been moving along since 1990, has to take place more rapidly. This task

is particularly vital and daunting as China has the largest population in

the world and half of its population lives in rural areas, implying further challenges in terms of coverage, poverty, inequality, and family policy. These characteristics have determined and will contribute to transforming the organizational framework of China’s pension system.

This framework is organized on the basis of three pillars: a safety net

structure, mandatory programs, and voluntary schemes. This organization looks classical on an international basis, but it entails different types of

challenges or inefficiencies related to the collection, distribution, and management of resources. The collection of resources suffers from an

increasing dependency rate, meaning fewer active people available for

funding the pensions of the elderly. This collection channel also suffers from irregular contributions; due to a large quantity of migrant labor and high levels of minimum contributions, the poorest of the population frequently

cannot afford to make contributions. In terms of the distribution of resources, it is necessary to continue expanding the coverage of the pension system, especially in rural areas. Moreover, the system not only does not reduce

inequalities, but even exacerbates inequalities between the public and private sectors. Finally, the management of the resources of the Chinese pension system could be improved in terms of transparency and profitability.

The best way to improve the system is to draw from the experiences of

successful and unsuccessful models at the international level, and take into

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account the current degree of China’s development. The American and Greek

models offer pictures of two starkly contrasting systems, both suffering from a less-than-ideal balance of flexibility and public-to-private ownership and

management. In contrast, the Swedish pension system, one of the world’s most successful models, provides an example of an optimal mix between private initiatives and public protection, with enough flexibility to reward

active investment but not at the cost of stability. Lastly, the Chilean model offers an example of a successful transition from an inefficient defined-benefit

system that was government supported, to an efficient defined-contribution model that is one of the most privatized pension systems in the world.

Taking into consideration these different experiences and the specificities

of China, we can draw several conclusions and recommendations:

• A balance has to be found between public and private systems to reduce government burden while maintaining the social safety net. The gradual privatization of pension funds should be encouraged.

• The flexibility of the system should allow for more freedom of investment but not at the cost of stability, underlining the necessity to

accompany privatization with savings protection, and conservativeness of investment.

• Standards of management, regulation, and transparency for the pension

fund industry and the financial markets as a whole could be improved to bolster stability and confidence in the system.

• The National Social Security Fund (NSSF) should play a larger role of

fund manager and advisor for local government pension funds. Its size

and mandates should be increased to weather the shocks of demographic changes, keeping stability and prudence as the main philosophies behind its investment policy.

• The macro-social factors of aging suggest that a reform of the pension

system could be completed with fiscal measures, which could help reduce the level of precautionary savings, which is running too high,

and to compensate for the weakening of family solidarity linked to urbanization.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

China’s Pension System Structure of China’s pension system Pillar 0: Safety-net program (dibao) The national safety net program is funded solely by the government’s budget, aiming to provide both urban and rural residents with a safety net

to cover basic living costs. The size of this program, comparable to a fiscal

transfer from the government, had reached CNY96.97 billion, or 2.4% of

GDP by 2010. This program is managed in the form of “pay as you go,” which means that benefit payments due are covered by the current year’s government budget.

Pillar 1: Basic pension = social pooling (Pillar 1a) + individual account (Pillar 1b) The basic pension is a mandatory scheme which is contributed by both the

public and private sectors. Both the local and central governments build up funds corresponding to a form of social pooling nurtured by fiscal revenues,

while employees and employers spare a constant proportion of wages for individual accounts. The contribution to social pooling from the central government is funded only via fiscal transfer, while local governments have

more sources of funds such as state-owned enterprises’ initial public offering (IPO) processes, landing processes, and even voluntary contributions by

nongovernmental organizations. The amount of contributions from local governments, and the origin of funds depend on economic capacities and structures at local levels.

Pillar 2: Enterprise annuity The enterprise annuity is a voluntary defined-contribution scheme set up by

employers as a supplementary benefit. Both employees and employers pay a

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negotiated proportion of wages, which goes directly to individual accounts of enterprise annuity. There is an upper limit on the employer’s contribution at no more than 8.33% of total wage expenditure last year, and no more than

16.7% for both sides’ contribution. Employees will benefit from the pension after retirement. As of 2010, 37,000 companies and 13.35 million employees

were involved in Pillar 2 schemes. The private sector runs the whole fund

in mandating several fund managers. Trustees, administrators, investment managers, and custodians cooperate to take responsibility for their own parts of the fund management scheme.

National buffer: The National Social Security Fund The NSSF was founded by the government in 2000 in preparation for dealing

with the peak of retirees to be reached in 2050, and to act as a buffer against strongly accelerating payment obligations for the pension system as a whole.

The fund is fully sponsored by central government fiscal revenues, and is directly controlled by the National Council for the Social Security Fund

(NCSSF). So far, this fund has not been used for pension payments. The NSSF depends on several major funding sources: (1) central government fiscal revenue; (2) IPO process or overseas listing of state-owned enterprises;

(3) other means such as license fee of state lottery and revenues generated by the investment return linked to security repo operations.

The NSSF, as a public reserve pension fund, requires that it be relatively

safer than Pillar 2, while producing higher return rates than Pillar 1. Hence,

the NCSSF has set short-, medium-, and long-term targets. In the short term,

the maximum yearly loss that has been authorized is 10%. In the medium and long term (from five years on), the return has to be above 3.5% per year on average and higher than the inflation rate.

113

114

Citizens living below minimum living standard

Safety net program Pillar 0

Employees

Pension system participants

Enterprise annuity Pillar 2

Employers

Managed by private sector

Individual accounts Pillar 1b

Individials

Private contribution

Managed by local governments

Safety pooling Pillar 1a

Local goverment

Sources Chinese government; Haitong International.

Managed by NCSSF

National Social Security Fund (NSSF)

Central goverment

Public contribution

China: Pension system structure

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

115

—

856.7

280.9

1,959.6

—

44.5

52.5

CNY billion

Size

2.12

0.70

4.86

—

0.11

0.13

% of GDP

—

13.35

Urban: 257 Rural: 73

52.10

23.10

Coverage (million people)

Sources Chinese government; various media; Haitong International.

—

Yes

Pillar 1b: individual accounts

National buffer: NSSF

Yes

Pillar 1a: social pooling

No

—

Rural

—

—

Urban

Pillar 2: enterprise annuity

Pillar 1: basic pension

Pillar 0: safety net

Mandatory

China: Pension system, by 2010

Central government

Enterprises

Pension participants

Central and local governments

Central and local governments

Funding and contribution

NCSSF

Private fund managers

Local governments

—

Management

Diffusing the Ticking Time Bomb: China’s Pension System

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Challenges facing China’s pension system The three-pillar pension system has been built for only 20 years, but many problems have emerged, threatening its sustainability. We discuss these

issues from the contribution dimension, coverage and benefit dimension, and management dimension.

Challenges from the contribution dimension Low collection rate Collection rate growth slowed down to 17.1% year-over-year in 2010 from the peak of 25.1% in 2008 despite accelerating participation in the basic

pension system. The collection rate measures the ratio of participants paying

the monthly contribution on time to total participants. It can be observed

that individual accounts have increased yet the monthly contributions are intermittently halted. Deceleration in the collection rate points out

the problems in terms of funding issue. There will be increasing numbers

of pension participants who could benefit from pension payments after retirement without contributing the required amounts, if the growth pace of collection rate keeps declining. The fund sustainability is threatened given that 82.8% of revenue comes from pension contribution collection.

There are two major reasons for the phenomena illustrated above. First,

the very high level mandatory contribution burdens participants. The total rate of 28% paid by employers and employees is close to some of the highest rates around the world. Participants are reluctant to pay such a large amount

of money. Second, complicated administration processes present difficulties

in transferring pension accounts when changing jobs or moving cities. This usually occurs among migrant workers because of their high mobility;

consequently they often have to give up the pension account after changing jobs.

Rising pension demand of an aging population China is now entering the stage of an aging society, and the share of people

above 65 years old to the total population has quickly picked up. This

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Diffusing the Ticking Time Bomb: China’s Pension System

proportion is quickly increasing: currently it is at 8.2%, and it is projected to rise to 30% by 2065, while people between 15 and 64 years of age to the

total population will drop sharply to 56% in the same timeframe. This can be explained by baby boomers hitting the retirement age in the coming decades; the number of retirees is to peak by 2050. Meanwhile, the One-Child Policy implemented in the 1970s constrains the supply of the labor force.

Consequently, aging problems weigh more on the pension system burdens,

with more rapidly increasing beneficiaries and only slowly increasing contributors.

We cite the dependency rate to clearly illustrate how serious the situation

is. The dependency rate is the ratio of the number of retired to on-the-job pension participants. Urban and rural old-age dependency rates surged to 32.5% and 27.9%, respectively, in 2012, from 6.6% and 8.4% in 1982. That

means that in 2012, each retired pension participant was only supported

by 3 or 3.6 on-the-job participants for urban and rural pension systems, respectively, rather than by 15 and 11.9 in 1982. Baby boomer participants will

become beneficiaries of pension payments, but the number of contributors is not big enough to provide sufficient funds, adding pressure on the balance of pension funds. We expect that the dependency rate will further increase

and may reach an unaffordable level sooner or later, unless there are some concrete measures to reform the demographic structure.

China: Urban pension system participants (million) 30 25 20 15 10

On-the-job

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0

1989

5

Retired

Sources: Ministry of Human Resources and Social Security of the People’s Republic of China; Haitong International.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Challenges from the coverage and benefit dimension Less-diversified source of supports Primary income sources need to be diversified in both urban and rural areas, according to statistics by China’s National Bureau of Statistics in

2005. The situation could be more serious as pension payments do not float with inflation; it is possible that provided benefits will decrease over time. Consequently, the elderly would have to rely more on family support or labor income, which is less viable given the changing family structure.

For the urban elderly people, basic pension (Pillar 1) is the bulk of their

income source, accounting for 45.4% of total income, while the other two pillars, the safety net and pension insurance, together only take a proportion

of 2.7%. In particular, pension insurance is still in the very nascent stage, contributing 0.3% to total revenue. Family support provides 37% of income. The One-Child Policy creates a family structure of “4–2–1” by generation, which heavily burdens the young generation.

Regarding the rural situation, the elderly mostly rely on family support

and labor income. Family support provides 54.1% of total income. This is definitely related to the traditional culture in China, but it is also related

to the closer relationship with elder relatives for those in rural areas. Labor income accounts for a very high level of their support at 37.9%, since many continue farming without a retirement requirement, and the absence of a

well-established pension system does not provide a viable alternative. Pension pillars in rural areas contribute a notably low level of just 6% of revenue.

Dual pension system burdening the fiscal budget and intensifying discontent The dual pension system raises the different contribution and benefit

schemes between government workers and private-enterprise employees.

Civil servants’ pension contributions are solely sponsored by the government budgets without any individual contribution, while the other pension

participants need to contribute 20% of total wages throughout their working

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Diffusing the Ticking Time Bomb: China’s Pension System

Primary source of support for China’s elderly, 2005 (%) Urban Source of support

Rural

Average

M

F

Average

M

F

2.4

1.8

2.9

1.3

1.8

0.9

45.4

56.9

34.6

4.6

8.1

1.3

0.3

0.3

0.2

0.1

0.2

0.1

Family support

37.0

20.7

52.3

54.1

39.3

68.5

Labor income

13.0

18.4

7.9

37.9

48.5

27.5

Property income

0.5

0.5

0.5

0.2

0.2

0.1

Others

1.5

1.4

1.6

1.8

2.0

1.7

Safety net program (Pillar 0) Basic pension (Pillar 1) Pension insurance and subsidy (Pillar 2)

Sources: National Bureau of Statistics of China.

lives. In terms of replacement rate, or the proportion of pensions to wages

before retirement, there is also a huge gap between former government workers and private sector employees. The average replacement rate of 80% for civil servants compared to the average of 40% among private enterprise employees causes inequality.

The differences result in two problems. First, government obligations of

pension payments to civil servants are growing towards unsustainable levels.

Government fiscal transfers to retired civil servants amounted to CNY21.8 billion in 2010, 5.4% of GDP. Second, the uneven pension benefits have raised increasingly widespread discontent in recent years. Reforms aiming at the civil servants have been introduced in five pilot provinces since 2008, but the progress is very slow.

Challenges from the management dimension Necessity for centralized management Basic pension funds managed at the local government level result in

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

significant fragmentation among provinces. The mobility of the labor force

leads employees to contribute towards pension funds in one province when working, but receive benefits in another province when retired. Provinces

with huge labor inflow usually have surpluses in the current balance of their pension systems, while provinces lacking contribution from on-the-

job participants often face deficits. For example, Guangdong recorded a

net pension fund inflow of CNY40.6 billion in 2010, in part from pension contributions by huge on-the-job participants and relatively fewer retired

participants. In contrast, Liaoning, as one of the original industry bases, registered a CNY3.5 billion negative current balance in 2010, mainly due to a large proportion of retirees to total pension participants.

Moreover, in most cases, local governments are short of sufficient resources

in social pooling in the face of increasing pension payment obligations. Although Pillar 1a and Pillar 1b are legally designed to be segregated from

each other, local governments prefer to divert funds from Pillar 1b that are contributed by individuals to Pillar 1a, which the government is supposed

to be responsible to build up, rather than fill the gap in social pooling. This has resulted in empty individual accounts. As of 2010, individual accounts were supposed to have assets of close to CNY1.96 trillion, but what they

actually had was only around CNY0.2 trillion, leaving a nearly CNY1.76 trillion deficit to be paid back by governments.

The Chinese government is planning to centralize pension funds that

are now being managed by local governments, yet a concrete decision has not been made. The advantage of centralization is obvious, as local pension fund deficits could be immediately eliminated through asset redistribution.

However, local governments with pension surpluses are reluctant to hand

over local pension control, as they are afraid that central governing may drag efficiency of fund managing.

Low investment returns For Pillar 1, there is almost no investment activity for managing pension funds. In terms of revenue breakdown, only 2.04% of Pillar 1 revenue comes from interest revenue, in contrast, 82.8% revenue relies on pension collection.

Fiscal transfer accounts for 14.56% of total revenue. It is very dangerous, as

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Diffusing the Ticking Time Bomb: China’s Pension System

the pension payment is now running like a pay-as-you-go model instead of a self-sustaining fund. The whole system may collapse if pension collections no longer cover pension payments, which is likely to happen in the future.

Currently, Pillar 2 allocated 51%, 38%, and 11% to fixed-income, short-

term, and equity assets, respectively. With a relatively diversified asset allocation, their performances have been disappointing. The weighted

average return rate was 3.41%, lower than the inflation rate of 5.4% in 2010. The

weak investment performance could be explained by the lack of competition in the fund industry. Only 11 eligible fund management companies run the whole pension fund, and the five largest manage 85% of total assets by value.

Lower-than-inflation return may make pension insurants lose confidence, and result in a shrinking Pillar 2.

Potential high risk in the national buffer The average return of the national buffer (NSSF) was 9.17% from the period

between 2001 and 2010, a higher amount than that of the Pillar 1 and 2. On

the other hand, it can be seen that the national strategic reserve fund has heavily depended on the return of equity investments, which accounts for

about a third of its assets, much higher than the average international level. This structure has high potential risk, and likely leads to the high volatility of the fund. For example, the NSSF gained significantly during the stock market

boom from 2005 to 2007 but then slumped sharply in 2008 after the Global

Financial Crisis and stumbled again in 2010. As a national buffer, stability is

the priority, so it is important to allocate assets more heavily toward modest but stable returns.

Lessons from International Pension Systems Pension systems around the world use a variety of methods, with varying degrees of success, to try and accomplish a common goal of providing a comfortable retirement for citizens. In attempting to reform China’s pension

system, it is vital to obtain an understanding of other pension systems

around the world, both successful and unsuccessful, to emulate the good

traits and avoid the pitfalls that other countries have already experienced.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

China: NSSF return rate (%) 50 40 30 20

10-year average = 9.17%

10 0 -10 2001

2002

2003

2004

2005

Return rate (%)

2006

2007

2008

2009

Inflation rate (%)

Sources: NCSSF, the People’s Republic of China; Haitong International.

China: NSSF asset allocation Others 2% Industrial investment 20% Fixed-income assets 44% Equity assets 34% Sources: NCSSF, the People’s Republic of China; Haitong International.

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Diffusing the Ticking Time Bomb: China’s Pension System

To use a popular saying, “those who cannot learn from history are doomed to repeat it.”

Pension systems vary from country to country, but for the purpose of

comparison, we can classify dimensions of each pension system into various pillars. Pillar 0 can be roughly described as a minimum subsistence pension,

a safety net. Pillar 1a refers to the mandatory public pension system, while Pillar 1b refers to a mandatory private pension system. Pillar 2 would then refer to any voluntary systems. While this system is far from perfect due

to the overlapping nature of many programs, it is nonetheless useful for comparing countries’ systems.

In our analysis, we will start by examining two starkly different pension

systems, the Greek and U.S. systems, both of which have run into some troubles following the Global Financial Crisis. We will then discuss the

Swedish and Chilean systems, which act as role models for a successful system and a successful transition, respectively. Finally, we will discuss some lessons for China that can be gleaned from these international case studies.

Two starkly different approaches: The U.S. and Greece The examples of the U.S. and Greece are useful as they can be used to

represent some of the common pension structures in the world today. Both

systems have some notable flaws that China should be aware of when reforming its pension system.

The U.S. pension system is a hybrid of a public and private system,

and is composed of two core components, Social Security and Individual

Retirement Accounts (IRAs) such as the 401k. According to OECD data, there was roughly USD12 trillion in assets (86% of GDP) in pension funds in 2009, and pension payments replaced roughly 80% of income upon retirement.

The issue of the funding gap concerns both the Social Security pillar and

pension funds as a whole. Social Security is a mandatory public program,

equivalent to China’s Pillar 1a. The program is funded by a mandatory 12.4% Federal Insurance Contributions Act (FICA) tax, and is invested in by the U.S.

Social Security Trust Fund, which invests 100% in securities issued by the U.S. Treasury; these investments earned a 4.4% return in 2011, and are all 100% guaranteed by the federal government. With the aging population, a

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

funding gap has emerged, and the Trust Fund is projected to be depleted by

2033, at which point all social security payments will have to come directly

from the FICA tax. In 2011, there was an estimated USD327 billion funding deficit for the 100 largest pension funds in the United States.

The concerns about too much flexibility and freedom of choice are related

to the IRA/401K system, or Pillar 2. The IRA/401k is a system that invests

individuals’ assets in their own accounts, and pays them out accordingly upon retirement according to the value of the account at that time; just under

half of total pension payments come from the 401k plan for the median earner. These plans have significant flexibility in allowing individuals to invest across stocks, bonds, and mutual funds, and there are no restrictions

on investment and so the systems consequently open up individuals to significant downside risk.

The strength of the U.S. system lies in providing a high standard of living

for retirees through a mixture of public and private funds, in theory limiting the public burden and giving individuals incentives to save towards their

own retirement. Combined with the Medicare and Medicaid system, there is a strong safety net for retirees in the United States.

However, there are some notable flaws. The first is the demographic shift

and aging population, issues that are shared with China, which will cause an

increasing funding gap for the public component of the pension system. As

mentioned, there was an estimated USD327 billion funding deficit for the 100 largest pension funds in 2011. The second is that there is too much flexibility with regard to individual investment in the IRA/401k system; individuals

can choose how much to invest and what to invest in, and this opens up the possibility that many individuals will have an inadequate pension on

retirement due to low investment amounts or poor investment choices. The U.S. system has a nice theoretical balance to provide a high replacement rate,

and the similar population aging trend illustrates the challenges ahead for China.

Greece has been much maligned since the sovereign debt crisis, with the

biggest criticism being directed at the government’s excessive spending. One

needs to look no further than the pension system to find a major cause of the heavy government spending. The pension system is widely perceived as the

world’s worst pension system and the subject of much derision; headlines

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Diffusing the Ticking Time Bomb: China’s Pension System

such as last June’s [2012] report from the Greek Labor Minister outlining how thousands of dead Greeks were still being sent pension payments for

many years after death (costing taxpayers approximately USD20.5 million annually) did not help matters. As a condition of the recent bailouts offered

to Greece, the Greek government has been made to make adjustments to its pension system by increasing the retirement age and cutting benefits.

Greece’s pension system is on the very extreme end of the spectrum. As

a wholly public system, the entirety of the Greek pension system is similar to China’s Pillar 1a with a component acting as Pillar 0. Greece, like many

countries, is experiencing an aging population, and this demographic shift

will cause significant strain on the pension system. The Greek system is an example of a very rigid pension system; individuals have no influence over their asset allocation, as it is all managed by the state, which invests all of the

pension funds in Greek domestic securities. Pension funds invested heavily in Greek sovereign bonds, with EUR21 billion in bonds that took a 50% cut in March [2013].

The Greek pension system is unsustainable, inequitable, and ineffective.

With the burden of the pension system falling on the government, it is fiscally unsustainable. Once the economy entered into a recession, the pension system took the brunt of the impact in three ways. First, investments in Greek stocks and bonds took a huge loss. Second, as employees were laid

off, contributions to the fund from employee paychecks diminished. Third, the loss of jobs likely pushed groups of workers prematurely into retirement,

adding additional strain on the system. The public pension system’s deficit is expected to reach 7.7% of GDP by 2030, and 15.7% of GDP by 2050. The

effective retirement age is too low, the contributions to the system are too low, the pension investments are too domestically concentrated, and the benefits are far too high and uneven.

The system is also inequitable and ineffective, largely due to the

aforementioned demographic shift. Older generations will receive better

benefits, while younger generations will have to increase contributions or receive diminishing benefits. This will continue until the system is reformed

or collapses. Despite the pension system’s high replacement rate of 95.7% and numerous stories of Greek senior citizens living opulent lifestyles, the senior citizen poverty rate is at a shocking 23%.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Successful role model: Swedish pension system Sweden is a Scandinavian country with a mature and wealthy economy,

and a population of only nine million, roughly 1/140 of China’s population. Sweden’s pension system is one of the most successful pension systems in

the world today. It has survived the Global Financial Crisis and dealt with

its own aging population successfully. Due to socioeconomic differences, it is difficult to argue that China should try to immediately adopt Sweden’s pension model. With that being said, it is nonetheless a target to aspire to move towards.

One of the most interesting features of the Swedish system is that

pension benefits are adjusted annually, and fluctuate as life expectancy

rates, inflation, and rates of return on investments change; this adjustment improves the system’s sustainability as it allows it to better weather financial

crises or large fluctuations of portfolio values that would have otherwise greatly strained the system. At the same time, there is a guaranteed limit

for how low the pension payments can fluctuate to; currently, it is set at a value of SEK7,000, or approximately USD1,030 a month, which reassures pensioners of a reasonable floor.

Sweden’s pension system is a hybrid between the public and private

systems. Sweden’s pension system has two main pillars, the National

Retirement Pension and the Occupational Pension. If individuals do not believe the two are sufficient, they can supplement their pensions with auxiliary private savings. Additionally, there are five buffer funds that

provide the assets to balance out temporary fluctuations during periods when pension contributions are not sufficient to cover pension disbursements.

OECD data shows that in 2009, the Swedish pension system had roughly

USD144 billion of assets invested across pension funds. USD35.3 billion (7.4% of GDP) was invested in funds owned by the general population, while USD108.7 billion (27.2% of GDP) of assets were in public pension reserve

funds such as the buffer funds. The retirement age in Sweden is currently 65,

but there has been recent debate about raising it to 67 or 69 due to longer life expectancies.

The National Retirement Pension is split into three subsections, a

guaranteed pension designed to provide a minimum safety net, wholly

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funded by the state budget (Pillar 0), the income pension funded by the employee that forms the core of the pension (Pillar 1a/b), and a further

premium pension funded by employer contributions (Pillar 1b). This pillar’s

pension benefits amounted to 35.8% of the median earner’s average lifetime salary in 2011, and will fluctuate according to the state of the economy; consequently, the burden on the system is not too heavy.

The Occupational Pension is a quasi-mandatory pillar funded by

employers as a component of employee compensation, mandatory for 90% of workers; this pillar had a replacement rate of 22.7% in 2011. Combined,

Sweden’s pension system offers workers nearly 60% of their average salary as pension payments; combined with Sweden’s bountiful public benefits, this is enough for a comfortable retirement; only 6% of seniors are below the

poverty line in Sweden, compared to around 23% in Greece and the United States.

The Swedish pension system has many strong points in its design and

execution. First, there is a nice balance between the public and private

components of the pension; the government covers the guaranteed minimum pension out of the state budget and sets up buffer funds to protect the system, but the rest of the pension is funded by employee and employer

contributions. This allows for a strong safety net but at the same time does not overly strain the government budget.

Second, the structure of the pension system not only provides a strong

safety net for workers but also gives incentives to contribute to the system.

The guaranteed pension and income pension managed by the government is sufficient for subsistence but not necessarily for a high standard of living. These components act as protection for individuals against poor investment

decisions. However, the premium pension (an additional 2.5% of income paid

by the employer), along with occupational pension plans, allows employees to have some freedom in their asset allocation. Through good investments, seniors can obtain a very high standard of living on retirement.

Third, the structure for benefits is sound. Across the two main pillars,

Sweden has a rough replacement rate of 60%, meaning that the average

earner receives 60% of his average lifetime monthly salary in pension payments; burdened pension systems of the United States and Greece offer

pensioners 78.2% and 95.7% rates, respectively. Additionally, there are the

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aforementioned variable pension payments that are adjustable annually.

These two factors combined also serve to reduce the burden on the public sector.

Effective pension reform in an emerging economy: Chile’s pension system While Sweden’s pension system may be a model to aspire towards, it is not

feasible for China to reach such a state in the short to medium term. When it comes to overhauling a pension system, as an emerging economy with a still low GDP per capita, China may have more in common with a country like

Chile. Like China, Chile is classified as an emerging economy, and also faces similar issues of aging and societal income inequality.

Chile completely overhauled its pension system in the 1980s, from a

public defined-benefit system to a privatized defined-contribution system.

This was a necessity because at the time, the public system had wide coverage and fixed benefits, but very low contributions, with workers paying only the statutory minimum, and dodging payments. The core problem was that received pension benefits had minimal correlation to contributions, and thus

there were no incentives to contribute. Currently, China is facing a similar problem, with low contributions and an aging population.

Chile overhauled its pension system, to become one of the world’s most

privatized pension systems. It created a system primarily based around

individual private accounts, managed by 20 designated pension fund administrators (Pillar 1b). There was only a small Basic Solidarity Pension

(Pillar 0) funded through general taxation to offer a baseline pension (USD132) for a portion of the population aged above 65. Prior to 2008, the coverage

for the government pension was just 40%. The statutory requirement for contribution to the system was set lower, and individuals were given high

levels of flexibility in asset allocation, quantity of investment, and retirement age.

The main lesson for China in Chile’s case is the process of transitioning

from a public system to a private system. By switching to a defined-

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contribution system, Chile successfully incentivized individuals to save for their own retirement. However, reforming a pension system is a politically

salient issue, and could backfire if the change is perceived by the people to be detrimental to their well-being.

Chile managed this change tactfully by giving current workers under

the old system the option to stay under the old system or to move to the new system, while making it mandatory for new entrants to the workforce to enroll in the new system. It incentivized workers to switch to the new

system by reducing the statutory minimum contribution for the new system, and was largely successful in doing so; 90% of workers were converted to the new plan.

The strongly private nature of the Chilean pension system was both its

strongest point and greatest weakness. The private nature of the system

reduced the government’s burden and addressed the issue of incentive, and the competition between asset managers increases efficiency as they jostle

for accounts. However, making the pension system so private and offering individuals so much flexibility resulted in an elevated risk level, and an

inadequate safety net for the population. Individuals lacking the adequate

means, or sufficient foresight to save for retirement would undercontribute to their own pension systems, and consequently lack necessary pension

payments on retirement; the replacement rate was only 44.9% of salary for the median earner in 2011. Poor investment choices also posed the risk of significant losses of value. The greatest weakness of the Chilean system

was too much flexibility and freedom; individuals were, for better or worse, largely left to their own devices, and consequently, there were naturally many that fell through the cracks.

According to OECD data, as of 2009, Chile’s pension fund size was

roughly USD110 billion in size (67.2% of GDP), with USD106 billion of this sum in assets invested by accounts owned by the general populace, and just USD3.4 billion in public reserve funds. This was one of the most heavily skewed (towards private pensions) pension systems in the world.

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Policy Implications for China’s Pension System There are several universal goals for any pension system, despite taking

vastly different approaches towards achieving them. Countries seek to create a pension system that is sustainable, effective, and equitable. China can learn from each of the cases mentioned in the previous section, and use these lessons to improve its pension system or avoid the mistakes already made by other countries.

Balance public and private systems to reduce government burden while maintaining social safety net One important lesson for China from observing international cases is the

importance of achieving a solid balance between public and private finances within the pension system. Ideally, a pension system would be privatized

enough that governments do not face significant difficulty in sustaining it through demographic shifts and shocks in the financial system. Additionally, there must be incentives for individuals to actively save for their retirement, while still providing a strong safety net. The right degree of privatization

can also create a healthy level of competition which may boost the efficiency

of the system. To use the framework of the pillar system, a successful pension system would ideally have a strong Pillar 0 (minimum subsistence pension) funded by the government, and a combination of Pillars 1a and 1b (mandatory public/private pensions) that would provide a strong safety net without overly straining government resources.

A system that is too strongly public such as in Greece will result not

only in an excessively heavy burden on the state to support retirees, but also remove the incentive for individuals to contribute and plan for their

own retirement. In contrast, a system that is too private such as in Chile does not provide an adequate safety net, and results in many retirees being

unable to support themselves in old age. China can learn from Chile’s case in particular when contemplating degrees of privatization; in 2008, Chile

engaged in another pension reform to boost their equivalent of Pillar 0, the

Basic Solidarity Pension for minimum standards of living after discovering

that too much privatization led to many individuals falling through the holes of the safety net.

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Balancing public and private aspects is particularly tricky and

particularly important for China, given its socioeconomic attributes. China

has the world’s largest population, while the GDP per capita ranks among the middle of the pack worldwide, and the population is rapidly aging due to the One-Child Policy abruptly cutting birth rates. Consequently, it is unlikely that a system that is supported too much by the public system

would be able to provide pension payments that had both good coverage

and good benefits. To compound problems, there is high income inequality and a persistent negative real interest rate on bank savings due to inflationary pressure, meaning that despite a strong culture of saving, there will likely

be a high number of seniors that cannot afford a comfortable retirement. A failure to provide a satisfactory safety net for such a large population could

have dangerous ramifications for the stability of the country. In its current state, China’s pension system does not provide adequate coverage and benefits, and it is already facing a question of sustainability.

China would benefit from increasing the degree of privatization in its

pension system, to reduce the burden on the government for the coming years. It is likely that any decisions for privatization unfold incrementally, as it would be too risky to attempt a grand overhaul of the pension system. China

can manage changes by following Chile’s example of setting up restrictions on funds to force conservative investment strategies to reduce risk, as well as

through incentivizing individuals to shift from one system to another. China can also follow Sweden’s example of having a strong government support

for the system but leaving the bulk of the contribution to individuals and

enterprises. A further challenge in increasing privatization is to set up a solid infrastructure for the management of pension savings, including finding reputable and qualified private investment funds and creating sufficient regulatory measures.

Develop a flexible system that allows for freedom of investment but maintains stability Another lesson that can be learned is that it is necessary for China to manage

the degree of flexibility it offers individuals regarding their pension plans.

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We define flexibility in this context primarily as the ability of individuals

to make decisions on the allocation of their retirement assets. The concept

of flexibility may seem at first glance purely a positive one, as it may be instinct to perceive more freedom and choice to be better than less freedom

and choice. Indeed, increased flexibility for investors can lead to a broader

diversification of risk, and provides investors with an incentive to actively manage their own retirement funds. However, there are also potential downsides to flexibility. While increased flexibility can lead to superior realized returns on investment for some, it also leads to increased investment risk, particularly for unsavvy investors.

There is no quantifiable ideal level of flexibility, though the attributes

of an ideal level of flexibility would be a state where investors not only have enough control of their investments and a broad range of investment options, but also enough rigidity to ensure that the bulk of an individual’s retirement funds are not in jeopardy. The Greek pension system illustrates

a case where the system is too rigid, as individuals have no voice in asset

allocation. Consequently, individuals often felt no direct ownership of their pensions and had no incentive to contribute to them; there are many stories

of Greeks conducting business without reporting to the government to avoid

taxation. In contrast, too much flexibility, such as in the Chilean system and the U.S. 401K system, can lead to individuals losing a large portion, if not all, of their retirement nest egg on poor investment decisions.

Addressing the issue of flexibility is also a challenge for China. With a

population that is largely lacking the requisite knowledge and experience

to safely invest without restrictions, and with still underdeveloped financial markets, there are notable limitations on how far flexibility can go in China;

it is unlikely that individuals will be given significant levels of freedom of asset allocation in the short to medium term. That said, currently there are

heavy restrictions on the local government pension fund managers that limit them to investments in bank deposits and cash, which hinder their ability

to keep up with inflation, let alone generate additional returns. Gradually

increasing the amount of flexibility in China’s pension system would allow for better diversification of assets and opportunities for higher returns, though it would also increase the level of risk.

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China may seek to address the issue of flexibility on an individual level by

introducing a greater focus on defined-contribution systems, with funds run by private fund managers under government regulation and supervision. .

They can learn from the Swedish case with regard to this: Sweden’s premium

pension funded by 2.5% of wages allows for personal investment decisions without jeopardizing the bulk of pension savings.

On an institutional level, China may gradually free up restrictions on

investment allocation for local government funds. Currently, the NSSF is

being used as a pilot test for doing so, after being allocated CNY100 billion

from Guangdong’s pension fund to manage. If this is successful, China may

begin to allow for additional flexibility in investments for other regions’ funds.

Finally, China may seek to take a leaf from Sweden’s book with regard

to the flexibility of pension payments since this can allow China to better weather unforeseen shocks to the financial system.

Maintain high standards of management and regulation to bolster stability The management of pension funds is another critical issue, as the quality of

management will often have a lot to do with the returns on investment, as well as the stability of the pension system in general. Competent management in a transparent system will give the system more legitimacy in the public eye; for instance, countries such as the United States and Sweden with high levels

of transparency and mature regulatory institutions inspire more confidence than a relatively opaque system in Greece. Additionally, management can

refer to the institutional supervision of the system as a whole, and the

regulation and legislation that they implement with regard to the pension system and approved fund managers.

In China’s current system, management of pension funds is largely

done on a local level, following restrictive regulations that are centrally decided. This equilibrium has resulted in subpar management of China’s pension funds, as local government funds often lack the expertise that

could be leveraged at a centralized level. The advantages of centralization

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include removing the local pension funding deficit, and boosting aggregate efficiency. By restraining the choice of investment funds to a limited number

of qualified funds, a country can maintain a higher quality of management for its pension system. Smaller and underperforming provinces may prefer

centralization as it would reduce their costs of managing the pension fund, and they would also likely obtain higher net returns with their funds under central government management.

The issue of regulation can span across a huge number of categories,

but arguably one of the most important purposes of regulation in a pension system is for risk management across the various levels of the system. Strict

levels of regulation with high standards of transparency, accountability, and control will lead to a more stable pension system, and diminish the element

of risk, particularly that of the principal-agent problem where the incentives

of fund managers may not have been perfectly aligned with the interests of investors.

Create strong buffers for the pension system to weather shocks and demographic changes Buffer funds are important to pension systems as a reserve that can be drawn on in times where pension contributions are insufficient to cover pension

payments. Most countries have some form of buffer fund to weather systemic

shocks and aging populations; Sweden has five buffer funds in place to help support the system, and the United States has the Social Security Trust Fund to invest the proceeds of social security taxation. One lesson that China can learn from the stability of Sweden’s system contrasted with the recent worries of the depleting Social Security Trust Fund in the United States is that a strong buffer fund is necessary for the stability of the system.

The NSSF has been set up as a strategic pension fund for bridging the

increasing gap between assets and liabilities of the national Chinese system. It is difficult to make a precise estimate of the unfunded state enterprises

liabilities. It is, however, generally recognized that the size of the NSSF is still

not big enough for filling the gap, despite a very quick expansion (its assets increased more than tenfold since 2001 for reaching a size of CNY857 billion in 2010), and despite good performances in terms of return.

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It is recommended that the NSSF should take the following actions:

• Keep making efforts to increase its assets

• Maintain the “safety first” approach. Some experts recommend a higher share for equities, which represent already 34% of the total assets of

the fund. To keep this “safety first” approach would probably mean to maintain the share of equities at this level.

• Extend the lessons of the Guangdong local pension funds consolidated in an independent investment arm, under the guidance of the NSSF for an

amount of CNY100 billion. Such a consolidation process could improve the return of local pension funds, without increasing the risk, and could produce economies of scale.

• Extend the recourse to alternative investment, such as private equity and

hedge funds, without losing control of risk. This can create costs. It is, however, recognized that adding alternative investment in a portfolio can make the portfolio more efficient.

Lessons linked to macro-social factors There are other lessons in the respect of macro-social factors:

• The access to private pension funds has to be supported, but in a smooth and nonaggressive manner, meaning a strict control of their investment policy, biased toward conservative strategies for protecting household savings. The intervention of foreign actors could be a way to make the private pension fund industry mature in a quicker manner.

• All the privatization process linked to private pension plans should be

regulated and monitored by a household protection agency. An “investor protection unit” has been created by the China Securities Regulatory

Commission in April 2012. This is a move in the right direction, but this unit should be given enough power and resources.

• A focus of the reform should be to increase efforts on improving coverage in rural areas, pensions representing less than 5% of elderly incomes. It

would reduce the harshness of the elderly working in these areas and

make health expenditures lower. It would reduce the elderly’s high dependence on family support systems.

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• The reform of the pension system has to be associated with a reform of

family policy, meaning to foster the intergenerational transfer of capital

via a favorable tax regime, to create or reinforce safety nets for people without family support, to reduce tax income in function of the size of transfers in the direction of family relatives, and to reduce tax incomes of households taking care of elderly relatives at home.

• China has a higher level of precautionary savings; a reform of the pension

system has to envision all the ways to transfer this pool of liquidity toward investments generating higher returns and better protection against inflation. Inflation-linked government bonds could be a good way

to do that. They would generate higher interest rates than deposit rates and protect against inflation. This pool of resources could be used by the government for increasing social protection and reducing precautionary savings, fostering growth at the same time.

• The higher level of China’s savings rates means a higher degree of

individual responsibility: this fact should facilitate the promotion of a

defined-contribution system, the sooner the better. Indeed, a government could face more difficulties in doing a transition from defined-benefit toward defined-contribution in a context of low savings rates.

Pension Reform: A Global Challenge All the pension systems in the world are currently facing the challenge

of aging populations. In the developed economies, this puts at risk the sustainability of public debt. In the emerging world, this topic is related to poverty issues and will contribute to the increase of public debt as well. Aging is not the only problematic issue related to the world pension systems. The macro-social determinants of elderly incomes in the world, such as

intrafamily solidarity, capital incomes, the relation to credit, working, and saving strategies, reveal big asymmetries between countries, and suggest different paths of reform.

Risk posed by population aging China is not alone in having to deal with the aging of its population, meaning

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growing challenges for its pension system. The United Nations reports that

378 million people were aged 60 or above in 1980 in the world. This number surged to 759 million between 1980 and 2010, and is expected to more than

double by 2050. An increasing life expectancy at the global level, baby

boomers approaching retirement age, and lower fertility rates represent three

factors which will make the support ratio of the world population increase significantly by 2050. The share of the working-age population in total world population will progressively decline. This means that people and resources mobilized for pension funding will decline in the context of growing needs in old-age expenditures, meaning increasing pressure on pensions systems.

In this context of the world’s aging population, public expenditures on

pensions will grow significantly, putting at risk the stability of already fragile

public accounts. The average OECD public expenditures on pensions should increase from 8.4% of GDP in 2010 to 11.4% of GDP in 2050. Moreover, the

accumulation of financial assets by households is not big enough, and does not produce sufficient returns for covering the future pension needs. The

table on the next page makes the comparison, on a discounted-value basis,

of current financial assets and future pension income needs. It shows, for example, that China, if the government absorbs the gap, could see its public debt increase by around 40% in the case of an unexpected shock of longevity.

This shock can be defined as life expectancy being higher by three years

than the official projections of the United Nations, an increase by 46% of GDP for the United States. Such shocks were common in the past due to the

unexpected beneficial effects of medical progress. The pension system needs a reform.

Macro-social determinants of world pension systems We have seen that it is crucial to make the distinction between urban and rural areas in China to understand pension issues. Beside institutional and

organizational factors of pension systems, macro-social determinants are fundamental, in particular the sources of revenues in the postretirement

period; i.e., intrafamily solidarity, financial and housing wealth, the number of elderly working, saving strategies, and other factors.

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Longevity risk (% of 2010 nominal GDP)

Country

Present General Household discounted values of government total gross debt needed financial (2010) retirement assets (1) income (2)

Gap (1) – (2)

Increase in public debt (% of GDP) given 3-year increase in longevity

U.S.

339

272 to 363

94

67 to -24

40 to 53

Japan

309

499 to 665

220

-190 to -356

65 to 87

U.K.

296

293 to 391

76

3 to -95

44 to 59

Canada

268

295 to 393

84

-27 to -125

42 to 56

Italy

234

242 to 322

119

-8 to -88

34 to 45

France

197

295 to 393

82

-97 to -196

40 to 54

Australia

190

263 to 350

21

-73 to -161

36 to 49

Germany

189

375 to 500

84

-186 to -311

55 to 74

Korea

186

267 to 357

33

-81 to -170

39 to 52

China

178

197 to 263

34

-19 to -85

34 to 45

Spain

165

277 to 370

60

-112 to -205

39 to 52

Hungary

108

190 to 254

80

-82 to -146

36 to 48

Poland

88

160 to 213

55

-72 to -125

27 to 35

Source: International Monetary Fund.

More family solidarity in emerging areas versus higher capital role in the developed world The share of persons above 60 years of age living alone is higher in developed

regions. This means that for the purpose of expenditures related to housing, these people benefit to a lesser extent in terms of family support in their retirement. In the emerging world, old people live more frequently with their

relatives, indicating higher levels of intrafamily support. We have seen for China that the bulk of the income comes from the pension system (45%) in the urban environment. But in rural zones, this is above all family solidarity,

which represents the bulk of incomes (54.1%). In these areas, pensions are only perceived by former civil servants, soldiers, and village cadres. In the

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urban areas, the share of work and pensions is closer to the OECD average. However, in rural areas, the share of pensions is significantly lower, implying

the need to work or benefit from family solidarity, also indicating a poor

coverage of the pension system and a higher probability to fall into poverty. At the global level, elderly people work less in developed regions than those in less developed regions, pointing to the higher importance of the public or private pension system.

The comparison within OECD countries reveals significant differences.

Property incomes are obviously significantly lower in China due to the

impossibility in the recent past to accumulate wealth or land, and regarding

the size of the pension fund industry, much lower than the OECD countries. There is, therefore, a lower capacity for Chinese people as a whole to benefit from rent incomes, or to organize intergenerational transfers. The revenues

from capital are significant, sometimes representing almost 40% of elderly

incomes, in the most liberal economies (the United Kingdom, Australia,

and Japan). At the same time, these populations are more exposed to the fluctuations of the market, which requires elderly people to come back into

the job market when the financial conditions have deteriorated too much, or when they have not saved enough.

Assets in pension funds and public pension reserve funds in OECD countries, 2009 Pension funds % of GDP

Public pension reserve funds

USD million

% of GDP

USD million

OECD members Australia

82.3

808,224

5.9

51,629

Canada

62.9

806,350

8.5

108,627

Chile

65.1

106,596

2.1

3,421

France

0.8

21,930

4.3

118,669

Germany

5.2

173,810

—

—

Greece

0.0

63

—

—

Ireland

31,049

44.1

100,278

13.7

Italy

4.1

86,818

—

Japan

25.2

1,042,770

23.2

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

(Cont’d) Pension funds % of GDP

USD million

Public pension reserve funds % of GDP

Korea

2.2

29,632

26.1

Luxembourg

2.2

1,171

—

Mexico

7.5

107,135

129.8

1,028,077

Norway

7.3

Portugal

Netherlands

0.3

USD million 217,768 — 3,605

—

—

27,852

5.0

18,693

13.4

30,441

5.7

13,068

Spain

8.1

118,056

5.7

83,387

Sweden

7.4

35,307

27.2

108,785

Turkey

2.3

14,017

—

—

U.K.

73.0

1,589,409

3.8

83,079

U.S.

67.6

9,583,968

17.9

2,540,348

OECD34

67.2

15,711,903

18.5

4,520,134

Other major economies Argentina

11.5

30,105

—

—

Brazil

17.1

224,218

—

—

China

0.6

19,980

—

—

India

5.4

61,971

—

—

Indonesia

2.2

9,614

—

—

Russian Federation

1.5

14,987

—

—

Source: OECD Global Pension Statistics.

Note that family support is significant in both rural and urban areas in

China. The phenomenon of family decomposition in developed economies makes this source of revenue lower, but it is compensated for by higher social

or public solidarity, and by intergenerational transfers of capital. This question of family solidarity is very important regarding the transformation of the pension system in China as the urbanization process, lower coresidence rates,

and the decline in fertility rates currently at work will lead to a weakening of

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the family links. There is a need to think of alternative sources of income for the progressively weakening family safety net. Different studies show that

better coverage of the pension system in rural areas would reduce poverty and increase health due to the lower necessity of working into old age, and this would not significantly crowd out private family transfers.

Insufficient savings in the developed world versus excess savings in the emerging world Pension issues have to be replaced in a context of high or low savings rates. A country will have more or less difficulty in reforming its pension system according to the level of savings in the domestic economy. In particular,

a context of a high savings rate will facilitate a shift from defined-benefit to defined-contribution system. The lifecycle theory, adapted to savings questions, explains why younger populations have higher savings rates,

which is the case for China in comparison with the OECD countries. We can see that with the increasing old-age support ratio, which measures the ratio of working-age population (20 to 64) relative to the number of retirement-

age population (above 65). A younger population is expected to have higher

savings rates as households build their savings before retirement and use them after retirement for financing their expenditures.

A savings rate that is too high can be detrimental to the economy as it can

represent a drag on private investment and can create imbalance with trade

partners. At the same time, a savings rate that is too low, as in the United Kingdom or in the United States, can expose households to poverty in the

case of a negative shock on their housing or financial wealth. Any reform of a pension system has to find an optimal degree of precautionary savings. The economic transition undergone by China that created high uncertainties for

households is another explanation of higher savings rates. The insufficiencies in terms of health coverage and social protection, as well as relatively high

education costs, also gave birth to high levels of precautionary savings. Once again, the distinction between rural and urban is important in China. Rural

households have had higher savings rates since 1978 due to more volatile incomes linked to weather conditions. The convergence of the rural savings rate in recent years has been driven by a reduction in education costs due to

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the introduction by the government of free compulsory education to rural

populations as well as the New Cooperative Medical System. In emerging economies, any reform of the pension system has to be put into perspective with the level of the supply of public goods.

In the developed world, the consolidation process engaged in public and

private debts will probably lead to increasing savings rates. The too high

weight of private debt (i.e. the too high weight of credit in these economies) has artificially inflated both housing and financial assets and created

an artificially high net wealth and a too high sentiment of security. The

problem is the same for public debt. The too generous public systems have

also contributed to inflating the sentiment of security of households. Both the public and private sector have now to deleverage, creating downward pressures on asset prices, diminishing net wealth, and therefore revealing

insufficiencies in terms of pension funding. The governments will be less

generous in terms of providing pension benefits, meaning a higher share of private contributions to pension funding. At the same time, underperforming

housing and financial assets will limit the progression of net wealth. The

precautionary savings and pension savings will therefore increase in this part of the world.

The aging of populations is a world phenomenon which has put at risk

the public accounts of all major economies. There is a need to reform pension

systems globally. In a context of deleveraging, and amid global imbalances related to savings behavior, there will be a convergence of pension systems,

meaning a degradation of protection for the developed economies and an improvement of protection for developing economies.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The rising amount of local government debt in China has triggered increasing concern over the sustainability of local public finance. Its close ties with

the growing shadow banking sector has led to various market estimations on local government debt, ranging from CNY10 trillion to CNY50 trillion.

A growing chorus of investors has been urging the central government to

conduct a thorough investigation on the existing local government debt, and propose possible solutions. China’s National Audit Office announced on July 28 [2013] an audit of government debts at all five levels of the government — central, provincial, city, town, village — in order to estimate their size

and the potential financial risks. The primary focus of this audit is debts

related to infrastructure including railways and subways, local government financing platforms, and projects backed by land transfer revenue. All transactions and related ledgers are expected to be audited individually, and

the audit report is expected to be filed to the State Council before the middle of October [2013].

How Serious is the Local Government Debt? The most recent official estimation of the local government debt outstanding was CNY10.7 trillion as of 2010 based on a report released by the National

Audit Office in March 2011. The estimate should be the lower edge of the coming estimate, as local government debt has surged significantly along

with shadow banking for the past two years and the coverage of this estimate

is more complete, including debts down to the village level. Bank loans to local government finance professionals hit CNY9.59 trillion in the first quarter

of 2013, 30% up from that in the fourth quarter of 2009, according to statistics from China’s Banking Regulatory Commission. The National Audit Office conducted another auditing program on 36 provincial capital cities earlier

this year [2013] and reported that their debts totaled to CNY3.85 trillion and 9 cities’ debt/GDP ratio had exceeded 100% by 2012. The names of those

9 cities were not disclosed, but the market has narrowed down the list to 10 cities: Nanjing, Chengdu, Guangzhou, Hefei, Kunming, Changsha, Wuhan, Harbin, Xian, and Lanzhou.

Based on our recent grassroots survey, we found the debt/GDP ratio

of the cities with sound financial positions ranged from 20% to 40%, while

the ratio could reach up to 80% to 120% in cities with serious problems. As

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a whole, our best guess on the outstanding overall local government debt would be 40% to 60% of GDP, in other words, about CNY20 to CNY30

trillion. Some local government financing platforms including Shanghai, Yunnan, and Shanxi have encountered difficulties of principal repayment

and requested to extend loan maturities. Besides the size, the mismatched structure of the local fiscal position is another concern. Based on the National Audit Office’s report in 2011, by the end of 2010, 53% of local government debt

had three-year maturity, while 60% of investments on infrastructure projects had 10-year maturity. The most pressing concern now is not insolvency but liquidity.

China’s local government debts remain, in my view, within the

manageable zone, despite their large size and mismatched structure. Unlike

in the United States, the Chinese government owns a large amount of assets including infrastructure, buildings, natural resources, and enterprises such as state-owned enterprises and collective firms. According to the estimate

of the national balance sheet published by the Chinese Academy of Social Sciences in 2012, by the end of 2010, the Chinese government’s operating assets, mainly including enterprises and infrastructure, totaled to CNY21.5

trillion, 47.4% of which belonged to local governments. The government’s nonoperating assets including buildings, equipment, and other fixed assets amounted to CNY7.8 trillion, and natural resources totaled CNY44.3 trillion. There is no updated data for 2012, but the size should remain large despite

deterioration at the asset side of the balance sheet according to the Chinese Academy of Social Sciences. Furthermore, China’s government tax revenues have grown steadily thanks to rapid economic growth, which doubled in

the past five years and reached CNY10.1 trillion in 2012. This implied a possibility of trouble for China in getting out of debt.

Overall, the local government debt issue is serious but remains

manageable, and immediate actions are needed to control the situation before any potential defaults.

Measures to Resolve Local Government Debt Deleveraging is the priority in solving local government debt. It is critical to set up a deficit and debt cap for China’s governments to establish a sound

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fiscal position. The Stability and Growth Pact in the Eurozone requires all

members to have deficits below 3% of GDP and public debt below 60% of GDP (Maastricht criteria). The Fiscal Compact has recently addressed this issue with automatic mechanisms of correction in the cases of no respect for

these criteria. It could be a good reference for China to apply 60% of GDP as the safe line for the central government. And the cap of debt for local governments should be lower considering its limited access to resources.

Thus, a range of 40% to 60% is likely to be a comfortable workable zone. Besides the debt cap, an explicit timetable to achieve the target is equally

important in order to give local governments a real push to deleverage within the time framework.

Once the debt cap is established, some measures including selling

government assets, securitizing debts, and wiping off by the central government are needed to be taken immediately in order to quickly lower

the leverage rates below or close to the target rates. Other measures including issuing local government debt, levying property taxes, and rebalancing

expenditure will be long-term solutions for a healthy and sustainable local fiscal position.

Short-term measures to deleverage Sell part of the local government assets Selling off assets is the fastest way to deleverage in the public sector, and it is particularly necessary for those with debts seriously above the cap. It could work well for the cities with a good economic foundation and high-

quality assets, mainly located in the Yangtze River Delta and Pearl River

Delta. For example, the government of Nanjing, the highly indebted capital city of Jiangsu Province, likely had debt over its CNY720 billion GDP by 2012, but it owned CNY 331 billion in assets at the same time according to the statistics from the Nanjing State-Owned Assets Investment Management

Holdings Group. Partly privatizing the government assets especially the underperforming operating assets could help deleverage as well as improve management efficiency.

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Restructure existing debts via the big four asset management companies Restructuring existing debts is another solution. In 1999, China restructured

CNY1.4 trillion in nonperforming loans of the four major state-owned banks via four asset management companies including Huarong, Cinda, Orient,

and Great Wall. The initial missions of the four asset management companies were completed, and restructuring local government debts could bring them

new business. Transferring nonperforming loans to the asset management companies at a discounted price and negotiating an extension of loan maturity are potential solutions (80% of government debts are bank loans).

It might raise moral hazard to some extent, but it is a reasonable one-time choice to quickly recover the overall fiscal position of local governments.

Direct support by the central government It is possible for the central government to help some local governments

pay part of their debts, especially those located in Central or Western China.

It was not uncommon before 2003, when the local governments in those regions faced difficulties and had no land sales proceeds available at that

time. For example, the central government financed the local governments

with proceeds from treasuries issuance in amounts of CNY40 billion, CNY25 billion, and CNY25 billion in 2001, 2002, and 2003, respectively.

Longer-term measures to rebalance the local fiscal position Allow local governments to issue bonds Local governments are not allowed to issue bonds directly in China. What

they can do after 2009 is to submit applications to the central government,

and the central government will issue bonds on behalf of them if approved. In this case, the annual quota is restricted, the procedure is long, and maturity options are limited. For example, the annual quotas for the years

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of 2011 and 2012 were CNY200 billion and CNY250 billion, respectively,

while expenditures of local governments totaled to CNY5.25 trillion and CNY6.16 trillion, respectively. Maturity options are limited, with only two

choices in general: three-year and five-year bonds and a pilot program of seven-year maturity launched in 2011 for Shanghai, Zhejiang, Guangdong, and Shenzhen followed by Jiangsu and Shandong in 2013. The relatively

short maturity makes it hard for local governments to fund long-term infrastructure projects such as roads, bridges, and subways. As a result, a

large proportion of local government bonds issued in 2012 were used to repay three-year bonds issued in 2009. For example, only CNY1.5 billion out

of CNY7 billion in local government bonds issued by Gansu Province in 2012 were for new investments.

Given the restrictions of bonds issuance, local government financing

platforms issued a high quantity of city investment bonds in the interbank

market for the past three years to finance infrastructure projects. Especially in 2012, the city investment bonds issued were CNY636.8 billion, pushing the

outstanding reach to CNY1.4 trillion, about 2.5 times that in 2010, according to the data released by China Central Depository & Clearing Company.

The unclearly identified ultimate borrowers of these city investment bonds intensify the market concerns on potential default amid a weak economy.

Overall, allowing local governments to issue bonds directly could clearly

identify the ultimate borrowers and make the government budget more transparent. Local governments should be incentivized to take responsibility for the bonds issued.

Levy property tax Property tax is potentially an ultimate “golden bullet” to calm down housing fever and narrow the inequality gap as well as provide sustainable revenue

sources for local governments. In the United States, property tax accounted for 33.1% of total tax revenues for the state and local governments in 2011,

according to the U.S. Department of Commerce. Two cities in China, Shanghai and Chongqing, were selected in 2011 as experimental cities for collecting

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property taxes. The pilot programs were not that successful mainly due to

narrow scope with a very limited number of high-end new apartments taxed and low collection efficiency.

The property tax is expected to be levied as early as the second half of 2014

in China, after the nationwide housing information system is established in the first half of 2014. Currently 60 cities are enrolled in the system already.

More pilot cities such as Hangzhou, Changsha, and Shenzhen could be chosen this year [2013]. The following features are expected:

• Annual tax rates are set between 0.5% and 2% per annum, possibly with

differences among cities based on various factors including the need to control property prices, affordability of housing, and GDP per capita.

• Taxes are likely to be levied on new deals rather than made retroactive, or on the third housing purchase. The first choice is more possible, and any transactions of old housing are regarded as new deals.

• Possible progressive tax rates on multiple property ownership

Rebalance local government expenditure “Pay as you go” should be set as the golden rule for local governments

especially for those with high leverages. Rebalancing local and central

government expenditure is another direction to curb local debts. There is a notable disparity between central and local governments in China regarding the distribution of revenue and expenditures. Generally, China’s

central and local governments share 50%–50% of tax revenues but the spending proportions are 30%–70%, respectively; this gap means that local

governments must utilize other sources of finance to make up the difference. This situation has lasted for two decades after China’s tax-sharing reforms

in 1994. The government therefore could rebalance expenditures more toward central government spending, especially in areas such as public

services, education, social security, medical services and healthcare, and environmental protection, where local governments have significantly overspent the central government.

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Prerequisites to be fulfilled Transparent government budget plan Local governments need to provide the public with more accurate information

regarding their spending plans, as well as the usage of proceeds from bonds

issuance. Excessive spending by government officials and overpriced products in government procurement have long been criticized by the public in China. For example, annual spending on vehicles, receptions, and overseas trips often accounts for 20% to 30% of total government spending. Publicly

available budget plans of local governments would be critical for a healthy public finance in the long run. On August 21, 2013, the Ministry of Finance announced that all local governments at the town level or above are required

to publish annual budget plans by 2015 including details on expenditures on vehicles, receptions, and overseas trips.

Sound technical infrastructure There is also a need to establish technical infrastructure, including a credible and transparent credit-rating system, a bond derivatives market for a more

efficient pricing mechanism, and a better supervision system with automatic

mechanisms of correction in the case of no respect of debt criteria. China’s bond future market was launched on September 6, 2013, after being delayed

for 18 years. Its underlying asset will be five-year treasury bonds with face

value of CNY1 million. The relaunch of government bond futures is expected to boost the trading volume of treasuries and offer a guideline for future bond derivatives.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Multiple Facets of China’s Economy Over the past three decades, China’s growth has been a wonder to behold. Since Deng Xiaoping instituted the start of China’s economic reforms in

1978, China has gone through a period of unprecedented growth. The

average year-over-year growth rate over the 32-year period was 10.02%, an impressive pace. As of the end of 2011, the nominal GDP had grown roughly to 23 times its 1980 value. Additionally, China managed to maintain

robust growth through the 2007–2009 Global Financial Crisis, while many economies suffered significant economic malaise if not outright recessions.

From a GDP growth perspective, China exhibits clear signs of a burgeoning superpower.

High GDP but low GDP per capita China itself grew much faster. Its GDP caught up with Germany in 2007,

totaling close to USD3.5 trillion and then took over Japan as the second largest economy in 2010 with USD5.9 trillion. Given its low GDP growth rate among developed economies, China with strong dynamics is narrowing its

distance with the United States in absolute value. Based on our assumption of a growth rate at 7% year-over-year, and 2% for China and the United States

over the next 10 years, together with the possibility of 20% appreciation of

the renminbi, China will replace the United States to become the number one economy in the world by 2020.

However, in terms of GDP per capita, China’s achievement is far behind

other big economies. Its GDP per capita amounted to USD4.4 trillion in 2010, ranking 90th worldwide. The ratio in the United States and Japan yields nearly 10 times that of China. Even much maligned Greece, which reports

only a fraction of China’s nominal GDP and is struggling under a mountain

of debt, has six times higher GDP per capita than China. In short, even if China may be the second largest economy in nominal terms and thus a

superpower in that respect, its citizens are far from the second wealthiest; there is still plenty of room to grow.

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GDP per capita, 2010 (USD billion) 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

U.S.

China

Japan

Germany

Greece

Sources: Thomson Reuters Datastream; Haitong International.

High exports but low value added Unlike falling export shares of the other three biggest economies, China’s

exports have been on a track of continuously fast growing, from only 1.1% in

1982 to 9.4% in 2010, just below that of the United States with 9.8%. In terms of imports, China again exerted an upward trend, registering at 10.4% of world total imports in 2010, one percentage point more than Germany. China

now is the second biggest trade partner of the United States and Germany, and the biggest trade partner of Japan and South Korea.

Despite rising export share, the value added of China’s exports has

remained low. About 60% of China’s exports are processing trade with very low value added. Taking the most popular iPhone and iPad as examples,

in the profit distribution from the sale of an iPhone and iPad, despite huge involvement in the production line, China only takes 1.8% and 2.0% of total profits, while Apple in the United States takes 58.5% and 30%, respectively, for design and innovation.

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iPhone 4 profit distribution Others 13.3%

Mainland China labour 1.8% Materials 21.7%

Korean companies 4.7% Apple 58.5% Sources: Aidan Technologies catalog; Haitong International.

iPad 2 profit distribution Mainland China labour 2.0%

Materials 31.0%

Others 15.0%

Korean companies 7.0%

Retail sales 15.0%

Apple 30.0%

Sources: Aidan Technologies catalog; Haitong International.

High foreign exchange reserves but low diversifications Due to continuous trade surplus and capital inflow, China’s foreign exchange reserves reached USD3.18 trillion by the end of 2011, over a third (34.8%) of

world reserves, recording the most of any country in the world. On the other hand, China’s foreign exchange reserves are not well diversified with huge

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risks and low returns. According to our best guess, U.S. dollar–denominated

assets account for as much as 65% of total assets. Among which, bonds

including treasury, especially long-term treasury, agency debt, and corporate

bonds take more than 90% of total investment. The rest are 20% of the euro bonds and another eight currency assets including the British pound and Japanese yen.

Healthy fiscal position but low welfare In a global economic environment where the United States has struggled

with an increasing trade deficit and mounting debt, and where the Eurozone has been dealing with a sovereign debt crisis that has threatened the existence of the currency union itself, China is still in a healthy fiscal position. It registered fiscal revenue with USD1.3 trillion in 2010. Despite

massive government fiscal stimulus after the Global Financial Crisis, China’s

public deficit is still at a low level, amounting to 1.6% of GDP, while the other four biggest economies record over 4% deficit to GDP.

Moreover, China’s public debt was USD949 billion in 2010, making its

debt-to-GDP ratio only 16.3% of GDP, while the figure in most developed countries was more than 60%. Even taking into consideration the local debt, we estimate the figure will not pass 40%. That ensures China will keep well

away from a possible debt crisis for now, and gives China leeway to accelerate the leverage process for further developing various programs, especially social welfare. Increasing spending on public welfare and social programs

such as healthcare and education will be crucial in the coming years, and

important in the consideration of China’s superpower status. Currently expenditures of the two sectors are only 3.0% and 4.6%, respectively, of

total spending. In the case of education, for example, China is the country spending the least among the emerging BRICS countries, let alone compared

to developed nations, with the proportion in total spending falling below the world average. This trend should be adjusted to improve public welfare.

High oil consumption but low efficiency As a world factory, China’s oil consumption has surged, reaching 12% of the

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world total in 2011 from 6% in 2000; while the shares of the United States and Europe gradually declined to 20% and 15% in 2011, respectively. On the

other hand, energy efficiency is low in China, as one terawatt of energy can only produce USD0.84 billion of GDP in China, where these figures in the

United States, Germany, and Japan are USD2.87 billion, USD3.60 billion, and

USD4.88 billion, respectively. As a result, low efficiency leads to higher CO2 emissions. China’s energy production per U.S. dollar produces 2.33 kg of

CO2 , over 50 times that in the United States, Japan and Germany, or over 40

times that of the world average.

GDP/TWh energy consumed, 2009 (USD billion) 6 5 4 3 2 1 0

China

U.S.

Germany

Japan

Sources: International Energy Agency; Haitong International.

CO2 emissions/GDP, 2009 (kg/USD) 2.50 2.00 1.50 1.00 0.50 0

U.S.

China

Japan

Sources: Thomson Reuters Datastream; Haitong International.

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Rising capital market with high initial public offerings China’s capital market has jumped over the past few years. Its market cap of the stock market increased over 400 times in the past decade, to 34.9%

in 2010 from 7.9% of the U.S. market cap in 2000, thanks to surging IPOs. IPOs in China together with Hong Kong capital increased by 20% year-over-

year on average for 2000 to 2010, compared to 6.5% year-over-year in the U.S. market. The number of IPOs in Mainland China averaged 300 to 400

firms even after the Global Financial Crisis, making about 3,000 listed firms

currently, and about 6,000 firms 10 years from now on if China keeps this pace of IPOs. At such a pace, many believe that China’s market capitalization could be parallel with that of the United States by around 2020.

Is China a Real Superpower? The quick answer to this question is “Not quite yet.” It is undeniably tempting

to look at China’s recent GDP statistics and come to the quick conclusion that China became a superpower when they overtook Japan as the world’s second largest national economy in 2010. It is also easy to get immersed in

the media coverage of China, and the growing trend of countries looking to

China as a savior, a scapegoat, or a combination of both, and assert that only a superpower would draw so much attention. With that being said, upon

closer inspection, there are some areas that need improvement, and some notable shortcomings that stop us from crowning China as a superpower in the present day.

Does the world see China as a superpower already? As with most topics,

there are diverging opinions, but there is no doubt that China has made huge strides over the last decade. From a G7 world where China was not even in

the picture as a major player, we have transitioned into a G20 world after the Global Financial Crisis, where China is gradually gaining importance in

global economic governance. Now, there is talk of a G2 world, where China

and the United States would be the two major states in the international system, though China has kept a low profile on this idea.

The European Union’s recent requests for Chinese assistance in the

sovereign debt bailouts are an example of the cost associated with being

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viewed globally as a superpower. As a superpower, China would be expected to contribute more to global aid and security, arguably a difficult sell for a

country that still ranks 99th in GDP per capita. In many ways, China is still not ready to be a real superpower just yet.

While China is not quite ready to be a real superpower at present, it is,

however, unequivocally a rising superpower. Its speed of development over

the last three decades proves this point. Assuming China continues to grow at an average of 7% per annum and that the United States grows at 2% per

annum in the coming years, together with potential 10% to 20% gains on the renminbi, China will overtake the United States by 2023 as the world’s largest

economy. Despite an aging population, China still accounts for less than onefifth of the global population. If China can boost per capita productivity to the top-tier level, it has the prerequisites required to become a superpower of the highest order.

Will China’s Legend Continue? The secrets of China’s growth for the past 30 years The past 30 years saw China’s export-led model of growth carry the country

through three decades of unparalleled fast growth. The secrets of success can be summarized as high production with rich resource inputs under severe market competition with a boost of institutional reforms.

Institutional reforms over the past three decades have had a vital role in

China’s growth story. There are three main events in China that have acted as

catalysts for growth. The first and arguably most important event in China’s recent economic history is Deng Xiaoping’s initial reforms in 1978, which

decollectivized agriculture and allowed private businesses to participate in

the economy. These reforms set the framework for China’s evolution into a

market economy. The second event was Deng’s southern tour of 1992, where Deng reasserted the importance of continuing economic reforms, and the

Shanghai Pudong area was revitalized. Deng’s southern tour sparked a huge wave of privatization and entrepreneurship that sharply drove growth, and

further encouraged foreign direct investment (FDI). The third event was

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China’s entry into the World Trade Organization (WTO) in 2001, which

greatly increased China’s potential for international trade. Joining the WTO opened up the world economy for China’s exports, as well as allowed for

more foreign investment into China. These three key events have each seen periods of surging GDP growth in their wake.

China: GDP growth (% year-over-year) 20 18 16 14 12 10 8 6 4 2 0

Decollectivizing Joined WTO

Deng’s southern tour 1980

1985

1990

1995

2000

2005

2010

Sources: Thomson Reuters Datastream; Haitong International.

Supported by a favorable framework, China’s growth has been strongly

propelled by large quantities of input factors, one of the main reasons that

China has been dominating competition in low value-added manufacturing.

The key inputs are labor and capital. China’s rapid growth has been driven in large part due to a large influx of laborers from rural agricultural areas

to urban manufacturing jobs. The migrant-worker population has supplied

China’s factories with a steady supply of low-wage labor that has gained China an incredible competitive advantage. Additionally, significant fixedasset investment over the last 30 years has provided China with the requisite capital and infrastructure to utilize the pool of low-cost labor. Large quantities

of FDI into China provided not only some additional physical capital, but more importantly, technology transfer and managerial know-how that have

had an osmosis effect throughout the economy. With a seemingly endless

supply of low-wage labor, and the infrastructure to back it up, China quickly rose to become the world’s largest manufacturer.

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China’s large input factors are not limited to labor and capital. China’s

growth has also been fuelled by huge quantities of resource inputs, such as energy, base metals, and construction materials. China has gone from a net

exporter of natural resources such as fossil fuels and base metals to become the world’s leading consumer of energy and base metals. Although China’s

efficiency with resource inputs may be low compared with developed nations, the sheer quantity of the resources consumed has powered China’s economy.

One of the other factors driving China’s growth is the severe market

competition in its economy. A major reason for the increase in competition

is the process of decollectivization and privatization that occurred over the last three decades. Prior to Deng Xiaoping’s first reforms, all the businesses

in China were state owned; as such, there was no open competition, and incentives to improve efficiency were limited. As the process of privatization

began and China’s economy shifted towards more of a market economy,

opportunities were afforded to private entrepreneurs that had great

incentives to maximize efficiency, and consequently the level of competition skyrocketed. In 1980, state-owned enterprises dominated China’s economy,

but by 2010, non-state-owned entities accounted for over half of China’s GDP as well as the majority of urban employment; this transition was one of the major factors fuelling China’s growth over this time period.

China: Urban employment (million persons) 400 350 300 250 200 150 100

State-owned

Non-state-owned

Sources: CEIC Data; Haitong International.

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2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

0

1980

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Is China a Real Superpower?

The factor that differentiates China from most other countries is the

structure of its provinces. One of the factors is that as provinces often have a

degree of autonomy, individual provinces often specialize in certain sectors of

the economy. For instance, Heilongjiang specializes in heavy industry, while Shaanxi and Xinjiang are leaders in natural resource extraction and energy

production. Provincial specialization leads to comparative advantages, and hence a stronger national growth overall when summing up the parts.

As each province is responsible for its own economic statistics, and

records are made of each province’s contribution to national growth, there

is aggressive competition from every province to outperform the field. This has led to many provinces being strongly probusiness and a concerted

effort to attract investment; often provinces will have to offer very favorable conditions, otherwise investment will go to another province that may offer better terms.

The competition among provinces can be seen by examining the growth

targets set by each individual province. When compared to the national growth targets set by the central government, almost across the board,

provincial targets are set higher than the national target. Provinces such as Chongqing, Guizhou, Hainan, and Inner Mongolia targeted growth rates of over 13% in 2011, far above the 8% growth rate target set by the central

government. This severe market competition has also been a drive for China’s

growth, as high levels of domestic competition have complemented China’s rich resource inputs to make China increasingly competitive internationally.

Overall, there are no cut-and-dry answers to the question of China

being a real superpower, as there is no standardized definition of what a real superpower is. One thing, however, is clear. China has been, and still

is, on the rise. China’s GDP is still growing at a rapid pace, even in the face of a global slowdown and despite facing inflationary pressures and

subsequent tightening measures in 2011. China’s capital markets are also rapidly developing, with the most IPOs in the world in the last few years. China is also seeking to gradually improve efficiency, particularly in energy

consumption; it is now the world’s leading investor in renewable energy.

Despite difficult global macroeconomic conditions, China is widely expected to maintain around a 7% growth rate for the near future, while developed countries are struggling near stagnation. Whether it is ready or not, China is rising towards superpower status.

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The next 30 years: Keys for China to become a real superpower Despite the last few decades, the next 30 years will be vital to decide if China

will become a bona fide superpower, or be slowed by obstacles. As suggested by Deng Xiaoping, China’s reform architect, China’s economic development needs two 30-year periods. The first 30-year period was to undergo the process

of industrialization, which has been completed; China has become the second largest economy and accounted for about 20% of world manufacturing in

2010. It is entering the second 30-year period and moving towards increased

productivity backed by high technology. A successful transition to the second phase will decide China’s fate as a potential superpower.

China needs to be transformed to a more sustainable model from the

previous fast-track pattern which was achieved at the cost of resources and

the environment. Growth quality rather than speed is to be more emphasized. Institutional arrangement and productivity enhancement are to be the two new key drivers of the economy.

As discussed, China’s three growth surges in the past decades were

triggered by policy promotions. Favorable institutional arrangements

have played an important role in China’s economic development. Further

institutional arrangements could bring new growth engines to China’s economy during a global slowdown. Possible policy reforms might have to touch the deep roots of the monetary and fiscal fields including forming

market mechanisms to decide on the levels of interest rates and improving

tax mechanisms to promote consumption and support small and mediumsized enterprises, among other methods.

Another arm of the engine is to come from productive enhancement

backed by technology. The current model of growth, which is export oriented and focuses on low-cost manufacturing, is unsustainable in the long run. China’s labor productivity has increased tremendously along with GDP growth, at a rate of 11.1% year-over-year on average in the past

three decades, much higher than the similar productivity-led growth in

the United States from 1960 to 1989, at an annual rate of 5.4%. As of 2009, manufacturing productivity per employee in China reached USD49,000,

where India registered at USD68,000. However, if compared with developed

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countries, China is still far behind. The United States continues its growth in

productivity and broke through USD150,000 in 2010, followed by Germany with USD121,000 and Japan with USD109,000.

China, like other East Asian countries, is at a productivity level much

lower than developed countries. As core technology is provided by high-

tech economies, China shares little in the production chain, and is mainly stuck at low processing manufacturing. Unskilled workers become a drag

on productivity growth. China needs to climb up the value-added ladder backed by technology innovation and technology transfer in the process of transiting to a sustainable domestic consumption–driven model backed by

high technology from a low value-added export-oriented manufacturing kingdom.

The middle-income trap: A potential pitfall China is likely to become a real superpower if it continues quality growth supported by favorable institutional arrangements in this 30-year

phase. Otherwise, it might be caught by the middle-income trap. China’s development over the next three decades will likely decide if it becomes the next United States or the next Latin America.

The middle-income trap refers to countries that have reached a middle-

income level ranging from USD4,000 to USD12,000 GNI per capita, but are

unable to advance further. The Latin American countries are frequently cited

examples of this phenomenon. The main cause of the middle-income trap is that countries are unable to move up the value chain as their governments

have not developed policies and institutions to transition into high-tech or greater value-added industries. However, as their income levels rise higher, they may also find that they can no longer adequately compete with lowincome countries in low value-added industries, and are thereby trapped in a zone where they cannot adequately compete on either level.

Two indicators of the middle-income trap approaching are when surplus

labor begins to dry up and when wages begin to rise. China appears to be on that path, with rising wage levels and rising rates of urbanization implying a shrinking supply of cheap migrant labor. Furthermore, we can see from the

chart below the gradual aging of China’s population. An aging population

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

also gradually reduces the pool of available labor, as well as adds pressure

on wages and social safety nets. While China has not fallen into the middleincome trap quite yet, it may be in danger of doing so unless it can move up the value chain successfully.

China: Aging population

2011

2010

2009

2008

2007

2006

5

2005

66

2004

10 2003

68 2002

15

2001

70

2000

20

1999

72

1998

25

1997

74

1996

30

1995

76

Population aged 0-14 (% of total) RHS

Population aged 15-64 (% of total) LHS Population aged 65+ (% of total) RHS Sources: CEIC Data; Haitong International.

Is China Ready to be a Superpower? In the global economic environment that has seen developed countries

struggle to regain growth momentum following the Global Financial Crisis and during the ongoing European Sovereign Debt Crisis, China has suddenly been thrust towards the forefront of the discussion as a potential superpower. There has been discussion of a G2 world, where the United States and China

are the two superpowers in the international system. The recent chain of

events has accelerated China’s rise in stature in the international system. All these have happened dramatically in the past three to four years, although it generally took other developed economies 100 years to reach the stage. In

other words, it seems too soon for China to fully realize its new identity and

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Is China a Real Superpower?

get prepared economically, institutionally, and diplomatically for the new tag as a superpower from a developing world.

Domestically, China is seeking to walk the path that took the United

States a century in three decades, in transitioning from an industrialized,

manufacturing heavy society to a society more focused on technology and labor productivity. This is the overarching goal, to be accomplished

by transitioning from the export-led model of growth to a domestic consumption–driven model. It is a daunting task, but one that must be done

to avoid the middle-income trap. Favorable institutional arrangements and

productivity enhancement along with high technology development and transfer are the keys to success.

Externally, China’s rise and transition from different stages of development

will mean that the focus for managing foreign affairs will change over time

as well. China’s “no intervention” foreign policy for the past decades have increasingly appeared awkward in dealing with international affairs due to its rising investments and interests overseas. Outward FDI surged from the

beginning of the 21st century due to the promotion of the “go out” policy,

reaching USD60.2 billion in 2010, about 60 times the level at the turn of the century. The gap in FDI with the United States is narrowing, as China continues to invest outwards. With consistently rising foreign exchange reserves of over USD3 trillion, China is seeking out investment opportunities

abroad. China has special interests in commodity investment; for example, accumulated investment in Africa and Latin America reached USD13 billion

and USD43 billion, respectively. At varying stages of economic development, there will be different agendas and views for policymakers. In the course of China’s rise to superpower status, China will have both increasing interests and influence worldwide, and consequently, there will likely be some notable changes in foreign policy direction for the coming years.

Lessons from U.S. foreign policy It is noteworthy reviewing the evolution of the diplomatic policy of the United States along with its growing economic power globally. Contemplating the initial policy of isolation and the subsequent historical evolution of

the Monroe Doctrine in the United States is a way to understand how a

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

country’s foreign policy changes with levels of economic development and with the quantity of assets overseas during a country’s rise to the level of a superpower.

Prior to the Monroe Doctrine being introduced in 1823, U.S. foreign

policy was largely based on neutrality and isolationism. This was due to both its lack of foreign interests at the time as well as its weak economy and military. Originally introduced in 1823, when the United States was still a

fledgling economy, the Monroe Doctrine was an almost purely a defensive policy designed to discourage European colonization of North and South

America. The Monroe Doctrine was a foreign policy declaration that any

future aggression by European powers in the Americas would be perceived as a threat to the United States; in essence, making clear an expectation that the European powers would stay away from the Americas, in exchange for the United States not interfering with European politics and existing

colonies. This phase of U.S. foreign policy development perhaps similarly reflected China’s attitude for the last several decades; with relatively limited foreign interests, the focus was mainly to protect domestic interests.

At the turn of the 20th century, the United States was gradually rising

to superpower status. At this time, the Monroe Doctrine was amended with the Roosevelt Corollary, which expanded the original meaning of the

Monroe Doctrine and stated that the United States would have the rights

to exercise military force to keep Europeans out of Latin America and have the right to intervene in case of “flagrant and chronic wrongdoing” by Latin

American countries themselves. This was seen by many as the United States’ departure from the previously defensive stance of towards a more aggressive

declaration of regional hegemony. More importantly, this marked the U.S. shift in foreign policy to actively defend their foreign interests. At that time,

the U.S. GDP per capita was estimated to be roughly USD4,000 to USD5,000, and America had just completed its transition from being an agricultural to an industrialized country, with a strong manufacturing infrastructure in

place. During this time, the United States also began rapidly increasing the amount of foreign interests that it held around the world. While data from

this era was sparse, it is estimated by economic historians that the United States had USD2.6 billion in outward FDI in the year 1914. As evidenced by the implementation of the Roosevelt Corollary, it became in the interests

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Is China a Real Superpower?

of the United States to shift its foreign policy and act to protect its interests abroad.

Finally, the United States became the world’s most prominent superpower

by the end of the Cold War, with the world’s largest economy driven by its high-tech and skilled workforce. When its spheres of influence and

foreign interests expanded across the globe, the ideology behind the Monroe Doctrine — in other words, the need to protect its assets and interests —

led to increasingly aggressive intervention in foreign affairs globally, which

remains the case today; the United States is often referred to as the world’s policeman.

The “adolescent” on the way to bona fide superpower As a rising economic and military power, China is concerned by Western

countries, especially since U.S. President Obama has been pushing a concentrated overseas military policy since taking office. An assessment report of the U.S. military interests, titled Sustaining U.S Global Leadership: Priorities for 21st Century Defense was announced on January 6, 2012. In this report, the United States linked its economy and security interests closely

to regional development ranging from the Western Pacific Area and eastern Asia to the Indian Ocean and southern Asia. It is evident that the redirection

of the U.S. military strategy focuses much more on China than other powers in this region.

With China’s rise as a superpower and increasing interests abroad,

together with concerns and fears of both Western and regional neighbors,

signs of changes in China’s foreign policies have gradually been seen. It

has become increasingly important and urgent for China to establish a new foreign strategy facing the new challenges and opportunities for its new status in a new international structure and environment.

Communication is as equally important as a new foreign strategy.

Tensions in the South China Sea areas and borders partly caused by concerns and fears of China’s rapid rise have increased recently. Issues range from

economic concerns such as currency valuation and trade disputes to politically salient issues such as increased military spending, environmental

concerns, and international relations. China would benefit from improving

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

communication to promote cooperation and diplomacy, which could be done through a variety of methods, both official and nonofficial. In doing so, they could gain more strategic partners and alleviate some concerns that other countries have about its rise.

China could seek to improve ties with Europe. While Europe has been

strategically linked to the United States, it may seek to develop strategic

economic partnerships with emerging economies. Out of the BRICS, Brazil

may be the intuitive choice due to a more aligned cultural and political background, but there are both opportunities and motives for China to fill that role. The ongoing European Sovereign Debt Crisis may offer an opportunity

for China to assist Europe in a time of need and strengthen ties for the future; indeed, China recently pledged to invest in the Eurozone bailouts, a sign of cooperation and extending a helping hand in a time of need.

That said, the most frequently discussed bilateral relationship is of course

that of China and the United States, and for good reason, as they are the two largest economies in the world. Despite the interdependence between the

two countries, there is still strain on relations due to a variety of factors; broadening and deepening ties would be beneficial to both countries. China

is following the similar path that the United States took to rise to the status of an economic superpower, and it is attempting to do it in far fewer years.

China needs time to continue to develop and adjust, economically,

institutionally, socially, and diplomatically before it can truly blossom into

a superpower of the highest level. If the growth of a superpower could be described in the same terms one would use to describe human development,

China would most likely fall under the “adolescent” stage of development.

China is not quite grown yet, and there will likely be some growing pains in the future, but it is well on the path to becoming a bona fide superpower.

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Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

One of, if not the most important reason for China’s rise over the past three decades has been its “labor bonus,” or the competitive advantage it has received from having access to seemingly endless supplies of low-cost labor. However, recent data collected shows that there are two statistically

indisputable truths about China’s workforce. First, the cost of labor in China is rising; China’s average wage has more than quadrupled since the turn

of the millennium. Wages have risen noticeably over the past several years, with the annual wage doubling from CNY20,856 in 2006 to CNY41,799 in

2011. Second, China’s population is rapidly aging; comparing 2011 data with

1982 data, the percentage of the population aged 0 to 14 fell from 33.6% to 16.45%, while the proportion of the population aged above 65 rose from 4.9% to 9.1%. Both these trends are set to accelerate in the coming years, leading to

a growing fear that China’s labor bonus is about to disappear. This is echoing

one argument about whether China is approaching a Lewis Turning Point,

where the surplus of low-cost subsistence labor is depleted, and wages and benefits are increased. The argument then follows that China will lose its

labor bonus advantage, and lose its ability to compete with other countries

such as Vietnam and Indonesia in low-cost manufacturing, an arena which it has dominated in recent decades and which has allowed it to become the “factory of the world.”

China: Average wage (CNY/year) 50,000 40,000 30,000 20,000 10,000 0 1981

1986

1991

1996

Sources: CEIC Data; Haitong International.

170

2001

2006

2011

Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

China: Population categories (% of total population) 75.0

35

Forecast

72.5

30

70.0

25

67.5

20

65.0

15

62.5 60.0

10

57.5

5

55.0 1950

1966

1982

1998

2014

15–64 population, LHS

2030

2046

2062

2078

0 2094

65+ population, RHS

Sources: United Nations; Haitong International.

In our view, China’s labor bonus is to continue in the coming years. The

labor bonus will continue to evolve with time, mainly due to four reasons: labor costs in China remain low relative to the rest of the world, particularly in manufacturing; China’s labor supply still has significant untapped potential;

China’s comparative advantages in labor are increasingly oriented to more-

skilled labor from unskilled labor, and the quality of labor will continue to improve; and China’s massive domestic market is to add a new dimension into the labor bonus concept.

Low Labor Cost Relative to the Global Level China’s traditional labor bonus of having an edge in low-cost jobs is far from

being depleted, even comparing with most developing countries. It is worth

pointing out that while average wages have risen rapidly over the past five or six years, they are still very low compared with the global average.

China’s average wage amounted to only CNY41,799 or USD6,568 in 2011; the United States, with an average wage of USD52,607, was over eight times the level in China.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

In particular, according to the U.S. Bureau of Labor Statistics,

manufacturing wages in China were at just USD1.36 in 2008. The average

annual wage has risen by approximately 45% from 2008 to 2011; it is nonetheless a mere fraction of the wage level in developed economies, and is still lower than or in a comparable range to most developing economies such

as the fellow BRICS countries (Brazil, Russia, India, and South Africa). Even in aggressive forecasts, such as in the Boston Consulting Group’s predictions of manufacturing wages in China rising to USD4.41 per hour compared to

the United States at USD26.06 in 2015, China’s labor costs will still be merely a fraction of U.S. costs for the near future.

Moreover, labor benefits in China remain far behind developed countries.

Pension coverage is kept low, and that of migrant workers, the total number

reaching 252.78 million (around 33% of total workforce) in 2011 according

to CEIC Data, is often neglected. Basic healthcare provisions, which are often taken for granted in developed countries, are generally low in China. Particularly in private firms, workers frequently work beyond contractual

hours, and some companies have been known to delay payment that is owed to the laborers. Legal protection of workers is also low; laborers sometimes

can be dismissed with minimal notice or without clear reason, and receive

low severance pay. These factors contribute to the low labor costs and provide companies with flexibility that would not be possible in a country

with better worker protection. The poor labor situation has aroused concerns and has been improved greatly in the past few years, but there is still a long

way to go before China reaches the standard of developed, or even most developing, countries.

Significant Potential for Further Tapping the Labor Supply The argument that China’s labor supply is drying up is also debatable. One of China’s biggest challenges ahead is its aging population and declining workforce, and this is central to those arguing that China’s labor bonus is vanishing. The United Nations projects China’s working-age population

to peak in 2015. The proportion of senior citizens will rapidly rise due to

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Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

lower birth rates and due to higher longevity achieved through advances in healthcare, leading to a smaller effective workforce. However, there are

several potential policy options in the future that could boost the effective size of the working population as China goes through a demographic shift.

One-Child Policy to be reviewed and revised A core assumption for analysts forecasting that China’s labor supply is about to shrink drastically over the next few decades is that the One-Child Policy remains in place. There has been increasing discussion in recent years on

whether China should continue the One-Child Policy after its 30 years of implementation as the country faces great challenges of an aging population and declining active labor population. As early as in 1980, when the One-

Child Policy was launched for the first time, China’s government claimed

that the policy could be revised 30 years later if its fast population growth could slow down to a reasonable rate.

Currently, China’s official figures indicate that China’s fertility rates are at

1.8 per woman, with fertility rates in big cities such as Beijing and Shanghai at levels below 1.0 child per woman; furthermore, the United Nations and

some scholars estimate that the rate is only about 1.4 to 1.5. According to the United Nations, a rate around 2.0 is a proper rate for healthy generation

evolution; that is, the One-Child Policy should be eased when the fertility

rate falls significantly below the line of 2.0, to avoid a population decrease. If China follows a similar pattern to developed nations, the fertility rate will

continue to drop as the process of industrialization is complete, and as the urbanization rate, wealth, and education levels rise.

The One-Child Policy therefore likely needs to be reviewed and revised in

the coming years, given the policy’s numerous impacts, including increasing social pressure, aging problems, and rising wealth and education levels. It is

unlikely that this policy will be maintained in its current form for the long term.

Easing has been observed; for example, the government has already allowed families with both couples from single-child families to have a second child. However, the progress has been slow despite increasingly open discussions on the subject. According to China’s 12th Five-Year Guideline for Population

Development, the total population is expected to be kept to 1.39 billion during

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

the period, implying that stabilizing population growth remains the primary objective at the current stage, and revisions will be minor and gradual. It is not unreasonable for the government to take cautious steps, as this policy is

one of the most critical policies in China and impacts from its revision could possibly be irreversible.

In our view, the trend showing a gradual easing of the One-Child Policy

is clear, and it is a matter of time before the process plays out. It is likely

for the government to allow a softening to a partial “Second-Child Policy” starting from 2012, and gradually transform it into a general policy after 2015; however, there will still almost certainly be restrictions on having a third child. Possible gradual reforms could include the following: • Gradually ease the age guidelines for childbirth

• Gradually ease the age gap guidelines for two children, which is to say when a family with both couples from a single-child family can opt to have a second child

• Gradually allow couples with one spouse from a single-child family to have a second child

• Gradually allow rural families to have a second child

Once the One-Child Policy is eased, what is known as the “two-high”

group (high-education and high-salary) will be more willing to have a second child, while less affluent households are likely to hesitate, given the high life pressures and high costs of raising children. According to a

grassroots survey in Shanghai, about 50% of families will consider having a

second child. In sum, easing the One-Child Policy will not only increase the

population size, but also rebalance the population structure to avoid falling

into a severe demographic distortion of a “4–2–1” structure, where each generation grows increasingly smaller and responsible for the wellbeing of a greater number of older relatives.

Possibility to increase the retirement age to expand the labor supply There has also been recent discussion to increase the retirement age in

China, following concerns over the sustainability of China’s pension

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Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

system. Currently, China’s retirement ages are among the lowest in the

world, with retirement ages set as early as 50 for female workers, 55 for female officials, and 60 for male employees. As retirement ages globally are

typically somewhere in the mid-60s, there is significant room to increase the

working-age population by virtue of extending the working-age limit. This

is particularly true for the female workforce, which has an enormous amount of potential to expand.

It is also worth pointing out that China’s retirement age keeps the

workforce far from being fully tapped, both in terms of official statistics, and in terms of de facto labor. This artificially skews the official working-age

population to be smaller than the de facto working population; a portion of the elderly in China, particularly in rural areas, often continue to work long

after their official retirement age. An early retirement age often forces many still qualified workers out of their jobs early.

Global retirement ages Country

Retirement age (M)

Retirement age (F)

Brazil

65

60

China

60

50–55

France

62

62

Germany

65

65

India

60

60

Japan

60*

60*

Russia

60

55

U.K.

65

60

U.S.

62–67

62–67

60

55

Vietnam

Sources: various news sources; Haitong International. * The lower house of Japan’s parliament passed a bill to raise the age to 65 on August 2, 2012.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

China’s high female labor participation rate China boasts a high female labor participation rate. Compared to developed and developing nations, China’s 68% female labor participation ranks among the highest. For the most part, China only

lags behind transitional economies such as poor African countries.

China’s rate is already significantly higher than its BRICS competitors, as well as developed economic powerhouse nations such as the United States, Japan, and Germany. If it were not for China’s particularly low retirement age for women, this rate would likely be higher.

China’s high female labor participation has the effects of increasing

its effective size, as well as ostensibly increasing the scope of available talent; ceteris paribus, with a larger eligible female workforce added to

the existing male workforce to increase the total labor pool, companies will be able to hire better or cheaper workers.

Female labor participation rate (% of females aged 15+ economically active) 80 70 60 50 40 30 20

Sources: World Bank; Haitong International.

176

India

South Africa

Japan

Germany

Russia

U.S.

Brazil

0

China

10

Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

Labor Comparative Advantages Tilting to More-Skilled Labor China’s labor bonus will likely gradually evolve to increasingly focus on low-cost skilled labor in lieu of low-cost unskilled laborers; this means that

China will find it easier to gradually move up the value-added chain. Valueadded industries and occupations that require skilled labor and higher levels of education are likely to play an increasingly larger role in China’s economy.

With great expansion of college education and significant improvement in

continuing education and on-the-job training under over a decade’s efforts,

China has accumulated a large pool of skilled labor to move up the valueadded ladder.

Increasing education levels China’s population is becoming increasingly educated, and its workforce

increasingly skilled as the population grows wealthier. According to China’s Ministry of Education, in 2011, a total of 7.99 million students graduated from undergraduate and specialist programs, and a total of 430,000 students

graduated from postgraduate degrees including master’s degrees and

doctorate degrees; the combined graduates of higher education have nearly multiplied fivefold since 1998, with postgraduate graduates in particular increasing nearly tenfold.

As China’s population is increasingly educated, a new area of competitive

advantage is that China has a large supply of college graduates and skilled laborers. Due to the sheer quantity available, college graduates in China can be employed at a very low cost relative to the rest of the world. According to

the 2012 Chinese College Graduates Employment Report by MyCOS Data,

the monthly salary for a college graduate was CNY2,766 or USD435, for a yearly salary of USD5,220, compared to the average salary of USD41,701 for

college graduates in the United States. While the difference in the quality of the education that college graduates receive is debatable, China is home to a huge pool of skilled laborers with college educations.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Additionally, China’s government is also very pragmatic with regard to

influencing the selection of majors available. In late 2011, China’s Ministry of

Education announced plans to gradually phase out “unemployable majors,” where a significant portion of graduates cannot find work, with the aim of

reducing the “ant tribe” population. Relevant majors such as business-related majors, law, medicine, and engineering are often promoted to pump out a

more “workplace-relevant” graduate demographic than what would be the case in a situation where all majors were treated equally, and to reduce the

likelihood of China falling a scenario where fresh graduates find themselves in a conundrum, laden with student debt but unemployable in their relevant fields.

There is still room for improvement in the education system as

well. According to United Nations Educational, Scientific and Cultural

Organization (UNESCO) data, secondary education enrollment was at 81% in 2010, while tertiary enrollment rose to very respectable 26%. Improving secondary school enrolment, particularly among the disadvantaged class, will result in an increasingly competent workforce. Important issues addressed

in recent policies also include improving the education and competitiveness

of minority groups in China; for instance, many government﹣sponsored

schools have been opened in Xinjiang, where minority children can have access to education for little to no cost.

Rapid spread of technology The rapid osmosis of technology and know-how in China can also help improve productivity. China benefits from a large quantity of joint ventures with and acquisitions of many foreign leading companies, which not only provide an immediate transfer of management and technological know-how,

but also eventually result in a significant spillover effect as this know-how spreads to other companies. This process has been escalating rapidly over the

past few years; China’s outward direct investment picked up significantly over the last several years, more than doubling to USD60.1 billion in 2011 from just USD24.8 billion in 2007.

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Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

Additionally, there has been a rapid dissemination of mobile phones and

Internet access throughout Chinese society. These can be used for easier and

quicker communication, and for faster dissemination of (as well as access to) knowledge and salient information. Over the past decade, mobile phone and Internet usage has jumped significantly in China; increasingly, mobile

phones and Internet are seen as essential tools for individuals, supplanting the television and the radio before them.

Improved labor productivity One point that should not be disregarded is the level of efficiency that China has managed to achieve, relative to other developing countries, which makes

Chinese labor attractive beyond the simple cost of worker wages. China’s labor efficiency is higher than potential competitors such as Indonesia, India,

Vietnam, and Bangladesh. For example, China generated almost triple the

amount of GDP per employee compared with India, and over five times as much as Bangladesh. Note that China’s labor productivity has been improving significantly and the trend will continue. Data from the Conference Board

indicates that China’s labor productivity grew nearly 10% per annum on average between 2005 and 2010, which exceeded the growth of fellow BRICS

countries India and Brazil, while far outpacing developed economies such as the United States, Japan, and Germany. This stark differential implies that

China is moving towards a long-term catching-up of labor productivity with the countries that currently hold an edge.

In the process of its ascension to the spot of the world’s largest manufacturer

following its major economic reforms, China managed to exponentially

improve its efficiency across a broad spectrum of industries, obtaining a high labor productivity compared to other developing economies thanks to

a relatively competent and skilled workforce, a sophisticated manufacturing infrastructure, and well-established domestic and international supply

chains that facilitate the purchase of inputs and distribution of outputs. These are just several of the tangible advantages that China currently has that improve its competitive edge; these factors among others make China an attractive location for manufacturers.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

New Meaning to the Labor Bonus Concept China’s great potential in the massive domestic market founded on its large

population is to inject new meaning into the labor bonus concept. With the world’s largest population, steadily increasing wealth levels, and a desire to shift to a domestic consumption–based model of growth from the old

export-led model, China’s domestic market will be one of the most desirable markets that companies could seek to capture, if it is not already. This will be a major reason for companies to base themselves in China.

In 2011, China’s final consumption expenditure was roughly a third of

that of the U.S. level, at around USD3.48 trillion or CNY22.47 trillion. While

the domestic market is already large in nominal terms, there is plenty of room for growth, as China’s per capita consumption is still very low

compared with developed economies. Since 2000, the growth of consumption

expenditure in China grew at an average of 14.9% year-over-year. Despite a difficult first half of 2012, retail sales of goods in China increased at a very rapid pace over the past several years; since the turn of the new millennium,

retail sales had grown from CNY3.910 trillion in 2000 to CNY18.392 trillion in 2011. Under the assumption of an average China GDP growth at 7% year-

over-year and U.S. growth at 2% year-over-year in the coming years, with an average appreciation of the renminbi of 3% per annum against the U.S.

dollar, and taking into account the rising share of Chinese consumption of

GDP, we forecast that China’s domestic consumption could grow to over half of U.S. levels by 2015 and over 80% of U.S. levels by 2020.

Of course, this will not be a new phenomenon; a whole spectrum of

foreign brands varying from Yum! Brands (such as KFC and Pizza Hut) to

Prada have already sought to capture a slice of China’s enormous market. China accounts for nearly a fifth of the global population, and its markets, if not already, will be an irresistible lure for companies and a huge driver

of global consumption in the future as the population grows wealthier and their spending power increases.

The influence of China’s market demand can provide a labor bonus in a

variety of ways. First, the fact that the potential for China’s market is so huge means that foreign companies are given strong incentives to locate in China,

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Evolution or Extinction: Amid Rising Labor Costs, What Is the Future for China’s Labor Bonus?

to have more direct access to the markets and save on transportation costs among other things. This incentive will increase aggregate employment in China, and create a labor bonus effect in the sense that Chinese workers will

be employed for the purpose of aiding foreign entities seeking to capture a share of the attractive market; this effect might not be seen in a smaller

developing country, where foreign companies may have less incentive to locate their operations.

Additionally, there is the element of creating demand for jobs like service

professionals that require a Chinese background to cater to the Chinese

market; jobs drawn to China can vary within a wide spectrum ranging from financial services professionals to luxury services providers. Naturally, it is likely that Chinese citizens and individuals with a strong Chinese background will be in prime positions to fill these roles to cater to the domestic market.

The evolution of the labor bonus to a stage where it is pushed primarily

by China’s demand side rather than its supply side is likely one of the final

stages for China’s labor bonus. This development is likely to be incremental, as China places increasing emphasis on encouraging domestic consumption as a driver of growth. China will not lose its labor bonus in the coming

decades despite rapidly rising wages; its labor bonus will only evolve and ultimately be rejuvenated on a different level.

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Shale Gas: Powering China’s Future?

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Near the end of March [2013], Shell signed a contract with the China National Petroleum Corporation to develop a shale gas block in Sichuan, the first deal to allow a foreign company to extract shale gas in China. The process

of developing shale gas was further escalated in April this year [2013] as China’s Ministry of Land and Resources announced on April 23 the intention

to expropriate blocks of land being held by energy companies that fail to invest CNY30,000 per square kilometer annually. Over the last several years, the United States and Canada have quietly enjoyed a boost to their energy

industries from developments in the controversial shale gas industry, which has provided the country with another source of natural gas. Shale gas is obtained by the process of hydraulic fracturing, which involves injecting a mix of sand, water, and chemicals at high pressure into a well, fracturing

shale rock, and releasing the shale gas which flows back up the well and is then recovered. This is a process that has drawn an increasing amount of attention recently, following the success of the United States and Canada in

boosting their natural gas production. In this essay, the potential for shale

gas in China, the challenges in developing the technology in China, and China’s current energy strategy are explored.

Vast Potential from Shale Gas One of the potential ways China may benefit from the recent elevated

interest in shale gas is as an investor worldwide from companies seeking funding. The development of shale gas projects can often be billion dollar investments, and often requires funding. China, as a cash-rich country with

plentiful foreign reserves, is a prime candidate to fund these projects. As

an investor in these increasingly economically viable projects, China could potentially secure a significant amount of resources or profits, and also improve their technical expertise.

The potential benefits that the development of shale gas in China can

bring domestically are huge, largely due to the enormous recoverable shale gas resources in the country, one of the highest in the world. China has shale gas resources of an estimated 1,275 trillion cubic feet; to illustrate the

enormity of this scale, the United States, the world’s leader in shale gas, a country that has already benefited significantly from the development of the

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Shale Gas: Powering China’s Future?

shale gas industry, only has recoverable shale gas resources of 482 trillion

cubic feet. According to data from the Ministry of Land and Resources, China’s ensured natural gas reserves only amounted to 133.4 trillion cubic

feet by the end of 2010; proper harvesting of shale gas resources in China would multiply this figure tenfold.

Recoverable shale gas vs. current conventional gas reserves (billion feet3) 1,600 1,400 1,200 1,000 800 600 400 200 0

China

Argentina

U.S.

Conventional natural gas reserves

Mexico

South Africa

Brazil

Recoverable shale gas

Sources: Financial Times; Haitong International.

Currently, China’s consumption of natural gas is very low, as electricity

production is done predominantly by coal. The uses of natural gas, outside of electricity production, include heating, cooking, transportation, and

fertilizer. This is unlikely to change significantly over the short term, as development of the infrastructure necessary to properly utilize natural gas

will be costly and time consuming. At the current low levels of consumption,

however, the amount of potential shale gas resources in China could last well over a century, with some estimates being 200 years. Consequently, the

long-term potential is very intriguing. The potential of shifting fossil fuel consumption increasingly towards heavier natural gas usage is the most

interesting possibility, as it will allow China to tap its sizeable domestic

reserves of shale gas and reduce its dependence on energy imports over the long term. Currently, China’s energy efficiency is very poor, resulting in high

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

quantities of pollution. Increasing the proportion of natural gas will not only help satisfy China’s energy requirements, but also allow China to produce

cleaner and more efficient energy as natural gas is the cleanest fossil fuel;

natural gas not only produces roughly 45% less CO2 than coal when used for electricity generation, but can also be turned on and off at will without wastage.

Notable Hurdles in Reality There are some potential drawbacks to developing shale gas technology.

First and foremost, there is the environmental concern, as engaging in hydraulic fracturing is detrimental on multiple levels. There are concerns of environmental damage such as earthquakes caused by the process, as well as the wastage and potential pollution of water sources; with China facing

a possible water crisis in the decades to come, these are significant risks. Consequently, it is vital that China imposes strong controls and regulations

on any shale gas development to minimize environmental damage. Second, there are significant short-term costs in developing the infrastructure necessary to extract, store, and transfer shale gas. Finally, while extracting

the shale gas may provide a source of energy, it may be advantageous to save these resources to harvest at a later date when they may be worth more.

While the process of hydraulic fracturing has been in existence for a

long time, it has only been recently that it has begun to be economically viable and more widely accepted as a method of procuring natural gas. As the first movers, the United States and Canada in particular are leaders in the shale gas industry. Currently, China is comparatively lacking expertise

and efficiency in many of the unconventional energy production methods such as the harvesting of shale gas and oil sands. While the potential that unconventional energy sources such as shale gas have might be enormous, China currently lacks the infrastructure and expertise to properly utilize it. The solution for expediting the process of tapping the potential of these

unconventional resources would be to secure a transfer of technology

and expertise from other countries, such as the United States, that are comparatively ahead in the field.

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Shale Gas: Powering China’s Future?

There are two important goals for China with regard to energy policy: to

improve their technical expertise and to bolster their own energy reserves. One of the most ideal methods to achieve both goals at once is to invest in

or acquire projects abroad that lack funding, which will allow Chinese firms to benefit from technology transfer, and to harvest natural resources from outside their own borders. This is particularly desirable for China as it is

currently flush with cash, and it would not have to deplete its own natural resources with this method. Two examples of this would be the China

National Offshore Oil Corporation’s (CNOOC) purchase of a 33% stake in two shale gas projects run by U.S. company Chesapeake Energy, and the

CNOOC acquisition of Canadian oil sands company OPTI in 2011, in which

a cash-rich Chinese company acquired an underperforming oil sands group.

China’s notable recent investments in unorthodox energy in the United States and Canada Year

Chinese company

Counterparty

Investment (USD billion)

Main target

2012

Sinopec

Devon

2.20

Shale gas

2011

Sinopec

Daylight Energy

2.10

Shale gas

2011

CNOOC

OPTI

2.04

Oil sands

2010

PetroChina

Athabasca

1.90

Oil sands

2010

CNOOC

Chesapeake

2.20

Shale gas

2010

China Investment Corporation

Penn West

1.25

Oil sands

2010

Sinopec

Syncrude

4.65

Oil sands

2010

CNOOC

Chesapeake

1.30

Shale gas

Sources: various news sources; Haitong International.

However, it is unlikely that many large acquisitions will occur in the

United States, as companies and politicians are reluctant to allow such

sensitive investments from China, due to the political ramifications of doing so. Allowing Chinese companies to benefit from both learning technical expertise and taking a portion of the resources harvested would spark public

outrage given China’s current status as a competitor and scapegoat for U.S.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

economic woes. A CNOOC attempt to acquire U.S. oil company Unocal in 2005 was thwarted by lawmakers due to heavy criticism.

A method of achieving technology transfer, however, could be from

inviting foreign companies to participate in joint ventures on Chinese soil. The recent agreement with Shell to develop a shale gas block in Sichuan is an example where China can hope to gain from technology transfer by having

a foreign company with technical expertise work on Chinese land. This is a less ideal method, as it would be foreign companies entitled to a share of China’s natural resources in exchange for technical expertise and extraction.

However, it is significantly easier to use this method to accomplish technology transfer as China is a country making rather than seeking the concession of natural resources.

The process of technology transfer will take time. It will likely be years

before China can fully catch up to the level of the United States or Canada, and utilize the technology to access untapped reserves both inland and in the contested South China Sea.

Shale Gas as Part of China’s Energy Strategy Shale gas is an ideal alternative to the current energy structure in China. Plugging shale gas into China’s energy structure will diversify energy

sources, and reduce pollution at the same time. Besides, huge reserves could provide China with less dependence on coal and oil, sectors which rely heavily on imports. That is in line with China’s energy strategy. However,

shale gas could not quickly play a role in energy sources due to the difficulties

of drilling technology transfer from the United States or Canada. Oil will remain at the heart of China energy strategy in the coming years.

Diversification of energy sources Traditional energy sources dominate China energy consumption. Coal weighted 67% of total energy consumption in 2009, which was followed by

crude oil, amounting to 17%. Both energy sources cost much in environmental terms, especially coal. CO2 emissions per head were recorded incredibly

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Shale Gas: Powering China’s Future?

high at 2.33kg/USD2,000, yet big energy consumers like the United States controlled this figure at 0.46kg/USD 2,000.

China: Energy balance, 2009 Natural gas 3%

Hydro 2%

Nuclear 1%

Geothermal & solar 1%

Biofuels and waste 9% Crude oil and products 17%

Coal 67%

Sources: International Energy Agency; Haitong International.

Unlike traditional energy, green energy emerged in the past decade, as it

is renewable and highly efficient. Environmentally friendly energy includes

hydroelectricity, wind power, geothermal and solar energy, and nuclear power. However, as of 2009, those new energies utilized in China accounted

for only 4% of total energy consumption. It is believed that green energy is experiencing a high-speed growth given technology supports.

Clean energy like natural gas and biofuels should get more weight in

the energy structure. Compared to renewable energy resources, clean energy

has relatively easy access of technology to utilization. As an unconventional

natural gas with huge reserves, shale gas has the potential to be explored in

the way natural gas was. Demand in natural gas surged by 17.4% year-overyear on average since 2006 and reached 9% of total energy consumption in 2010. According to the U.S. example, this proportion could go even higher to 24.1% of total energy consumption.

Shale gas that belongs to clean energy resources is very similar to natural

gas, low carbon consuming and energy efficient. In addition, as mentioned

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

above, in terms of clean burning, Shale gas produces 30% less CO2 than oil,

and 45% less than coal. For now, it may not be the time for China to use shale gas as a major energy source yet. Shale gas is still in the very nascent stage in China. Lacking drilling technology drags development in this industry. But

it has the opportunity to get on the track of developing under government preferential policies.

Preferential policies on new energy 12th Five-Year Guideline The Chinese government puts much emphasis on new energy development as traditional energy reserves are running out quickly. The central government

pointed out targets in the coming five years in the 12th Five-Year Guideline, which detailed each subindustry.

China: 12th Five-Year Guideline Energy type

Target by 2015

Solar thermal energy

Commercial operation

Wind power

Building with industrial turbines to raise generation capacity to 1.3 billion kW

Biofuels

Consumption: liquid fuel 7 million tons, biogas 24 billion m3, solid fuel 1.2 million tons

Unconventional natural gas

Technology development

Sources: Chinese government; Haitong International.

China Renewable Energy Scale-up Program The Chinese government also sought for international support at the same time. The World Bank and Global Environment Facility together with China’s

government developed the China Renewable Energy Scale-up Program. The

major task is to help green energy enter into the stage of commercial operation. Measures include supports to renewable energy policy development and

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Shale Gas: Powering China’s Future?

investment. The whole program contains three phases, taking 10 to 12 years to complete. So far, Phase 1 had been done by 2011.

• Phase 1: Implementing mandated market policy in four pilot provinces, aiming to involve commercial renewable energy suppliers into large-

scale renewable energy market. The Global Environment Facility provided USD40.22 million in financial assistance to foster provincial demonstration projects focusing on technology development and capacity

building and to encourage the engagement of commercial entrepreneurs, especially private investors. In this phase, a policy framework (laws and regulations) was set up at the national level.

• Phase 2: Applying mandated market policy in selected provinces • Phase 3: Spreading mandated market policy to all provinces

Renewable energy development fund China’s Ministry of Finance established a Renewable Energy Development Fund in December 2011. The fund consists of a special fund sponsored by the

central government (which is besides the basic subsidy to renewable energy)

and a feed-in tariff on electricity consumption (except Tibet and agricultural

use). Tariff was set as fixed CNY0.08/kWh. The size of the fund is estimated to be CNY34 billion, and may break CNY500 billion by the end of 2020. The

central government takes charge in managing the fund. The fund is used to support renewable energy projects in agricultural production and the localization of renewable energy utilization equipment.

Oil to remain at the heart of China’s energy strategy As applying new energy utilization takes time, China has to take an oil

reserve strategy at the same time in case of an energy shortage. Given that industrial production quickly picked up since the 1990s, demand in crude

oil surged. As of 2011, China’s oil consumption reached 440.6K metric tons, accounting for 12% of global consumption.

Note that China’s oil consumption relies much more on imports: about

50% of crude oil consumed was from imports in 2011. Crude oil imports recorded a high at 2,525.4K metric tons in 2011 from 155.6K in 1993, while

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

exports were reduced to only 25.3K metric tons in 2010 from the same level

in 1993. It is expected that China’s oil dependency will go even higher in the coming years.

Not only is oil dependency a worry but so are limited oil sources: 46%

out of the total oil imported is from the Middle East, and 30% is from Africa where the political environment is unstable. That for sure adds more pressure on oil supply.

China: Crude oil trade (K metric tons) 3,000 2,500 2,000 1,500 1,000

Exports

Imports

Sources: Thomson Reuters Datastream; Haitong International.

China: Crude oil imports by region Latin America 9%

Europe 11%

North America 0%

Middle East 46%

Asia and Pacific 4% Africa 30% Sources: China customs; Haitong International.

192

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1993

0

1994

500

Shale Gas: Powering China’s Future?

On the other hand, China, as a rising giant oil consumer, has been carrying

out strategic oil reserve plans to guard itself against price fluctuations since

2003. It started its strategic petroleum reserves after 2007, aiming to store state-controlled reserves of 475.9 million barrels and enterprise reserves of

209.4 million barrels for 90 days’ oil consumption. Three phases are planned to build up government reserve facility holding 101.9 million, 107 million,

and 204 million barrels, respectively. China’s government had completed the first two phases by the end of 2011. Reserve bases spread along the eastern coast cities and western areas, such as Liaoning, Zhejiang, and Xinjiang.

Three state-owned companies, Petro China, Sinopec, and CNOOC

contributed most of the enterprise reserves. Most reserve bases have been completed and have started operating.

China: Strategic petroleum reserves

Reserve type

Government

Enterprise

Phase/ contributor

Oil reserve (million barrels)

Phase 1

101.90

Liaoning, Shandong, Zhejiang

2008

Phase 2

170.00

Xinjiang, Gansu, Liaoning, Shandong

2012

Phase 3

204.00

Tianjin, Hebei, Henan, Chongqing

2023

Total

475.90

Petro China

11.33

Sinopec

—

CNOOC

11.30

Others

—

Total

209.4

Reserve bases

Completion year

Xinjiang, Liaoning

—

Zhejiang, Shandong, Guangxi

—

Gansu

— —

Sources: various media; Haitong International.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Price Fluctuations and Strategic Oil Reserves The world economy has become more sensitive to fluctuations in crude

oil prices. The Organization of the Petroleum Exporting Countries (OPEC) frequently limits production to get higher prices, which makes the world

economy heavily (and easily) shocked. Economies with high oil consumption sequentially built up strategic oil reserves after the oil crisis in the 1970s in order to provide a buffer for possible shocks linked to sudden jumps in oil

prices or shortages in oil supply. For China, with its strategic oil reserve plan

started in 2003, the country is now on its way to being quite well prepared to weather the economic fluctuations, and supply shocks, of the world oil market.

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Looking for the New Sources of Growth

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Periods of crisis often lead to movements of creative destruction and

reconstruction. Aggressive government stimulus packages pulled the world out from the first wave of the Global Financial Crisis in 2007 to 2009. However, a second crisis resulted for the global economy: an even deeper

debt crisis. Conventional policies have been losing potency for driving global growth, and new sources of growth are urgently needed. Finding

these sources is a difficult task, especially for major economies such as the United States, China, and the European Union (EU). This search requires the

easing of monetary policies to win time and structural reforms to define the new growth engine.

Easing monetary policies are currently winning time to allow the

governments to develop their fiscal consolidation and industrial policy. Via different securities purchase programs, such as QE3 and Operation Twist, the

U.S. Federal Reserve continues to support the housing market, government bonds, and the banking system, as well as maintains the U.S. dollar at a low

level. The People’s Bank of China will likely maintain an accommodative monetary policy to facilitate infrastructure investment, which will remain crucial in the short to medium term for maintaining economic growth as China completes structural reforms and transitions. The European Central

Bank’s (ECB) newly created Outright Monetary Transactions program has contributed to the reduction of market pressures on European debt, while the long-term refinancing operations maintain abundant liquidity in the

interbanking market. The European banking system will benefit from these liquidities and form an extended supervisory role for the ECB. Besides

monetary policy, which is oriented toward the short term, fiscal policy is also necessary for winning time, but the long-term solution for the three major economies lies in major structural reforms and industrial guidance.

In the United States, the structural reforms are to focus on fiscal

consolidation, the development of ambitious industrial policies, and the completion of financial reforms. The reindustrialization policy will play a

central role in the rebirth of the U.S. economy. It will be based on the defense of strategically important industrial sectors; the support to the potential for growth via infrastructure projects, research, and education; the target

of energy self-sufficiency; and the development of a protectionist external trade policy, coupled with the support from “reshoring” efforts [moving

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Looking for the New Sources of Growth

outsourced American manufacturing operations and jobs back to the United States — ed.].

In China, we expect an investment boom to provide a short- to medium-

term boost following the leadership transition and this will initiate another “Golden Decade,” while structural reforms will be essential for sustaining

long-term economic growth. China is in a long process of transitioning towards a domestic consumption–driven growth model from an exportled and investment-driven model, and the nation needs various structural

reforms including enhancing the contribution of consumption and services in the GDP structure in particular.

In the Eurozone, the long-term objectives are short-term necessities as

the austerity policies depress the demand and the general level of activity.

In the long term, fiscal consolidation will be pursued, foreshadowing low levels of growth. The capital, job, and goods markets will undergo profound

reforms. Regarding the capital market, the Banking Union project will

progress quickly in giving the ECB a central supervisory mission. The quick

liberalization of the job and goods markets in the Eurozone periphery should contribute to slowly improving their competitiveness.

The three major economic powers will also find new sources of growth in

technological innovation. Both strong political willingness and ample budget resources are important factors for countries to outperform in innovation,

as countries do their best to increase their competitiveness with a strategy

focusing on IT, healthcare, and energy sectors. U.S. domination in the R&D

field will continue, with China rapidly catching up, while the innovation capacities of the Eurozone countries will weaken.

Searching for the New Sources of Growth in Structural Reforms Two major crises in less than two years have made major political leaders well

aware of the necessity to change their model of growth. The governments now assume the difficult task of stabilizing their economy in the short term, and finding new sources of growth via ambitious structural reforms.

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Rebirth of the U.S. economy For a long time, the U.S. economy has had the capacity to recreate itself.

This capacity historically came from a supply of efficient labor, and the ability to quickly reallocate work and capital after negative shocks, and high productivity based on an extensive exploitation of innovations. These factors have been at work in the aftermath of the Global Financial Crisis

and will continue to generate growth in the future. However, the virtuous circle linking jobs creation, productivity, and innovation would have not

been possible without an intervention of the government, which supported both the demand and the supply sides of the economy during the crisis. These interventions have led to an accumulation of public deficits. The

stabilization of the public debt has become now an urgent necessity. The

rebirth of the economy will require first a fiscal consolidation, which will

continue over the long term. Congress and the U.S. government should

organize a smooth transition to austerity, reassure investors on the resilience of domestic demand, and convince them of their seriousness in tackling the

issue of public debt. The U.S. economic policy should also focus on industrial priorities and the extension of financial reforms.

Stabilizing U.S. debt as a short-term and long-term priority The main thing at stake following the last U.S. election is the future orientation of the U.S. public budget. After tense negotiations on the U.S. debt ceiling in 2011 and 2013, Congress and the president agreed on the necessity of further

fiscal consolidation for the next 10 years amounting to USD917 billion. In the

absence of a deal reached by the bipartisan “super committee” on the way to organize this consolidation, automatic cuts to federal spending took place in January 2013 (the sequester).

The solution to the fiscal issue and a smooth transition to austerity should

provide favorable effects for the U.S. economy, representing new short-term sources of growth:

• The emergence of a bipartisan solution and the progressive disappearance

of the fiscal cliff threat will reassure the market and support stock prices.

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• The solution brought to the fiscal cliff issue will also reassure investors

and the corporate sector. Most of the U.S. companies are cash rich but have put on hold a certain number of projects due to the uncertainty linked to a possible recession. The diminishing aversion for the risk will unblock credit, investments, and merger and acquisition activities.

• The progressive path toward austerity will convince international

investors of the consistency and seriousness of U.S. fiscal consolidation. It will reduce the risk premium on the U.S. public debt and this will contribute to the maintenance of interest rates at low levels.

• Households will be reassured and will keep a stable pace of expenditure.

Reindustrialization in the United States Besides the stabilization of the housing market and the progressive recovery

of the U.S. economy, the reorganization of the U.S. industrial policy was another success of Obama’s administration. The share of the manufacturing sector as percentage of total employment and GDP stopped declining. This

industrial policy has taken several roads between the Global Financial Crisis

and Obama’s reelection: the defense of strategically important sectors; the boosting of growth potential (via the promotion of R&D, education, and infrastructure projects); the targeting of energy self-sufficiency; and an aggressive external trade policy coupled with a promotion of reshoring.

Defense of the U.S. automotive and other strategic sectors The rescue of the automotive industry during the Global Financial Crisis played a decisive role during the election. Voters in states which benefited from the government’s support for the rescue of the car industry generally voted for President Obama. President Obama defended the bailout of Chrysler

and General Motors (GM) during the crisis. By 2009, GM and Chrysler were indeed close to bankruptcy. Under the Troubled Asset Relief Program (TARP)

authority, Obama decided to allocate USD40 billion to the car industry. The government estimates that 1.4 million jobs were saved in 2009 and 314,000 jobs were saved in 2010. In return for the financial assistance, the sector had

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

to restructure itself. The car industry recovered quickly and was rapidly a

net positive contributor to the job creation process. The defense of this sector

was appropriate as it represents one of the most innovative sectors of the U.S. economy and stands at the heart of one of the most significant clusters.

More generally, the most strategic sectors of the U.S. economy have also benefited from a protectionist policy under Obama’s administration. This targeted protectionist policy, and the reinforcement of strategic sectors such as the car or aircraft industries, will continue in the future.

Promotion of growth potential in the United States The necessary deleveraging of the economy has made an essential engine of

the economy stall abruptly. In this context, the recovery of growth required not only a temporary support of the demand, but also the promotion of

the economy’s potential via important R&D activities, large investments in infrastructure, and promoting education. These supportive actions were

present from the beginning of the stimulus package’s implementation. The tax credit for research in the corporate sector will be probably extended under the second term of President Obama. His new program plans to

invest USD25 billion for the modernization of 35,000 schools, USD5 billion for the modernization of community colleges, and USD30 billion to prevent

280,000 teacher layoffs. Given the still unsatisfying quality levels of U.S. infrastructure, Obama will probably continue to invest in this area even if

the room for maneuvering will be more limited with the implementation of a

stricter fiscal policy. The United States has indeed not recovered its precrisis ranking in terms of infrastructure quality according to the estimates of the

World Economic Forum. In 2009, the American Society of Civil Engineers

gave America’s infrastructure a “D” and urged the president to pursue his

efforts in this area. In July 2012, the president signed the Moving Ahead for Progress in the 21st Century Act (MAP-21), which will not only reduce the

federal budget deficit by USD16.3 billion in the 2012 to 2022 period, but also

unblock the nation’s surface transportation funding. This act authorizes USD105 billion of federal spending for the fiscal years of 2013 and 2014 on

federal highway and public transportation programs, surface transportation safety and research, and different rail programs.

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Targeting of U.S. energy self-sufficiency New techniques such as horizontal drilling and hydraulic fracturing

have made the exploitation of shale gas and shale oil economically viable in the United States. According to different estimates, shale gas drilling rigs are three times more productive than the conventional gas industry. Conventional gas is traditionally trapped in large pockets or reservoirs. The

shale gas can be found only in small quantities in shale formation, a mix of mud and minerals. The horizontal drilling allows large sections of the

rock to be exploited, whereas hydraulic fracturing, or fracking, consists of injecting sand, water, and chemicals at high pressure into shale formations to

make them permeable so as to allow extraction of the gas afterwards. These technologies have been rapidly applied to oil exploration and exploitation.

Higher productivity and efficiency, a large availability of shale gas and

oil reserves, as well as favorable geological conditions, good preexisting network infrastructures, the support of the government, and a favorable regulatory framework have been game changers in the energy industry of

the United States, and for the U.S. economy as a whole. In the United States, the production of shale gas increased from 0.4 trillion cubic feet in 2000 to 4.8 trillion cubic feet in 2010, representing 23% of U.S. dry gas production

and even 33% of total gas production in 2011. Gas is now the second largest

source of energy in the United States behind oil but above coal. According to

the estimates of the U.S. Energy Information Administration, shale gas will represent 45% of total natural gas production by 2035.

These new techniques also allow the United States to exploit new sources

of oil. U.S. oil production has increased by 25% since 2008. In its last World Energy Outlook, the International Energy Agency estimated that the United States will overtake Saudi Arabia and Russia as the largest oil producer in the world, and should be self-sufficient in energy by 2035. The increase of

gas and oil supply in the United States has not benefited other countries as the usage of this new source of energy has been primarily domestic.

The consumption per head of gas and oil is relatively high in the United States and the export flows remain low. No significant export facilities are expected to be operational before 2015. Instead of exporting this resource, the United States has modified its energy mix in favor of gas to the detriment

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

of other commodities such as coal. The electricity industry has in particular substituted gas from coal and oil as an input of production. The lower

demand for oil from the supply side of the economy will directly benefit consumers, who should face lower gasoline prices.

The significant increase in the supply of gas and oil in the U.S. represents

a positive supply shock for the U.S. economy. Gas and oil needs are indeed important in the United States relative to the rest of the world. Gas and oil represent an important factor of production, especially for electricity, and have an important weight in terms of household consumption.

• The corporate sector and households will benefit from these lower energy

and electricity costs. Households will have lower energy bills and will be able to generate revenues from the leasing of their properties, where shale gas and oil have been found and are exploited.

• The sensitivity of the U.S. economy to shocks on energy will be lowered,

which is favorable for the stability of the economy and therefore favorable to investment.

• The industrial sector will benefit to a large extent from this positive supply shock. In particular, energy-intensive industries, such as chemistry,

cement, construction, metallurgy, food processing, paper, aluminium, glass, and refineries will be the main beneficiaries. Direct competitors of

the U.S. industry have already expressed their concerns regarding this positive supply shock on the U.S. industrial sector.

• This will contribute to the reindustrialization of the U.S. economy. Costs of production indeed decline, and growing infrastructure needs also boost investment. There are indeed higher needs in terms of drilling machines, transportation, refineries, and export infrastructures.

• Tax income revenues linked to the activities, and profits generated by

the shale gas and oil industry and related sectors will contribute to the reduction of the public deficit. Countries being energy rich face generally better fiscal conditions and have a higher debt sustainability.

• There are potentially huge benefits in terms of environment, investment, and consumption linked to the production of cars using gas as fuel.

Besides the domestic macroeconomic impact, we can identify the

following fundamental external effects:

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• The positive supply shock will increase the competiveness of the United States.

• The U.S. trade balance will continue to improve due to lower energy needs, higher energy exports, and increased competitiveness.

• The U.S. shale gas and oil producers, having an advantage in these industries, can also export their products, tools, and know-how. They are

already participating actively in the development of shale gas production in South America.

• The reduction of the trade deficit will be slow and progressive. We cannot

expect the exports of energy to increase rapidly as the United States does not have the infrastructure for liquifying gas, a necessary step before

exporting to countries not connected with pipeline networks. There is also a reluctance of the U.S. administration and the Department of Energy

to let this liquefaction structure develop. We can see here that there is a choice for the government: either foster profitability and let this new

source of energy be exported and sold at better prices or give priority to domestic demand and households and keep this source of energy for

domestic usage. The shale gas and oil resources represent another tool of economic policy.

American protectionism and reshoring Obama’s administration has developed an aggressive policy in terms of external trade and investment, once again for defending strategic industries. The National Export Initiative aims to double exports by the end of 2015 and consequently create two million jobs domestically. By achieving this,

the U.S. government shall operate in three major dimensions: supporting export financing, removing trade barriers, and enhancing the enforcement of trade rules. This will be facilitated by a lower energy dependency due to the

emergence of the shale gas industry fostering exports and reducing imports. A lower energy bill, a process of reindustrialization, and the promotion of

new free trade areas will make the government’s objective achievable. An

increasing focus of the United States on the Asia-Pacific region is visible at the level of the Trans-Pacific Partnership, which was established in 2007 and founded by Mexico, Chile, Singapore, and New Zealand.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The United States has been proactively promoting its “Return to Asia”

plan since 2008, taking part in the Trans-Pacific Partnership and becoming the most active member. The organization has been expanded to 11

members, including Canada, Mexico, and Australia. Japan and South Korea are considering joining the partnership, while China remains on the sidelines for now.

The external trade policy of the United States was particularly aggressive.

The United States initiated eight cases against China to the World Trade

Organization (WTO) during Obama’s first term. All of these were related to

strategic industries. At the same time, the United States continues to push exports to China. Obama is likely to deepen trade cooperation by unlocking restrictions on products where the United States has an edge, including high-

tech services, energy, and cultural products. The barrier on high-tech service transfers is likely to be lowered, along with better protection on intellectual property rights in China. The recent trend of increasing trade between China and the United States will continue.

The Obama administration has implemented a series of preferential

policies to stimulate the reindustrialization of the economy via the reshoring of activities. The Manufacturing Enhancement Act (2010) suspended or reduced

tariffs on materials imported for manufacturing use. The Creating American

Jobs and Ending Offshoring Act (2010) proposed 24-month payroll tax relief for

companies bringing back jobs from overseas, as well as terminating several subsidies such as tax breaks and tax reductions for facilities and productions

moving offshore. Local governments also offer considerable incentives to attract companies to locate within their borders.

Reforms on the U.S. financial sector The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act

was one of the major achievements of Obama’s first term. The next steps of his overhaul of financial regulation will be the following: • To strictly apply the Dodd-Frank law

• To control the compensation practices of the financial industry. Such a

reform requires that shareholders and company directors change the

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Looking for the New Sources of Growth

compensation system.

• To enforce the “Volcker Rule” of the Dodd-Frank act, which currently faces legislative hurdles in its voting and implementation

• To encourage banks to absorb some losses on underwater mortgages for reducing the financial pressure on households in trouble

The strict implementation of the recently voted new legislation, and

its reinforcement, will weigh on the profitability of banks. However, the

stabilization of the housing sector will imply lower losses and a rebound of credit. A less risky environment will reduce risk premiums on banks’ debt, reducing their financing costs. At last, the reindustrialization of the economy

will create new sources of revenue for the banking sector. The reining in

of the U.S. financial system as a whole will be a positive contributor to the restoration of its growth potential.

China striving for another Golden Decade China is entering the first year of the 10-year governance of the fifth generation of leadership with an increasing urgency for structural reforms amid global uncertainty, with a goal of rebalancing. This rebalancing in China is an effort to transition toward domestic consumption–driven growth from an export-led and investment-driven model. There is a long way to go

on the rebalancing path; therefore for the short to medium term, investment will remain the core driver of growth, while consumption needs a big push

via a series of economic reforms before firmly taking the lead. China saw a boom in investment following the last two administrations taking office. Following China’s leadership change in 2013, we expect an investment

boom especially in the field of infrastructure investments such as railways,

expressways, subways, airports, and ports. Infrastructure investment most likely will be concentrated in the following areas:

• High-speed railway construction: 42 high speed railways with 16,000 km in length will be built by 2015, and 9,356 km have been achieved by 2012; 73 projects are currently under construction.

• Highway construction: 85,000 km of highways will be built by 2015 with

71,000 km already built by 2012; this target has recently been extended to

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

118,000 km by the year 2030; 22,000 km are currently under construction.

• Airport construction and enhancements: 230 airports, including 55 to

be newly built, will be constructed by 2015; 24 airport projects worth

CNY100 billion were approved in 2012, and 2 new airports worth CNY2 billion were approved in the first half of 2013.

• Subways: 40 cities will have subways by 2020, or 3,000 km of subway lines by 2015, and 7,000 km by 2020; 17 cities are already in operation; 1,726 km

have been achieved by 2012; 8 new subway projects were approved in the first half of 2013, and 10 will be approved in the second half of 2013.

• Intercity railways: 3,000 km of intercity railways in 28 cities will be built by 2015 and 7,000 km in 40 cities to be built by 2020; 1,385 km have been completed as of 2012.

• Port construction: 440 new ports will be built by 2015.

• Energy plants for alternative energy sources: wind, solar, and nuclear

plants will be a focus, while developments in shale gas also offer significant promise.

We forecast this boom to last three to five years, backed by supportive

policies from the government, which is likely to bring another “Golden Decade” for China’s economy, implying 5% to 7% annual GDP growth for

the next 10 years. However, China’s growth momentum, which is likely to be fueled by investment for the coming years, will gradually phase out after

a decade unless domestic consumption can catch up aggressively to become a strong engine for growth thereafter.

It is indeed a tough task to push consumption to catch up to investment

growth, and to gradually transform the growth model to a more domestic consumption–oriented structure. Besides requirements on maintaining

continuous great efforts on improving the social welfare, housing, and

education systems, increasing household income in both absolute value and in relative share of GDP is critical for economic transformation. If these reforms are successful, China will be well on the track towards becoming a de facto superpower; if not, it is likely to fall into the middle-income trap.

Structural reforms require significant guidance from the “visible hand” of

the government. In China, the government policy push has historically been

able to provide huge boosts to growth for the economy; China experienced

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three spurts of growth following decollectivization, after Deng’s southern tour, and after China joined the WTO.

Currently, there are many reforms that are necessary for China, but

reforms related to the contribution of consumption and the contribution of service in the GDP structure are especially urgent and important. Both ratios

in China are particularly low despite improvements in the past decade. China’s consumption accounted for 49.1% of GDP in 2011, a number well

below that of countries such as the United States, the United Kingdom, Japan, and Germany, which had 71%, 64%, 59%, and 57%, respectively.

Additionally, China’s service sector accounted for just 43% of GDP in 2011,

far below the world average of 62%. These two issues reflect many related economic and structural problems. It is particularly urgent to improve these structures in the coming years.

Enhancing the contribution of consumption in China’s GDP structure Theoretically, there are three channels to stimulate consumption. One is to increase the propensity of consumption, that is, the willingness of

households to spend more under given income. The second is to increase household disposable income, that is, households could purchase more given the propensity. Finally, there is a need to promote consumer credit, in other words, allowing households to consume by leverage.

Increase the propensity to spend by improving social welfare and services China, despite recent improvements, still has a weak social safety net and poor social services compared with many other countries. Consumers cannot

spend freely on nonessential goods if they must concern themselves with paying for necessities such as education, housing, and healthcare, or saving

for retirement, in addition to the core essentials such as food and clothing. Improvement in the following categories can greatly boost the propensity for consumption: strong safety net for retirement and the unemployed; quality

coverage for social services such as healthcare and education; and affordable housing.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Increase household disposable income Boosting the propensity for consumption alone is a necessary but not

sufficient condition for a successful transition to a domestic consumption– driven model. In other words, even if consumers raise their propensity to

consume, their spending capacity remains largely constrained by their low disposable income. Increasing disposable income will play an increasingly important role in improving the consumption-investment structure, given

the general high propensity of saving for most Asian economies, even those with well-developed social welfare mechanisms and services.

Increasing household income means a rise in both absolute values and

relative share of GDP. China’s household income has increased greatly in

the past few decades; however, its share of GDP has decreased continuously. That is to say, household incomes grew slower than those of enterprises and

government, and this has driven the share of household income to decrease

by about one percentage point down every year in the past decade. In other words, households have become relatively poorer despite the rise in nominal income, which makes it even harder to enhance the role of consumption in the GDP structure.

There are several necessary reforms to critically increase household income:

(1) income-doubling reform; (2) tax reforms; (3) increasing government

transfers; and (4) promoting urbanization. Domestic consumption will rise as all these factors are strengthened, which could facilitate China’s ultimate transformation toward a domestic consumption–driven economy. Income-doubling reform

During the 18th National Congress of the Communist Party of China, a need to alter the reliance on excessive investment and rebalance towards

individual consumption was outlined. One of the statements was called the “Income-Doubling Reform,” which indicated a goal of doubling per capita

income for both urban and rural citizens by 2020. This is a good step towards

the track of raising disposable income levels. However, the government will have to consider some critical points before such a plan is a success. A plan

outlined at the 17th National Congress to gradually increase the proportion

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of household income in the national income distribution and to increase the proportion of labor remuneration in household income had less than stellar results. Several key factors must be kept in mind to make the plan outlined at the 18th National Congress a success.

First, real income is equally important as nominal income. The current

income-doubling target aims for household income are to be doubled based on the 2010 level, that is, about 7.1% year-over-year yearly growth on average for 2012 to 2020. The real income growth will be only 2.5% to 4% year-over-

year if inflation is taken into account. This pace of real income growth is relatively low compared with the rapid GDP growth.

Second, household income’s relative share of GDP is more critical than

its absolute value in transformation. As shown in the chart, real household income growth is below that of GDP growth in most years during the past

10 years. As a consequence, household income share in GDP has been getting smaller and smaller in the past decade. With targeted 7.1% growth of

household income, again slower than those of fiscal and corporate revenues, the household income share of GDP will be driven further down. Household

income’s proportion in national income has fallen over the last decade, dropping from 67.8% in 2000 to 60.7% at the end of 2009.

Lastly, the income-doubling reform should be a systematic reform

requiring many related reforms to make it effective. Japan’s “IncomeDoubling Plan” during their “Golden Sixties,” which is widely seen as an

enormous success, is a good lesson for China, as China’s current state of economic development is similar to Japan’s in that era. Japan announced the

Income-Doubling Plan in December 1960, with an original target of doubling real income within 10 years. Japan had achieved this feat by 1967, several years ahead of schedule. There were some overarching features of Japan’s

plan beyond the basic goal of doubling real income, including raising wages and cutting taxes, pushing efficiency enhancements, and raising crop prices to aid the agricultural sector, that China can learn from when attempting to achieve its goal:

• Emphasize balancing economic development with societal harmony.

Japan’s Ministry of Finance described this as “quantitatively expanding massive growth” while “pursuing qualitative rationalization.” This

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

included improving household living conditions, providing attention to

addressing the difficult issues of inequality, and balancing the gains from economic growth between the urban and rural areas.

• Narrow the competitiveness gap between large enterprises and small and medium-sized enterprises (SMEs). This is a major concern in China, just as it was for Japan at the time. Larger state-owned enterprises in China enjoy significant benefits, from simply economies of scale to easier

and cheaper access to credit, and often build upon these competitive advantages to marginalize competitors.

• Emphasize the upgrading of infrastructure as a priority of the government.

This is a feature that is in line with China’s recent actions, as the National

Development and Reform Commission and other government bodies encourage various infrastructure projects.

• Improve the competitiveness of corporations and individuals via investing in technology and training. This is an area where China has a lot of room for progress. Currently, China’s innovation in technology is still lacking, and its labor productivity is still very low compared with most major developed economies. Tax reforms

One of the important reasons for a fall in the household income share of GDP comes from high personal income tax in China. China has one of the highest income tax rates in the world with tax rates ranging from 3% to 45%. An individual making CNY80,000 per month is already subject to the highest

tax bracket. Tax is an efficient tool in the first-round wealth distribution that

can boost household disposable income. China’s current personal income tax system imposes significant burdens on households, with relatively high

tax rates, fairly low income brackets for taxation, and a lack of deductibles. Addressing these issues would lead to more disposable income for households, and promote consumption. • Personal income tax reforms:

• Lower tax rates on personal income tax. This would directly reduce tax burden and raise the disposable income of most households.

• Adjust tax brackets. Currently, even individuals making up to CNY1,500 per month, including those below the poverty line, are

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taxed at 3%. China’s highest income tax bracket is currently set at

45% for individuals making CNY80,000 per month, and individuals making over CNY9,000 per month are already taxed at 25% or more.

Adjusting the tax brackets more leniently, via eliminating the tax on the bottom income earners and by reducing the burden on the middle class would also free more disposable income for households.

• Introduce or expand tax deductions. Currently, China lacks a sophisticated tax deduction system, particularly on the individual level. There are currently several deductions — credit for charitable

donations, income from personal services and rentals, disaster tax relief, and relief for the disabled, widowed, or orphaned — but these

are relatively minor in the big picture. Introducing deductions for married couples, care for children and the elderly, depreciation, self-

education, and housing purchase interest payments, among other

deductions would also bring welcome relief for citizens and boost disposable income.

• Levy additional taxes to balance out the loss of tax revenue from personal

income tax reforms (Several tax reforms were proposed in the 1996 9th

Five-Year Plan, but were never implemented):

• Social security tax. Currently, there is no social security tax, but social security contributions are mandatory between a band with limits of 60% to 300% of the average wage of the city.

• Inheritance and gift tax. At the moment there is also no inheritance or gift tax in China. This means that there is no redistribution of wealth

on the estate of the deceased, and this exacerbates the inequality problem.

Government and social transfers

Tax reforms are generally difficult to push due to existing interest groups; therefore government transfers need to play a more important role in the second round of wealth distribution to narrow income inequality.

In China, the level of social transfers as a proportion of nominal GDP

was 6.5% in 2009, far below the Organization for Economic Cooperation

and Development (OECD)’s average of 22.1% and the U.S. average of 19.4% that year. While the OECD average is buoyed by many developed European

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

economies with high social transfers, China also remained behind the likes of countries such as Turkey, South Korea, and Mexico, which registered transfers as a percentage of GDP of 12.8%, 9.4%, and 8.2%, respectively,

in 2009. In 2012, the OECD average slid slightly to 21.7%, but it was still

significantly higher than China’s transfers. This means that relative to other countries around the world, Chinese citizens receive less money back from their government.

Furthermore, in China, the majority of government transfers are in the

form of social security spending, rather than allowances and other transfers. This is not accessible by the majority of the population, as it is unavailable

until retirement and consequently not driving consumption. Discounting

this money, China’s social transfers only accounted for merely 2.9% of GDP in 2009.

China should also raise the poverty line, which would expand the

number of individuals who could benefit from state welfare, and receive

payments from the government’s minimum living standard system (dibao). China addressed this issue at the end of 2011, raising the rural poverty line

to CNY2,300 per annum, an admittedly still meager sum. However, there is

no official government poverty line for the urban poor, and it is difficult to

estimate how many individuals are living in poverty. We can use the dibao

claimants as a very rough gauge for the government definition of poverty,

however. In October 2012, there were 21.39 million urban individuals claiming dibao payments; using 2011’s urban population level of 690.79

million urban individuals, this implies an “officially recognized” urban poverty level of only roughly 3.1%, which is far below the U.S. levels of 13.2%

despite the significantly lower standards of living in China. This disparity

illustrates that the urban poverty problem is not being adequately addressed by China’s government.

Urban poverty is a significant concern due to the higher costs of living

in urban areas and increasing urbanization rates. Rural poverty often overshadows urban poverty in popular discourse due to the growing

divide between urban and rural salaries; the urban per capita income has been registered at nearly triple the rural levels for the past several years.

However, there is also a significant quantity of the urban poor, especially

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in the migrant-worker population. These workers are often unable to claim

social welfare, with limited to no access to many of the social transfers such

as the urban dibao, as they are working outside of their hukou (household

registration) region and lack an urban hukou.

Furthermore, despite the recent great efforts to expand the dibao system

since 2010, dibao payments are still quite minimal and are insufficient in

many cases. Increasing the scale and scope of social transfers will create more disposable income for households. Urbanization

Consumption, particularly of services, will benefit from China’s rising urbanization rate, which eclipsed 50% for the first time in 2011. Urban

residents typically consume more than rural residents. Despite China

having a population that is roughly evenly divided between urban and rural

residents, urban citizens purchase vastly more consumer goods; in the past

three years, roughly 86% of consumer goods sales went to urban regions,

while only 14% of sales went to rural regions. This is particularly the case for

social services such as education and healthcare, as well as general services such as catering and transportation, and nonessential goods including luxury items. We can see that urban ownership rates vastly exceed rural ownership

rates for all the major durable consumer goods such as televisions, cars,

computers, washing machines, refrigerators, and air conditioners. This is due to both the increased availability and diversity of consumption goods and services in urban areas relative to rural areas, and due to the higher

urban income. Furthermore, rising urbanization will also increase demand

for housing and utilities. This logic is self-evident: as more people move to cities, they will need accommodation, while public transportation systems and utilities must be improved to adapt to more usage.

Promote consumer credit to allow households to leverage After boosting household income and household consumption propensity, promoting consumer credit could be another effective way to boost consumption. China currently does not significantly utilize household loans

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

compared with most major economies in the world. China’s household loans

registered at just 5.5% of GDP in 2012, compared to the likes of the United States and United Kingdom, which were as high as 80% to 95% in 2012, even after the deleveraging following the Global Financial Crisis. Even the relatively more modest developed economies such as Germany and France

have household loans accounting for roughly 55% of GDP, dwarfing China’s percentage.

Furthermore, most of the household loans that are issued in China are

long-term loans such as mortgages rather than short-term loans being used to facilitate consumption.

This is partly because of cultural reasons, but consumption rates are

improving as the growing Generation X has a higher consumption impetus. This is also because of the underdevelopment of the credit market; credit cards were not widely used in the country until recently. Developing the credit market is likely to bring significant incentives to consumption.

Increasing the contribution of services in China’s GDP structure China’s growth has been led by the manufacturing sector for the past three

decades; the secondary industry has registered the highest proportion of

total GDP. China’s economy has even gotten “heavier” in the past few years

with the rapid growth of machinery equipment and building materials buoyed by the real estate boom. The service industry appears to be slowly growing as a proportion of China’s economy, rising to 43.4% in 2011, but this

is still quite low compared with the developed economies and even many developing economies. In 2011, the service sector in the United States, Japan, and Germany accounted for 76.7%, 74.6%, and 71% of GDP, respectively;

while in the other BRICS nations of Brazil, Russia, India, and South Africa, the service sector accounted for 67.3%, 58.9%, 55.6%, and 65.9% of GDP,

respectively. The proportion of China’s service sector of 43.4% in 2011, much below the world average of 62%, made it the lowest of the 10 largest economies in the world.

Furthermore, China’s service sector created 34.6% of the total jobs in

China in 2011, again much lower than the world average of 45% and the developed economy average of 75%. With the urbanization process speeding up, the employment issue will become an increasingly urgent issue for China.

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China had to create 6 to 10 million jobs per year in the past five years, and the pressure will become more serious with more migrant workers gradually residing in the cities. Given the huge capacity of job creation of the service

sector, it is particularly meaningful for a labor-rich country like China to promote the development of the service sector.

China has promoted the service sector for years and made great progress,

but still needs much more concrete measures to expedite the process as

the country has at most another 10 “golden years” ahead. Three measures are critical in promoting the service sector: (1) lowering the market entry

barriers; (2) optimizing the structure of the service sector; and (3) providing clear policy supports.

Contribution of the service sector, 2011 (% of GDP) 80 60 40

U.K.

U.S.

Japan

Germany

Brazil

South Africa

Mexico

World avg.

Rusia

Korea

India

Thailand

0

China

20

Sources: Central Intelligence Agency; Haitong International.

Contribution of the service sector, 2011 (% of total employment) 60 40 20 0

China

East S.E. World North CEEC Middle Latin Asia Asia avg. Africa East America Sources: International Labor Organization; Haitong International.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Lower the market entry barrier In an OECD ranking of major countries, where countries were rated between 0 and 6 on how high the barriers to entry were for the service sector, with 6

being the highest barrier to entry, China had a score of over 4.5, eclipsing all the major economies in the world. By constraining new firms from entering the

market, competition is stifled, which could cause market distortions. Many of China’s “strategic” service sectors such as banking and telecommunications

have very high entry barriers. Even the mid-end services such as education

and healthcare are also subject to heavy market entry restrictions. Gradually

lowering these barriers will improve the competitiveness of China’s service sector both domestically and internationally.

A State Council report in September outlined the need to open up the

service sector, highlighting the sector’s relatively small proportion of GDP and relatively low levels of competitiveness. The State Council plans

on doing this via relaxing controls on market access to the service sector,

expanding service exports, and encouraging additional overseas investment

in the sector. A successful opening up of the service sector may provide a source of growth for moving forward.

Optimize the structure of the service sector The structural composition of the service sector in China needs to be improved. A balanced structure is shaped like a pyramid with high-

end services including IT, finance, and consulting at the peak, education and healthcare services in the middle, and low-end services including transportation, retail, and leisure as the large base. This is the case for

countries such as the United States, with about 40% of employees in low-end service fields. China’s service sector structure looks, however, like a barrel,

with employees equally distributed in the three segments. Low-end services in particular only account for 21.9% of total employees in the whole service sector. China has made great efforts in promoting high-end services in the

process of liberalizing the capital market in recent years, but it needs to put

more emphasis on developing low-end services going forward, as these lowend services can absorb a large amount of labor especially in the process of

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urbanization. The development of low-end services will also make city life much more convenient, livable, and efficient.

Provide strong policy supports The government needs to provide more policy supports for the service

sector to further assist in the development of the sector. Tax benefits, loans,

and subsidies are methods to help the financial viability of service firms especially for the low-end services. The low-end service firms are generally

typical SMEs, starting with a small number of employees and a limited

budget. A push by the government can make these small firms thrive and grow. Many developed economies set up a series of policies to support those

SMEs to get started and develop. This is especially needed in China, as it is hard for Chinese SMEs to get loans from banks under the current financial

structure. For example, in Hong Kong, there is a SME loan guarantee scheme

aiming to help SMEs get loans. SMEs in the service sector with less than 50 employees can apply for loans up to HKD6 million for up to six years, and 50% of approved loans are guaranteed by the government. Furthermore, if

the SMEs have fully paid the loans, they could benefit from the scheme one

more time with a guaranteed amount up to HKD6 million. China can learn from this example and possibly provide a similar policy.

Europe struggling to restore its potential In the Eurozone, the negative effects of austerity will continue to last in the

coming years. The severity of the adjustment puts at risk the unity of the Eurozone, as a situation of recession, lasting since over a year ago, increases the temptation for the peripheral countries to leave the Economic and

Monetary Union of the EU in order to benefit from a devaluated currency. We

have seen that the recent interventions of the European Central Bank (ECB) aim to reduce this risk of fragmentation. The creation of the EU Outright

Monetary Transactions program and the large injections of liquidity have already markedly reduced the spread of the peripheral debt in comparison with the German debt. The prompt intervention of the ECB, the existing

stabilization mechanisms, and the consistency of the political class across

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Europe make us think that the risk of fragmentation is indeed low in the short term. However, structural reforms, related to not only the fiscal adjustment, but also to the job and capital markets, and the promotion of the European industry, will have to move forward in order to avoid the accumulation of

internal imbalances, which could jeopardize the monetary union project in the long run.

In the short term, the austerity policy will continue to drag down growth

and push unemployment rates up. However, the first positive effects linked to the fiscal consolidation policy are already observable. The official numbers

of Eurostat show a decline of public deficits between 2010 and 2011 for all

the major countries of the Eurozone. The public deficit of the Eurozone has declined from 6.2% of GDP in 2010 to 4.1% of GDP in 2011. The peripheral countries have accomplished significant progress in this area and they are currently pursuing their own efforts. The different programs of consolidation are on the right track and we can expect a stabilization of the debt by 2015.

As soon as 2013, in the case of consolidation plans, the Eurozone as a whole will win in credibility, and should benefit from easier liquidity conditions and lower levels of interest rates.

Fiscal consolidation in the Eurozone (primary surplus as % of GDP) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Austria

-1.7

-1.0

-1.0

-4.1

-4.5

-2.6 -2.9

-2.1

-1.8

-1.1

-0.8

-0.8

France

-2.4

-2.8

-3.3

-7.6

-7.1

-5.2 -4.7

-3.5

-2.8

-2.1

-1.1

0

Germany

-1.6

0.2

-0.1

-3.2

-4.1

-0.8 -0.4

-0.4

-0.3

-0.1

0

0

Greece

-6.0

-6.8

-9.9 -15.6 -10.5

-9.1 -7.5

-4.7

-3.4

-2.5

-1.4

-1.4

Ireland

2.9

0.1

-7.3 -13.9 -30.9 -12.8 -8.3

-7.5

-5.0

-3.0

-2.2

-1.8

Italy

-3.4

-1.6

-2.7

-5.4

-4.5

-3.8 -2.7

-1.8

-1.6

-1.4

-1.2

-0.7

Netherlands

0.5

0.2

0.5

-5.4

-5.1

-4.7 -3.7

-3.2

-3.6

-3.1

-3.4

-3.5

Portugal

-3.8

-3.2

-3.7 -10.2

-9.8

-4.2 -5.0

-4.5

-2.5

-1.9

-1.9

-1.8

Spain

2.0

1.9

-4.2

-11.2

-9.4

-8.9 -7.0

-5.7

-4.6

-3.9

-3.2

-2.8

Eurozone

-1.3

-0.7

-2.1

-6.4

-6.2

-4.1 -3.3

-2.6

-2.1

-1.6

-1.2

-0.8

Sources: International Monetary Fund; Haitong International.

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Looking for the New Sources of Growth

The seriousness of the fiscal consolidation and the determination of both

the ECB and governments to preserve the unity of the Eurozone will further reduce the risk premiums of public debt. European banks, largely exposed to sovereign risk, will benefit from a lower aversion for European risk and

should face better funding conditions at the international level. European economic actors, anticipating a softening of the consolidation plans in relation to a relatively successful decline of public deficits, will progressively

show a higher level of confidence, supporting residential and nonresidential investment.

This high level of unemployment rates will continue to compress unit

wage costs, contributing to extending the recent progress observed in

competitiveness. The decrease of external deficits, as well as the decline of healthcare expenditures, shows that advanced structural policies have already produced positive results.

Besides fiscal consolidation, European governments have initiated

ambitious structural reforms. The accumulation of the past imbalances

was indeed related to a structural lack of competitiveness, an inefficient functioning of the labor and capital markets, and the absence of a clearly

defined industrial policy. There are three different areas of concern due to the new wave of structural reforms in Europe: (1) the capital market reforms; (2) the job market reforms; and (3) the goods market reforms.

Capital market reforms in Europe The most ambitious part of the capital market reform relates to the creation of a European Banking Union. This project was announced in June 2012

when the EU leaders envisioned the possibility of giving the European Stability Mechanism a mandate for potential bailouts of the national banking

systems. Following the issuance of the EUR100 billion line of credit from

the European Financial Stability Facility for the bailout of Spain’s banking

system, and after long hesitations which created financial instability, there was a growing awareness among European leaders of the necessity to create

an efficient resolution framework in the case of a significant banking crisis. The European Banking Union was a condition of the German government

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for authorizing the European Stability Mechanism (which will replace the

European Financial Stability Facility in the future) to directly bailout national banking systems. This banking union project initially laid the groundwork for a common system of bank supervision and the pooling of deposit insurance

systems after January 1, 2013. The framework was officially presented by the president of the European Commission on September 12, 2012, and plans were offered to give a central role to the ECB for monitoring more than

6,000 European banks. This would pave the way for the direct supervision (according to the capital requirements of international law) of the banks and

also give the central bank the power to wind down the operations of any failing bank. This supervision will be done in coordination with the national systems of supervision.

The German government has recently slowed the negotiations due to

mounting concerns on the pooling of deposit insurance so Germany has recently added new conditions including a provision that the supervisory mandate of the ECB would only concern the systematically important

institutions. The German banking system has still a regional basis, characterized by a large number of small and medium-sized banking actors.

These regional banks play a vital role in the funding of the German industrial sector. The German government wants to keep control of these small actors. The German conditions, supported by other Nordic countries, give a low chance for the banking union’s project to be voted on before the end of the

year [2013]. No real progress has been observed at the level of the most significant elements of the framework: the creation of a single guarantee

scheme on deposits, a single resolution fund, and a single resolution authority. Mario Draghi, the president of the Governing Council of the ECB,

apparently opted for a minimal approach as he joined the German side in

saying that a common insurance system of deposits was not needed. In agreeing with a nonnegotiable condition of the German government, he

increased the chances for the common supervision system to be voted on in the coming months.

The other part of the capital market’s reform is under the responsibility

of European Commissioner Michel Barnier. The banking union project

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represents an essential part of these reforms. Other major decisions relate to the following fields, among others:

• Short-selling. The European Commission has adopted uniform rules specifying in which cases short-selling can be banned — uncovered sovereign credit-default swaps, for one.

• Protection of individuals investing in financial products. The European

Commission has adopted a package of reforms fostering information standards related to financial products, and better protection against selling practices of the financial sector.

• Rating agencies. The European Commission wants to reduce the

overreliance on rating agencies, increase their diversity and transprency, and make them more accountable.

• Basel III implementation. The European Commission is about to complete the negotiations on how to implement Basel III accords in Europe,

requiring higher capital and liquidity buffers, as well as specific rules for systematically important institutions.

• Regulation of bonuses. Barnier proposed a maximum 1:1 ratio of bonuses to normal salary. The negotiations on the control of pay and bonuses have

been ongoing since May 2012 but have not concluded yet as of the time of this writing.

• Shadow banking. Barnier wants a better defintition of shadow banking as it repressented 30% of the global financial system in 2010. The European

Commission will propose new laws for supervising this sector and avoiding regulatory arbitrages. At the same time, he wants to develop alternative sources of funding besides the traditional banking sector.

Job market reforms in Europe The OECD recently showed that countries, like Germany, which implemented early reforms of their job market, withstood more efficiently

the successive shocks of the last financial and sovereign debt crisis. The peripheral countries have undertaken ambitious reforms of their job market under the pressure of the ECB, the Troika, and the European Commission.

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In Spain, labor legislation has been profoundly modified, simplifying the clauses of redundancy, giving more freedom for employment termination, decreasing severance pay, removing administrative authorization for

collective dismissals, giving the right to the employer to temporally suspend

employment contracts, and giving the employer more rights to change working conditions. In Italy, firing procedures have been eased, protection

of temporary workers has increased, and unemployment benefits should be

broadened from 2017. In Portugal, holiday entitlements have been slashed, as well as redundancy pay, overtime rates, and unemployment benefits. Collective bargaining has been weakened, the idea of flexible working

hours has taken on growing importance, and employers have gained ease in termination policies. Greece faces pressures from the Troika for increasing

the flexibility of work schedules, delinking opening hours and working hours, eliminating restrictions on minimum time between morning and

afternoon shifts, establishing a unique statutory minimum wage, as well

as cutting nonlabor costs and employers’ social contributions. Besides the

peripheral countries, most of the European countries continue to reform their job markets toward more flexibility. This higher flexibility of the job market

and lower wages due to a high unemployment rate will slowly increase the competitiveness of Europe.

Goods market reform in Europe The countries hit by the sovereign debt crisis have also launched further reforms of their goods markets. Most of the time, these measures aim to

open markets of goods and services still protected by the administration, reduce regulatory burdens which hamper efficient competition, and simplify the intellectual property laws. This is particularly true for the peripheral

countries. However, the degree of performance of the goods market in

Europe as a whole is comparable to the United States, which has a high ranking in international standards.

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Goods market competitiveness index 5.5 5.0 4.5 4.0 3.5 3.0 2006

2007

2008

Greece Spain

2009

2010

Italy EU-15

2011

2012

Portugal U.S.

Sources: World Economic Forum; Haitong International.

Another Major Source of Growth in Technological Innovation We have seen that the three major economic areas in the world are currently

engaged in structural reforms, aiming to boost their potential of growth. The stabilization of public finances in Western economies and the rebalancing of China will certainly contribute to the establishment of the bases of a more

stable world economy. However, to opt for a less risky model of growth

is a necessary, albeit not sufficient, condition for sound development. In a context of global deleveraging, the real new sources of growth, after the era of excessive credit and public debt, have to be found in technological innovation.

Technological innovation fosters growth and produces positive effects

via different channels and:

• increases the productivity of the company or sector benefiting from it;

• leads to the creation of new products and creates new needs among consumers;

• contributes to the increase of the competitiveness of its detentor;

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

• helps preserve jobs as noncompetitive sectors are relocated to less costly countries;

• supports the rest of the economy through the spillover and cluster effects; • provides vital support for the national security of countries;

• increases the well-being of the population and is favorable to the preservation of the environment.

The leading economies are well aware of these positive effects. This is

why the governments and the most innovative companies have continued

to support R&D activities even during and after the two recent crises. The

United States will keep its lead in this area, but the postcrisis period revealed interesting features, in particular the catching-up process exhibited by China. On the contrary, the European dynamism has been dented because of the

austerity policies. The reduction or deceleration of innovation expenditures

in the developed economies represents another signal of a power shift at the global level in favor of emerging economies. IT, healthcare, and energy will

be at the heart of governments’ strategies. The costly and hazardous nature of R&D activities, the risks implied by innovation, and the intensifying

competition in this area will be more efficiently managed by strongly centralized and coordinated economies.

Political willingness and budget resources The OECD recently revealed the main features characterizing the current

state of global R&D activities. The United States still dominates the world in terms of size of R&D activities, but new features have emerged:

• The 2007–2009 Global Financial Crisis has negatively impacted business innovation and R&D activities globally.

• Most of the countries have supported innovation via the implementation

of stimululus packages, focusing on cutting-edge infrastructures. However, the governments have reduced their expenditures in this area since the trigger of the European Sovereign Debt Crisis.

• Emerging Asian nations, especially Korea and China, have continued to outperform during and after this period in terms of investment in research and innovative technologies.

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• The crisis revealed technological weaknesses among Southern European countries and inside the financial sector.

• The difficulties of lagging countries in terms of research and innovation have been accentuated after the crisis.

• The United States, Japan, and Northern Europe have recovered in terms

of investment and performances in innovative fields, but their future performances remain uncertain.

The United States to continue to lead in innovation The United States will continue to lead the race in terms of innovation.

Existing cutting-edge infrastructures of research, strong competition among researchers organized at the interstate level, strong links between research

and industry, quick exploitation of innovation by the industry and consumers, large pools of financing available due to a mature financial market, large

clusters with global dominance, strong support from the government, and a

highly efficient job market bringing the most talented workforce to the most

innovative parts of the territories will all contribute to making the United States one of the most dynamic countries in the world in terms of innovation. Despite a high degree of freedom in the different markets, the U.S. system

of research can be viewed as being significantly centralized for the following reasons:

• It assumes huge investments in R&D linked to infrastructures, military programs, and space programs, reducing the obstacles of high entrance costs.

• As the main responsible party for education, the U.S. government is well placed for organizing the coordination of the research with the industrial sector, and it is one of the main providers of innovation.

• As the main provider of infrastructures, traditional and modern, the government contributes to the organization of networks of research, creating clusters, and connecting innovative sectors or geographic areas with the rest of the economy.

• The regulatory framework fosters innovation with strong intellectual rights.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

China to rapidly catch up Though the United States will remain the dominant source of innovation and

technological advancements in the future, China has been gradually catching up by virtue of continuous support from the government in fostering R&D activities via tax reforms, military expenditures, and via the promotion of

technology clusters, education, and international cooperation. While it still remains far behind in terms of research and innovation activities on a per

capita basis, China’s sheer scale will help expedite the catching-up process. Given a high degree of centralization of the system of research, China will also benefit from such an organizational framework, i.e., the reduction of

entrance costs linked to large programs, the coordination of innovation between universities, and the corporate sector.

National R&D spending targets and gap (% of total GDP) 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0

2012 2020

Target years indef.

Korea

Japan

U.S.

2020

2020

Germany France

2020

EU27

2020

China

2020

India

Gross domestic R&D expendiutre (2008) Gross domestic R&D expendiutre (2010) R&D spending target (2012) Sources: OECD; Haitong International.

Tax reforms The Chinese government has created a variety of incentives for R&D by

utilizing tax reforms and benefits. China has some existing favorable tax

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policies to promote R&D, and may push additional tax reforms to boost growth. Some of the current policies benefiting R&D firms are listed below:

• Corporate tax breaks. These include a reduced rate of 15% (as opposed

to 25% regularly) for qualified new and high-tech enterprises or technologically advanced service enterprises. Additionally, there are

tax holidays for new firms operating in special economic zones such as Shenzhen, and exemptions and deductions for R&D expenses and technology transfers.

• Subsidies. China subsidizes a variety of strategic industries, for example, the much publicized solar power industry, in time-division long-term evolution (TD-LTE) technology.

• Intellectual property rights. China has made improvements in protecting intellectual property rights, with increasing attention on stopping piracy.

Military expenditures China’s military expenditure has garnered a huge amount of attention from

international observers over the past several years. Military expenditure often has a very high correlation with research progress, as investment

into military research often brings about useful technology for civilian use

as well. According to a Stockholm International Peace Research Institute

(SIPRI) report, China’s military expenditure in 2011 was at USD143 billion. This accounted for 8.2% of the global share of military expenditure, and was

at 2.0% of China’s GDP, for an expenditure of roughly USD74 per capita.

While this is still far behind the level of the United States on both nominal terms and per capita terms, China’s nominal expenditures have significantly eclipsed any other country in the world. R&D funded by the military budget

will also contribute to China catching up to the rest of the world in innovation.

Promotion of education Education plays a large role in China’s society, and higher education in particular has been progressively rising in importance in China since the

education reforms at the turn of the millennium. China has continuously expanded government support for education; starting from an allocation of

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

1.9% in 1999, this spending has been estimated to have risen to 3% to 3.5% in recent years. While this level is still behind many competitors, China has caught up to the likes of Japan and Russia and is showing great progress.

The Eurozone to be weakened In the Eurozone, austerity will also impact the R&D activities and penalize the potential of innovation. The lack of a strong centralized government

reduces the efficiency of R&D activities as they normally benefit from large economies of scale at a continental level, like in the United States or

China. The division of the selection process for researchers leads to lower

competitiveness and the dilution of resources. Each government is eager to preserve the different centers of research in their territory. This limits the formation of clusters, where research and industrial activities normally

gather. In the case of a negative shock, the small units of research cannot withstand budgetary restrictions, leading to large layoffs and instability in

high-skill jobs. The austerity shock, leading to reductions in R&D spending and a lack of competitiveness in terms of salaries, results in an outflow of the

highly skilled workforce toward the most attractive areas such as the United States. This “brain drain” reduces the potential of innovation in Europe.

Pivotal role of IT, healthcare, and new energy IT, healthcare, and energy sectors will be at the forefront of innovation as these sectors are at the heart of the industrial policy of the United States, Europe, and China. The strategic importance of IT is easy to understand

as the technology has taken a growing importance in all the sectors of the

economy. The aging of the population and the necessity of controlling health expenditures — a common challenge for the United States, Europe, and China in the coming years — requires constant technological progress in

the medicine and pharmaceutical industries. Energy innovations are highly strategic, even more important on the eve of a new era announced by the soon-to-be accomplished energy independence of the United States.

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IT integrating all sectors of the economy IT has integrated all sectors of modern economies. This now represents

close to 8.5% of the total value added of the OECD economies. Besides the content in IT or new technology of national production, innovations play an important role in productivity. IT is generally the way through which innovations enter the process of production and foster productivity.

Productivity is made up of labor quality, physical capital deepening, multifactor productivity, and intangible capital deepening. The investment

in IT will add to physical capital deepening. However, its main contribution will consist of reinforcing multifactor productivity via the improvement of

communication among employees and the acceleration of the coordination

of the production process, or organizational improvements. Moreover,

an investment in software will be considered an intangible asset, and we know that intangible assets, a proxy for innovation, contribute greatly to the progression of productivity. Countries traditionally associated with a lack of

competitiveness, like Spain and Italy, have indeed performed poorly in terms

of intangible accumulation or the contribution of multifactor productivity to total productivity. The United States will keep the lead in information and

communications technology (ICT) as reflected in the relative specialization Index of the World Intellectual Property Organization (WIPO), a gauge based on the number of patent applications.

Index of relative strength of innovation for the ICT sector Finland Sweden Canada Israel U.S. Korea China Netherlands Japan U.K. France Australia Germany -0.317 Others -0.377 Italy -0.48 Switzerland -0.5

-0.068 -0.069 -0.099 -0.104 -0.165

Sources: WIPO; Haitong International.

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0.024

0.188 0.166 0.144 0.129

0.273

0.377

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Healthcare innovations needed to deal with global aging The aging of the population is a global phenomenon. The acceleration of the

healthcare expenditures and the increasing burden of the pension system will be the main challenges for public budgets in the coming years. The

progress of medical research and healthcare innovations could represent a way to limit the explosive trend of expenditures. However, the example

of the United States, the most innovative country in this field, shows that far from limiting the pace of expenditures, healthcare innovations make the average cost of healthcare higher due to a higher technological content of

the services, cutting-edge know-how, and more sophisticated drugs. The role of the government is fundamental for orientating healthcare innovations toward higher levels of productivity and lower costs.

Innovations in new energy to accelerate As reflected by the multiplication of programs and initiatives at the governmental level, R&D activities in the field of green energy have taken

a primary role. The EU’s Growth Strategy for 2020, the importance of green

growth in China’s Five-Year Guideline, specific programs in Korea and

South Africa, and several U.S. laws limiting CO2 emissions underline the

necessity to develop new forms of energy which are less polluting and more

Index of relative strength of innovation in medical technology Israel Switzerland U.S. Australia Russia Sweden U.K. Netherlands Others Italy Canada Germany France Japan China Korea

-0.26 -0.341 -0.382

-0.032 -0.073

Sources: WIPO; Haitong International.

232

0.317 0.284 0.272 0.238 0.178 0.177 0.158 0.07 0.03 0.003

0.554

Looking for the New Sources of Growth

Index of relative strength of innovation in pharmaceuticals India Belgium Switzerland Israel U.K. Sweden Italy Others U.S. China Canada France Netherlands Germany Korea Japan

-0.479 -0.53

0.523 0.513 0.398 0.281 0.253 0.22 0.192 0.173 0.146 0.145 0.119 0.015

-0.16

0.74

Sources: WIPO; Haitong International.

stable than the politically sensitive sectors of fossil or nuclear energies. The

perspective that the United States will be self-sufficient in energy by 2035,

due to the shale industry, will radically change the global outlook on energy. The sudden apparition of a significant comparative advantage in favor of the United States will incite competitors to develop new forms of energy. This

geostrategic issue, mounting concerns on global warming, and increasing social awareness on environmental problems will boost government

expenditures on R&D related to energy. In this area, China ranks among the world leaders.

Index of relative strength of innovation in environmental technology Brazil Sweden China Russia Spain France Germany Italy Canada Others Korea U.K. Netherlands Japan Switzerland U.S.

-0.128

-0.01 -0.026 -0.044 -0.082

Sources: WIPO; Haitong International.

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0.089 0.076 0.051 0.04 0.023 0.022 0.013

0.212 0.19 0.168 0.154

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Structural Reforms and Technological Innovations as the Twin Pillars of Growth Major crises continue to reshape the economy. The 2007–2009 Global Financial Crisis followed this rule and highlighted again the central role of governments in the reconstruction process. After having stabilized growth, and facing the daunting task of reducing public deficits, governments

have to find new sources of growth urgently. In this context, central banks are winning time with accommodative monetary and fiscal policies as industrial guidance, creating much needed time for undergoing the essential structural reforms and transitions in each economy. Such an environment of

accommodative policies should be favorable for a slight rebound of growth in the near future at a global level.

In conclusion, the new sources of growth have two primary dimensions:

structural reforms and technological innovations. Neither of these pillars can

be neglected in creating a new model of growth based on a balance between

consumption and investment, sound industrial development, continuous innovation, as well as the maintenance of internal and external balances. In the race toward global leadership, the degree of centralization and coordination of economic activities will play a fundamental role. Despite cyclical and

structural differences, the United States, China, and the Eurozone nations share a common innovation strategy focusing on IT, healthcare, and energy,

and each will face the challenges of competitiveness, an aging population, and self-sufficiency.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Ben Bernanke and the other members of the U.S. Federal Open Market

Committee have implemented a significant shift in their communications since June 2013. The announcement of a soon-to-be initiated progressive exit

from quantitative easing (QE) triggered a significant increase in long-term

yields and mortgage rates in the United States. Given the central role of the

U.S. dollar in determining global liquidity, the announcement was followed by a surge of volatility across world financial markets and it eventually

triggered a tightening of global monetary conditions. The QE exit, which we

expect in fourth-quarter 2013 or early next year [2014], has already influenced global variables via different channels.

Deceleration in the U.S. Housing Market with Limited Shock on the U.S. Economy Ben Bernanke confirmed on June 19, 2013 that the Federal Reserve would envisage an exit from its QE policy once the job market provides clear signs

of improvement. This announcement was not really new but the scenario presented by the Fed Chairman suggested an exit taking place much earlier

than expected, which rattled the market. Bernanke communicated on an

implicit 7% threshold in the unemployment rate, under which QE would be terminated. According to the Fed’s own macroeconomic staff, this threshold could be reached as early as mid-2014. Once the unemployment rate falls below 6.5%, an increase in the Fed funds rate could be envisaged, but not before 2015 if we accept the macroeconomic assumptions of the Fed. The

market immediately readjusted its expectations and targeted September 2013 as the first month seeing the beginning of a QE exit. In our view, the exit will take place later, from the fourth quarter of 2013 only, possibly from December.

Notwithstanding the fact that the exit could take place later than

September, the market’s reaction triggered a significant increase of not only

U.S. but also foreign interest rates. This concomitant surge of long-term

interest rates represents a global tightening of monetary conditions. In the United States, the shock on the level of interest rates was rapidly visible at the level of mortgage rates, which also registered a large increase, embodying knock-on effects on the real side of the economy.

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Global Impact of the U.S. QE Exit

The share of adjustable-rate mortgages stand currently at around 6% of

all distributed loans. It means that the recent increase of interest rates will not

impact the U.S. housing market as severely as the U.K. housing market, where mortgages with a variable rate represent a significantly higher proportion of the outstanding ones. However, it will impact the refinancing activities and

mortgage rates of newly distributed loans. Mortgage applications, housing starts, and building permits reflected the impact of this shock as early as June [2013].

With the increase of mortgage rates, housing prices and sales and

construction activities will decelerate. The increase of mortgage rates will

be accentuated when the Fed progressively ceases buying mortgage-backed

securities, currently at a pace of USD40 billion per month. This tightening

of monetary conditions could be problematic for the U.S. economy, in which stability essentially relies on the sound performances of household

consumption. In a context of increasing income tax, positive wealth effects from the housing market have played a central role in supporting

consumption. With the coming deceleration of housing prices, and lower construction activities — meaning fewer job creations at a national level —

the U.S. economy could be severely impacted. Nevertheless, several reasons let us think that we will observe a soft landing of the housing market and the shock on the U.S. economy will be absorbable:

• The low proportion of adjustable-rate mortgages means a low level of transmission of the interest rate shock to the real economy.

• The unemployment rate represents the decisive factor behind the evolution of housing prices. In our scenario, cyclical factors (still expansionary

monetary policy) and structural factors (lower participation rate and

the reindustrialization of the United States) will make unemployment continue its trend of a progressive decline.

• The quality of credit is currently pretty high in the United States with historically low default rates (the delinquency rate was at 7.25% in first-quarter 2013 compared to 10% in first-quarter 2010) and a degree

of household indebtedness still oriented on the downside (household indebtedness reached 80% of GDP in first-quarter 2013 compared to 97% of GDP in 2009). This cautious comportment of U.S. households,

coupled with a continuing conservativeness from banks in distributing

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

credit, means that the credit quality is currently high, and that the shock

of interest rates will have a lower impact than the 2007–2009 Global Financial Crisis.

• Profitability currently reaches record high levels in the United States.

Therefore, an increase of monetary conditions, which announces an increase of the cost of capital, should be easily absorbable by the U.S. economy without endangering the stability of investments.

• The contribution to growth from external demand should be stronger in the second half of 2013 with a progressive stabilization of the Eurozone

and a more supportive policy to be implemented in China. Better external conditions should help offset the negative effects linked to the housinginduced deceleration of domestic demand.

Global Tightening of Monetary Conditions The change of stance in the Federal Reserve’s communication has a global impact. Monetary and financial conditions indexes of the United States, the

Eurozone, China, the United Kingdom, and Japan show that these conditions are the tightest in Europe, where demand for credit will remain weak and increasing risk-free rates and risk premiums will penalize growth amid low profitability.

Europe to be the victim Paradoxically, the impact of a QE exit could have higher and more depressive impacts on the Eurozone economy. Given a high correlation between U.S. and

European interest rates, Eurozone interest rates should register an increase, which will further hamper a very weak demand for credit.

Interest rates of the core European countries are well correlated with U.S.

interest rates. It means that European risk-free rates will register increases in

the coming months alongside the tightening of monetary conditions in the United States. The tightening of monetary conditions will also impact the risk premium of periphery countries as they already struggle to fund their deficit. Given a significant increase of interest rates, they could be exposed

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Global Impact of the U.S. QE Exit

to further distrust from the market. They could also suffer indirectly from

the competition with core risk-free countries. Pension funds have indeed

invested in bonds of the peripheral countries to increase their return in a context of extremely low interest rates. With the normalization of the

monetary policy and the concomitant increase of interest rates, these funds could be incited to reinvest in risk-free countries now paying higher interest

rates with lower levels of risk. The risk premium of the peripheral countries could therefore increase as a result of this competition from core countries,

or the United States. The spread of credit-default swaps in the Eurozone already reflect this phenomenon; the European Central Bank has already

underlined the significant tightening of monetary conditions and reacted by easing the haircut conditions of asset-backed securities being eligible

as collateral in normal liquidity operations with the central bank. At last, and contrary to the United States, profitability conditions are the poorest since 2009. This therefore means that the Eurozone economies have a lower capacity to absorb a shock on the cost of capital and that investment should suffer relatively more.

Japan to be a major source of risk The economic situation of Japan seems to be better than the Eurozone.

However, we maintain our analysis (Global Monthly of February 2013) on the risks associated with overly expansionary monetary and fiscal policies in this country. The benefits linked to this policy will be short lived as the recent fiscal stimulus will be hampered by a necessary increase of the value-added tax (VAT). Moreover, large injections of liquidities by the Bank of Japan will

see a limited downward potential for the Japanese yen as Asian countries will intervene on foreign exchange markets to restore their competitiveness.

The inefficiency of the Japanese policy mix will polarize the attention of

the market on the unsustainable level of public debt (above 200% of GDP), triggering a large sell-off of Japanese assets and so accentuating difficulties of Japan’s banks in terms of funding. In a context of a global tightening of

monetary conditions, the distrust of the market toward Japanese institutions and companies could quickly reappear.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Divergence of Solid and Fragile Emerging Countries The communication shift of the Fed was accompanied by a large movement of

asset repricing. Emerging assets have been amongst the ones most impacted by this process. The excess of liquidity, observed at a global level since the implementation of unconventional monetary policies by major central banks, has created a thirst for returns amid low interest rates. This thirst for higher returns has naturally benefitted emerging countries, which are

characterized by higher levels of growth, higher risk premiums, and a large potential for the appreciation of their currencies. The world monetary basis

has been decelerating since mid-2012 as the European Central Bank’s longterm refinancing operations for liquidities were progressively reimbursed by the most solid European banks. The world monetary basis is now stagnating

despite the aggressive stance of the Bank of Japan which consisted of targeting a doubling of the monetary basis in less than two years. The stagnation of the global monetary basis will transform into a decline of the monetary basis

when the Fed starts progressively reducing its amount of monthly security purchases. Solid and fragile emerging countries will diverge, the latter observing outflows of capital.

The deceleration of global liquidity and the market’s expectation of its

coming decline explain the recent outflows of capital from emerging countries,

as this resulted in a lower risk appetite of global investors. This is all the more true as major emerging economies, in particular the BRICS countries (Brazil,

Russia, India, China, and South Africa), have had to face major obstacles in their uninterrupted race against high-speed economies. The deceleration of

global trade amid steady low-level growth in the United States, alongside the recession in Europe, represents the main culprit for the difficulties of growth

models still dependent on export performances. The necessity to rein in

shadow banking has also tightened credit conditions in China. The Brazilian government had to deal with widespread riots amid increasing concerns of

the population on the quality and cost of public services. The social situation was also particularly tight in Turkey and the Russian government saw its revenues significantly decline amid falling energy prices. The deceleration

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of growth and the appearance of idiosyncratic shocks have increased the distrust of the market toward emerging markets. These outflows translated into the recent underperformances of stock and bond markets, as well as

depreciating currencies, accentuating the downward effects on total return.

Stock indexes of developed economies have completed their catching-up of

emerging stocks after a decoupling initiated from 2009. In 2013, emerging stocks suffered from the deceleration of global liquidity and decelerating growth, whereas the market rewarded the success of structural reforms in the

United States and Europe, and the audacity of Japan’s policy. Interestingly, our monetary and financial condition indexes, which take into account not only the variations of interest rates but also stock performances and exchange

rate variations, show that monetary and financial conditions have tightened in China and eased in developed economies. However, credit conditions remain the tightest in the Eurozone, which could further penalize a weak demand for credit.

The most fragile emerging countries have to get prepared for the

outflows of capital following the U.S. tapering of the QE program. To tackle

the issue of capital outflows and depreciating currencies, some countries

have already reoriented their monetary policy and adopted measures of stabilization. Turkey’s central bank sells its foreign exchange reserves to limit the depreciation of the Turkish lira. Brazil’s central bank has increased

Special Clearance and Escrow System (Selic) rates three times since April

2013 despite the deceleration of the economy to slow the pace of the Brazilian real’s depreciation. Brazil’s central bank also stopped taxing derivatives, a bet on the depreciation of the U.S. dollar. Indonesia’s central bank increased its

official rate and announced its readiness to acquire Indonesia’s government bonds to support the currency. India’s central bank increased the rate of the

Marginal Standing Facility, capped the amount that banks could borrow in

daily repo operations, and announced its readiness to sell government bonds

to reduce liquidity, which potentially fosters speculative positions betting on the downward movement of the currency.

The progressive ending of the cheap money era will weaken the most

fragile emerging economies. In August [2013], capital outflows from fragile

emerging markets characterized by large current account deficits, high fiscal deficits, or high external debt such as India, Indonesia, Brazil, Turkey, and

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

South Africa continued to rattle the market following confirmation of an

approaching tapering of the U.S. QE program. These emerging countries were impacted by several factors.

• The market had the growing perception of insufficient reforms during the period of large excess liquidity, making these countries fragile in the case of capital outflows.

• The depreciation of their currencies contributed to aggravating their

current account deficit or increasing the cost of their debt denominated in U.S. dollars.

• The context of low commodity prices but increasing oil prices was another factor contributing to the enlargement of their trade account

deficit as they not only are net exporters of commodities but are also net importers of oil.

Despite these difficulties, we do not expect another emerging market

crisis like the 1997–1998 Asian Financial Crisis, as these countries have a much bigger buffer of foreign exchange reserves and stronger levels of

growth than developed economies, and international institutions such as the IMF are better prepared to deal with current account crises. A probable

lesson of this current time of nervousness is that these countries, which have opted for a gradual opening of their capital account like China, are better protected against sudden and large capital flows.

The situation remains under control for emerging economies as they

continue to register higher levels of growth and still benefit from their recent

policies consisting of building up their foreign exchange reserves. For an

international investor eager to maintain an exposure to emerging assets, it is now important to discriminate between the most solid and potentially

fragile economies. Given the context of increasing rates and capital outflows,

countries depending the most on foreign capital and having a high level of public debt should be avoided. Countries with a positive net international

investment position and positive current account balances are less exposed

to destabilizing outflows of capital. Taking into account these criteria, Brazil,

Ukraine, Turkey, and India are not in a good position. China and Russia are in a more comfortable situation. However, given the rapid deterioration of

public accounts in Russia, which is related to the negative impact of declining commodity prices on fiscal revenues, we recommend overweighting Chinese

242

Global Impact of the U.S. QE Exit

assets, given the country’s low level of public debt and low dependence on external capital. The stabilization of commodity prices should eventually keep the situation in Brazil and Russia under control.

Net international investment position and current account balance (% of GDP, 2012) Current account balance 8

Malaysia

6 4

-2 -4 -6 -8 -10

-120

Net IIP

2 0

Korea Russia Philippines China Thailand Bulgaria Mexico Ecuador -80 Poland -40 Brazil 0 Argentina 40 Czech Republic Egypt Romania Colombia Chile Peru India Turkey South Africa Ukraine

Hungary

Morocco

-12 Sources: Institute of International Finance; Haitong International.

Stabilization of Commodity Prices A clear link exists between commodity prices and excess supply of money at a global level. The announcement and confirmation of QE exit has reinforced

the recently observed downward pressures on commodity prices. The laterthan-expected exit of QE, to take place in the fourth quarter of 2013, will produce a temporary rebound. We expect commodity prices to be stable in

the coming months as the rebound of the Chinese economy will exert upward pressures, whereas the winding down of speculative positions linked to the

diminishing global excess of liquidity will exert downward pressures. In the

medium term, once the adjustment of speculative positions is terminated, commodity prices will adopt a new regime of positive growth, albeit at a

slower pace than the recent periods due to lower influences of speculative

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

positions. The stability of the three major economic areas (China, the United States, and the Eurozone) should be the main contributors behind this

sounder pace of progression in commodity prices. While oil prices will be exposed to shocks of volatility amid growing geopolitical tensions related to

the situations in Syria. Brazil and Russia, as important commodity exporters, should benefit from this stable outlook in commodity prices.

Repricing of Risks and Assets Calls for New Strategies of Portfolio Allocations The global tightening of credit conditions has already produced a repricing of risk unfavorable to emerging assets and bonds. This repricing will produce higher volatility and a possible deceleration of the world economy. In this

context, we have the following cross-asset recommendations for global investors:

• To hedge against higher volatility. Investing in gold traditionally

represented a good hedge against increasing uncertainty and volatility.

This time, however, gold prices could suffer from a progressive decline of global liquidity. Volatility funds are worthy to invest in. Strategies based on straddles can also be developed.

• To hedge the negative impact of higher rates. Higher interest rates will

penalize bonds. Funds-developing strategies related to variable interest rates should be fostered. Direct purchases of floating-rate bonds can be, of course, imagined.

• To reduce the exposure to commodity assets and countries. Commodity

exporter countries will be penalized by China’s new regime of growth. Inflation-linked products will also underperform given stabilizing commodity prices and low inflationary pressures at a global level.

• To discriminate among emerging economies. The related assets of

emerging economies have to be sold without discrimination. Emerging economies and assets still represent an interesting opportunity for

investors interested in higher growth and return. Countries with low

levels of debt and low dependency on foreign capital will suffer relatively less from higher interest rates and capital outflows.

244

Global Impact of the U.S. QE Exit

• To increase the exposure to U.S. equities. The U.S. economy can withstand a tightening of monetary conditions after having absorbed the sequester. As long as unemployment remains oriented on the downside, the housing and financial markets will continue performing well, albeit

at a slower pace than the recent period. Performances of European stocks could also positively surprise with further signals of success in structural policies of consolidation.

As we expected, and against market expectations, the Federal Open Market

Committee decided to not taper in September [2013] as labor market conditions were not satisfying despite a gradual decline of unemployment rates. Not tapering at this time reflected the influence of Federal Open

Market Committee members, probably incoming Fed chair Janet Yellen

among others, who attach a high importance to a qualitative approach to the job market and give no priority to market expectations. In this context,

and amid heightened fiscal uncertainties linked to the shutdown and debt ceiling negotiations, we expect the Fed to not taper in October [2013]. The

next window for QE tapering could be December [2013], given the resilience

of the U.S. economy. However, there is also a chance for this decision to be postponed to early 2014 as Ben Bernanke’s term will expire in January 2014.

245

Japan’s Stimulus Policy of Brinkmanship

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Another Lost Decade On January 11, 2013, newly elected Prime Minister Shinzō Abe announced

a JPY10.3 trillion (USD116 billion) stimulus package which represented 2%

of Japan’s GDP. This plan aims to reinvigorate the Japanese economy, which was severely impacted by three consecutive shocks: the Global Financial Crisis of 2007 to 2009, the ongoing European Sovereign Debt Crisis from the

year 2009, and the Great East Japan Earthquake of March 2011. Despite the implementation of 14 different stimulus plans between 2008 and 2012, growth in Japan remained desperately low after two consecutive lost decades in the 1990s and in the first 10 years of the new millennium. The average growth

rate between 1990 and 2010 reached 1.2% year-over-year, compared to an

average of 4.8% year-over-year between 1970 and 1990. Japan’s consumer price index (CPI) inflation amounted to, on average, -0.3% year-over-year

since the beginning of 2000. The so-called liquidity trap — the lack of

incentive for the corporate sector to invest and for households to consume

given declining prices — is still at work, which reflects the devastating effects of the long-lasting deleveraging of Japan’s economy.

Abe’s new stimulus package was mainly a campaign measure to regain

the control of the Diet’s lower house in the December 2012 elections. This was also an essential part of his party’s campaign for the elections of the

upper house, which was to take place in July 2013. The Liberal Democratic Party, which held onto power for more than 50 years, has been a traditional

advocate of Keynesian policies for supporting the economy. The JPY10.3 trillion stimulus package introduced by Abe may increase to JPY20.2 trillion

after local government contributions are taken into account. Certain priorities were fixed by the prime minister: reconstruction and disaster prevention,

creation of wealth through growth, and securing safety of livelihoods as well as regional revitalization.

According to the Reconstruction Agency, reconstruction in impacted

regions has not been finished yet nearly two years after the Great East Japan

Earthquake. Less than 30% of debris clearance had been accomplished in July 2012, the whole clearance plan having to be completed by March 2014. Although public services such as hospitals and schools have resumed their

activities, projects including household relocation, land adjustment, and

248

Japan’s Stimulus Policy of Brinkmanship

public housing development will take a longer time to be completed (not

less than two years). Abe’s stimulus measures for reconstruction include the building and improvement of infrastructures for residents’ settlement, and the restoring of industrial plants. New infrastructure efforts for protection

against potential disasters and the improvement of the national disaster

response system will complete this framework. The central government will spend JPY3.8 trillion on this issue. The two other parts of the stimulus are related to the promotion of investment (JPY3.1 trillion) and the reviving of

local economies (JPY3.1 trillion). The prime minister expects this stimulus plan to shore up real GDP by 2% and create about 600,000 jobs. • Post-earthquake

reconstruction

and

disaster

prevention

government JPY3.8 trillion for a total of JPY5.5 trillion) • Acceleration

of

reconstruction

in

damaged

regions

government JPY1.6 trillion for a total of JPY1.7 trillion)

(central (central

• Disaster prevention and mitigation (central government JPY2.2 trillion for a total of JPY3.8 trillion)

• Creation of wealth through growth (central government JPY3.1 trillion for a total of JPY12.3 trillion)

• Stimulating private investment (central government JPY1.8 trillion for a total of JPY3.2 trillion)

• Fostering small to medium–sized enterprises and small-sized business

as well as agriculture, forestry, and fishery (central government JPY0.9 trillion for a total of JPY8.5 trillion)

• Facilitating overseas expansion of Japanese businesses (central government JPY0.1 trillion for a total of JPY0.3 trillion)

• Developing human capital and employment (central government JPY0.3 trillion for a total of JPY0.3 trillion)

• Ensuring daily life security and reviving local economies (central government JPY3.1 trillion for a total of JPY2.1 trillion)

• Ensuring daily life security (central government JPY0.8 trillion for a total of JPY0.9 trillion)

• Reviving local economies (central government JPY0.9 trillion for a total of JPY1.2 trillion)

• Facilitating funding for local governments and ensuring quick response of emergency economic measures (central government JPY1.4 trillion)

249

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Structurally Inefficient Fiscal Policy Offers Few Hopes of Success There exist serious structural problems in Japan, which will handicap the effectiveness and efficiency of its stimulus policy.

Political instability undermines the impact of fiscal policy. Japan has seen

seven prime ministers in six years. The last anticipated elections were the results of blockades on the voting on the budgets. The lack of continuity in the conduct of the fiscal policy and the absence of long-term perspective

are probably two of the main explanatory factors behind low growth performance and a record high public debt, which is currently at 204% of GDP.

Fiscal multipliers (the ratio of a change in output to an exogenous and

temporary change in the fiscal deficit with respect to their respective baselines according to the International Monetary Fund’s definition) are traditionally low in Japan. Markus Brückner and Anita Tuladhar estimated in “Public

Investment as a Fiscal Stimulus: Evidence from Japan’s Regional Spending During the 1990s” (IMF Working Paper No. 10/110, April 2010) that Japan’s government expenditure multipliers are low and have decreased over time,

reaching 0.8 for the period of 1975 to 1989 and 0.6 for the period of 1990 to 2000. Fiscal multipliers are typically low in open economies such as Japan as a large share of the domestic demand support will in fact foster imports.

High savings rates represent another obstacle to an efficient transmission

of the fiscal policy. The context of deleveraging, which weighs on the

performances of financial and housing assets, incites Japanese households to adopt a cautious approach despite a low unemployment rate, currently at 4.1%. A growing aging population should be favorable to consumption, but

the insufficient performances of their assets and savings incite them to keep a high level of precautionary savings.

Low productivity, inefficient allocation, and waste are generally

associated with public investment in Japan. Some form of pork-barrel

spending linked to the attribution of public markets, considerations such as regional equity for the distribution of public funds, a strong influence of local

authorities in implementing the stimulus plans, and a still high influence of

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Japan’s Stimulus Policy of Brinkmanship

lobbies from traditional sectors such as agriculture and fisheries explain this lack of efficiency.

Crowding-out effects have been particularly strong in Japan. The

succession of investment plans implemented by the government has discouraged private initiatives, besides a context of deflation. Corporate investment currently amounts to 13.3% of GDP compared to 16% at the

beginning of the 1980s. During this period, public expenditures have increased from 14% of GDP to 20.6% of GDP.

The absence of the most-needed structural reforms, attached to this

last stimulus package, foreshadows its limited efficiency. No real initiative has been taken to retake the control of public debt in the long term. The

value-added sharing, based on an insufficiently redistributive tax system, will remain unfavorable to households, thwarting any significant rebound

of consumption. The government has not provided any credible answer to

the aging of the population and the burden it represents for public accounts. Immigration and the female participation rate remain too low. No reform

has been proposed for tackling the problems related to a too rigid labor market. The energy policy does not seriously consider alternatives to nuclear technologies.

The timing of this stimulus package is inappropriate as the Eurozone

and the United States are engaged in austere fiscal policies. In the absence

of coordination among major partners, any stimulus policy has a lower firepower, a lower multiplier. The countries engaged in austerity policies benefit from the support of the demand in the country conducting an expansionary policy via higher imports from this country.

The Bank of Japan Officially Targeting Inflation and Implicitly Reigniting a Currency War Shinzō Abe also won the election on the promises of reforming the Bank of

Japan statutes and more aggressively combating inflation. He implemented strong pressure on the Bank of Japan’s governor who finally announced

an increase of the inflation target from 1% to 2% and supplementary

liquidity injections from January 2014 onward via an open-ended purchase

251

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

program of assets. The Bank of Japan has been a leader in unconventional

monetary policy, as reflected by the purchases of treasury securities, which

were implemented in a first unconventional program as early as 2001. The purchase of government bonds started in the mid-1990s, but the bonds

were linked to the reform of the financial system, during which the Bank of Japan gave more importance to open market operations. The 2001 to 2006

unconventional program encompassed the zero interest rate policy (ZIRP),

and some quantitative easing which increased and modified the structure

of the bank’s balance sheet. A tentative exit from the first unconventional program took place between 2004 and 2009. Unfortunately, the trigger of the 2007–2009 Global Financial Crisis compelled the bank to actively restart

outright treasury securities purchases, besides numerous unconventional

measures. The Bank of Japan has increased the pace of treasury securities purchases from 2009 onward. The above-mentioned new liquidity program,

announced in January 2013 and to be implemented in January 2014, will implement JPY13 trillion of treasury securities purchases per month (about

JPY2 trillion of Japanese government bonds and treasury bills for about JPY10 trillion).

The first unconventional program of 2001 was more efficient as it was

accompanied with massive and unsterilized foreign exchange interventions between 2003 and 2004, which triggered a significant depreciation of the

Japanese yen which continued until 2006 due to global carry-trade strategies.

Between 2007 and 2012, yen-denominated assets have continuously played the role of a safe haven, leading to a strong appreciation of the yen which in turn reduced significantly the efficiency of the monetary policy. As in 2003

and 2004, foreign exchange interventions have taken place for weakening the yen against the U.S. dollar, but the large unconventional programs of the U.S. Federal Reserve and the European Central Bank have blocked any movement of depreciation for the yen, annihilating the monetary efforts of

the Bank of Japan. More recently, the announcement of the new stimulus program, and the obedience of the Bank of Japan to the government have led to a significant depreciation of the yen. The current USD/JPY exchange

rate is still not satisfying according to Yasutoshi Nishimura, Japan’s deputy

economy minister. Several eminent central bankers expressed their concern about this hidden policy of devaluation. Mervyn King, the governor of the

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Japan’s Stimulus Policy of Brinkmanship

Bank of England, expected that this policy would create tensions between

global political leaders. Jens Weidmann, the president of Germany’s Bundesbank, expressed worries on the growing lack of independence of

central banks and underlined the dangers of a currency war. Mario Draghi, the president of the European Central Bank, continued to insist that the G20 countries do not manipulate their exchange rates.

Regarding the new program to be implemented from January 2014, the

market has not been impressed as nothing new has been announced for 2013. Moreover, the Bank of Japan will continue to target the short end of the

yield curve, which represents a limit to the efficient transmission of liquidity

injections. At last, the overnight borrowing rate has been left unchanged by the Bank of Japan. All these points represent a limit to the efficient transmission of the monetary policy, especially regarding the objective of reaching a higher level of inflation.

Unsustainable but Manageable Debt Thanks to a Low Degree of Foreign Ownership The succession of expansionary fiscal policies, without real tangible effects on growth and inflation, has induced an increase of public debt now above 200% of GDP. The weakness of growth and a too low level of taxes have

structurally maintained fiscal revenues at a low level, amid too high public

expenditures. The repetition of major shocks such as the credit crisis of

the 1990s, devastating earthquakes in 1948, 1995, and 2011, and the Global Financial Crisis of 2007 to 2009 have repeatedly weakened the economy and

required further reconstruction and stabilization policies. At last, the aging of

the population has triggered a sharp acceleration of healthcare expenditures. The only factor making the Japanese debt sustainable is the degree of

foreign ownership of the public debt. The particularly low level of this rate protects Japan from any speculative attack or sudden aversion for Japanese

treasury securities. However, any surge in interest rate, following a tightening of the monetary policy in a context of accelerating inflation, or following a

sharp depreciation of the yen, could turn out to be disruptive even for the domestic market of Japanese government bonds.

253

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

2009

2010

U.S.

U.K.

Spain

Portugal

Korea

Japan

Italy

Ireland

Greece

Germany

France

Canada

100 90 80 70 60 50 40 30 20 10 0

Australia

Public debt owned by nonresidents (% of total public debt)

2011

Sources: International Monetary Fund; Haitong International.

Moreover, two new external shocks recently occurred, hampering

Japan’s competitiveness and possibly exposing this country to higher foreign

dependency in the future. The interruption of nuclear plants, which produced 30% of Japan’s total energy needs before the earthquake, has significantly contributed to the degradation of the current account as imports of energy surged. In the meantime, diplomatic relations with China have worsened

due to the spat over the Senkaku (“Diaoyu”) Islands. The decline of Chinese

imports from Japan has also contributed to the deterioration of Japan’s current accounts. In the case of the long-lasting effects of these factors, Japan

could see no significant improvement of its external trade, which therefore increases its dependency on foreign investors, which in turn could be disruptive to the stability of the debt.

The Policy of Brinkmanship to Produce a Negative Outcome The economic policy of Japan can be seen as being particularly bold given

a context of persisting nervousness in global financial markets. The U.S.

254

Japan’s Stimulus Policy of Brinkmanship

debt remains under the threat of a downgrade due to the incapacity of the

U.S. Congress to agree on a long-term path of stabilization. The situation in Europe, even if the fail risk seems to have disappeared, remains critical

due to a recession caused by the multiplication of austerity policies. Any

slippage of public accounts in Japan could trigger a movement of distrust in the market. Of course, this movement would have minor effects on the level of Japanese yields given the low level of foreign ownership of Japanese

government bonds. However, this aversion for the Japanese risk could take

the form of a sharp depreciation of the yen. The large volume of liquidity available globally could trigger significant disruptions on the exchange market in the case of strong aversion for Japanese risk. The Japanese government has already pointed out that it would be comfortable with a higher exchange rate.

The risk on Japan will increase significantly as a vicious circle, leading

to a sharper-than-expected depreciation of the yen, remains totally possible due to the following:

• A rebound of growth will be observed in Japan in 2013, with the first effects of the stimulus to be observable from second-quarter 2013 and the depreciation of the yen to slightly reinforce exports and make trade current accounts return to being positive.

• Competitors in Southeast Asia will retaliate in terms of foreign exchange

interventions in order to avoid a too sharp loss of competitiveness,

limiting the positive effects of the Japanese stimulus policy as soon as the second half of 2013. These interventions should contribute to a significant appreciation of the euro and U.S. dollar.

• A quick deceleration of growth in 2014 will take place in Japan due to the

absence of domestic growth relay after the dilution of the stimulus effects, with austerity in Europe and the United States continuing, and foreign exchange interventions being neutralized in the Asia Pacific region.

• Given the uninterrupted increase of the public debt, disruptive

movements of exchange rates will occur on the foreign exchange market with speculators shorting the yen. The Bank of Japan in coordination

with other major central banks will have to intervene to stabilize the yen.

• The Bank of Japan will have to envisage some increase of interest rates as the progressive exit from unconventional monetary policy in the United

255

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

States, from first-quarter 2014, will lead to a progressive increase of U.S.

interest rates, accentuating the downward effects on the yen. Carry-trade strategies will develop quickly.

• The increase of interest rates could severely damage the balance sheet

of Japanese banks, which are heavily invested in Japanese government bonds. The downward pressures on these bonds could be reinforced as Japanese households will be more and more incited to reduce their savings and therefore sell their bonds for financing their retirement.

• The difficulties of the banking system would translate into a tightening of

credit conditions, penalizing consumption in parallel with households’ impoverishment after the bond and equity price correction.

• This scenario makes no hypothesis regarding the geopolitical situation of Japan, which could also deteriorate quickly given the tense situation in

the Asia Pacific region, which would create further downward pressures on the yen.

Japan’s Fiscal Policy Choices There exist serious structural problems in Japan, which will handicap the

effectiveness and efficiency of its stimulus policy. While growth in 2013 is a possibility, there is still a real risk of depreciation of the Japanese yen. With its

strong linkages with the economies of China and the United States, Japan’s economy is at a critical juncture at this time.

256

Investment Strategy amid a Global Currency War

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Shinzō Abe, the prime minister of Japan, has instructed the Bank of Japan in

2013 to be more aggressive in combating deflation and this reignited a global

currency war. The Bank of Japan aims to double the monetary base within

two years. This strategy of massive liquidity injections aims to depreciate the Japanese yen via the increase of inflation expectations and is a response

to the unconventional monetary policies of major central banks in order to boost exports and increase imported inflation. The U.S. Federal Reserve, the

European Central Bank, and the People’s Bank of China have kept a high level of liquidity in circulation in their respective countries, in order to support their economies and avoid an overvaluation of their currencies. Emerging

economies will also participate in the currency war by accumulating foreign

exchange reserves or establishing capital control measures in order to avoid a too sharp appreciation of their currency.

The global currency war will accentuate the differences of the “three-

speed world,” the new global paradigm as identified by the International

Monetary Fund. In this configuration, emerging economies will remain relatively strong. Southeast Asia and Latin America will benefit from

easier financing conditions linked to a wave of hot money, with a risk of overheating. China embodies this regime of high growth. The mid-speed

group is made up of the United States and Canada, with a modest level of growth but brighter spots appearing. The U.S. economy will be stable, as

the housing recovery will allow the domestic demand to withstand fiscal austerity and external uncertainties. Japan and the Eurozone will remain in the low-speed group. The Eurozone nations will find it hard to escape the

negative effects of austerity in the short term, and the depreciation of the Japanese yen will weaken German exports, one of the rare sources of growth on the old continent. In Japan, the aggressive stance of the current policy mix will bring only temporary benefits.

The context of the global currency war and the three-speed configuration

of world growth require international investors to develop adapted strategies of investment: cross-country allocation, a “carry trade” currency strategy, a

bond and equity strategy, a commodity strategy, and a global risk panorama.

258

Investment Strategy amid a Global Currency War

Cross-Country Asset Allocation In the short term, the performance of the Japanese economy will be boosted by the aggressively expansionary stance of Abe’s economic policy. During

this time, Japanese stocks will outperform, the price of Japanese risk will

decline, and stocks of Japanese main competitors will underperform. We provide below a methodology for identifying these main competitors. Over

the medium term, the best strategy consists of being exposed to commodity

exporter countries given the still growing excess of liquidity at a global level. Over the long term, the Japanese risks will materialize, and it will be time to

sell the assets (acquired at a cheap price in the short-term period) hedging this risk.

Outweigh Japan and avoid Japanese competitors in the short term, hedge the Japanese risk at a cheap price Normally, a country exporting relatively more toward Japan should be

more penalized by a depreciation of the yen. Inversely, a country importing relatively more from Japan should be advantaged by a depreciation of the

yen. Regional proximity will certainly play a significant role regarding the impact of the yen’s depreciation. Not surprisingly, the Philippines, Indonesia,

Thailand, and Korea, with their higher shares of exports to Japan, could suffer relatively more from a higher degree of Japanese competitiveness. At the same time, these countries would also be the main beneficiaries of yen depreciation as their imports from Japan also represent a high share of

their external trade. To have an idea of countries most penalized by the yen’s depreciation, we can simply compare the differences between the percentage

of exports and the percentage of imports. With this criterion, the Philippines

and Indonesia seem to be the ones which will be the most impacted, followed by Brazil, India, and the Eurozone nations.

To really study the impact of the yen’s depreciation on Japan’s competitors,

it is better to isolate the factor of regional proximity. The yen’s depreciation will above all penalize the countries which Japan is in direct competition

with for the access to the world market of goods, and not only the markets

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

corresponding to their bilateral trade. This factor is more difficult to identify. To identify the main competitors of Japan, we assume that they have the

same structure of specialization. We use a study of the Banco de Portugal working paper: “Relative Export Structures and Vertical Specialization:

A Simple Cross-Country Index” (January 2007) as a basis of comparison. The authors, João Amador, Sónia Cabral, and José Ramos Maria, provide a ranking of countries for different levels of technology content as presented in

the table below. We can immediately note the presence of China among the top scorers in the category of high-technology products.

Relative product specialization index

High-tech products

U.S.

France

Germany

U.K.

Japan

China

2.4

1.6

1.3

2.4

2.0

2.2

Aircraft and spacecraft

8.2

6.6

1.8

6.6

0.5

0.2

Pharmaceuticals

1.6

2.5

1.8

3.0

0.5

0.4

Office, accounting, and computing machinery

1.7

0.8

1.0

2.4

2.0

4.2

Radio, TV, and communications equipment

1.6

0.9

0.8

1.4

2.5

2.2

Medical, precision, and optical instruments

3.8

1.7

2.4

2.5

3.4

1.5

Medium-high-tech products

1.9

2.0

2.5

1.7

2.5

1.0

Other electrical machinery and apparatus

1.5

1.5

1.7

1.4

2.0

2.1

Mother vehicles, trailers, and semitrailers

2.0

3.0

3.9

2.0

4.1

0.3

Chemicals excl. pharmaceuticals

1.5

1.5

1.4

1.4

1.2

0.6

Railroad equipment and other transportation equipment

1.5

1.5

1.8

0.7

5.5

3.4

260

Investment Strategy amid a Global Currency War

(Cont’d) U.S.

France

Germany

U.K.

Japan

China

2.5

1.9

3.1

2.1

2.9

1.4

0.5

0.6

0.6

0.6

0.5

0.5

Coke, refined petroleum products, and nuclear fuel

0.2

0.2

0.2

0.4

0

0.1

Rubber and plastic products

1.3

1.4

1.5

1.1

1.1

1.2

Other non-metallic mineral products

0.7

1.2

1.1

0.8

0.8

1.3

Building and repairing of ships and boats

0.1

0.4

0.2

0.2

1.3

0.4

Basic metals

0.4

0.6

0.6

0.5

0.6

0.3

Fabricated metal products, excl. machinery

1.2

1.3

1.9

1.3

0.9

2.0

Low-tech products

0.4

0.5

0.3

0.4

0.1

0.9

Other manufacturing and recycling

0.7

0.6

0.6

0.7

0.5

2.3

Wood, pulp, paper, and printed products

0.8

0.6

0.7

0.6

0.1

0.3

Food products, beverage, and tobacco

0.4

0.7

0.3

0.4

0

0.2

Textiles, textile products, leather, and footwear

0.2

0.3

0.2

0.2

0.1

1.3

Other machinery and equipment Medium-low-tech products

Source: João Amador, Sónia Cabral, and José Ramos Maria, “Relative Export Structures and Vertical Specialization: A Simple Cross-Country Index” (Banco de Portugal working paper, January 2007).

From this data and for each category, we build an indicator of proximity

of specialization taking Japan as the basis of the comparison. In the ranking, the two countries immediately above and below get a score of 15, the third

and fourth ones that rank below and above get a score of 14 and so on.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

We thus obtain an indicator of proximity in terms of specialization, which allows us to identify the countries which could suffer the most from the yen’s

depreciation. It is a reasonable assumption to say that price competitiveness, and therefore the value of the currency, has a higher importance for countries

which have a close structure of specialization. It means that these countries are in competition at the world level for the same kinds of products. We are

able to build an aggregate technology index of all the categories to provide an implicit ranking of the countries most exposed to a depreciation of the yen.

We observe the presence of France and Germany, the two biggest economies in Europe among the top five countries in terms of specialization proximity

with Japan. Germany is in the second position behind Switzerland. The position of Germany and France in this ranking, together with the ranks of

other European countries, suggests that the Eurozone could suffer more from

a higher degree of Japanese price competitiveness allowed by a depreciation of the yen. Given these results, equities from Germany and France should be underweighed in the short term.

Indicator of specialization proximity with Japan 40 35 30 25 20 15 10

Portugal

Ireland

Finland

Finland

Austria

Sweden

Canada

Netherland

Hong Kong

Denmark

U.K.

France

U.S.

Germany

0

Switzerland

5

Sources: João Amador, Sónia Cabral, and José Ramos Maria, “Relative Export Structures and Vertical Specialization: A Simple Cross-Country Index” (Banco de Portugal working paper, January 2007); Haitong International.

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Investment Strategy amid a Global Currency War

Prioritize commodity-exporting economies in the medium term Over the short to medium term, the global phenomenon of excess liquidity,

nurtured by the expansionary monetary policy of major central banks and the accumulation of reserves by emerging countries, tells us that it could be

an opportune moment to outweigh commodity exporter countries. This is now the right time to adopt this strategy as these countries have been recently

penalized by the deceleration of global demand. This global demand, amid stability of the U.S. economy and an expected rebound of Japan and China, will outperform in the coming months.

Outweigh the BRICS countries between the medium term and the long term Over the medium term to long term, the ideal strategy consists of outweighing emerging countries, which will pay higher returns, but at the same time have a lower risk of bubbles, which are traditionally associated with a global

excess of liquidity. The BRICS countries (Brazil, Russia, India, China, and

South Africa), characterized by high levels of growth as well as sound and strong regulatory authorities, seem to be the best candidates.

Currency Carry Trade The strategy of “carry trade,” consisting of selling a low-yield currency

and buying assets in another currency paying higher interest rates, has historically taken the yen as a basis given the zero interest rate policy

(ZIRP) implemented by the Bank of Japan. The interest to implement such a carry-trade strategy is even bigger now as the supplementary injections of the Bank of Japan will maintain the Japanese yields at very low levels, and at the same time, the appreciation of currencies relative to the yen will boost the total return of assets owned in different currencies other than the

yen. Moreover, international institutions have semiofficially validated the

new approach of the Japanese government and the Bank of Japan, as they

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

were not accused of currency manipulation. There is, therefore, an official acceptation at a global level of this policy consisting of depreciating the yen.

In such a context, carry-trade strategies become even more opportune and safe. For identifying the most appropriate currencies to be bought under the carry-trade strategy, we look for the ones which historically paid the highest returns. Emerging economies close to a situation of overheating,

such as Turkey or New Zealand, can be targeted to develop these strategies

as they will maintain a high level of interest rates and an appreciation of their currency. Only measures of capital control could limit such a process in the coming months.

Long DKK/ Short JPY

Long EUR/ Short JPY

Long SKK/ Short JPY

Long CZK/ Short JPY

Long GBP/ Short JPY Long HUF/ Short JPY

Long PEN/ Short JPY

Long MYR/ Short JPY

Long ISK/ Short JPY

45 40 35 30 25 20 15 10 5 0 -5 -10

Long AUD/ Short JPY Long NZD/ Short JPY

Best and worst carry-trade strategies based on JPY, returns since January 1, 2010 (%)

Sources: Bloomberg; Haitong International.

Equities and Bonds to Benefit from a Global Thirst for High Returns International investors have in their vast majority induced from the new policy announced by the Japanese government that large outflows from

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Investment Strategy amid a Global Currency War

Japan would occur in the direction of markets paying higher returns than

the Japanese market. However, recent data on the capital account of the

United States suggests the inverse and shows a phenomenon of capital repatriation into Japan. In our view, this process is normal as the Japanese

economy is expected to outperform given the particularly loose stance of its policy mix. At the same time, the global perception of risk is lower as the

European Sovereign Debt Crisis has decreased in intensiveness. The role of the U.S. dollar as a safe haven is therefore not as important as before. In our

view, the assets outside Japan will win some attractiveness once the Japanese economic policy is judged as having generated moderately positive effects only.

Japanese investors, especially pension fund investors, will face a context

of low return due to the accentuated pressure on government bond prices

exerted by the Bank of Japan’s quantitative easing (QE) program. This program will absorb more than 50% of new issuances of coming government

bond issuances. In this context, Japanese institutional investors will have to find other types of assets. Moreover, foreign assets, both bonds and stocks,

have historically produced higher returns than Japanese assets. Thus,

Japanese institutional investors’ incentives to diversify their portfolios will be progressively stronger.

Cumulative total return of government bonds, since January 1, 2000 (%, JPY) 12 10 8 6 4 2 0

Australia

Canada

Euro zone

Sources: Bloomberg; Haitong International.

265

U.S.

Japan

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Total return index (100=January 1, 2000; JPY) 180 160 140 120 100 80 60 40 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 S&P500

Nikkei

Euro stoxx 50

Sources: Bloomberg; Haitong International.

The following assets are likely to be the beneficiaries of this thirst for

higher returns visible in Japan and the rest of the world because of the global excess liquidity:

• Safe haven assets producing higher returns, such as Canadian, Australian, and core European treasury securities

• Japanese stocks in the short term

• Emerging market bonds and stocks

• High-dividend stocks and high-yield bonds

• Multinational companies’ securities, which produce higher returns than government bonds and at the same time present a safe and defensive profile given the geographic diversification of their activities

Commodities to Benefit from a Liquidity Binge Commodities are the traditional beneficiaries of an excess of liquidity at a

global level. Paradoxically, their prices have recently declined as reflected

by the S&P GSCI Total Return Index, which has dropped by more than 7%

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Investment Strategy amid a Global Currency War

since February 2013, embodying the current slack of global demand. With a more supportive policy to be seen in Japan and China in the second half of

2013, global demand should get stronger, and commodities could once again undergo the influence of speculative positions.

To identify excess liquidity at a global level, we can estimate first the

global money supply and demand. The world monetary base has expanded by 15% year-over-year every year on average since the beginning of 2000

due to expansionary monetary policies in the industrialized countries. After

the outbreak of the Global Financial Crisis, the world monetary base soared sharply with a growth rate at 20% to 30% due to QE policies. World money

demand could be estimated roughly in a traditional equation of world GDP,

yield curve rates, and exchange rates. As expected, an acceleration of world

growth leads to a higher demand for money. We then can calculate excess liquidity as the difference between world money supply and demand. Our

models show that this variable of world excess supply of money is significant in explaining the fluctuations of oil prices. There is therefore a direct and positive correlation between the quantity of money in circulation in the world economy and commodity prices.

S&P SCI Index (level) 1,000 800 600 400 200 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Sources: Bloomberg; Haitong International.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

World monetary basis (USD trillion) 20 18 15 13 10 8 5 3 1998

2000

2002

2004

2006

2008

2010

2012

2014

Sources: Thomson Reuters Datastream; Haitong International.

The cyclical orientation of the global economic policy will exert pressures

on the level of commodity prices. Commodity prices will accelerate, albeit at

a moderate pace, with gold continuing to trend upward after normalization,

and agricultural products outperforming. The coming increase of commodity prices will not be as important as in 2008 for several reasons:

• The growing importance of the shale gas and oil industry in North America and in the rest of the world has significantly changed the global energy landscape. The increase of supply let us think that we will have stable prices in the two coming years for gas and oil.

• Speculative operations are better controlled and monitored by financial regulators.

• Besides Japan, the supportive economic policies of other major countries are not as aggressive as in the recent past, in particular in China.

• New and more environmentally friendly forms of energy production continue to have growing importance.

• The structural adjustment of the Chinese economy toward less importance

on investments and a higher weight on consumption should play in favor

of less pressure on metal prices and more on food and agricultural prices.

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Investment Strategy amid a Global Currency War

• Global demand of commodities cannot overshoot as the Eurozone will undergo a structurally low regime of growth.

• We expect a structural appreciation of the U.S. dollar to take place, and it should contribute to the moderation of upward pressures on commodity prices.

Oil and gas prices The emergence of the shale gas and shale oil industry and the reduction

of political tensions in the Middle East will boost the supply of energy commodities at a global level. The rebound of the world demand in the second half of 2013 will be moderate as the Chinese policy mix will not be as aggressive as in 2009, the macroeconomic situation in Europe will remain depressed, and the United States continues to be engaged in a regime of

stable growth, albeit with a higher contribution to growth from residential investment (it normally contributes to an increase of the demand for energy

and metals). The increase of supply and the moderate rebound of growth let us think that Brent oil prices could evolve between USD100 and USD120

in the coming years. U.S. gas prices should undergo a steady increase in the coming two years as the increase in demand will slightly outpace the

increase in supply. Gas is a cleaner source of energy than oil and coal. The U.S. industry is currently undergoing a shift in terms of energy consumption

in favor of gas as this energy is cheaper and cleaner. At the same time, energy producers continue to develop their infrastructure for export and

liquefaction. We should therefore see a growing capacity of the United States for exporting gas in the direction of Europe and Asia. As a result, we

will therefore observe an increase of the U.S. gas prices, currently close to USD4 per million British thermal units, toward European and Asian prices currently close to USD13 and USD15 per million British thermal units.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Precious metals We expect gold prices to continue to trend upwards after normalization. The

recent decline of gold prices mirrored a normalization process as the surge

of risk aversion in a context of crisis made gold prices overshoot. After the completion of this normalization in a few months, gold prices will adopt a

steady pace of growth, which mainly originates, besides the global excess of liquidity, in structural factors.

Strong need for diversity reserve assets in emerging countries The strong need for diversify reserve assets in emerging countries will

structurally support gold price amid limited levels of supply at a global level.

According to statistics of the International Monetary Fund, foreign exchange reserves of emerging countries account for 70% of the world total, and gold

represents less than 5% of their total reserves, whereas gold represents close to 23% of developed economies’ total reserves. The diversification of emerging countries’ reserves to gold is a necessity for several reasons. First,

they have to reduce their exposure to treasury securities, in particular U.S.

government bonds, to reduce the growing risk surrounding these assets. Second, currencies of developed economies have kept depreciating against those of emerging economies, so emerging countries need to reduce exposure

to these currencies. Third, a larger accumulation of gold also allows more independence in terms of the orientation of the monetary policy.

Growing demand for gold jewelry from emerging countries The growing demand for gold jewelry from emerging countries also

represents a structural factor, which will support prices over the long term. The growing importance of the middle class in countries such as China, Brazil, and India, and the quick increase of the spending per capita in these countries, will continuously reinforce the demand for gold jewelry.

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Investment Strategy amid a Global Currency War

Base metals Base metal prices should rebound in the second half of 2013 with infrastructure projects being developed in China. However, the rebound should be

moderate in comparison with the period following the implementation of a giant stimulus, due to the structural reforms of the Chinese economy and

due to the difficulties of Europe. We broadly expect base metal prices to come back at levels similar to the beginning of 2012, characteristic of a stable level of growth before the worsening of the European Sovereign Debt Crisis.

Food prices Food prices should be one of the main beneficiaries of the current context of

excess liquidity as structural reforms will support household consumption in

China. Global protectionism should continue to be active in this sector, and

consumer sectors will continue to outperform in a defensive environment. This category is not concerned by a situation of overcapacity as compared with the base metal case in China. In such a context, we expect the slight rebound of the FAO (Food and Agricultural Organization of the United Nations) Food Price Index to continue on the same trend.

New Panorama of Global Risk Contexts of global excess liquidity are generally accompanied with an

increasing level of volatility. We identify four types of risks. The risks centered on Japan, with its brinkmanship approach and explosive level of debt, are

probably the most significant. The residual European risk remains significant.

The political risk will continue to play an important role in the coming years. The risk of bubbles will increase in the emerging countries. Southeast Asia

is currently the most vulnerable to the development of bubbles. We will identify which countries are the most exposed to an overheating situation and to a sudden correction of their markets.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Risk from Japan The risk from Japan will increase significantly as a vicious circle, leading

to a sharper-than-expected depreciation of the Japanese yen, which remains totally possible via the following steps. The current policy mix will produce

positive results in 2013, but over the medium term, maybe as early as first-

quarter 2014 or second-quarter 2014, the Japanese economic policy could show its limits in combating inflation or supporting growth. Given the loss of

confidence of international investors in this approach and the overly elevated level of public debt, further downward pressures could be exerted on the

yen. The Bank of Japan would have to envision some increase of interest rates as the progressive exit from the unconventional monetary policy in the United States from the first quarter of 2014 will lead to a progressive increase

of U.S. interest rates, which would accentuate the downward effects on the yen. Carry-trade strategies would develop quickly. The increase of interest rates could severely damage the balance sheets of Japanese banks, which are

heavily invested in Japanese government bonds. The downward pressures on Japanese government bonds could be reinforced as Japanese households will be more and more inclined to reduce their savings and therefore sell

their bonds to finance their retirements. The difficulties of the banking system would translate into a tightening of credit conditions, penalizing consumption in parallel with the impoverishment of households following

bond and equity price corrections. A run on the yen remains possible at a global level.

Residual risks in the United States and the Eurozone The worst is over in the Eurozone. With the Cyprus crisis, European authorities

have again shown their determination in maintaining the Eurozone unity. The liquidity assistance from the European Central Bank played, as in the Irish and Greek cases, a very important role in convincing the Cyprus

government to not envision an exit from the Eurozone. In the absence of

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Investment Strategy amid a Global Currency War

this liquidity assistance, the banking system would have collapsed, which

would have significantly aggravated the macroeconomic situation of this small country. As underlined several times by Mario Draghi, the president of the Governing Council of the European Central Bank, the systemic risk

is under control in the Eurozone. The Outright Monetary Transactions

framework of the European Central Bank will be fully operational in the near future. It represents a safety net against any default of a Eurozone country or

any major banking institution. Despite this stabilization framework and the political will to maintain Eurozone unity, a residual risk remains.

In the United States, it is possible that the highly polarized Congress will

be unable to find a bipartisan solution to the stabilization of the U.S. debt, but we think that any shutdown has a low probability as it would be highly

disruptive for the U.S. economy. On the other hand, the risk of another downgrade of U.S. debt remains high.

Global political risk The recent geopolitical context has been marked by increasing global political

risks. From the elections in the United States, fragmentation in the Eurozone,

and rising protectionism in South America, to conflicting sovereign claims in the Asia Pacific region, the level of political risk has reached the highest

levels since the mid-1990s. The political risk integrates several dimensions. Risks of war, terrorism, revolts, and strikes are the most visible ones and

are mainly present in Africa and the Middle East. Political interference such as nationalizations, protectionism measures, and expropriations have been recently more frequent in South America due to the will of governments to

redistribute the benefits of their booming economy to all the population.

The sovereign default risk is currently dominating the European political agenda. Legal and regulatory risks can be associated to the new forms of protectionism. Exchange transfer risks, linked to money laundering and

terrorism condemned by the international community, cost international banks billions of dollars. The global political risk remains historically high

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

in the world despite some improvement linked to the stabilization of the European Sovereign Debt Crisis.

Risk of bubbles in the emerging world The context of a global excess supply of money has created new waves of

hot money attracted by the higher returns of emerging countries. Situations

of bubbles have already been identified in Southeast Asian countries such as Indonesia (property bubble), Thailand (consumer loans), Philippines (property bubble), and Malaysia (household debt bubble). Emerging economies will have to implement measures of capital control to avoid a destabilization of their economies.

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

In May 2012, Caterpillar, the world’s biggest construction machinery maker, completed its USD120 million project, a new plant in Victoria, Texas, returning some of their assembly processes for hydraulic excavators from Japan to the United States, and bringing back more than 500 jobs. In March 2012, General Electric (GE) opened a new factory in Louisville, Kentucky, to

produce refrigerators that were originally manufactured in Mexico and 1,000 workers were hired to work in this factory with more to be added later. This

is only one piece of GE investment in Louisville; by 2014, total investment will amount to USD800 million. Whirlpool also launched its new cooking appliance manufacturing plant in Cleveland, Ohio in March 2012, which

cost USD200 million and created 130 new jobs. The U.S. auto giants Ford,

General Motors (GM), and Chrysler signed a four-year deal with United Auto Workers in 2011 and will relocate parts of their production back to the

United States. The “Big Three” auto companies plan to invest more than

USD13 billion in the following four years, which will support over 14,000 new jobs. A good number of U.S. companies have started “reshoring” — a

colloquial term for the reversal of offshoring — manufacturing operations to American soil.

According to a survey by the Boston Consulting Group in 2011, more

than one third of the surveyed managers in the industrial sector have been planning or considering returning production from China to the

United States, with 67% of rubber and plastic products companies, 42% of mechanical products companies, 41% of electrical products companies, 40% of computer manufacturing companies, and 35% of metal products companies expressing such an interest. The survey sample consisted only

of United States–based companies with annual sales of more than USD1

billion. About 48% of American companies with revenues over USD10 billion expressed a willingness to reshore to the United States. The Boston

Consulting Group estimated that reshoring could bring more than two million jobs to the country. The process of reshoring has only just begun, and it is likely to peak by 2015.

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

Factors Leading to Reshoring At first glance, the United States does not appear to be a very attractive destination for manufacturing in recent years, and it may be puzzling why

companies would choose to bring manufacturing to American shores. The United States levies a very high corporate tax, which ranks the second highest among members of the Organization for Economic Cooperation and

Development (OECD). The United States also has significantly higher average manufacturing wages, which in 2010 were USD35 per hour, compared to

just USD2 per hour in China. Following the economic difficulties of the last

several years, companies such as GE have sometimes been able to pay as low as USD13 an hour for starting wages; however, even in this case, the labor costs are still significantly higher in the United States. There is no clear indication that the gap will be significantly narrowed in the coming decade.

Manufacturing wages, 2010 (USD/hr) 50 40 30 20

Philippines

China

Mexico

Taiwan

Brazil

Argentina

Korea

Singapore

Greece

Spain

U.K.

Japan

U.S.

France

0

Germany

10

Sources: U.S. Bureau of Labor Statistics; Haitong International.

Given the still huge gap between the two countries’ wage levels, the

United States would appear to be at a competitive disadvantage when compared with emerging economies such as China. The question then turns

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

to why this phenomenon of reshoring exists. There are several key factors

that make manufacturing in the United States attractive to certain companies.

Preferential government policies to support job creation Employment and job creation are among the most pressing issues in the United States. After years of offshoring manufacturing jobs leaving blue-collar workers unemployed, there is increasing pressure to bring

manufacturing jobs back to the United States. About 3.9 million, or 33%, of the total jobs in the manufacturing sector were removed during that period. With the U.S. economy still struggling to recover from the Global Financial Crisis, a point that may facilitate the recovery is a return to the real economy, or a process of reindustrialization.

The Obama administration has implemented a series of preferential

policies to stimulate the manufacturing sector. The Manufacturing

Enhancement Act was passed in August 2010, which would suspend or reduce the tariff on materials imported for manufacturing use. According to

a U.S. National Association of Manufacturers report, this bill could increase production by USD4.6 billion and create almost 90,000 jobs. Moreover, a bill called the Creating American Jobs and Ending Offshoring Act was introduced

in September 2010. The bill proposed a 24-month payroll tax relief for companies bringing jobs back from overseas, as well as terminating several

subsidies such as tax breaks and tax reductions for facilities and production moving offshore. According to U.S. Treasury Department statistics, in 2009, U.S. multinational companies accumulated USD700 billion in earnings but only paid USD16 billion in taxes, which meant that the effective corporate tax was only 2.3%, compared to the official corporate tax of 35%.

Local governments also offer considerable incentives to attract companies

to locate within their borders. For example, GE received funding from the

Commonwealth of Kentucky and the City of Louisville worth a total of USD37 million, as well as a tax reduction of USD2.48 million from the federal government. Caterpillar received USD1.18 million in support from the Texas Enterprise Fund, due to its contributions to local employment.

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

A strategic way to avoid trade protectionism particularly amid global downturn With the U.S. mired in high levels of debt and a persistently large trade deficit,

public sentiment has increasingly shifted towards favoring protectionism, particularly when directed at China, a common scapegoat used by politicians

and media to explain economic woes. The United States has implemented various tariffs on Chinese products such as solar products, tires, and garlic over the last several years.

There is increasing trade friction in international trade. Due to their

outsourced production facilities, the U.S. manufacturers are very much

affected by the heavy U.S. tariffs on imported goods. Moving back manufacturing seems more economical when taking tariffs into account.

Domestic manufacturers can benefit from subsidies provided by the

government to promote employment and exports. In Obama’s “Blueprint

for an America Built to Last” presented in January 2012, the government proposed measures to boost American manufacturing, including providing

a 20% tax credit on relocation costs for reshoring companies and to remove similar benefits for offshoring companies, a USD50 billion tax relief for manufacturing enterprises purchasing equipment, and new tax credits

of USD6 billion for companies investing in areas which were heavily

hit by layoffs. Additionally, an expansion of tax credits for clean energy manufacturing amounting to USD5.4 billion was passed in March 2012. Furthermore, American lawmakers are now considering a 20% cut in

corporate tax for US manufacturers that move their production back to the United States from overseas.

The rise of protectionist sentiment has even led foreign companies to

locate in the United States to circumvent trade protection. For example, the

Chinese company Suntech, a leading solar panel manufacturer, purchased

a plant in Arizona, soon after U.S. tariffs were placed on Chinese solar photovoltaic (PV) panel imports.

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Other benefits associated with reshoring Costs associated with companies offshoring include logistics costs, traveling

costs, technology transfer costs, and an increased risk from a longer supply

chain. Reshoring production will reduce or eliminate some of these factors, and also brings various intangible benefits such as goodwill, reputation, and perception of quality.

Reduction of logistic costs Due to rising fuel prices, shipping costs have become a major concern for

offshored companies. According to statistics from IHS Global Insight, shipping costs have surged by 71% in the past four years. Rising costs

reduce profit margins and hurt the profitability of outsourcing. Reshoring production in the United States will reduce shipping costs as products will no longer need to be sent across the world.

Reshoring manufacturing will also eliminate the need for United States–

based management and engineers to have to frequently travel across the

world, cutting the expenditure on overseas flight tickets and hotels as well

as reducing time wastage and language barriers that may be present in offshored facilities.

Better protection of intellectual property This is particularly attractive for high-tech companies, and it will reduce the costs of technology transfers. Loss of intellectual property frequently

occurs when basing facilities in emerging economies due to less stringent intellectual property protection laws, leading to knockoff products sprouting up and the company losing market share and value for their R&D.

Shorter supply chain and faster market feedback As the U.S. domestic market is still the largest market in the world, local-

based production provides companies with quick feedback to consumers’ demand. Reshoring also eliminates certain extra steps such as the customs

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

process for bringing finished goods to the United States. The customs process usually stretches the supply chain, especially in situations where there are public holidays in one of the locations.

Intangible value of the “made in U.S.A.” label Goods made in the United States are perceived as having higher quality, and invoke a sense of patriotism in many American consumers. There is

a grassroots resurgence of the “Buy American” sentiment, in line with an

increasing sense of protectionism. Companies relocating production to the United States will benefit from goodwill from various stakeholders,

including a portion of consumers who will gladly pay extra for an Americanmade product.

Impact of Reshoring on China One key question emerges when discussing the broader issue of Western

relocation of manufacturing from the perspective of emerging economies. What impact will a wave of Western reshoring have on China and the rest

of the emerging economies’ manufacturing prospects, and their growth as

a whole? Specifically, how will the case of U.S. companies returning home affect China?

Limited short-term impact There will be a certain short-term impact on China, as Western countries

begin to bring some of their offshore investments back to their own borders.

The U.S. reshoring of its manufacturing facilities abroad will have some effect on China on a micro scale, where the relocation of certain companies that had operations in China will result in a loss of jobs and a spillover effect

from the loss of know-how and technology transfer. With that being said, it

is tempting to overstate both the trend of U.S. companies returning home

and the impact it will have on the Chinese manufacturing sector; the effects should be relatively minimal for two main reasons.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Scale of reshoring remains small A dramatic scenario with big short-term ramifications is unlikely to unfold, as the scale of this reshoring is likely to be modest and minimal in the short

term. Both the scale and quantity of recent U.S. relocations from China have

been small, numbering in the hundreds or thousands of jobs, and only in

certain specific scenarios. U.S. companies are not leaving China en masse to return to American soil; for the foreseeable future, relocation from China to the United States will continue to remain an exception to the rule. The process of reshoring has only just begun.

Relocation seems more from countries other than China The fact is that despite rising wages for China over the last several months, the country still remains one of the most competitive countries in the world

in manufacturing. Even if there are domestic reasons for the United States

to bring its companies back to its own shores, it is likely that many of the facilities relocated will come from other less competitive countries rather than China.

High long-term competitiveness in manufacturing at a global level In the longer term, the biggest reason why the impact from Western countries moving manufacturing processes back home will not affect China significantly is because China is and will remain one of the most competitive countries for manufacturing in the world. There are two key reasons for this.

Labor costs to remain low Despite the rapidly rising wages, the argument that it will soon be more cost

efficient to relocate to the United States on a large scale is invalid for a vast majority of cases. The core reason for this is that manufacturing wages in

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

China are still significantly lower than the wages in the United States and

the rest of the countries. Even in aggressive forecasts, such as in the Boston

Consulting Group’s predictions of manufacturing wages in China rising

to USD4.41 per hour compared to the United States at USD26.06 in 2015, China’s labor costs will still be merely a fraction of U.S. costs for the near future.

Pension coverage in China is kept low, and that of migrant workers

is often neglected. Basic healthcare provisions, which are often taken for

granted in developed countries, are generally low in China. Particularly in private firms, workers frequently work beyond contractual hours, and

some companies have been known to delay payment that is owed to the

laborers. Legal protection of workers is also low; laborers sometimes can be dismissed with minimal notice or without clear reason, and receive low severance pay. These factors contribute to the low labor costs and provide companies with flexibility that would not be possible in a country with better

worker protection. The poor labor situation has aroused concerns and has

been improved greatly in the past years, but there is still a long way to go before China reaches the standard of developed, or even most developing, countries.

Labor productivity to continue to improve One argument is that China’s labor productivity is still very poor and far

inferior to the levels of developed economies; a BCG Partners report lists the hourly productivity of Chinese workers to be at just a third of the level in

the United States. On the other hand, it is worth nothing that China’s labor

productivity has been improving significantly and the trend will continue. Data from the Conference Board indicates that China’s labor productivity

grew nearly 10% per annum on average between 2005 and 2010, which far outpaced developed economies such as the United States, Japan, and Germany, while also exceeding the growth of fellow BRICS countries India

and Brazil. This stark differential implies that China is moving towards a

long-term catching-up of labor productivity with the countries that currently hold an edge.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Workforce productivity, 2011 (GDP/total employment) 120,000 100,000 80,000 60,000 40,000

Bangladesh

Vietnam

India

Indonesia

China

Brazil

Russia

South Africa

Germany

Japan

0

U.S.

20,000

Sources: Thomson Reuters Datastream; Haitong International.

Labor productivity growth, 2005–2010 average % growth (GDP/employee) 10 9 8 7 6 5 4 3 2 1 0

China

India

Brazil

U.S.

Japan

Germany

Sources: Thomson Reuters Datastream; Haitong International.

Growing domestic market as the magnet to world players With the world’s largest population, steadily increasing wealth levels, and a desire to shift to a domestic consumption–based model of growth from

the old export-led model, China’s domestic market will be one of the most

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

desirable markets that companies could seek to capture. This will be a major reason for companies to base themselves in China.

In 2011, China’s final consumption expenditure was roughly a third of

that of the United States at around USD3.48 trillion or CNY22.47 trillion.

While the domestic market is already large in nominal terms, there is plenty of room for growth, as China’s per capita consumption is still very low

compared with developed economies. Since 2000, the growth of consumption expenditure in China grew at an average of 14.9% year-over-year.

Under the assumption of an average China GDP growth at 7% year-

over-year and U.S. growth at 2% year-over-year in the coming years, with an average appreciation of the renminbi at 3% per annum against the U.S.

dollar, and taking into account the rising share of China’s consumption of

GDP, China’s domestic consumption could grow to over half of U.S. levels by 2015 and over 80% of U.S. levels by 2020.

Increasingly, factories located in China will be producing goods for

China’s domestic market rather than for export purposes, consequently

negating a lot of the arguments about rising shipping and transportation costs and time inefficiencies, all of which would be vastly reduced if the products were sold in China instead.

The example of Caterpillar illustrates the allure of the Chinese market.

Despite relocating manufacturing facilities from Japan and Canada back to

the United States, and acting as one of the first major companies to bring

manufacturing jobs back to the United States, Caterpillar is still expanding

in China, increasing the scale of its Xuzhou manufacturing facilities in an effort to increase the range of products and services offered in China in order

to capitalize on Chinese demand; plans were made to quadruple excavator production at the Xuzhou facility.

Moreover, if Chinese domestic markets become the main target, even

with rising production costs, there will be incentives for companies to locate

within China, to take advantage of local expertise in terms of logistics, supply

chains, and market knowledge. Consequently, there will be an increasing

shift in focus from companies locating in China to capitalize on low input costs toward companies locating in China seeking to capture a share of China’s consumer spending. China will remain an attractive location for companies to locate in, despite rising costs.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Likely future trends Based on the analysis above, there are two possible trends for manufacturing in China.

Parts manufacturing in China, assembly in developed countries Parts will continue to be produced in China, while some assembly lines will

likely move back to the developed countries. China is likely to continue to dominate in the manufacturing of parts and components, as few countries

can match China’s combination of low costs, world class infrastructure, and huge scale. However, with increasing protectionist sentiment worldwide,

China may find it beneficial to relocate some assembly processes, such as

in the Suntech case outlined earlier. China can move the final assembly of

parts to a location, and even if all the parts were made in China, assembling them in another country allows companies to label the product as such; this

is the case for Chinese plastics injection molding machinery (PIMM) maker Haitian International, which through its daughter company Zhafir Plastics

Machinery in Germany can assemble goods that are then labeled as “made in Germany.” At this current stage of development, China’s economy is highly complementary to that of the United States. China is still primarily operating in low value-added sectors of manufacturing, while the United

States is concentrated on high-end production; the United States is lacking workers that would be willing to do the low value-added tasks at a globally

competitive wage, while China is still lacking the requisite innovation and vision to compete at a global level.

China to become an important R&D center China is likely to improve its status as a R&D center in the future, due to its abundant supply of cheap skilled college-educated workers, and due to the government focus on moving up the value-added ladder and investing in

strategic industries. Acquisitions could facilitate this process, such as in the

case of Lenovo acquiring the International Business Machines Corporation

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Reshoring of U.S. Manufacturing: A Ripple or a Tide Approaching China?

(IBM)’s personal computer unit in 2004, which increased China’s acquisition of technology.

China at the Top of Manufacturing Competitiveness While several big name companies have made headlines for their reshoring activities, the impact of U.S. reshoring on China at an aggregate level is likely

to be limited in the foreseeable future. Even in the long run, low labor costs, good infrastructure, and continuously improving labor productivity will still

give China a clear competitive edge. Even more attractive to global players

is that China’s already massive domestic market is growing daily; sooner or later, they will see a large portion of the goods coming out of factories in China consumed domestically.

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How Weighty Are BRICS?

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

On April 15 of 2011, all the BRIC (Brazil, Russia, India, and China) countries

gathered together for the third Leaders Meeting in China following the first one in 2009 after the BRIC idea was initially suggested by Jim O’Neill in

2001. The significant breakthrough from previous meetings was that now

the BRIC membership has been extended to five countries to include South

Africa. As a result, the name of the emerging country group has evolved into BRICS from BRIC. Brazil, Russia, India, China, and South Africa signed a declaration and a financial cooperation framework agreement, and the major areas of discussion included increasing the use of local currencies for

trade settlement which could help expand the trade size among the BRICS

countries; strengthening cooperation among the BRICS countries in the area of low-carbon resources; strengthening cooperation among capital markets

of the BRICS countries, including bond issuance and initial public offerings;

strengthening communication among the BRICS countries; as well as calling for reforms of the international monetary system.

The BRIC idea had incited much controversy when it was first initiated.

The fact that these four countries are geographically located in different regions and are greatly different from each other economically, politically, as well as culturally would render it difficult for them to cooperate with each other as an emerging group. BRIC is neither a political alliance like the

European Union, nor a formal trading association like ASEAN (Association

of Southeast Asian Nations), but the BRICS countries are large in size and

account for 40% of the world’s population and 25% of the world’s lands. They also have great growth potential.

The BRIC idea has become increasingly accepted. The BRIC countries

have been able to demonstrate their contribution to global growth. In 2010, BRIC’s share of world GDP increased to 17.8% from 8.0% in 2001. After the 2008 Global Financial Crisis, a sharp contrast has formed between this

increasingly powerful emerging power group and Western countries which had been greatly affected by the crisis. Despite the financial crisis, China

and India have been able to maintain robust economic growth. China’s GDP grew by 9.6% year-over-year in 2008, 9.2% year-over-year in 2009, and 10.3%

year-over-year in 2010; and India’s GDP increased by 10.4% year-over-year

in 2010. After the crisis, emerging countries such as China and India started to take the lead to pull the global economy out of the recession. China’s

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How Weighty Are BRICS?

status has been boosted and the country has now overtaken Japan as the world’s second largest economy. In addition, China, Russia, Brazil, and India

together hold about 42% of international reserve assets, excluding gold. A shift in power from rich nations to emerging markets has gradually emerged.

After the Global Financial Crisis, the BRIC countries have been the main

engine of the recovery. They represent a fundamental source of demand in

this postcrisis context. The growing competitiveness of Asia, the emergence of the middle class in Latin America and China, the gradual relocation of low-end goods production in the poorest nations, and the increasing concentration of capital in export-based economies clearly indicate that

the potential of growth is now in emerging countries. The cause of the last crisis in developed countries was not only the consequence of excess in the financial sector, but also the fundamental lack of potential in terms

of growth. The denial of declining competitiveness at the global level, the refusal to reduce the level of consumption in a context of declining value added, characterized by a sharp increase in the level of public and private

debt, has also been important factors which explain the financial crisis in developed countries. Looking forward, the BRIC countries will continue to serve as the main engines of economic recovery and growth.

The growing importance of emerging countries is also greatly

demonstrated by their energy consumption. Since China opened up its

economy, its energy consumption has grown tremendously both in absolute terms and as a percentage of world total consumption. In the past 30 years,

China’s consumption has multiplied by more than 4.5 times, raising its share

of world consumption from about 6.1% in 1980 to over 16%. Its growth path was especially steep in the new millennium, with growth rates of about 14.3%, 16.5%, and 23% in 2001, 2002, and 2003, respectively. These numbers

are well above its GDP growth. India’s consumption more than doubled its

share of world consumption in the same period, while Russia’s and Brazil’s consumptions climbed in absolute terms. By contrast, although the United

States’ energy consumption in absolute terms has also grown steadily over the years, its share of world consumption has shrunk from about 27.6% in

1980 to about 21% in 2007. The rising significance of the BRIC countries is greatly demonstrated by their increasing demand for energy resources.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Now that South Africa is included, BRICS’s importance will only become

more significant. BRICS includes a total population of nearly three billion,

which is equivalent to 42% of the world’s total population. Economically, BRICS possesses an economic volume worth USD11.5 trillion which accounts for 18.4% of the world economy.

Joining of South Africa The power of BRICS has been significantly increased by the joining of South Africa. In December 2010, South Africa was officially invited to join the

emerging group of BRIC (the name changed to BRICS with the addition of

South Africa). This was surprising news in a way, yet at the same time it was rather expected. It was surprising in the sense that the original founder of the

BRIC idea, Jim O’Neill, had dismissed the possibility of South Africa joining

the BRIC ranks, as South Africa’s population of fewer than 50 million people

was just too small to join the emerging group. The joining of South Africa into BRICS was a milestone on the path of South Africa becoming one of

the world’s major emerging economies and this has had major implications on South Africa’s development. Although South Africa’s population and

economic volume are not very large compared to other BRICS member nations, it represents the entire African continent in the international arena. Furthermore, the joining of South Africa into BRICS is beneficial to the

country’s development, as South Africa’s views on a number of issues such as global governance, international financial system reform, and climate change are consistent with those of the BRIC countries. The joining of South

Africa has strengthened the status of emerging countries both economically and politically and would continue to do so.

Moreover, the joining of South Africa into BRICS also opens the door for

the BRIC countries to expand into the African continent. From 2000 to 2008,

trade volume between the BRIC nations and Africa increased sevenfold. As South African companies are prevalent throughout the entire African

continent, establishing a close collaborative relationship with BRIC would certainly promote the economic development of South Africa as well as support all of Africa.

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How Weighty Are BRICS?

Before the Global Financial Crisis, South Africa had experienced the

fastest economic growth since 1994. Nonetheless, the South African economy was devastated by the financial turmoil and the unemployment rate surged as a result. The fact that the status of its Western trade partners is declining

demonstrates the increasing role of emerging countries in South Africa’s trading relationships. Currently, China is the largest trade partner of South

Africa and South Africa is the first destination of Chinese investments on

the African continent. Trade volumes of South Africa with Brazil, India, and Russia have also been increasing rapidly.

Strengths of BRICS Economic complementarities In the postcrisis period, the BRICS nations have been able to maintain

relatively strong economic growth, but still continue to face such challenges as abundant liquidity, inflationary pressure, and asset bubbles. It is thus

crucial for the BRICS countries to coordinate with each other’s economic policies and complement each other in the areas of capital, resources, system, technology, and human resources. Their respective advantages in different sectors demonstrate that they are highly complementary economically:

• Brazil possesses an edge in the agricultural, mining, manufacturing, and service sectors. It also has a huge labor force.

• Russia has abundant amounts of oil and natural gas.

• India possesses an edge in information technology and exports products including software and engineering goods.

• China possesses an edge in manufacturing as well as abundant labor resources. As the world’s second largest economy, it has a huge demand for raw materials and energy resources.

• South Africa is rich in minerals, gold, diamonds, metals, as well as corn and sugar.

The recent joining of South Africa could provide Brazil, Russia, India, and

China with access to the gigantic consumer market of the African continent, whereas BRICS could contribute to the infrastructural development of South

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Africa through investments and providing experts. Equally important, such

economic coordination among the BRICS countries could put an end to Western monopolies in many industries and reduce the gap of technological development between BRICS and the Western countries.

Inter-trade and rise in power The fact that the BRICS economies are highly complementary explains why

the trade volumes among them have been growing so rapidly. From 2001 to

2010, trade volumes among BRICS increased by 28% on average, representing a 15-time increase over a 10-year period. In 2010, the bilateral trade of China

with Russia, India, Brazil, and South Africa increased by 43.1%, 42.4%, 47.5%, and 59.5%, respectively, which were all higher numbers than the overall 35% growth rate of China’s foreign trade. More specifically, China is currently the

largest trade partner of Russia, Brazil, and South Africa, and it is the second largest trade partner of India. The closer relationship among the BRICS members is also demonstrated by the fact that in the first quarter of 2011, China’s trade with the Eurozone countries and the United States increased

by 17.2% and 21.4%, respectively, whereas trade with South Africa and Brazil surged by 107.1% and 57.7%, respectively.

The close economic and political relationship among the BRICS members

would only continue to increase the power and status of the emerging group in the world. Not only have the BRICS nations made significant achievements

in economic terms, the emerging power group has also become increasingly important in the political arena. On April 25, 2010, the World Bank announced

a series of reforms including a sharing of voting rights in favor of emerging countries. The emerging countries had won 3.13% of voting power, bringing

their share to 47.19% of the total votes. This reflects a higher contribution

of these countries to the financing of the World Bank. More than 50% of the capital increase has been financed by emerging countries. China, India, and Brazil are the big winners of this reform. The reorganization of the World

Bank is therefore the result of the growing economic weight of emerging countries and mounting pressures coming from them to be better represented at the international level.

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How Weighty Are BRICS?

As an illustration of their growing importance, the G20 countries became

the permanent council for international economic cooperation, eclipsing the G8. The G20’s newfound status reflects how the recent slump was sparked

by the developed economies and the rebound is being powered outside of their ranks.

The increasing importance of BRICS is also demonstrated by the rising

status of emerging countries in the International Monetary Fund (IMF). In the Pittsburgh summit, the G20 group committed itself to a shift in quotas to emerging markets and developing countries of at least 5% from

overrepresented to underrepresented countries as well as to protecting the

voting rights of the poorest in the IMF. Emerging countries now have around a 43% share in the stake of the IMF, whereas industrialized economies own

57%. Another engagement of Pittsburgh was a shareholding review in the World Bank with a significant increase of at least 3% of voting power for developing and transition countries.

More than 50% of the 3.1% increase of voting power given to emerging

countries has been obtained by China. This gain is explained by several facts: • The growing economic weight of China at the global level. China recently became the world’s biggest exporter.

• The active policy of China in the direction of emerging countries and the poorest countries.

• An increasing dependency of the United States on China with regard to its debt, which has increased the bargaining power of China in international institutions.

• A strategy of small countries, which want to contribute as counterweights to the United States and Europe.

• The weakening of developed countries after the Global Financial Crisis.

The consequence of this increasing role of China might be a rebalancing of

help given to the poorest nations, to countries less under U.S. influence. But more power means also more responsibilities, in terms of global government and environment, and less help coming from international institutions.

During the third BRICS Leaders Meeting in Sanya, Chinese President

Hu Jintao stated the necessity to increase the representation of emerging

countries in the international financial system, whereas the prime minister

of India stated that there was a need to strengthen global governance. More

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

explicitly, the president of Brazil stated that the IMF and World Bank could not be dominated by the United States and Europe as this would diminish the

participation of other countries. The power of BRIC countries will increase

and the BRICS countries will have stronger voices in the political arena in the future.

Impact of BRICS on the World Impact on global economic development The role of emerging countries is becoming increasingly significant in the

global arena. Other countries such as Turkey, Mexico, Nigeria, and Indonesia are perceived as likely contenders to join the BRICS group. According to

the “Next Eleven” idea proposed by Goldman Sachs, Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey, and Vietnam possess a high potential of becoming the world’s

greatest economies in the 21st century, along with the BRICS nations. These

11 countries were chosen mainly due to their macroeconomic stability, political maturity, openness of trade, and investment policies, as well as the quality of education. Nonetheless, whether or not these countries will become part of the emerging group remains an open question. Looking

forward, the BRICS countries could complement each other during times of

transition. At the moment, China is shifting its focus from being an exportoriented economy to a consumption-oriented economy. The Global Financial

Crisis that rendered Western demand highly unstable increased the necessity

of such a shift. China is striving to shift to high-end manufacturing from low-end manufacturing where the rising labor costs of China are making the country lose its edge in competition with other countries that could provide

cheaper labor costs such as Vietnam and Indonesia in Southeast Asia. To

this end, China could shift its manufacturing base to the African continent. With the joining of South Africa, China could gain easier access to the huge consumer market of Africa. On the other hand, China and the other BRIC

countries could help with the infrastructural development of South Africa. The BRICS nations could help each other, obviously.

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Impact on the global monetary system Currently, major world reserve currencies are the Western currencies which

have continuously depreciated against emerging currencies especially after

the Global Financial Crisis. To this end, there have been debates on a new and broad-based international reserve currency system. There is still a long

way to go before emerging countries could become world reserve currencies, but they have certainly played a more crucial role in the global monetary

system. Given the rising status of the Chinese economy and the renminbi, the IMF has suggested to include the renminbi into the special drawing rights

(SDR) basket. As the Chinese yuan is unconvertible, the Chinese government

proposed to peg the SDR to a basket of emerging currencies including the

currencies of Brazil, Russia, Indian, China, and South Africa. This idea was discussed in the recent G20 meeting of finance ministers in April [2013]. More importantly, expanding the SDR size could help support global economic

growth, reduce imbalances, produce a safety net during a financial crisis, as well as increase the representation of the international currency system.

We expect emerging currencies to play more important roles in the global monetary system.

With the increasing importance of the BRICS countries in global trade,

the BRICS currencies are more often used in global trade as well as intra-

trade among themselves. For example, China has aggressively pushed trade settlement in the renminbi since 2012, and almost 90% of China’s imports for the first quarter of 2011 were settled in the renminbi, which shows the

increasing popularity of China’s currency in global trade. At the same time,

the BRICS currencies are promoted in trade among themselves. For example,

China has established cooperation with Russia in using local currencies for trade settlement and allowing the renminbi and the ruble to be traded

in the interbank foreign exchange market between the two countries. This could increase the efficiency of bilateral trade settlement and reduce foreign exchange expenses.

Monetary cooperation among the BRICS nations has been greatly

promoted in recent years. The BRICS countries have signed bilateral currency

swaps with each other. China signed currency-swap agreements with Brazil

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

and Russia in 2009 and 2010, respectively. Going forward, it is not unlikely

to that there will be a BRICS multilateral fund or a BRICS currency to reduce the currency risk associated with the current U.S. dollar–dominated

global reserve currency system. Overall, the BRICS countries are playing

increasingly important roles in further enhancing the global monetary

system by calling for more international financial regulatory oversight and reform.

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China’s Long-Term Strategy in Africa

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Africa’s appeal to the world is undeniable. Rich resources and untapped markets have attracted non-European powers to the continent. Outreach

to Africa from China, India, and Japan is symbolic of the new postcolonial global dynamic.

Africa’s Appeal to the World Rich resources Africa has long been known for its rich resources. From oil to minerals and agricultural products, African countries have much to offer to global investors.

The continent is extremely rich in oil, iron ores, diamonds, platinum, and other minerals. African reserves of diamond, gold, and platinum make the

continent the dominant player in the global distribution of these resources. Africa’s oil reserves are not as rich as those of the Middle East, but they still account for about 10% of the world’s reserves.

Africa: Major resource distribution (% of total word reserves) Resource

Country

%

Oil

Nigeria Angola Algeria

3 2 1

Diamond

Botswana Congo South Africa

16 16 8

Gold

South Africa Ghana Angola

12 3 4

Namibia Niger

7 7

Aluminum

South Africa Mozambique

3 2

Platinum

South Africa

60

Uranium

Sources: Center for the Study of Intelligence, Central Intelligence Agency.

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Global primary energy consumption has been on the rise to fuel rapid

growth especially in emerging countries. China’s share of world primary energy consumption doubled in the past 20 years, and the country became

the second largest consumer following the United States. Resources in

African countries, particularly oil, are now more highly prized than ever before. Africa now accounts for nearly 30% of China’s oil imports. The recent

deals struck between China and African countries show the magnitude of these energy deals. For instance, Africa now accounts for nearly 30% of China’s oil imports. In January 2010, African Minerals provisionally agreed

to sell the China Railway Materials Commercial Corporation about 40% of the iron ore it plans to produce from its Tonkolili deposit in Sierra Leone.

Growing markets in recent years From 1999 to 2007, before the Global Financial Crisis, African countries’ GDP was growing by more than 4% on average a year. The trend of growing population and GDP and, as a result, the rising demand for goods and

infrastructure made Africa an important market to absorb overcapacity. That

was not only due to better economic management, debt relief programs, and increased capital flows, but also to the higher commodity prices driven by demand from China, the country with the fastest growing clout in Africa.

Africa boasts large untapped markets for low value-added products and

a good niche market for emerging manufacturers, particularly China. For example, South Africa has the most diversified economy on the continent,

and its top trading partners in the past three years show that the volume of imports from China have risen markedly, while that from the other countries has roughly stayed the same.

Global Power Shift in Africa A global power shift has now been manifested in Africa, as China’s clout in the region has clearly been growing. In addition, Japanese firms have also

been venturing into Africa. Aid for agriculture and infrastructure projects

has long been Japan’s defining presence in Africa. But attention has now been

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turned to the private sector. Japan’s goal is investment through loans from its state-controlled banks. Japan’s small corporate presence at the moment

consists mainly of trading companies involved in resource extraction and the construction of energy infrastructure. Coveted strategic resources

aside, African countries are prime destinations for foreign investment and

increasingly important trade partners. Manufacturers also see opportunities for selling products to Africa’s low-income consumers.

Foreign investment boom in North Africa Foreign investment in Africa has been robust in recent years, especially as

countries not traditionally involved in Africa continue to pour in funds. In 2007, USD22.4 billion was directed to North Africa and USD30.6 billion

to Sub-Saharan Africa. North Africa’s sustained privatization programs

and investment-friendly policies continue to attract large foreign direct investment (FDI) inflows in key sectors (textiles, oil, chemicals, and generic

pharmaceuticals). West Africa continue to benefit from the commodity boom and ambitious privatization schemes. Behind a large share of the rise in FDI lies surging prices for raw materials, particularly oil, which have fueled a

boom in commodity-related investment. Nevertheless, with the advent of the recent Global Financial Crisis, lower world demand and depressed prices for Africa’s commodity exports are expected to affect investment levels, with

particularly negative short-term effects for resource-exporting countries in the region. Although global FDI might have fallen by up to 20% in 2008, flows to Africa have remained resilient, growing by 16.8% to USD61.9 billion over 2008, despite the slowdown.

These agreements between African and other nations often include a

resource-for-infrastructure element. For example, China has signaled its

interest in funding part of a multi-billion-dollar Kenyan project to develop a port and transport corridor that could provide a new export route for

Chinese oil from Sudan. In the case of China, significant state involvement and backing have made Chinese firms more competitive. The Chinese

foreign minister made a statement that Chinese companies would like to

explore the possibility of cooperation with Kenya on such projects. China’s

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state-led approach to foreign investment is muscling India aside by investing

USD700 million in a special economic zone in the Indian Ocean island of Mauritius. China’s participation will help Mauritius diversify away from a

sugar cane and tourism economy into logistics, IT, and financial services. African countries can greatly benefit from the improved infrastructure brought about as a result of China’s investment.

China has left its footprints in an array of African countries. In 2006

alone, China signed trade deals with African countries worth USD60 billion. Africa now accounts for nearly 30% of China’s oil imports. In a similar but

less aggressive fashion, Japanese manufacturing and trading companies are venturing into Africa. In 2008, Tokyo set the twin goals of doubling its

development aid to Africa and helping Japanese companies to double their own investment in the continent to USD3.4 billion.

India is also racing with China to secure energy assets. Indian oil

companies are pushing to create the country’s first sovereign wealth fund to expand its investment in Africa by developing oilfields in Angola, Nigeria, and Sudan.

Trade growth in recent years As Africa has now become a growing market and resource producer, trade has soared in recent years. Take South Africa as an example: growth was robust

from 2004 to 2008 as South Africa reaped the benefits of macroeconomic

stability and a global commodities boom, but began to slow in the second half of 2008 due to the Global Financial Crisis’ impact on commodity prices and demand. The country’s major imports include machinery and equipment,

chemicals, petroleum products, and scientific instruments, while its exports

primarily include gold, diamonds, platinum, metals, and minerals. Exports rose by 30% from 2005 to 2009 while imports also increased by 29% in the same period.

In the first half of 2009, while African exports to Germany, the United

Kingdom, Japan, and the United States plummeted, China kept growing and

took in increasing amounts of South African iron ore, chrome, and other raw materials. More broadly, South Africa’s communications and transportation

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infrastructure makes it an attractive location for Chinese companies operating elsewhere in the region. Additionally, Chinese electronics and textiles industries have found a large market in the country. Volumes of both

exports and imports from China have shot up significantly in the past three

years. As of 2010, China had become South Africa’s largest trading partner,

and was even making deals in the country’s financial sector. The Industrial and Commercial Bank of China paid USD5.5 billion for a 20.5% share in South Africa’s Standard Bank in 2009.

Dubbed “the continent of the long game,” Africa boasts vast untapped resources and markets that an outward-looking nation would be foolish to

neglect. Given its strategic importance, Africa has long been dominated by European and American powers in both the colonial and postcolonial eras. The postcolonial times also see the rise of new players, however. China, along with Japan and India, has become increasingly active and assertive in the continent.

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ASEAN: A Rising Hot Destination for China’s Outbound Investment

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The ASEAN (Association of Southeast Asian Nations) region has become a hot investment destination for China’s outbound investment amid a weak global economy. For example, Xinyuan Mining, a Chinese mining company,

has obtained an exploitation license for a 28-million-square-meter gold

mine in Cambodia. Additionally, Canxiang Mining purchased a portion of Canadian company Angkor Gold’s exploration projects in Cambodia;

the first strategic transaction, a USD2.4 million deal for 78 km2 out of a

scheduled 300 km2, was completed at the start of 2013. In 2012, China’s

outbound investment reached USD77.2 billion, ranking number five in the

world. The pace is accelerating this year [2013], as the investment overseas reached USD29.5 billion in the first four months.

The ASEAN region is attractive to Chinese investors due to its rich

commodity resources, low labor costs, intrinsic ties to the renminbi bloc, and gradually developing capital markets, despite risks including high levels of debt, weak infrastructure, and political risk. Overall, the high potential of

the ASEAN region will continue to attract Chinese investment in the years to come.

Mutual Benefits between ASEAN and China Infrastructure-for-commodities deals to promote win-win cooperation The ASEAN countries boast rich commodity resources, with many natural resources concentrated in the region. The ASEAN region is also relatively rich

in resources such as fossil fuels (Indonesia, Malaysia, Vietnam, and Brunei), mineral resources (Indonesia, Malaysia, Thailand, and Myanmar), wood

products (Malaysia, Vietnam, and Cambodia), and agricultural products

(Thailand, Philippines, and Cambodia). For example, the proven reserves of

Indonesia are ranked as the world’s 12th largest for natural gas (3.9 trillion cubic meters), and 29th for crude oil (4 billion barrels), and Malaysia is slightly behind at 16th (2.35 trillion cubic meters of natural gas) and 30th (2.9 billion

barrels in crude oil), respectively. The ASEAN countries have significant

resources of copper (Indonesia), gold (Indonesia and Philippines), and tin

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ASEAN: A Rising Hot Destination for China’s Outbound Investment

(several major ASEAN countries). The ASEAN region is also notable for its dominance in global rubber production, where just three ASEAN countries

account for 76% of global production: Thailand 34%, Indonesia 30%, and Malaysia 12%.

China requires an enormous amount of commodities to fuel its economic

activity and has a large dependence on resource imports, particularly crude oil. As a result, a primary target for Chinese companies investing abroad has been resources companies. A win-win arrangement for China and

ASEAN countries is to utilize “infrastructure-for-commodities” deals, which

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are prevalent in China’s interactions with Africa. During these activities,

Chinese companies heavily invest into developing mines and infrastructure, the latter of which makes a significant contribution in local development.

These “infrastructure-for-commodities” deals have helped China to win

big deals in ASEAN countries over the past few years. For example, China’s

Dongfang Electric recently completed three 315-megawatt power generating units at Indonesia’s Longwan Power Plant, worth USD808 million, following a history of cooperation escalating in 2007 when the company (along with

Shanghai Electric) won a contract for building a power plant valued at

approximately USD2 billion. Another example is the gold mines in Cambodia, where exploratory licenses were given to 24 local and foreign companies in 2011, and most of these foreign companies were owned by China or Vietnam.

ASEAN to benefit from China’s transition of low-end manufacturing As China advances up the value-added ladder, it is to gradually relinquish some of its dominance in lower-end manufacturing, where its massive labor

bonus has made it the world’s leading manufacturer in the past few decades.

The growth model shift and the rapidly rising wage levels add pressure on Chinese manufacturers to relocate to cheaper locations for low-end laborintensive manufacturing. This transfer will provide increased opportunities for cooperation in production and investment with ASEAN nations.

One of the biggest advantages that many of the ASEAN countries now

boast over China is lower costs in manufacturing labor. A major reason

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for this has been China’s surging labor costs over the past few years along

with rapid GDP growth. The average manufacturing wages surged 35% between 2010 and 2012, and nearly doubled from the level in 2007; the

average manufacturing wage in 2012 registered at CNY41,650 per annum, or CNY3,470 (USD566) a month. This is compared with neighboring ASEAN countries such as Indonesia, Thailand, Vietnam, Cambodia, and

the Philippines, which have average monthly manufacturing wages ranging between USD100 and USD300 per month.

As the relocation of low value-added production in China is to happen

sooner or later, it is a good strategy for China’s government to guide an “orderly” transfer of these production lines to emerging neighbors that have

good relations with China. This model could be particularly effective in

China’s case, as it will have the chance to integrate the huge domestic market in China and rich resources in the ASEAN region, and thus can manage both

upstream and downstream flows. A specific model for transfer could be to

transition to the lower value-added manufacturing to the ASEAN countries,

and then carry out some higher value-added assembly processes in China; the ASEAN region’s geographical proximity to China will allow for easier and cheaper trade and logistics, which will make both the transition process

and future supply chains more efficient. Together with matching investment, this “orderly” transfer could help the development of local economies in

ASEAN on one hand, and on the other hand create an economic relationship

with China. Smooth relationships with neighbors could also provide China with more freedom to focus on its own growth and on big global scenarios.

To incentivize countries to improve win-win ties, China can start this process with friendly neighboring countries such as Thailand, Nepal, and Pakistan, and then extend the process to strategically important neighboring economies.

ASEAN to play an important role in internationalization of the renminbi The trade situation between China and the ASEAN countries offers great promise for the internationalization of the renminbi. There are several

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ASEAN: A Rising Hot Destination for China’s Outbound Investment

reasons why the ASEAN region is favorable for the diffusion of the renminbi and a natural step for the internationalization of the currency. First, the trade

structure is favorable, as China often has a trade deficit with various ASEAN countries. Unlike its trade structure with most developed economies, this allows the renminbi to diffuse into other countries as payment for trade,

rather than China taking in the currencies of other countries. Promotion

of the renminbi as a trade settlement currency, via incentivizing exporters to denominate exports in the renminbi and continuing currency-swap agreements, is also a major measure boosting the role of the currency

internationally. The renminbi trade settlement in 2012 was up to CNY2.63 trillion, a growth of 37% year-over-year from 2011. But as a proportion of China’s trade, it is still quite limited; only 8% to 9% of China’s trade is

currently settled in renminbi with 6% of China’s exports currently invoiced in the renminbi and 13% of its imports.

Currency swaps are a powerful tool for facilitating currency

internationalization, as there is a large quantity of money exchanged in each

arrangement, and this directly places the currency with other nations and allows for the holding of the currency as foreign reserves, as well as utilizing it for trade settlements. Currently, China has currency-swap deals in place

with several ASEAN countries, including Malaysia, Thailand, Singapore, and Indonesia, with the value of these deals being approximately CNY500

billion in sum. Given the rapid growth of trade volume and the favorable structure as well as the high volumes of currency swaps, popularizing the

use of the renminbi in the ASEAN countries is a natural progression in the path to renminbi internationalization.

During the internationalization of the renminbi, a regional renminbi bloc

might be formed gradually. The Peterson Institute for International Economics has argued that the renminbi has increasingly become a reference currency

for East Asia, where 7 out of 10 economies have seen the comovement of their currency with the renminbi increase and even surpass that with the

U.S. dollar (40% higher than the U.S. dollar) or the euro. In their findings, the currencies of South Korea, Indonesia, Malaysia, the Philippines, Taiwan, Singapore, and Thailand more closely track the renminbi than the U.S. dollar.

These higher comovements of their currency with the renminbi reflect the

natural effects of higher economic integration due to the intensification of

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

trade exchanges with China. Developing a regional renminbi bloc could represent an efficient intermediate target and a natural stepping stone before reaching a status of world reserve currency, as sacrificing the exchange rate

channel of economic policy would be both premature and costly. The ASEAN countries, due to their geographical proximity as well as their growing

strategic importance both worldwide and to China, represent important countries in the natural development of the renminbi.

Chinese investors to benefit from early-entry advantages and diversification opportunities in burgeoning ASEAN capital markets The most developed capital markets in the ASEAN region are in Singapore, Malaysia, Indonesia, Thailand, and the Philippines, and these countries have

well-established capital markets. One of the ambitious goals for the ASEAN countries is to develop a unified capital market. Recent steps have been taken

in pursuit of this goal, such as Singapore, Malaysia, and Thailand adopting a single disclosure standard at the start of April 2013 for the issuance of equity and debt securities.

However, though there are relatively well-established capital markets in

several of these countries, capital markets are still in the fledgling stages in the other ASEAN countries. For example, capital markets in Cambodia have

only recently been developed. The Cambodian Securities Exchange was

founded in July 2011 and only began trading in April 2012. The Vietnamese capital markets have a relatively longer history, with its exchange started

in 2000, but its total market cap is still significantly lower than its more developed ASEAN peers, at a mere USD43.5 billion. The capital market presence in Laos (with only two listed companies) is negligible, while Brunei

and Myanmar are two of the few sovereign states in the world without stock exchanges.

These fledgling markets provide opportunities for China’s securities

firms to provide brokerage services, and chances for China to cooperate in

the development of the markets. For example, Myanmar had been in talks with both Japan and Thailand and signed memorandums of understanding

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ASEAN: A Rising Hot Destination for China’s Outbound Investment

to establish a securities exchange by 2015; while it may seem that the other ASEAN countries have an upper hand in such cooperation, China’s status as a regional leader should also provide ample opportunities.

The more developed ASEAN capital markets (and potentially the

fledgling markets in the long run) act as sources of diversification for asset allocation for Chinese investors. In the new paradigm of the “three-speed

world,” the ASEAN countries remain in the fast growth group, and are an

attractive investment destination given the medium-speed recovery in the United States and the low-speed growth in the EU and Japan.

Major Concerns over ASEAN The ASEAN region, despite various attractive points for Chinese investment

as detailed above, also presents elements of risk. The major concerns are as follows:

High levels of debt Despite the recent contention over the accuracy of the Reinhart-Rogoff 2010 paper, empirical evidence still points to surging debt impeding economic

growth and development. While the ASEAN countries’ debt levels are still very low relative to developed economies such as the United States and major European economies, it is still quite high compared to other emerging

countries. The per capita debt level in the ASEAN countries is estimated to be just under USD700, compared to USD300 in China and USD200 in India.

Weak infrastructure Though the lack of well-established and effective infrastructure in ASEAN

countries provides great opportunities for cooperation with Chinese investors to assist in infrastructure development, the flip side of this is that weak infrastructure often results in poor logistics networks and a lack of

facilities, which lead to various inefficiencies. Any range of problems, from poor roads to a lack of electricity, can create potential investment losses.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Political risk This risk appears in different forms, and varies greatly from country to country in the ASEAN region. For example, the political risk in Myanmar remains high despite recent reform, and the country holds the most potent

risk of structural instability with a potential collapse of the government. Riots and domestic disturbances, such as the political protests in Thailand

in 2010, are also concerns of investors. Resource nationalism is another

serious risk for international investors. A worst-case scenario would lead

to government expropriation of foreign-owned investments, such as in the case of Argentina’s Yacimientos Petrolíferos Fiscales (YPF), where the government unilaterally nationalized a foreign-held entity at a questionable

price. A milder case of resource nationalism can also be detrimental; for example, Mongolia appears to be an attractive destination for China given

its rich resources, but its government is perceived to be cautious in allowing China to control its mineral resources, and there is a pervasive sentiment in

Mongolia for avoiding an overdependence on China for economic growth and stability. In 2012, when Canadian-owned SouthGobi Resources was considering being sold to Chinese state-owned enterprise the Aluminum

Corporation of China (Chalco), the Mongolian government pushed the Strategic Entities Foreign Investment Law, which was perceived as a move to discourage the acquisition.

Despite several risks linked to the ASEAN region including high levels of debt, poor infrastructure, and political risks, the region would appear to be one of the more attractive options for Chinese investment in the near future.

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What Is at Stake with Cybersecurity?

STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

The Edward Snowden case has shown the importance of cybersecurity

in today’s world. His revelation of the U.S. National Security Agency’s

surveillance and other activities on U.S. and foreign citizens will have significant consequences:

• The diplomatic relations between the United States and China and Russia have become tenser as the three countries are tangled up in this case.

• The U.S. government’s accusations of cyber-espionage by China will be less credible as this case has revealed that the United States has organized a global system of surveillance.

• The protectionist measures of the United States against Huawei and ZTE

will also be undermined as it has come to light that the U.S. government cooperates with U.S. global multinational firms to gather information on U.S. and foreign citizens.

• Protectionist measures on high-tech products could be tightened globally.

In this context, it becomes crucial to understand the central role played

today by the digital economy. Its domination of the other sectors of the

economy means that a higher level of cybersecurity is required globally. The diplomatic spat over Snowden also reveals a new economic race between

China and the United States and the reality of a systemic dimension of the cyber risk.

The Economic Approach of Cybersecurity Cybersecurity has become vital as the digital economy represents a growing

share of national value-added modern economies. The proportion of economic actors, households, or companies having Internet access reaches nearly 90% in the countries of the Organization for Economic Cooperation and

Development (OECD). Revenues linked to information and communications technology (ICT) have rapidly expanded since 2000 and represent more than

USD1 trillion today in OECD countries. The share of ICT in the value-added

portion of the private sector is now close to 10% in modern economies. Cybersecurity has therefore a highly strategic and economic dimension as large financial losses can be linked to a breach of this security. To develop

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What Is at Stake with Cybersecurity?

cybersecurity also represents a way to fight money laundering, increase competitiveness, and ensure the stability of the financial system. The

increased development of cybersecurity also becomes a necessity amid the current cloud computing revolution.

Financial losses for consumers and companies Consumers and companies have become increasingly dependent on

computers, databases, information systems, and networks. The breach of security in all these elements can lead to direct financial losses such as credit

card fraud, money lost from accounts, activities to reset financial credentials, and interests on overdraw accounts. On the macroeconomic point of view,

financial losses linked to cybercrime structurally damage the degree of confidence of economic actors.

Reputation costs Financial losses of consumers and companies produce reputation costs,

which represent an obstacle to e-commerce and e-transactions. The victims will reduce their utilization of the victimized system. Cybercrime hampers e-commerce and e-transactions as a whole, inducing further and higher

transaction costs as well as insurance expenditures which hamper the liquidity of the economy and its overall efficiency.

Competitiveness issues Both the private and public sectors are implicated here. Cyber theft and

cyber espionage damage intellectual property and distort competition. At

a macroeconomic level, there is consequently less incentive to innovate and less incentive to respect or develop trade agreements. This eventually

hampers the volume of trade and the potential of growth of economies. Nontariff measures linked to cybersecurity and national security can be used to set up new forms of protectionism.

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

Parallel economy, development of corruption, and money laundering Cybercrime, money laundering, and corruption are intimately associated.

New forms of e-currencies, opacity of financial transactions in networks and computer systems, and dematerialization of financial flows all contribute to money laundering resulting from cybercrime or normal crime. In the last decade, the virtual currency Liberty Reserve had become the main instrument

of money laundering at a global level. The parallel economy induces lower fiscal revenues for the government and an inefficient allocation of resources, and thus acts as a brake on investment.

Endangering of banks and financial systems Banks are the top target of hackers. Verizon recently released the ranking of

industries targeted by hackers. The financial industry is in the top position. ATM skimming, diversions of customer funds, breaches of clearing houses, card payments or market trades via the stealing of users’ information, third-

party payment process breaches (consisting of penetrating large computer

networks of banks to gather information on millions of customers and create fake debit cards thereafter), securities and market trading exploitation

(consisting of market manipulation schemes and unauthorized stock trading), telecommunications framework disruption, insider access (for

example the stealing of high-frequency programs), and other occurrences are all dangers to the cyber system. These are all putting the viability of the

financial system at risk, and increasing insurance and infrastructure costs. All of this will eventually increase the funding costs of economic actors.

Hampering of productivity At the micro level of the firm, worms, viruses, and data or account corruption clearly hamper the productivity of the company by leading to bad decisions, slowing the production process, and increasing insurance costs. The

replacement of infected machines is particularly costly while disruptions in

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What Is at Stake with Cybersecurity?

the access to data or interruptions of connectivity can seriously endanger the production chain. In 2012, 16% of companies in Europe reported that they

suffered from data corruption. The overall cost for the economy is significant as trade in new technologies is also hampered by protectionist measures,

which aim to keep control over the digital economy. In such circumstances, the access of emerging economies or economies not powerful enough

to develop their own R&D activities will suffer from a lack of technology transfers, which eventually will penalize their overall productivity.

Cloud technology requiring higher levels of cybersecurity measures Cloud technology will revolutionize the economy, as enterprises of all sectors progressively change their business model through using the cloud.

Cloud computing represents a process in which IT functionalities will be

externalized, shared, or rented via the Internet. It means a significant

reduction of the costs linked to the purchase of hardware and software, and, at the same time, a higher capacity to innovate. In this new environment, cybersecurity will become even more vital.

Global Need for Cybersecurity The Council of Europe Cybercrime Convention associates cybercrime with all the offenses (computer-related offences and content-related offences)

against the confidentiality, integrity, and availability of computer data and systems. Cybercrime is a multilayer phenomenon encompassing monetary offences, cyber espionage, and hacking practices.

The rapid proliferation of cybercrime can be associated with the rapid

development of global connectivity. According to the statistics of the

International Telecommunication Union, 2.3 billion people had access to

the Internet in 2011. That number represents almost 40% of the world’s population in 2013, compared to only 13% who had Internet access in 2002. In parallel with the explosive growth of connectivity, cybercrimes have quickly

developed as illustrated by the statistics provided by law enforcement

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officials. Between 2007 and 2011, law enforcement officials across the world

have all observed an increasing number of cybercrimes, broadly 50% of them describing a strong increase of this number.

Cybercrime trends observed by law enforcement, 2007–2011 (%) 100 90 80 70 60 50 40 30 20 10 0

Africa

Americas

Asia and Oceania

Europe

Increasing number of cybercrime acts

Strongly increasing number of cybercrime acts Stable number of cybercrime acts

Source: United Nations Office on Drugs and Crime.

It is very difficult to provide a clear estimate of the global cost of

cybercrime. There are direct financial costs, indirect costs, and defense costs. Most of the time, numbers are provided by antivirus providers, who

have a natural bias to inflate the numbers. According to the 2012 Norton Cybercrime Report, 556 million individuals are impacted by cybercrime each year, representing a cost of USD110 billion. The total cost of cybercrime to

individuals and companies might have been as high as EUR338 billion in 2011. According to Norton’s statistics, among the USD110 billion of costs per year, USD46 billion is assumed by China, USD21 billion by the United States,

and USD16 billion by Europe. Official U.S. estimates of cyber theft range from USD250 billion to USD1,000 billion per year.

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What Is at Stake with Cybersecurity?

Cyber Disputes and the Fight for Economic Hegemony China-U.S. cyber theft disputes mirroring a new economic race The harsh tone of the discussions between China and the United States

regarding cybersecurity is consistent with the emergence of China as a superpower. Chinese goods are the most penalized by U.S. restrictions related to intellectual property rights. The U.S. Senate envisages the creation

of a legislative arsenal to block the imports of products having benefitted

from cyber theft practices. The White House national security advisor

recently accused China of cyber hacking, which prompted a response from

China that it was the main victim of cyber attacks. The Snowden affair has created a diplomatic row.

Value of goods seized in the United States because of intellectual property rights violations, 2012 (USDbillion) Others, 183

Hong Kong, 156 Singapore, 9 India, 7

China, 906

Sources: Financial Times; U.S. Customs and Border Protection.

We have seen that the digital industry is now at the heart of modern

economies. Besides the importance of the digital economy and the vital

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STRATEGIC PRIORITIES: CHINA’S REFORMS AND THE RESHAPING OF THE GLOBAL ORDER

need to protect strategic sectors (military, banking, and energy), the regular disputes in this domain between China and the United States reflect a new

type of economic race in which China is progressively catching up to the United States in terms of the production of cutting-edge technologies. As reflected by the ratio of product sophistication relative to Japan, China has

almost accomplished its catching-up process relative to the most advanced

economies. In 1998, the United States represented more than 22% of world

high-tech exports and China around 6%. Just 10 years later and China

represented more than 20% of these exports and the United States 13%. The fact that the fastest and most powerful computer, the Tianhe-2, is now

located in China provides another illustration of the growing competiveness of China in the construction of supercomputers. China has now 66 out of the

500 most powerful supercomputers in the world, up from zero 12 years ago.

Ratio of product sophistication relative to Japan (%) 100 90 80 70 60 50 40 30 20 10 0

South Korea 1988

China

1990

Russia 1995

India 2000

South Affrica 2005

Brazil 2010

Underlying causes of China-U.S. cybersecurity disputes Four underlying reasons explain the cybersecurity disputes between China and the United States:

• China will soon be the world’s largest economy, but the risk of a middleincome trap exists for this country. For the United States, in order to keep

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What Is at Stake with Cybersecurity?

its economic and military domination, it becomes crucial to keep China at bay by reducing all the transfers of technology, therefore significantly

increasing cybersecurity. The U.S. Department of Commerce’s Bureau of Industry and Security has already identified the fact that at their current

pace and without any interruptions, technology transfers from the Untied States to China would soon make China a real military challenger of the United States.

• China and the United States, despite being at different stages of development and holding different ideological viewpoints, share the

same highly centralized organizational structure economically. In a modern economy, this high degree of centralization requires a cutting-

edge system of information, which requires an equally strong security

system to protect it. In the case of any breach in this system, the central power could easily lose control over the rest of the economy.

• The digital economy will extend its domination in the coming years. To take the lead in this area is a necessity for a country to be the most competitive.

• Military issues will be increasingly linked to cybersecurity.

For all these reasons, at the level of a nation, cybersecurity has to be

centralized, streamlined, and stress tested. The dematerialization of the world economy now makes the digital risk systemic. After several major financial crises, a digital crisis could have a severe impact on the real economy and on political stability.

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About Haitong International Haitong International Securities Group Limited Established in 1973, Haitong International Securities Group Limited (“Haitong International” or “the Group”; Stock Code: 665.HK) is the only

overseas business platform of Haitong Securities Co., Ltd. (“Haitong Securities”; Stock Code: 600837.SH; 6837.HK). Haitong Securities is one of the leading securities companies in Mainland China. Leveraging its established

advantages in retail broking business, Haitong International is proactively expanding its coverage of corporate finance, asset management, FICC,

structured finance, quantitative trading, and wealth management to provide

comprehensive financial services to institutional and individual investors domestically and around the globe.

Brokering The Group provides comprehensive securities brokerage services to over 160,000 global institutional and individual investors including trading in

local and global equities and derivatives, bonds, forex and bullion, margin

financing, and custodian services. The Group has been named the “Best Equity House in Hong Kong” for 13 consecutive years.

Corporate Finance Haitong International specializes in the provision of corporate finance and

financial advisory services to listed companies and private enterprises worldwide. Services include sponsorship of initial public offerings,

underwriting and placing, and financial and compliance advisory. According to Bloomberg, Haitong International ranked second in the market in terms of the number of Hong Kong IPO projects undertaken, and seventh in terms of the underwriting amount in 2012.

Asset Management Haitong International has extensive asset management experience and offers

a full spectrum of investment products and services. In particular, Haitong

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International has maintained a leading position in the Renminbi business sector and pioneered the successful roll-out of the first RQFII product in early 2012. Haitong International is also the first Mainland-funded institution in Hong Kong to receive QFII and RQFLP qualifications in 2012, rendering the

Group the world’s only Mainland-funded institution to own all of the RQFII, QFII, and RQFLP qualifications in 2012.

Fixed Income, Currencies and Commodities The FICC division was established in early 2012 to strengthen and diversify

the Group’s income source through proprietary investment and trading in fixed income, currencies, and commodities products. The Group identifies

investment opportunities through in-depth analysis and applies conservative strategies to secure financial return.

Structured Finance and Sector Fund As an innovative business of the Group, the structured investment and finance business has become an important business of Haitong International.

The Group has achieved remarkable results in expansion of its pledged finance and structured finance businesses, particularly financing to corporate

clients. After obtaining the first RQFLP qualification, the Group has made

great strides in its development in the sector fund business, including the setting up of a business team focused on sector fund investment in Mainland

China. With a determined goal to become a world class investment bank, Haitong International is constantly striving for improvement. The wealth management arm of the Group provides a wide array of products and services to meet clients’ individual financial targets and needs. In addition to its feeand commission-based business, the Group had set up Quantitative Trading in recent years to broaden the business scope. With the traditional sell-side businesses being the principal area of operation, the Group also focuses on the development of institutional business and capital-driven innovative business. As the only overseas business platform of Haitong Securities, the Group is well prepared and strives to be a modern and comprehensive investment bank with a leading position in the Greater China region.

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