Select Committee on Treasury Minutes of Evidence


Examination of Witnesses (Questions 20-39)

8 FEBRUARY 2005

MR RAY BARRELL, DR GERARD LYONS, MR PETER NIGHTINGALE AND DR LINDA YUEH

  Q20 Mr Beard: Changing the subject, the current pattern of the world economy can be broadly categorised as the emerging economies focusing on manufacturing while the developed economies focus on services, but a number of studies have shown that up to five million service sector jobs could move offshore over the next decade from the USA and Europe as new technologies allow the service sector to be more tradable. As the world's largest net exporter of services, how is the UK likely to fare and compete if this shift happens and should we be concerned that China is going to emerge as a service provider in the world?

  Dr Lyons: In terms of this issue, I think it is important not just to talk about China, but also to recognise the huge importance of India, but also in the same way it is vitally important to recognise that India is likely to become as competitive as China in manufacturing as well given that 45% of its population is under 19, for instance. Many emerging countries have gone for manufacturing, so to speak, because that is where their natural immediate advantage is, and it is seen as job creating, but we are seeing, as you mentioned, as telecommunications skills, etcetera, become easily transferable, India has probably led the way initially by moving into low value-added services, but when one visits India it is quite clear, given their skills base, that they intend to move into higher value-added services across the board, and if India is likely to do that it is likely that China too in time will do that. I think we should view China and India both as huge economies in terms of manufacturing and in service skills. Is that a threat or an opportunity for the UK? In terms of the financial sector, it is a huge opportunity for the UK, and we are seeing this already in China itself. My bank, Standard Chartered, has a significant operation in China. We, like other international banks, are seeking to buy into China. We have just bought 20% of Bohai Bank and we are seeking to acquire again in China. It is both an opportunity as well as an interesting competitive issue for international financial companies. The way I see it, international banks bring many skills to China. I call it the (a), (b), (c): (a) they accelerate pace of change, (b) they bring in best practice and, (c) they add to competition in these banking and financial sectors. Given the huge competitive advantage one sees in the UK in terms of the financial sector, one should view this as an opportunity. In terms of broader range services, I think there will be challenges as well. I think it is difficult to map out. I think we have to accept that the service sector across China as well as India will become a lot more competitive and therefore it is important for us to make sure that we continue to build on our first mover advantage. In terms of the financial sector, I see it as a huge opportunity. One only needs to look at the success of Hong Kong and its position in China to see that is the case.

  Q21 Mr Beard: The implication of that is that far from the economies differentiating themselves, they are almost converging, the structure of western economies and India?

  Dr Lyons: Skills are easily transferable and investment is the key. If trade is open, then there is no reason why other economies such as China and India cannot move up the value curve in services.

  Q22 Mr Beard: China is already the largest consumer of many of the key commodities in the world, particularly oil and energy. On current trends it is suggested that by 2020 China could account for nearly a quarter of the world's energy consumption. Are the recent trends in Chinese energy and commodity consumption sustainable given the price rises they have prompted already?

  Dr Lyons: This is a big challenge really. China has a huge issue. The demand at the moment is in terms of hard commodities including energy. The big future issue for China is going to be soft commodities as it tries to feed its growing population. In terms of the current trends, it is always very difficult to extrapolate, but if an economy like China has a trend growth rate of around 8 to 8½% then its future energy demands will be huge. Brown-outs have been quite common in China in the last couple of years, but what is interesting, as opposed to when they happened here in the UK in the early 1970s, is that China has been able to cope; the labour force is very flexible. The immediate response has been to try and improve energy capacity within China, but if one looks at the current trends, then the big issue is in terms of price of energy and commodity prices. The long-term trend for commodity prices is that they tend to fall in real terms. Many economists expect that to continue, but when you look at the sheer size of China and India, it is quite possible that that trend might be reversed, and quite clearly there is going to be huge demand from China and from India. The supply side, particularly in terms of energy output, is likely to be changing, and some people claim that we are about to hit a peak in terms of oil output, but I think the trend for energy prices is unlikely to follow the long-term trend of commodity prices, which is down. I think we could easily see volatility increasing, but it is difficult to predict. It is a big challenge for China how it meets its current demand for hard commodities and for energy, and in the next 15 years how it meets its demand for soft commodities, particularly food.

  Dr Yueh: A lot will depend on how China's energy policy gets underway. It does have an energy policy in place. More than half of China's energy consumption is in coal, and it is trying to move away from that and into hydro-power and alternative sources, including nuclear power. I believe they are working on a pebble type reactor. So there is a strong move, because China realises, like most Asian economies, it is not energy efficient. As a percentage of GDP the energy efficiency of its consumption is much higher than it is for OECD countries. In fact in terms of efficiency it is only one seventh of Japan. Provided that China can work on its energy policy, increase the efficiency of that consumption, and China was also an oil producer even though it has imported oil since the mid 1990s, and in terms of diversifying its own energy use, I think this is something which is going to be hugely important, but I think in terms of the world economy China is but one player in this. Say China grows at the rate it is currently growing at, India continues to grows at the rate it is currently at add the growth of Brazil and South Africa, then I think that is a real issue in terms of global energy demand, because even if they are completely efficient, they will still over consume—it is the nature of a product such as energy—and therefore not internalising the externalities such growth causes. So I think in terms of working at it from a policy front it will be very important to do so.

  Q23 Mr Beard: If you have a limited amount of oil and we cannot see it expanding hugely beyond present supply and you have all the expansions that you are referring to (8 or 9%) in China? Are there not going to be tensions arising before the price mechanism Dr Lyons spoke of trips in? Is it likely that we are going to see a tension or an ambition to expand northwards into Siberia and secure these energy resources by force of possession?

  Dr Lyons: There is a whole host of issues there. It is important to stress that new investment in China is incredibly energy efficient. The new plants in the Pearl River Delta, Yangtze River Delta are incredibly clean and environmentally friendly. There is a whole host of plants. There are legacy issues in the north-east of the country, so even though the figures suggest it is energy inefficient, I think it is important to stress that that is rapidly changing. One of the key issues the new premier in the last couple of years has stressed is the environment. They are keen to improve on that. Are there challenges? It is important to stress that China is seeking to expand its political ties in terms of countries that are energy exporters—West Africa, Central Asia—so it is developing trade links with energy producers.

  Q24 Mr Beard: Siberia is on its doorstep?

  Dr Lyons: Yes, but Russia. China could easily develop trade ties to exploit that. Russia has its pipeline going to the coast and that will service China and Japan.

  Mr Fallon: Let us move on to another section. David Heathcoat-Amory.

  Q25 Mr Heathcoat-Amory: We have talked about the Chinese economy as though it is a single entity, although we have heard about the federal structure, Westerners visit the coastal areas and think they have visited China. Can you tell us a little bit about the past hinterland, that inland area with millions of people living in it? Is it simply a reservoir of cheap labour or are there interesting economic developments going on there? Can you characterise them?

  Dr Yueh: It is hugely interesting, the rest of China. What is interesting about China is the division is between the coast and interior, but also rural and urban. For the visitors to China, if you manage to get out of the cities, you will see a lot of the interesting rural areas. We must remember that China's growth started in the countryside. When reforms began at the end of 1978 it was in a reform of the rural economy. It was the creation of township and village enterprises which was the real engine of growth in China before urban reforms took off in the mid 1980s. If you go to the rural areas today, there will still be TVEs which have been transformed from the old collectives, and even though livelihoods have not been grown as well in rural areas as they are in urban areas, in terms of real standards of living, they have improved from before the reform days. For those reasons the rural economy the engine of growth, and if China is to grow in the future it is going to have to return to how to stimulate the rural economy, and recent policy measures aimed at cutting grain taxes, improving infrastructure investment, facilitating FDI into the interior, are all facets of this recognition that the rural economy must keep up if China is to attain sustainable forward growth. Also, if I might add, many people have brought up poverty reduction in China as a huge success an this is because of a number of factors. I think very good research done by the World Bank has shown that half this kind of poverty reduction happened in the early 1980s with the creation of TVEs in the rural countryside; so it has been an engine of growth, and I expect that there is a lot of potential still. However, I should say there are a lot of difficulties for the rural economy because China has less than 10% arable land, so there is a lot of pressures on the land and getting these areas industrialised, allowing you to compete effectively in this new industrialised more competitive sphere is going to be difficult.

  Q26 Mr Heathcoat-Amory: Is this rural economy based on security property rights, the contract economy that we witness when we move from state to contract in our industrial revolution, is this familiar to a Chinese dweller in the interior, planning laws and administrative efficiency, tax payments which pay for local public services? Is this a reality now for the ordinary Chinese?

  Dr Yueh: I think local government structures are in some places in some ways much more like what we see here than even in urban areas, because there has always been a fairly self organised communities. The rural economy is self-governing, the townships and the villages have a centre, a committee, some of whom there have been recent experiments with democratically electing the officials, and although there is not security of property rights there is very clear demarcation of residual control rights, and this has been in place since the abolishment of the communes and the collectives, but even during that period we find that there was a claim to certain types of property and that was the basis of the Household Responsibility System which allowed people to retain a share of what it is that they put into the land, implicitly giving them some of the property rights. In terms of tax and public finances, it is difficult to generalise. My understanding is that there are some areas in China for which it has done much better because for a number of institutional reasons, the way that the people have been running it in the past, but it is not a clear system, a lot of the problems in the banking sector and problems with statistics in terms of recording public finances has a lot to do with how decentralised a lot of these services are locally, and then a lack of monitoring as to how it is actually done.

  Q27 Mr Heathcoat-Amory: Dr Lyons, you are an economist. How would you characterise the secondary Chinese economy? Is it a free market economy, is it based on property rights or is it a separate model?

  Dr Lyons: The economy is evolving, and one can see this in terms of the way in which the price mechanism is taking hold. I would say that it was very much centrally planned previously, and one can see that—not only reinforcing the point about property rights, but very much from the macro-economic perspective, you can see that market mechanism is taking hold across the country in terms of prices not being set centrally but being determined by demand and supply, and that is also forcing macro-economic policy to therefore evolve as well. From the middle of 2003 to October of last year, to control the economy it was very much administrative measures aimed at certain sectors. That proved partially successful, but what we are seeing is that in response to the way in which the economy itself is changing the central government and the policy makers are having to move towards more market based mechanisms to control the economy, such as raising interest rates last autumn and likely to move to more flexibility in interest rates this year. So from a macroeconomic perspective you can see that the economy is evolving in terms of the price mechanism in the way in which policy is responding. The other way in which you can see the economy evolving is very much by looking at the income statistics, income per head. The trend is clearly up across the whole of the economy, but within that there are clearly differences that have been mentioned between the coastal and rural areas and between the urban areas and rural areas. In terms of the other aspects of China, if one goes to Western China it is quite interesting. Sichuan is the big province there and Chengdu the regional capital city. That has developed quite significantly in the space of the last five years, and it is easy to see that what has happened in the Pearl River Delta and Shanghai region is now being transferred to the other areas, but what is clearly holding back the Western part of China is primitive investment. I known in North-east China—Peter was there last week—but you will see that region as well is developing. What we are seeing is things are happening in different timescales. The initial phase of adjustment and change has been very much in the coastal areas and it is now spreading inland. The big challenge is, of course, as more people move from the rural areas to the city areas in terms of urbanisation that creates problems in itself. The immediate issue we have seen in terms of China is that there are 95 to 120 million displaced workers who have moved from inland and from the former state-owned enterprises to the cities. That has created an immediate pool of cheap labour, but we are likely to see more displaced workers in the future as urbanisation and infrastructure investment takes place. You are likely to see a complete change in terms of the rural part of the economy in the future.

  Q28 Mr Heathcoat-Amory: Can I ask Mr Nightingale a question that leads on to this, which is the WTO rules. Broadly, China seems to be complying with the rules, but there are issues of intellectual property. I have been asking whether Chinese people could have heard of their rights. Perhaps Mr Nightingale can reveal whether foreign investors or British people trading with China can defend their rights, particularly in the intellectual property sphere in China now?

  Mr Nightingale: I think you are right. On the whole international business has been quite pleased with the way that China has met the obligations that it signed up to when it joined the WTO. Sectors have opened up, rules have changed and foreign companies have been allowed to participate in much more of China's business than was the case before hand. I think what has been seen, however, is that there have been a number of non-tariff barriers raised in certain sectors, and the banking sector is one of them, which the negotiations for WTO did not anticipate; so that while the sector opens up, according to the agreement under WTO, other barriers are raised which make it correspondingly more difficult for foreigners to operate in that sector, and those barriers have to be negotiated and dismantled one by one. I think there has been some success in doing that in certain sectors, but it has proved to be an unexpected barrier to developing in some sectors. On the question of intellectual property, I think that the rules and regulations are there; the real problem is how those are implemented across the enormous country that China is at all sorts of different levels. They are not implemented very well, but I think there is evidence, firstly, that the leadership in China is very keen that implementation process should be improved. The other thing that is significant is that there are now Chinese companies that have intellectual property to protect and therefore there is pressure from Chinese companies on the Government to make sure that the implementation process is improved, and I think that helps foreign companies as well because, as the pressure gets greater across China to improve intellectual property protection, that will assist foreign companies and Chinese companies alike, and there is evidence that that is happening, although it is not, of course, by any manner of means perfect.

  Q29 Mr Heathcoat-Amory: Is there a danger that China is so powerful economically that we lose our leverage over Chinese policy? In other words, every other country wants to be in China and will make almost endless concessions to try and get ahead in the energy contracts or trading of one sort of another, and therefore matters like property rights, rights of contract, transparency of corporate law, intellectual property, simply get downgraded and we lose any means to counter these trends because we have lost our leverage. Mr Barrell, I wonder if you have any view on that? You have not answered these questions so far?

  Mr Barrell: On the trade issues, the leverage we have comes through the agreement we have through the WTO, and we can interfere in the process of Chinese exports to the extent that they break WTO rules. If, however, the question is are other people willing to spend a lot of money trying to get into the Chinese market and therefore allow the Chinese to avoid these rules, there is little we can do about that. I think a desire to be in the market just because it is there may be unwise. It is an expanding market, but the Chinese share of world imports and the Chinese share of world exports is still smaller than the UK's; it is still a smaller market in that sense, and therefore one has to be cautious about thinking that these developments are so important. We do have rules to stop them doing things that are very wrong, and I think they are beginning to behave a better way in the areas where in the past they have broken the rules.

  Dr Lyons: There are two levels to this. First, the Chinese authorities want their economy to be successful. Therefore to be successful clearly they need to adopt the best international practice. Clearly they might do that at the pace that best suits themselves.

  Q30 Mr Heathcoat-Amory: Let me stop you. That is a non sequitur. They could all want it on their terms to keep to the rules when it suits them but not when it does not?

  Dr Lyons: Okay, there are two aspects to that. In terms of the WTO where there have been measurable and objective obligations the Chinese are seen to have applied to the WTO rules. The disagreements and criticisms of the WTO are where you cannot objectively measure things, where there is a lack of transparency, etcetera. Clearly where there are ground rules such as where they have to apply in terms of tariff barriers with specific numbers, then you can measure progress and it is quite clear that the Chinese have implemented these changes. Where is less clear and where there have been objections is where there are no figures or measures in place. That might suggest that they always want it in on their terms, but if you want it in terms of best international practice, best corporate governance, if you want foreign companies to continue to invest, you have to apply by the international rules as well. If you are telling me that China will set its own rules, the down side to that is that they might suffer in terms of FDI for those coming into their economy, and ultimately their economy will suffer as a result of that, but the other point is that in terms of global trade deals at the moment, the US is doing lots of bilateral trade deals. If countries see a huge market to sell into, countries are quite likely to make short-term deals to serve their own country's needs, and you will see that in bilateral trade deals. Could that possibly happen in the future of China? Yes, but what is interesting is that in the last couple of years China started to play a much bigger role in the ASEAN+3, for instance, in Asia, and you can actually argue that whilst China is the big economy or the big emerging economy so they might exert greater influence, there seems to be collective agreement in terms of what needs to be done. I think your question is a very valid one, but the way things have gone to date suggests that it is an evolving process, but it does not seem to be the case that they want everything on their own terms.

  Dr Yueh: If I may come in, on two points. The first is that China's own terms are actually consistent with maintaining the power of the Chinese Communist Party, which is predicated on economic success. I see where your question is coming from, because in the recent 15 years FDI has flowed freely into China and it holds the world's third-largest stock, it is easily the leading destination behind, just, the United States or before it, regardless of the fact that there happen to be a lack of clearly defined property rights and an insecure legal regime. So the presupposition is that it may be that there will be more influential as they become more economically powerful. I would argue it is somewhat the other way around: one because there are limits to what one is able to do when you become more open to the global economy and, also, to do well in the open global economy then international standards do have to be met and every indication is that Chinese policymakers seek out advice on how to improve corporate governance, how to improve constituting corporate directorships, how to make better laws and how to implement them because they are keen to hold on to power. I think the second part of that is that to become increasingly open means you are subject to the strictures of international economic law, which extends beyond trade: it covers financial liberalisation, it covers intellectual property rights (TRIPs), it covers trade in services, and the WTO mechanism is such that there is a body before which disputes can be brought. To give you an example, 20% of all actions brought before the DSU in the WTO relate to the TRIPs Agreement already. By all indications, most countries do not want to run afoul of and will abide by a DSU-type ruling. So there are going to be strictures that the Chinese will be keen to avoid and, I think, more importantly, they are keen to comply with because they are very interested in success.

  Q31 Mr Walter: I wanted to carry on with this theme of foreign direct investment and, really, look at the quantum of it. You have just mentioned, Dr Yueh, that China has moved up the league and very much leapfrogged over the UK in terms of being a destination for foreign direct investment, and India has seen significant growth as well. Is there any evidence of investment in China being at the expense of investment in the UK; that projects have taken place there rather than here?

  Dr Yueh: I think because of the differences in the structure of the economy what tends to happen is that FDI, possibly (again, it is hard to know from aggregate data about individual firm decisions ), is growing rapidly in China but it is FDI that would have gone, possibly (I do not know this for a fact) to other developing countries at a similar stage in its manufacturing capacity. What we do know is that FDI has been growing quickly in China, over 60 billion last year, and the amount that goes into China has exceeded the entire amount which has gone into the Asia region since 1992. However, the amount of FDI going into the Asia region has actually grown over this period, just more slowly than China. So I think what we are seeing is a growth as the pie gets larger and there are more funds to invest, so China's competitors, in terms of FDI, are likely to be Latin American developing countries and unlikely to be developed countries, because the nature of the FDI is different. If anything, there is quite a big potential for FDI from China to go into FDI, for instance, in the UK and the US. The final thing I will say about FDI is that the figures that we see for China are not necessarily reliable because they include a lot of what is known as "round-tripping". Chinese capital that leaves China and then comes back into China is granted better tax concession than if they were invested domestically. So the leading investors in China come from Hong Kong and the Virgin Islands. Those are conduits rather than initiators of capital.

  Mr Nightingale: I was going to say that if you look at the main foreign investors in China, Hong Kong is certainly one but they are Taiwan, South Korea and Japan, and I think those are investing in China because it is regionally a powerful economy.

  Dr Lyons: I think there are two points which are very relevant for the UK, reinforcing what has been said. First is that it is not direct competition between the FDI that has gone to China and would have come to the UK, but the UK can make itself an attractive location for future investment from China in terms of RD and D (Research, Design and Development) particularly in education and those sorts of areas, just as there was big Japanese investment during the 1990s. So we can make ourselves a very attractive recipient of future investment from economies such as China as they open up. The second point, which is very relevant to the near-term macro-economic picture in the UK, is that the FDI into China has gone hand-in-hand with supply chains across Asia becoming more interlinked, so economies across Asia are more interlinked. Trade from other Asian economies to China has risen at three times the pace of world trade in recent years. So you now have lots of supply chains interlinked across Asia, and the big issue across Asia is what is called "supply chain optimisation", which means that basically if you bought a good in a shop for £4, roughly speaking, £1 of that is production costs. Those production costs have now been squeezed, so companies are trying to get that other £3 of value out of the supply curve, and you are likely to see increased competition now. That is the second big issue that is going to be linked into this FDI into China; we are going to see increased competition in supply curves which means another big disinflationary threat for economies such as the UK. However, you are basically seeing, in summary, FDI into China, and FDI into China may be at the expense of other economies initially but in time—and we have already seen this occur—China has become interlinked with those other economies, so they are all starting to benefit and supply chains are starting to become very interlinked across the whole of Asia.

  Q32 Mr Walter: If supply chains are becoming interlinked across the whole of Asia, is the FDI at the expense of other Asian economies?

  Dr Lyons: You could argue that, in the first instance, but really if you look at what is happening collectively in those economies, you could say that it is wrong to think of it as "at the expense of" because, collectively, they all now seem to be benefiting. Basically, we calculated at Standard Chartered about a year ago that half of the exports from the rest of Asia into China were re-exported, effectively, to the US and other G7 countries, but half of the exports from the rest of Asia into China were to meet domestic demand. If you went across Asia three or four years ago and spoke to companies, they talked about China very much in terms of competitive threat. They still see China being competitive but they are now seeing China increasingly as a big growth market to sell into. So to say "at the expense of" tells only part of the story.

  Mr Barrell: To add to that, we should not think of there being only a fixed pool of FDI that moves around the world and if it is in one location it is not in another; FDI takes place for a number of reasons. The competition for FDI comes, really, only over the FDI that goes to a country to set up a plant for export to send the goods back to the market the FDI came from or from another market. FDI can also take place to make the production process as a whole more efficient, the area becomes more integrated, and increasingly in China FDI is taking place to set up plants owned by foreigners to produce their goods for the Chinese market. They are able to make a profit by producing in China things the Chinese want, and that is good both for the country sending the FDI to China and for the Chinese because the profits of the firm that is investing there are higher and the efficiency of production is higher. Only in limited areas is there competition over FDI anyway; that competition for FDI is probably regional not global, it is also industry-specific and one could only see a few industries where there would be export-based competition for the UK. That is in things like the production of chemicals—relatively simply things—that can be produced very efficiently in China. I think the amount of competition between the UK and China for FDI is going to be limited both by the type of things that are produced in China and the distance between them.

  Q33 Mr Walter: Are there any losers? You are talking about the interlinked Asian economy and the squeezing of costs, and so on, and China being, obviously, a lower-cost economy. There is some evidence, is there not, that with, let us say, Japanese products that appear here branded as Japanese goods, the real high-tech bits are made in Japan but the rest is made in China? Is that not a diversion of direct investment that would otherwise have gone to Japan or, possibly, to Taiwan or Korea?

  Dr Yueh: Up to 50%, it is found in studies of Chinese exports, are actually produced using intermediate goods from other countries. That is actually much higher in certain sectors like the high-tech sector. So, if you look at the supply chain and patterns of trade, you are seeing essentially a growing connection between a part created by South Korea and then it will be produced in China and shipped out to Japan. All the indicators for intra-industry trade are rising for China and the Asian region as well, including the South-Asia region. So what this suggests is that if moving across borders improves the production process and reduces costs then this would make goods cheaper, it would increase profits and it is beneficial for investors to go in in that way. This is why, I think, you are finding that FDI is going in and there may be an issue of locating in China, but they are taking advantage of neighbouring countries because of risk diversification, amongst other reasons, for why FDI would go into several ather than one country. I think the other thing about FDI to know, which has been mentioned, is that if you look at the statistics of the form of FDI, in 2000, a year before WTO accession, 75% of FDI used to have to go in as joint ventures, either equity or co-operative and only a quarter could go in as wholly-owned enterprises. In 2003 the proportions have entirely shifted; three-quarters of FDI goes in as wholly-owned enterprises and these enterprises have much more control over the nature of their investment and, also, they are in because they intend to penetrate China's domestic market. So if they are going in to penetrate the domestic market then the competitive element is much less because the East Asian countries that we are talking about which are its nearest competitors do not have, although it is growing, significant domestic consumption, which is why they have always been very reliant on exports and US growth to drive a lot of their growth rates. So I think we must look very carefully at the type of FDI and possibly what type, if it is entirely export-oriented as it has been in the past, and how much of it is actually going into the domestic economy.

  Q34 Mr Walter: Can I come back to my original question? Are there any losers? Are there economies that are worse off as a result of FDI to China?

  Dr Yueh: There is one, in terms of trade, and it is Hong Kong, but it is not necessarily—

  Dr Lyons: I dispute that completely.

  Dr Yueh: Hong Kong is the only of its neighbours that has lost global market share in manufacturing goods. Global market share in manufacturing products comprises about 83% of world markets and Hong Kong has lost 30% of its share between 1990 and 2000. The reason for its loss is not necessarily due to trade or China's competitiveness; it is largely a change of the domestic structure in Hong Kong's economy, but it does not mean that Hong Kong does not have growth prospects in other areas. If you want to draw a very simple analysis, simply on global trade share or market share or share of FDI, then I think, at least on the trade side, we have seen Hong Kong decline, but, again, my caveat is that the most growth potential for an economy is not dependent on trade, it is dependent on its own domestic capability, and that is what is affecting Hong Kong's competitiveness.

  Dr Lyons: I would like to clear up the point about Hong Kong, because I have a different view. It is interesting in the UK that we tend to overlook Hong Kong, thinking that it is a historical legacy and we should focus on Beijing and Shanghai. Hong Kong has done phenomenally well; Hong Kong is actually really well-positioned in the Pearl River Delta. The Pearl River Delta, geographically, is a tiny part of China but it has accounted for one-third of the exports of China over the last 25 years. In fact, it has been the fastest growing region in the whole global economy and part of the reason for that growth is not just because of the changes on the mainland side of the border but because of the inter-linkages with Hong Kong, which has phenomenal skills. It comes back to some of the questions earlier: Hong Kong has the law, it has the language and it has the Western corporate governance. So all of those are things that have put Hong Kong in a very good position now to help the Pearl River Delta, and are probably an indication of what else needs to be done in other parts of China as well. In terms of who are losers, we are presenting a picture here where it is hunky-dory and it sounds phenomenal but one of my biggest worries is that the whole global economy is becoming very much synchronised at the moment. In previous cycles, if the US went up and came down, if the US slowed we would have Europe and Japan kicking in. Europe and Japan have ageing populations, and are slow growth economies; China is now increasingly interlinked with the US economy, so the synchronisation between China and the US is such that if the US slowed, as is quite likely (having had a pre-election boom it will have, at some stage, a post-election slowdown), you will then have China slowing, and because of China's inter-linkages with the rest of Asia and Africa you will see slowdown elsewhere, so it becomes harder, maybe, to manage the global economy. That in itself is a worry. In terms of the UK, where are our future jobs going to come from? That is a big challenge. We need to move up the value curve. All economies are moving up the value curve—China, India, all other economies in Asia—so it becomes a lot more difficult to compete. The benefit in historical terms has been that when world trade has increased all economies have benefited, some at faster rates than others. So the hope is that that continues in the future. So it is difficult to say who will be the losers, but if the world economy takes a big shock then everyone will suffer, if world trade is hit then everyone will suffer, but if we start to see the opening up and integration of China as a very open, tradable economy, then everyone should benefit, but quite clearly in Western Europe the future pace of growth (let us not kid ourselves) will be much slower than the pace of growth in the young economies in Asia.

  Mr Barrell: In terms of who might be losing, there is a very interesting pairing in East Asia. Over the last 20 years Japanese exporters have lost market share very noticeably. Japanese firms have not lost world market share noticeably because Japanese firms have been relocating. This has actually, probably, been one of the few cases where outward foreign direct investment has damaged the growth prospects for the economy because the capacity of the Japanese economy has not grown as fast as it might otherwise have done. That relocation out of Japan into countries like China has taken place for two reasons: one of them geopolitical and the other one simple economics. The geopolitical one is Japanese firms based in Japan seem to have had problems entering markets with their exports—that is in the US and in Europe. The US and Europe both appear to have put up non-tariff barriers to Japanese exports in the 1980s that they did not put up to exports from countries such as China. Therefore, a Japanese firm might find it more profitable to locate in China to take a share of the European market than to locate in Japan. So, firstly, firms have relocated for geopolitical reasons, not only to China but China has been a major gainer. Secondly, the yen has been rather stronger, which has been the cause of deflation in Japan over the last decade, than one might have liked, and that has been another reason for relocation. China has been a cheap location for Japan because the yen has been strong, not just because labour is cheap. So if anybody is in the counterparty which has lost out for the growth of the rest of Asia, it might be Japan. That may not be a source of complaint in Japan but it is a relatively efficient way of increasing your economic power in the area to have foreign direct investment throughout it, and you at least make the profits from plants. There is an answer to your question, that potentially one country which may have lost in the last decade or two is China (sic), and other countries have gained. In the statistics it is not always obvious that it is Japanese firms who are doing the foreign direct investment, and that is partly why there is so much flow through Hong Kong. For historical reasons, Japanese investment has not always been welcome, so money arrives in Hong Kong and it then leaves Hong Kong. It has changed its nationality on leaving, but the firm has not changed its nationality.

  Dr Lyons: Just one point: the ending of the MultiFibre agreement, clearly, will pose big competitive threats for some economies which were previously protected by quotas as China comes into that field.

  Q35 Mr Walter: Could I move on very quickly to the quality of the foreign direct investment? Dr Yueh, you have mentioned that two top sources of funds coming into China are from Hong Kong and from the Virgin Islands. The Virgin Islands is a delightful place, and the population, I think, is just under 20,000 and Road Town is hardly the centre of the world economy. It is round-tripping. Can you sustain a situation in which you are building your economy on direct investment that is a tax scam—there is a tax evasion exercise?

  Dr Lyons: I will not comment on the tax scam but it is quite interesting that just in numerical terms there is no ideal level of investment in any economy but the level of investment in China now is similar to levels of investment seen ahead of the Asian crisis in other countries. You can have too much of a good thing, there is no doubt about that. From a pure macro-economic perspective, and I think your question was coming from a slightly different angle, you can have too much investment, and that is a potential danger for the economy in the near-term—having over-heating in some sectors and over-investment in other sectors. The authorities have tried to manage that in the last year-and-a-half in China, but I think that is a potential near-term worry.

  Q36 Mr Walter: I was more concerned about the questions of governance and transparency, and so on.

  Dr Yueh: I think we should probably put FDI into some type of perspective. It is difficult to estimate the stock in China but it is thought to be about $500 billion, and last year and in years before we have seen a lot of flows of FDI exceeding $50 billion per annum. Nearly 50% of China's GDP is actually actually made up investment, so that makes FDI a very small fraction of what total investment is in China. Even if, for instance—I do not know very much about the Virgin Islands—

  Q37 Mr Walter: They are a lovely place.

  Dr Yueh: Say those avenues collapsed, or what-have-you; I do not think, in terms of China's growth prospects, FDI has that particular central role. Why FDI is important and attractive is because it is the traditional vehicle to allow countries to imitate more advanced technologies in order that they grow and catch up in the growth process. So FDI has that advantage in that the Chinese need not reinvent the wheel and Western companies can gain from utilising its abundant and cheap labour to produce. That being said, FDI even of itself is only one component of capital flows, so what is worrisome and destabilising is actually short-term capital flows and not FDI; FDI is long-term investment in plants and projects. Short-term capital flows—hot money—dominates FDI flows and that dominates world markets. It is the hot money flow going into a liberalised credit sector which is going to be a huge concern for China, but that is not going to bring with it any of the good things that we have talked about. Liquidity in markets is a very good thing but if you are asking about corporate governance—and I am also talking about technology, knowledge transfer—that comes from FDI, good practices, bringing together a board of directors that is, say, half foreign and half Chinese and bringing along better standards of corporate governance. That is actually, in terms of introducing a commercial credit culture and a commercial market culture, what the Chinese authorities are very keen on. So I think it is important that we recognise that FDI is meant to serve this type of role. There is not that much evidence that it has, and this is a little theoretical, but even of itself FDI is still much more attractive than other forms of capital, but it is not the basis upon which China has actually grown. In fact, until 1990 China grew spectacularly well with a relatively closed economy.

  Q38 Mr Walter: One final point, which is really about a level playing field. In terms of the foreign direct investment, the domestic investment and the round-tripping investment, I am looking here at an article from The Daily Telegraph, talking about foreign companies—Wal-Mart and Tesco—being very successful and the Chinese government saying: "We can't allow this to happen; we have to build up the competition." Is there any evidence of protectionism in the sense of trying to defend what could be Chinese investment against foreign investment? Also, I wonder if anybody has any thoughts on what has been said to me by a number of people who have been involved in this, that there is still a level of corruption in terms of: "You grease my palm and I will make sure you get that particular project."

  Dr Yueh: I think there is an issue of corruption, but I think it is, again, something which the Chinese are keen to address because it can be detrimental to growth. So they are looking to reform, and there have been several high-profile instances of this. Funnily enough, the complaint in terms of legal protection has usually come from Chinese firms because joint ventures have traditionally been given better property rights protection than Chinese entrepreneurs and enterprises, but that is not to say that there are not a lot of barriers to operating in China, and China is well-known for having geographical restrictions as well. When I was a lawyer in China, it was quite difficult to negotiate moving ahead with a particular project for any number of reasons: it could be competition or because they wish to build up their own retail/wholesale sector, but a lot of the big players—like Carrefour, for one—are foreign firms since that sector of the economy opened up in the early 1990s. However there could be other reasons; there could be a reluctance to allow a certain firm to come in not necessarily for competition reasons but because of political reasons. I am being a little big vague because I do not want to name companies that have really struggled with this, but it is a long process, and I do not think anybody would doubt that. The motivation for it is not as simple as protectionism, although that is an element, because China's big companies are competitive and they are national champions in that their industrial policy has been designed to help promote them, so this could range from traditional companies, like PetroChina, all the way to new sector companies like Lenovo, which used to be Legend.

  Mr Nightingale: I think what has been said is entirely right and it is a difficult country to do business in, which is one of the reasons why the China-Britain Business Council exists to help; if it was like doing business in Holland we would not exist. On the other hand, I think, there is plenty of evidence that companies, large companies and small and medium-sized enterprises, can make headway in China, can set up in China and do very successful business. So that it is not a barrier which prevents everybody from getting in, it is a barrier which prevents some companies from doing things smoothly. On the other hand, we have got plenty of examples of companies getting on with their business, registering and licensing in a relatively smooth and easy way, and I think one should not forget that.

Mr McFall resumed the Chair

  Q39 Mr Fallon: Could we now turn to the exchange rate, and the key issue of whether the renminbi is undervalued or not? Clearly, Dr Lyons, you say, in your memorandum: "We believe that the economic case for a revaluation . . . is strong." Ray Barrell, if I understand your memorandum correctly, you say that this perception is really attributable to something else, the expansion of the economy. Could you start on that, Ray?

  Mr Barrell: Evaluating whether exchange rates are undervalued or not is very difficult indeed. I have spent a lot of my career doing it and I have decided it is too difficult to be too concrete on. China may look undervalued but it is not clear that it is. Firstly, China is a very flexible economy. China looked overvalued in 1996/97 and prices fell. Therefore, the real exchange rate adjusted, and if China is now undervalued because it has moved with the dollar, what one would expect to see is that prices will rise. Domestic prices in China have started to rise quite rapidly. Indeed, the Chinese are worried about that. I think within a year or two the competitiveness gain the Chinese have had from the fall of the dollar (they have been linked to the dollar) would disappear through domestic inflation. That is a reasonably strong thing to say. I would also judge that if the Chinese decided to float and liberalised capital flows there is no necessary reason to expect the exchange rate to float up because the capital flows might be largely outwards, pushing the exchange rate down. So it is not clear that either the economy cannot adjust quickly or that the exchange rate must float upwards. The reason why the Chinese have been gaining market share, especially in the last three or four years, is they have become increasingly efficient; they have been able to cut the prices of their manufactured goods relative to their domestic prices. That is just increasing the scale of production. I think it is not just a matter of having a low exchange rate; their import penetration is increasing in other markets because of the sheer scale of production and that pushes their prices down, and it pushes other people's prices down. So the fact we have seen falling export prices for China but a relatively stable real exchange rate in terms of domestic prices is very interesting. That is what leads me to think that it is the scale of production that matters, at least as much as anything else, for pushing export prices down. However, the dollar has been very weak recently and the renminbi has gone down with it, and when I say any undervaluation would be removed by inflation that may be a worry for the Chinese authorities. The fact that I do not think there is a particular worry on undervaluation does not mean to say they will not shift the exchange rate, because they may be so worried about the destabilising effects of inflation that they would need to get rid of any undervaluation a fall in the dollar has produced. So one possibility over the next two years might be that at some point the Chinese authorities decide to shift the exchange rate peg; not float with no capital controls but to shift the exchange rate peg in order that non-inflationary growth can continue. Low exchange rates cause high growth, low exchange rates cause high inflation. So a revaluation might be designed to control domestic inflation.


 
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