House of COMMONS
MINUTES OF EVIDENCE
TAKEN BEFORE
TREASURY COMMITTEE
IMPACT OF CHINA ON THE WORLD AND UK ECONOMY
Tuesday 8 February 2005
MR RAY BARRELL, DR GERARD LYONS, MR PETER NIGHTINGALE
and DR LINDA YUEH
Evidence heard in Public Questions 1 - 61
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Oral Evidence
Taken before the Treasury Committee
on Tuesday 8 February 2005
Members present
Mr John McFall, in the Chair
Mr Nigel Beard
Angela Eagle
Mr Michael Fallon
Mr David Heathcote
John Mann
Mr Robert Walter
________________
Witnesses: Mr Ray Barrell, NIESR, Dr Gerard Lyons, Chief Economist, Standard Chartered Bank, Mr Peter Nightingale, China‑Britain Business Council, and Dr Linda Yueh, Oxford University and LSE, examined.
Q1 Chairman: Good morning. Can I welcome you to the Committee and thank you for your attendance at our first session on the impact of China on the world and UK economy. May I ask you to introduce yourselves for the shorthand‑writer, starting with Mr Barrell, please?
Mr Barrell: I am Ray Barrell. I am at the National Institute of Economic and Social Research where I run the team who study the world economy.
Dr Lyons: Good morning. I am Gerard Lyons. I am Chief Economist and Group Head of Global Research at Standard Chartered based here in London. Standard Chartered is a British bank that has significant operations in Asia, Africa and the Middle East.
Dr Yueh: I am Linda Yueh. I am an Economics Fellow at Pembroke College, University of Oxford, and I am also appointed to the Department of Economics at the London School of economics. My research focuses on economic and legal reforms and prospects for China. I also undertake the teaching on China at Oxford.
Mr Nightingale: My name is Peter Nightingale. I am the Chief Executive of the China‑Britain Business Council, which is the agency set up to help British companies do business in China.
Q2 Chairman: You are all welcome. Can I start with some introductory questions? The UK Government has told us in their memorandum that it expects China to account for nearly a fifth of the world GDP within a decade. In consequence, the share of the world economy accounted for by the current G7 is almost certain to decline, but the hope is that the emergence of new economic powerhouses such as China will boost world growth enough to ensure that the current G7 economies continue to see rising prosperity in spite of the shrinking share of global GDP. Is that a plausible assessment of the current outlook?
Dr Yueh: There are a number of things to consider here. I think the first thing is if you take China's current growth trajectory and you think that you can make projections based on where it is growing at present, then I think there is quite a lot to be said for the rapidness of its growth given the fact that it is already larger than half of the members of the G7, not taking into account any addressments or purchasing power. It is a big economy, but on the other hand the sustainability of growth will depend on a number of factors, and it is by no means assured. The sustainability of growth will very much depend on how much China resolves the structural issues in its economy which derive from its transitional path; and I would argue that, although China has made a very good set of reforms, there is still quite a way to go before we could make such projections.
Q3 Chairman: Any other comments?
Dr Lyons: In terms of your question, I think a key issue is demographic factors. There is no doubt that the shift in economic power will be to the new emerging economies, and in particular towards Asia, and that poses challenges and opportunities for economies in the West. In terms of the G7 you have mentioned, I think we have already had a taster of this in the last decade when one has looked at Japan. Admittedly, Japan has had an economic crisis to contend with, but Japan has already entered into a slower pace of economic growth. When one looks at demographic trends particularly on continental Europe as well as in Japan, income levels are high to begin with, which helps prosperity in terms of your question, but future pace of economic growth in these economies will be far slower in the future than in the past, and that is a key issue that the G7 has to contend with. The States and the UK are less affected by such demographic trends. Basically the G7 will still be very important, prosperity will rise, but the future pace of economic growth for many of the members of the G7 will be much slower in the future than in the past, and that is a particularly acute problem for Western Europe and for Japan.
Q4 Chairman: You mentioned challenges and opportunities. Many people have mentioned those to us in the past, some saying, "Oh, no, we should embrace China", and others saying, "Oh, it is a problem for us in the future." Could you highlight the single key issue that advanced economies, in your opinion, should be focusing on in terms of responding to the emergence of China as a major economic force in the world? Should it be a challenge? Should it be an opportunity?
Mr Barrell: Obviously, as an economy grows and expands and penetrates markets it is a challenge for those who are currently producing the same goods as the Chinese, but, as we have known for at least 200 years, the extent of the market is dependent upon the size of the economy. The division of labour and the gains from the division of labour depend upon the size of the economy and, as China grows, the whole world economy can grow; everybody can gain from the fact that China is becoming a larger economy. We gain, first, from becoming more specialised. We specialise in things we are good at; they specialise in things they are good at. We gain also from increased competition. Increased competition is painful for people immediately facing it, but good for the economy as a whole because it means resources are used more efficiently. Those, I think, are two of the reasons why you might expect the strong growth of China to be a positive opportunity for the G7. China will inevitably grow relative to the rest of the G7; it is poorer, it has a well educated population, it has a lot of capacity over the next 20 years to grow as rapidly as it has over the last 20 years, but over the next five years there may or may not be crises that could hold it back.
In the absence of the Chairman, Mr Fallon was called to the Chair
Q5 Mr Fallon: We are looking for the single key issue. Mr Nightingale?
Mr Nightingale: I think from a practical business point of view there is no doubt that companies in this country should be interested in China. They need to consider China if they have any international dimension to their business because China is going to affect them, and I think that a large number of companies will find probably that they have opportunities in China which they ought to try and take.
Q6 Mr Fallon: Any of the others? You do not all have to answer each question; it is not that kind of exam!
Dr Yueh: If I may. I think the single biggest challenge for the G7 and for other countries in the light of China's ascendancy is really to take a hard look at domestic core competencies because we know in the long run growth and prosperity is not driven by trade, although, yes, there are gains from trade and as the world expands the pie gets larger, but when you look at what drives domestic competitiveness, shifting out the growth potential of an economy, it is domestic factors. Of course, this is taken with the caveat that when you have a growing trading partner who is beginning to dominate markets, one has to think hard about how to move up the value chain of trade rather than just domestic factors. To give you an example of where China has enhanced its neighbours despite widespread perception, my research shows that China's rapid growth, nearly 500 % in the high technology sector in terms of global market share, has been accompanied by similar growth rates in the East Asian high growing economies.
Dr Lyons: I would agree with much of what has been said. Clearly it is an opportunity, the sheer scale of the economy, but the immediate issue is also very much linked to the competitive threat from China. It is not just a direct threat; it is an indirect treat that the UK needs to face up to. The Treasury has talked about it in terms of the UK needing to be flexible, innovative, entrepreneurial, but we need to back up those words with actions to ensure that that is the case: because it is not just China that is becoming more competitive, China is forcing other economies around the world to become more competitive, India as well. There is a lot of near-term competition, but at the same time I very much reinforce Peter Nightingale's point about the opportunities, the sheer scale of the market. Remember that China is already invigorating much of Asia as well, and similarly, as India comes on stream, India will reinvigorate much of South Asia. These are huge markets, and compared to continental Europe, in Europe, which has an Asian population, you have Asia which has a very young, dynamic and emerging middle‑class, so that is a clear opportunity for UK companies, not just now, but in the future as well.
Q7 Mr Fallon: The evidence we have heard so far in this inquiry has shown us that, for example, nearly half of all UK manufacturing companies see China as the biggest threat. The impact of China on the European chemicals industry is described to us as "potentially catastrophic". Would that not indicate that the official Government view of the impact of China is perhaps is a little complacent?
Dr Lyons: The reality is that in any industry around the world where there are not quotas China does grab a huge market share, because it is both competitive and innovative and it is investing very heavily in new industries; so it is not just based on price. Thirty years ago goods produced in Asia were cheap, low quality. The reality is that goods produced in Asia, particularly China, are both cheap and of increasingly high quality. Companies in the West cannot just compete on price, and, as Ray Barrell mentioned earlier on when he talked about specialisation, the reality is that you have to compete in areas where you have a competitive advantage. Clearly there is going to be a clash as China comes into industries where in the past it was not competing with us; so that means an immediate adjustment phase which is very competitive.
Q8 Mr Fallon: Does anybody else think the Government's view of the impact of China is out of line with that of industry?
Mr Nightingale: Can I mention one thing. The growth of the Chinese market in all these different sectors offers opportunities for British and other western companies that are investing in China to participate in this growth, and in certain sectors, of course, western companies are very strong so that the growth of China does offer an opportunity for foreign companies, which many of them, of course, are taking up.
Dr Yueh: I think to the extent that the British Government needs to take a more proactive stance, it is to help industries gain or increase their productivity. If you look at the composition of world trade, a quarter of it happens intra industry. That means that there is quite a lot of differentiation, and to the extent that we have a skills deficit or that there are reasons why R&Ds are not being invested in, those are the things and those are the reasons why the Chinese are becoming competitive, but we need to look hard at what kinds of policies can stimulate the kind of higher quality product differentiation that is going to mark certain sectors of the economy in the future.
Mr Nightingale: May I add one thing to that, and that is that it is early days yet, but, of course, China is beginning to invest outside China in the West and in other parts of Asia. As China's capacity for doing business outside China grows, I think that trend for investment outside China will also grow.
Q9 Mr Fallon: Finally from the Chair, could I ask you, Dr Yueh, about the Chinese model, if you like? The approach of China to economic liberalisation has often been described as gradualist compared to, for example, the "shock therapy" recommended by the IMF in other developing countries. Do you think there is a model that can be usefully applied to other developing countries, for example in Africa?
Dr Yueh: I think in China's success there are traits which would be useful for other developing and transitioning economies, but I do not think it is a model which can be applied wholesale because the particular prototype is very much dependent on its initial conditions and its institutional and political structures. For instance, a gradualist type approach was tried in the former Soviet Union before 1989, but it was not successful. For China it was successful because of a number of key features. One is that on the eve of transition the state sector was not as much in decline, therefore you could have a gradualist or dual‑track approach in which you create a market alongside a non-market. Imagine if you tried to do that and you had no control over the market so therefore everybody goes into the market and sells their goods at market prices, that lack of control has defeated many other economies which have tried to phase in reforms. Also China has a semi‑federal structure, meaning that it allows experimentation in areas along the coast, and even as early as 1978 it created a special economic zone. So, if you think about an experiment in policy happening in one area, it becomes self‑contained and, if it is successful, it is rolled out; if it is not, it is self‑contained. There are a number of features along these lines. Finally, China's goal has never been straightforward. There was not an aim of becoming a certain economy; there was no rush. Therefore China has always crossed the stream while feeling the stones, because they are not in a hurry to get anywhere; they are simply reforming and reviewing what works and what does not work. That being said, the trait which I think other economies ought to take notice of is the success of the particular sequence of reforms in China. I think that is the current debate. How do you sequence reforms if we reject a wholesale approach? There are no clear‑cut answers, but I think there are a lot of features which are worth looking at.
Q10 Angela Eagle: I wonder if the success of that gradualist approach has relied upon a very centralised state power which has been able to almost keep a handle on things until it gradually loosens the reins. There are not many governments around the world that I can think of that match the structure of the Chinese Communist Party. How important have the political institutions been in attempting this gradualist transition?
Dr Yueh: It is quite important in the sense of maintaining stability. Gradualism relies on the ability of the state sector to control the two sectors of the economy until convergence occurs, and when that convergence occurs, for instance, food prices were liberalised and converted in 1992, even though there is a huge differential between the state prices and the market prices, the sector converged without a shock; the same thing in the Forex Market by 1994. This very much depends on the Government being able to maintain the state sector alongside the non‑state sector. I think that does not necessarily mean you need a particular political system to do that. It essentially means you need stability in order to control the direction of the economy. In the examples of the other East Asian economies which have often been characterised as one‑party or self‑authoritarian, they were able to direct their industrial and FDI policy along the same lines; and, yes, I do agree with you: I would find it difficult to see how economies, developing countries which have weak states, would be able to undertake a dual‑track approach. I do not think that particular strand of gradualism is widely applicable. What I think is applicable is the way in which China sequenced its reforms, because even in a shock therapy approach you have to sequence your reforms implicitly, but in gradualism you have to sequence it with time bands, with a longer period, and where China has been successful, I think, has been in the type of reforms that it has sequenced not necessarily in the type of regime that has brought about the reforms.
Q11 Angela Eagle: Is the paradox that you need a strong central power to devolve economic decision‑making?
Mr Barrell: Bringing up the point Dr Yueh has said‑‑‑
Q12 Mr Fallon: Almost like planning.
Mr Barrell: Yes. China is actually quite a federal country. It is not a deeply centralised country. It is not like the Soviet Union. The power that resided in the regions was much greater and, although there was a central party, the local parties were running their regions, their own economies. I think that decentralisation was a very important part of the early flexibility in Chinese development. We look at a strong party, but the fact is it is a very decentralised economy compared to most. It is more decentralised than the UK in many ways. The other thing that comes with that decentralisation, the very federal structure from the commune upwards, is that agricultural reform could come in very early so that food production and incomes for peasants were dealt with relatively early in the process, whereas if we look at many African countries, reform of the agricultural sector is the last thing on their agenda. One of the major lessons I would learn from the development of China is food production is the first thing one addresses and decentralisation in food production.
Q13 Angela Eagle: There have been some extraordinary successes in some of the economic areas, particularly along the coast, and from evidence we have received there seem to be some difficulties developing, particularly in the old state‑owned enterprises where clearly they are not as competitive as some of the new dynamic organisations, and we are now seeing the emergence of urban unemployment as those state‑owned enterprises shed jobs, quite similar to some extent to the transformation of East Germany after the reunification. What kind of tensions and problems in your assessment do you think this poses and is this a really difficult part of the gradualist transition, a danger time?
Dr Yueh: It is. The gradualist transition is premised on essentially an easy to hard sequence because it does not maximise efficiency, it minimises implementation costs. The hardest issues tend to be left for later. This includes the fact that urban unemployment did not exist in China until the mid 1990s. The fifth year plan, which started in 1997, actually implemented a large scale lay‑off programme; that plus culmination of an urban bias in industrialisation, meaning that it has always been the case that the agricultural or the ruling economy, which used to comprise three‑quarters of China's population and now is about two‑thirds, food prices were kept artificially low while industrial goods' prices were kept relatively high, and that kind of industrialisation has meant the world urban income gap had been growing over the past 25 years; that plus the increase in lack of competitiveness of state‑owned enterprises due to increasing competition but also due to the limitations of lack of productivity advances and the limitations of growth being driven by factor reallocation, has meant that we are now looking at urban unemployment which well exceeds the pass rate of two, three percent and a significant amount of people who are considered to be laid off or we learned there is a whole category of people who are non‑vacation or who are simply not in post. This figure can be staggering if you add it together; it could range up to ten percent - some would argue higher, some would argue a bit lower. That, plus the inward migration of rural/urban migrants, because of the income gap that I have discussed, has meant that you are looking at urban poverty for the first time in China, and that is something which can potentially be destabilising and warrants‑‑‑ The Chinese Government is taking a serious look at the issue, and I think it is well worth it.
Q14 Angela Eagle: The party in China now talks about five balances, and some of those are between rural and urban, as well as geographically. How important are they in trying to stabilise the growth so that the world does not come to rely on China's fantastic contribution to keep the world economy going only to see that perhaps, if there is a sudden shock, it disappears?
Dr Lyons: Chinese economic policy‑making has been phenomenally successful. I do not think anyone 25 or even ten years ago would have anticipated China being as powerful or as successful as it is now. One of the successes has been the way in which policy has evolved, not just in terms of the regions but also at the centre. You mentioned the five balances. Last March at the National People's Congress there was a phenomenal shift, or a very significant shift rather, in terms away from growth at all costs to ensure that growth was more sustainable, and that is likely to be reinforced by the similar congress this year with the focus on the rural areas. The Chinese have highlighted the issues; the key test is in the transition economy to ensure that they can continue to get the balance right. I think the trend clearly will be up for the Chinese economy, but we should expect increased volatility around that upward trend. In terms of your last couple of questions, in terms of the economic success two factors that are very important are, first, the way in which the price mechanism has started to take hold in China ‑ the private sector is very evident ‑ and the second is the way in which the Chinese economy has become more open. Trade now accounts for roughly 70 percent of the economy. China is becoming more interlinked with the rest of the world, is having a phenomenal boost on Africa, Asia and also the Middle East; so it is having a big plus on all these regions. It poses greater challenges for the policy‑makers to get things right, but the macro-economic environment externally is relatively favourable in terms of low inflation. Clearly in China they have greater challenges ahead and the regions‑-- The way I would say it is that if we think of Continental Europe we try to have a one‑size‑fits‑all monetary policy for Continental Europe. That does not work. China has to have a one‑size‑fits‑all policy for an economy that has greater diversity, greater differences. That is clearly a huge challenge. Up to now they have got it right. I would imagine it is going to become more difficult in the future, therefore we should expect increased volatility, but so far so good.
Mr Nightingale: May I add one point, and that is that there is no doubt that China's Government is encouraging the growth of the non‑state sector, what we would call the private sector. It is quite difficult sometimes in China to tell what is privately owned and what is not privately owned. Nevertheless, there is a great emphasis on developing the non‑state sector, which, of course, it is hoped will absorb the people who are being laid off in the state‑owned sector.
Q15 Angela Eagle: Again, taking this example of the German reunification, that has been managed with high levels of unemployment in making a transition by having an extremely expensive and generous welfare system which has enabled many to look forward to a fruitful life without working again if they are in their fifties, it has ensured that there is not social unrest and it has cost a lot of money. What is the Chinese answer to the social problems which may come about as a result of massive restructuring and unemployment, because they simply do not have a kind of German model of welfare?
Dr Yueh: It is actually a good question, because it touches on why it is so difficult to restructure the state‑owned enterprises. The state‑owned enterprises in China, the work unit, or the Dan Weih(?), is the provider of social security, everything from housing, to health, to employment, to pensions, and the Iron Rice Bowl, which is a permanent lifetime job for a worker and then his or her offspring, that is the system that has been in place and when the SOEs became less competitive. If they cannot operate, then they cannot pay out the kind of social securities which have been expected in the economy. Essentially the Chinese Government is faced with a very difficult task of uncompetitive SOEs, which, if they were to be reformed and downsized, they shed the social security provisions that they have always historically undertaken and, most importantly, is expected in a socialist economy. What they have done is they have done it, not surprisingly, gradually. Housing was reformed at the end of 1998 and by 2001 housing had been sold off and essentially privatised and no longer allocated along with your job. In terms of pensions, health and unemployment, each of these have been tackled in a slightly different way, but essentially they have looked at combining federal or central government resources or local resources and, by experimenting as to which kind of system works, they will roll out, for instance, the minimum income guarantee from the north-east and then downwards. The same applies for the unemployment system, which is a three in one system, where the state, plus the local government, plus the SOE ought to contribute to a particular pot and they develop re-employment centres and they are beginning to dismantle the housing registration system, which has traditionally impeded labour mobility, which, of course, does not help when you have misallocated resources. I think it is that difficulty of reforming the state‑owned enterprises whilst providing a social safety‑net that is, indeed, one of China's major challenges today and could potentially be destabilising, to go back to your earlier question. I sort of see the destabilising factor in terms of two sets, domestic and foreign. In terms of domestic factors, it is the growing rural/urban divide, it is the inability to resolve the close relationship between the state‑owned enterprises and the state‑owned banks which have generated non‑performing loans; it is the increasing awareness of a lack of social security provision and the growing inequalities by the Genie Coefficient. The coastal provinces are getting quite a lot richer than the interior, despite the policies as early as in the past 20 years to try to divert foreign investment, and so on, into the interior. Then I think externally, China did not suffer very much from the Asian financial crisis because they simply did not have the trades associated with the third generation financial crises models, but as they loosen capital controls and begin to extend credit into its private sector, without sufficient corporate government structures in place it will begin to take on the traits associated with devastating macro-economic instability, and I think it is those two sets of factors which are worth watching.
Q16 Mr Beard: The Treasury view that has been expressed to us is that China's labour force "remains characterised by low skills and productivity levels and western economies generally seem to hope they remain competitive by raising skills". On the other hand, the European Union Commission has warned that China is increasingly competing in high skills areas and China is now educating two million graduates annually and producing three or four times more engineers here than the United States. Are we in a position to win a skills race with China?
Dr Yueh: The answer is, yes, because the tertiary education enrolment is still low in China, and so, depending on the slice of the population that you are looking at, it is only recently that there have been returns to human capital. On the whole China is a relatively skilled‑‑‑ My research in the labour market has looked at to get returns to human capital, the degree of skill accumulation, and you do not usually accumulate skills unless there are returns in the labour market. China is still labour abundant, it is still deficient in tertiary education, although it has a very solid primary and secondary level of involvement in education. If we recall the experience of the East Asian economies, it is actually primary and secondary to development at that level of development, which is fairly important for developing an industrialised set of core competences, but what we also know, as I mentioned a bit earlier, even though China's growth is very fast across many sectors, it is actually the high‑tech goods which are growing the fastest albeit from a lower level, but the debate there is unresolved. If you produce high technology goods mostly with foreign invested enterprises and technology and capital and managerial skills, is that the same thing as domestic productivity advances? Very well known economists would say it is not. Others would say it is; that it indicates that even assembly of things like semi‑conductors is important and the increasing transfer of knowledge from foreign invested enterprises means that the catch‑up rate will be quite fast, especially as China teaches English in the coastal regions in order to allow its labour force to absorb the foreign technologies.
Q17 Mr Beard: So the conclusion is that it is going to be a dead heat, is that it?
Dr Lyons: It is not just China. China is already indirectly forcing other countries to move up the value curve. China itself, as the answer in your questions has indicated, is moving up the value curve. One only needs to visit the Pearl River Delta bordering on Hong Kong, the Yangtze River Delta bordering on Shanghai to see that China is benefiting not just from abundant low‑cost labour but increasingly highly skilled labour, and the key aspect is not any of the individuals themselves learning more, but there is huge investment, both domestic and foreign direct investment, into China. They are not in the having better skills themselves but the equipment they are using is the newest, the modern versions, so the total factor productivity is incredibly high in China across the coastal areas. That in itself is an opportunity for those firms involved in those industries. As we are seeing, over 50 percent of the firms who export from China are foreign; three‑quarters of the exports from China are produced by foreign companies, many American; so foreign firms are already benefiting from that and labour forces around the world have been able to consume very cheap goods, but also there is a very indirect impact we are seeing already in India. India is starting to move up the value curve, not just into the immediate threat, as people talk about, from India in call centres. You are seeing other countries, such as India, responding to the challenge from China by moving into higher value‑added sectors, across the service sector as well. The issue, therefore, for the UK is to make sure we are not only good in the areas in which we specialise but that we are increasingly moving up the value curve as well, education, as well as encouraging more firms to invest in the UK. There is a direct challenge and opportunity from China, but there is also the indirect one as other countries respond as well, particularly India.
Mr Barrell: It is partly a response on knowledge and information, partly on the UK's position. One of the things I found interesting when recently doing work on China was to discover it is now the third largest investor in research and development. It is well ahead of the UK. Although China may not be catching up Japan and the US in those stakes, it is clearly in some ways advancing on the UK, and that research and development is liable to be productive. Not all R&D is productive. In certain areas I think the Chinese are beginning to make big moves towards increasing the intellectual input into their production, but there is also a comparison to make on education that one has to be careful about. When we saw the liberalisation of Eastern Europe, many of us thought there would be very rapid growth in countries like East Germany, the Czech Republic and others because the workforce had very high levels of formal education. The thing that we had not really observed, which has become very clear from studies of East Germany, is that the problem that the workforce had was not that they were uneducated but that they were unused to working practices outside the state sector, and one has to ask and not only watch the level of education that one formally has, but what is one's ability to operate in the market economy? The Chinese do have the advantage over many central Europeans of having had a market economy longer, but the problem for the Chinese State sector, which is very much smaller than the German state sector was, is that the people who worked in it are not always used to market incentives when they move into the market, so it is very difficult. Knowledge is both the skills you acquire in the institution as you do in your education and the knowledge you pick up when you are working. The knowledge you pick up when you are working is probably at least as important for growth as the knowledge you pick up at schools, and the Chinese are doing well at both, but we should be seeing more the growth of the market as the growth of knowledge than the growth of education. It is still a largely uneducated population but much more highly literate than many African populations.
Q18 Mr Beard: What indicators are there of the quality of the research and development that you are referring to?
Mr Barrell: That is very hard, because their growth of research and development is relatively new. One of the things that one would use outside countries like China is what proportion of it is in the private sector, because there is a degree of evidence that public sector R&D, which is mainly research‑based, is not necessarily productive. In China the division public/private is harder. It is not so far clear that they are gaining market share because of the R&D they do. The Germans gain market share because they do a lot of R&D. It is not yet clear that that is true in China. There are two faces to R&D. They are very important faces. One is creating new things, and the other one is to have the capacity to understand the new things other people have created; and a lot of Chinese R&D will be understanding the new things other people have created. It is the second face, the face that is not grand but the face that is important. It is the ability to absorb the technology from Japan and from the US.
Mr Nightingale: Could I add one thing to that? Gerald Lyons has already referred to the important part that foreign investor firms in China are playing in terms of export, market share and so forth, and that is true, but the majority of people working in those firms are Chinese people learning new skills, learning new technologies, and so on and so forth, and of course a number of western companies are putting R&D into China so that they can develop products specifically for the Chinese market and then export them, if that is also appropriate, but I think that from a business point of view in the UK we should not be complacent because we do need more business people here who understand what is going on in China, who speak Chinese. Again, Gerard Lyons referred to the number of people who are learning English, particularly in Eastern China, but not only in Eastern China, all over China, in order to be able to participate in the global economy. I think that we are rather slow, as very often we are in the UK, in learning foreign languages and forth, but I do think we should be paying more attention to this aspect of learning or teaching future business people about what the opportunities are in China, and how to get at them.
Dr Yueh: May I add one thing on R&D. R&D became the focus in China only in 1995. If you look at the opening of China, starting really with Deng Xiaoping's tour in 1992, in 1995 China developed what are known as high technology development zones (HTDZs). They now exist in all but three provinces. These are specific zones which are like science and industrial parks, and they have a three in one system which essentially takes a research facility and attaches it to a production facility and attaches that to a marketing facility. It is less than 10 years old, so it is difficult to assess real productivity advances, but we know that since the creation of these things patents have actually increased rapidly in terms of both patents filed both by domestic Chinese but also by foreigners. Since WTO accession and the eventual acceptance of the TRIPS agreement, which is part of the WTO which governs intellectual property rights, patents filed by foreigners have actually shot up by 33 percent over the past three years within China, and I think that is a trend that we ought to be following.
Q19 Mr Beard: This question of patents was one of the things that held a lot of high‑tech companies back from exploiting opportunities in China. Are you satisfied that that has now been solved, not just in legislation, which is there to do with patents, but in the actual enforcement of it?
Dr Yueh: I think patent enforcement as well as copyright and trademark is a huge problem in China. It is a problem which is more general in that contract enforcement is difficult in China because it has an incomplete legal system. Legal reforms are happening very quickly, and, as you mentioned, the first patent mark actually came into effect in 1985, but the corporate law, the mainstay of the corporate law, company law, came into existence in 1995, and all the laws are coming onto the books, but in this kind of common law type regime what you really need is reforms of the legal system so that enforcement can then create the case laws by which future actions can be judged. This is an area for which China still has quite a lot of reforms to do, but I should add that international economic law with WTO accession will speed up and improve the standards of these, and also China has always been open to fairly good arbitration within China as well as internationally.
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 percent 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 Charter, has a significant operation in China. We, like other international banks, are seeking to buy into China. We have just bought 20 percent 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 move 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 eight to eight and a half percent 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 trends 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 trends, 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 grows, India grows at the rate it grows, it is expected to grow out Brazil, South Africa, then I think that is a real issue in terms of global energy demand, because even if they are completely efficient, pro rata efficient, they will still over consume - it is the nature of a product such as energy - and therefore not internalising the externalities it causes, so I think in terms of working at it from a policy front it will be very important to see.
Q23 Mr Beard: Have you got a limited amount of oil that we cannot see it expanding hugely beyond present supply and you have got all the expansions that you are referring to (eight, nine percent) 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 resources.
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 but will not service China and Japan.
Mr Fallon: Let us move on to another section. David Heathcote-Amory.
Q25 Mr Heathcote-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 coastal 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. I think, for those reasons, it happened, 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 brought up about poverty reduction in China as a huge success 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 ten percent of arable land, so there is a lot of pressures on the land and getting these industrialised, allowing you to compete effectively in this new industrialised more competitive sphere is going to be difficult.
Q26 Mr Heathcote-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‑‑‑ 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 House Wood 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 regions, 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 Heathcote-Amory: Dr Lyon, 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 reinforcing the point about property matters, 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, rural areas, between the urban areas and also between the 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 big city. That has developed quite significantly in the space of the last five years, and it is easy to see what has had in the Pearl River Delta and Shanghai region 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 displaced workers who have moved from inland 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 Heathcote-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 Heathcote-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 Heathcote-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. 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 where they have to apply in terms of tariff barriers certain numbers, then you can measure it and it is quite clear that the Chinese have implemented that. Where it is less clear, where there have been objections is where there are not figures or measures in place. That might suggest that they always want it in those 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 well 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 ACM Plus 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 clearly defined property rights and an insecure legal regime. So the presupposition is that it may be that there will be more powers, and become more economically powerful. I would argue it is somewhat the other way: one because there are limits to what one is able to do when you become more open and, also, to do well in an 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 constitutional 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 covers beyond trade: it covers financial liberalisation, it covers intellectual property rights, it covers trade in services (TRIPS), 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 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 where the individual decisions are), 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 RDD (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 outer-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 competition 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 by 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 other countries because of risk diversification, amongst other reasons, for why FDI would go in. 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, a 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 manufacturing(?). Global market share manufacturing comprises about 83 % of world markets and Hong Kong has lost 30 % between 1990 and 2000. The reason for its loss is not necessarily due to trade or China's competitiveness; it is simply a change of the domestic structure to 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 try 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 are ageing populations, 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 is 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 multi-flyer (?) 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 the 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 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. Nearly 50 % of China's GDP is actually 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. In liquidity markets there are a lot of good things but if you are asking about proper governance - and I am 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 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 on 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 markets 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 world 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.
Q40 Mr Fallon: Just before we go onto how they might respond in China, let us just be clear about whether the renminbi is undervalued or not. Dr Lyons?
Dr Lyons: In my testimony I referred to China as a Robin Hood and Goldilocks and Superman economy. The Robin Hood, aspect, I think, is relevant here. Here in the West we tend to think of China as having huge trade surpluses, as it does with Europe and the States, but it is important to remember that China is having a Robin Hood effect in other regions, having a big boost to activity, and it has a huge trade deficit with the rest of Asia. So when we talk about the currency and the prospects for the Chinese currency it is important to stress that it does not necessarily have to move in the same direction against all currencies in the future. I think there is a case for the Chinese currency to be stronger against the G7 currencies but in time, or in the near-term, it could weaken further against Asian currencies. It is important to stress that financial markets have moved from one extreme to the other on this. In 2001 the markets were calling for China to devalue, and last year the same people were calling for China to revalue. Fortunately, at Standard Chartered we have been consistent in arguing over those years that there was no case for China to change its currency policy. I think there is a case now, partly because of what has happening in terms of the external value, in terms of the dollar's continued trend downward, but also domestically inflation pressures are starting to appear in China; producer prices are picking up, and consumer price inflation is becoming more evident. I think, therefore, in terms of currency policy, one of the lessons from Japan in the late-80s is that you should set your currency policy to suit domestic needs and not just to suit the US or external circumstances. So I think Chinese currency policy should be set to ensure that China continues to achieve strong domestic growth. On that basis, I would say that there is now a case for revaluation, and I would stress that the case is very much based on gradualism. At Standard Chartered we constructed a Chinese currency barometer, and we have taken into account sustainability, competitiveness, and overall economic performance. On that basis we would say that there is now a case for revaluation but the important point to stress is that I think it should be a gradual revaluation. I certainly agree with Mr Barrell's point that if, overnight, currency controls were lifted in China it is just as likely the currency would go down as up, and therefore I think the Chinese are sensible and realise this. The very fact that there is such an intense debate going on in China highlights the fact that there are many different factors to consider on this.
Q41 Mr Fallon: How do you think the Chinese authorities will or should respond?
Dr Yueh: I think on renminbi valuation, in the long run it is clear that the exchange rate should be determined by the balance of payments, but in the short run the economic models may find it very difficult to actually establish precisely what the value ought to be, and I think that is the crux of the problem. I think the view is, because China has import restrictions and there are distortions on the import side, it is likely that, vis-à-vis the dollar and given the rapid decline of the dollar, there is probably an imbalance in the exchange rate, and it has not been inflationary. What is inflationary in China is after Volatov Enterprises (?). So, from that end, the concern is not currently there but there is a concern that it is very expensive to maintain a fixed exchange rate; it is costing the People's Bank of China a reported $600 million a day to stabilise the renminbi. That even of itself is expensive and not particularly sustainable. So I think the feeling now is that if, as Mervyn King has called for, these discussions can take place in private so that speculators do not erode any immediate value, then it is likely we may see a move in terms of what the Chinese authorities would feel to be consistent with their growth strategy towards thinking about the effective exchange rate - not the bilateral but the effective exchange rate. If China moved to a trade-weighted basket of currencies, for instance, it could take into account the fact that its trade is increasingly with the other Asian countries which are following its lead, but it tends to run a trade deficit with them as opposed to a trade surplus with the rest of the world. So, making an effective exchange rate, and thinking about moving it gradually towards one with help in terms of stabilising the economy. However, I should finally say that their main concern is of macro-economic instability. I mentioned earlier that one of the biggest concerns is the twin crisis: that if you had a crisis in the currency market it can transform into a crisis in the financial market. This is what we saw in the Asia financial crisis; this is what we saw in the crisis that spread through Russia, Argentina, Turkey and Mexico in 1994. These are destabilising crises, if China were to move too quickly on its currency. Despite the fact that it has capital controls, and we know those are being eroded by any measure of the amount of hot money going into the economy, then China is very worried about macro-economic instability resulting from a brash move on its currency.
Mr Nightingale: China's financial structure is extremely underdeveloped and it will be very cautious about doing anything that its own structures might not be able to cope with. Basically, it is underdeveloped because it has only been developing for the last 20 or 25 years, and literally just does not have enough people well-trained to undertake the jobs that need to be done. It has got to train those people up.
Q42 Mr Fallon: Ray Barrell, could you add something on the issue of very large foreign exchange reserves that China has built up? Can these be reduced without disrupting currency markets generally?
Mr Barrell: The build-up of very large foreign exchange reserves, I think, has been partly due to the peg, and partly intentional on the part of a number of authorities throughout the region. There were, eight or ten years ago, some discussions of setting up an Asian Monetary Union and an Asian Monetary Co-operation area, and I think central bankers in much of, at least, that part of the Pacific Rim still have it at the back of their minds. The build-up in reserves is there for a very long-term reason, perhaps. However, the build-up of reserves recently has also been partly associated with trying to maintain a peg. It is very difficult to know what central bankers are now doing, but there is some evidence from US statistics that East Asian and, especially, Chinese central bankers are no longer so willing to buy US Government debt. US Government debt was the thing that the reserves were in, and in the last few months probably since about September/October there has been a significant decline in demand for US Government debt by central bankers in East Asia. That may be one of the reasons for the further decline of the dollar. The Chinese almost have a dual problem: they are one of the reasons why the dollar has not fallen so much, they have been buying assets which perhaps were not the best ones to buy in order to prevent that, and as soon as they stop buying those assets, US Government securities, the dollar falls further. The build-up of reserves has, I think, been partly intentional and partly accidental. It might be wise to dispose of them but the disposing of them pushes down the dollar further, so it is a very difficult situation they have got themselves into. They may have started that disposal now; it is impossible for us to know that.
Q43 Mr Fallon: Finally, from me to Dr Lyons: what else do the Chinese need to do if they are to move to a more flexible exchange rate?
Dr Lyons: I was just going to add, on the previous question, that it is interesting to notice that a decade ago Asian central banks held one-third of global currency reserves, and now they hold two-thirds of global currency reserves. It is not just the Chinese, it is across the whole region. Ray is completely correct, after the Asia economic crisis I think South Korea used the phrase: "We were solvent but not liquid." Countries decided to build up reserves to add liquidity, then they decided to keep their currencies competitive. So there is a valid economic reason, and the Bank for International Settlements, particularly in Hong Kong, has done a lot of work that says that maybe these countries have not reached yet the ideal level of currency reserves. There has been passive diversification. You can look at the amount the US Treasury has bought as a percentage of the increase in reserves, so these central banks have not yet sold dollars but they now put less of their new money into dollars than before. So it is passive, not active, diversification. What does China need to do? I think what they need to do is move gradually. The way I describe it is in three stages: within that, first, they need to move to a wider band; second I would suggest that they need to move to a trade-weighted currency basket and, third, they need to then clearly float. To get to the third stage you need to have convertibility on your capital account, but maybe what is more relevant for the current debate is what you need for the first and second stages. You need to have effective hedging mechanisms in place for companies within China to be able to hedge future currency exposures. Also, you need to be able to make sure that people can trade the currency and that domestic banks who previously had been used to a peg can cope with more flexibility in the currency. So the bottom line is you need to introduce more liberalisation into your domestic financial system. As I say, it is very important that China moves gradually. As I say, it is a three-stage process, and in terms of helping that process (coming back to your question) it is very much a case of introducing liberalisation so that not only the financial sector but also the domestic corporate sector can cope.
Q44 John Mann: What are the biggest opportunities in the next 15 years for UK plc, in terms of China?
Dr Yueh: It is services. Currently the UK runs a trade deficit with China in manufacturing, but it actually runs a trade surplus in services. The recent movement of Chinese firms to raise capital overseas provides more opportunities for trade in that they are seeking financial expertise and expertise in corporate governance matters. These are areas in which the UK is well-placed to help. I think that is going to be what we see in the next 15 years.
Mr Nightingale: Certainly from what we see now, in terms of the growth and interest of British companies in China, the majority of these companies are small and medium-sized and the majority are in service-type sectors. High-tech and other service sectors, I think, will be the future for firms in this country.
Dr Lyons: I would just highlight two areas. First, we need to make sure that the UK is an attractive place for inward investments. In the last decade, when the Japanese invested heavily in the UK, it was not just in terms of setting up manufacturing plans, it was research, design and development, and I think the UK, particularly given its educational expertise, should be attractive in that respect. The second area is, clearly, and I see it directly from my own field, the financial sector. British banks, the British financial sector, has phenomenal opportunities because as the Chinese economy evolves the financial sector in China will become much bigger and this is where the UK still has one of its main competitive advantages. We, as a bank, have been in China 146 years, but the interesting thing is that it is going to be an attractive place for new banks to go into as well. So those are at least two points which reinforce what Peter and Linda have mentioned.
Q45 John Mann: What are the key barriers?
Dr Yueh: The service sector in China is opening very quickly, in a sense. The WTO accession terms means that China is going to liberalise financial services, banking, insurance, education and law - it has been described as breathtaking - but the agreement to do so does not necessarily mean that it is going to do so quickly. So, for instance, you are going to find that one of the main barriers will still be geographic because the nature of the decentralised system in China is that provinces have a great deal of control over economic investments into their areas. The breaking down of those barriers within China will take time. They are beginning to do so, such as the creation of the Pan Pearl River Delta, which is intended to link the southern provinces with Hong Kong and Macau. So there are moves to reduce some of these barriers, but I think some of the other barriers are the ones that we have seen: the infancy of the legal system, a lack of enforcement of property rights, and lack of transparency and regulatory structure. I might add, on the last point, there are very few things within WTO rules on international economic law that are truly enforceable, and transparency is actually one of them. If the laws of an accession member state are not transparent that is actually grounds to bring action, and I think for that reason we will see improvements in terms of these barriers.
Mr Nightingale: I think another barrier is lack of knowledge in this country. We still need to have a lot of education in this country about the opportunities in China and how actually we get into China.
Q46 John Mann: Who is "we"?
Mr Nightingale: UK plc. The China-British Business Council, the Government - a number of different organisations - but we do need to increase.
Q47 John Mann: Let us take the China-British Business Council as an example, then. How does your grant compare to competitor bodies from other countries?
Mr Nightingale: I cannot give you an answer to that because I do not think we know, but we certainly feel that we need to be reaching out more in our own regions in the UK so that we reach more companies to tell them about what the opportunities in China are, and we need to be able to help those countries when they get to China - ie, we need to have more reach in China itself.
Q48 John Mann: Who has got the most effective trade body in China? Is it us?
Mr Nightingale: I think we are quite competitive. There is no doubt that the countries that are closest to China, the Hong Kong people, the South Koreans, the Taiwanese and the Japanese, of course, have huge advantages in terms of the network that they have with China already.
Q49 John Mann: Mr Barrell, how are we placed?
Mr Barrell: How we are placed depends on what we produce. I think the places where Europeans can enter the Chinese market effectively are in things like telecommunications equipment of various sorts. Investment goods are sought; a lot of German companies have been successful, and the Finns have been very successful in telecommunications. The other area, perhaps, more relevant for the UK is aerospace. Those are the things that do travel long distances. We are a reasonable producer of aerospace products (that is aeroplanes). We may find that we can increase share there, but the goods that we tend to produce are not the goods that the Chinese are particularly demanding at the minute. This is not necessarily a bad thing. If the Germans sell goods to the Chinese they then import goods from the British, but at the minute it is investment goods (which is particularly Japan and Germany) and telecommunication goods (which is, to an extent, the UK but much more Finland, Sweden and Japan). So there are certain countries that are producing the goods that this economy needs. One must remember, for instance, there are some very interesting things the Chinese can do, they can leap the whole of the existence of the fixed line telephone system and move the economy over to small handset telecommunications. That is not something where we are particularly strong. So there are opportunities there, but they are not necessarily our opportunities.
Q50 John Mann: What about nuclear technology?
Mr Barrell: That is beyond my ability to comment, I am afraid.
Q51 John Mann: Do the Chinese want to build lots of nuclear power stations? We are quite good at doing that.
Mr Nightingale: I think they do, but it tends to be French technology that they use, or even, in today's newspaper, it appears to be their own technology and South African technology that they are developing.
Q52 John Mann: But why?
Mr Nightingale: I suspect because that is more advanced.
Q53 John Mann: Dr Lyons, who is better than us in terms of our trade bodies and missions? Where are we in the league tables, in terms of ----
Dr Lyons: I do not know about that aspect, but in terms of the trade figures this touches on some of Mr Barrell's point about the capital demands from China. In terms of the league table, Britain does not export as much as Germany or France to China, which is quite interesting. I think, the last time I looked at the figures, even though our value of trade to China is going up, our competitive positioning is maybe not as high as we would like it to be. By default we have moved out of a lot of manufacturing sectors. I think the key point is, really, coming back to the Treasury's own document, that the UK needs to be flexible, innovative and entrepreneurial. The question we have to ask ourselves is: are we as innovative, flexible and entrepreneurial as we should be? We need to make sure that policies are in place to ensure that we are.
Q54 Chairman: Just a few questions to wind up with. The weakness of the Chinese banking system has been mentioned. How long do you think it will be before the Chinese financial system is operating on a solid, sustainable basis? Is full Western access to the Chinese financial markets likely to have to wait until that exercise has been completed? Any one person on that?
Dr Lyons: As a banker, I think it is important to stress that the Chinese financial sector has clearly started to improve. The creation of the Chinese Banking Regulator and Commission in 2003 under Liu Mingkang has had a big impact. There is now a sounder supervisory system; the banking network is improving and foreign banks are bringing expertise in terms of necessary expertise into the sector. The important point is to have some sort of patience. The pace of change could take far longer. When you meet regulators and people at the centre in China their expertise is phenomenal, but we have to accept that China is a very diverse economy, and the changes will take a long time.
Q55 Chairman: On that point, are Chinese regulators playing a major role in slowing the entry of overseas players into the Chinese financial services market?
Dr Lyons: As Standard Chartered, we have just bought a 20 % stake in Bohai Bank, we have worked with the Chinese authorities and we have seen other foreign banks buy stakes in the Chinese banking sector, so there is nothing to suggest that they are slowing it. If you look at the data, the number of foreign banks which have set up positions in China is increasing. I think a lesson from the Asian financial crisis is very valid here: economies across Asia opened up their financial sectors extensively in 1997, and the lesson from that is that you need to change your financial sector at a pace best suited to your domestic economic needs.
Q56 Chairman: The Deputy Prime Minister's China Task Force recently identified five key areas - energy, financial services, water, health care and ICT - in terms of building UK commercial links with China. Is that list exhaustive or are there any other areas that you think should be on the list that demand equal focus? Education and legal services have been mentioned.
Dr Yueh: I think education is important. I think there are quite a few other areas where I would like to see more collaboration, but I think legal education is another one - clinical legal education - extending the type of system and expertise that we have gained over the years. I think, also, research and development. That could fall within the ICT sphere, but research and development can actually be broader. I think that is another important area where there could be a good sharing of expertise.
Mr Nightingale: I do not think these are meant to be exhaustive, and water is partly environmental, I suppose, but the whole environmental sector is a very big sector for China, and I think we have some expertise there that we probably can do more with in China.
Q57 Chairman: The China Task Force stated that we need to combine and increase currently disconnected resources and deploy them more effectively in the UK and China. What is happening to tackle that problem? Will we wait till we get to China to ask that question?
Mr Nightingale: Probably that refers to the China-British Business Council and the way we work with the government services in China. One of the thrusts of that particular recommendation was to make sure that we do not overlap with them, that we demarcate the work that we do and the work that government does in China. We have made quite a lot of progress in doing that, and that is in the process of being implemented now. So the companies that want help in China know where to go to get it and they do not find that two organisations are doing the same sort of thing and, therefore, it is complicated or expensive to get that sort of help.
Q58 Chairman: Mervyn King, amongst others, has been talking about the reform of international institutions such as the G7, the IMF and the World Bank. Is there an equivalent pressure for change from China? What is the US view of reform in that area?
Dr Lyons: I do not know what the US view is. I think there is a regional aspect as well as a global aspect here. Within Asia, China is playing a much more important regional role, and we are seeing regional groupings become more important. The ASEAN + 3 (Association of South East Asian Nations plus the three, being Japan, South Korea and China) has become very important. Also, when one visits Asia it is very evident that APEC is becoming very important (the Asia Pacific area). Europe is seen as marginal. In terms of the global picture, I think there is very much a clear case for global institutions to change because if you are to address the big, growing economic issues of the future then you need to have membership that is able to address those. For instance, G7 needs to evolve to include the merging economic superpowers of China and, ultimately, India, particularly for currency issues. It is very difficult to push people off and a new forum may emerge, and G20 is seen as very important.
Q59 Chairman: Will there be G10, from a G7?
Dr Lyons: Whatever number you want.
Dr Yueh: The European Union, in geopolitical terms, is actually quite important for China. There have been declarations that China is very keen for the European Union to become if not its top trading partner then certainly a rival to the United States. I think we ought to see this as indeed a shift but there are political reasons why many countries may not want to be seen simply tied to the United States. I think, in terms of expanding something like the G7, there are economic reasons for doing so because China is already larger than half of its members, but there are also political reasons. When Russia was added as a member of the G8 in the 1990s it was due to a complex set of reasons, not because of its economic prowess. So I think, in terms of China's impact, and indeed some of the other economies' impact on world markets, if the G7 finance ministers or leaders need to discuss the global economy and these economies are having an effect, then I think there is a reason for including them in an increased grouping. What I think is actually harder is the question in terms of the United Nations Security Council. There is a lot more resistance to changing the constituency of that, but China is already a permanent member so it is not particularly relevant for China, but it is relevant in that it is thinking about how we reconstitute, who the major players are and how we define the major players. Is it just based on economic powers? Or, surely, there must also be other considerations for why we would want international fora to be representative of a wider set of countries.
Q60 Chairman: Vis-à-vis the US and EU, in relation to China, are we seeing the development of tensions in that area, maybe, starting to be highlighted by the possible lifting of the arms embargo by the EU? Will issues like that develop in the future, do you think?
Dr Lyons: Certainly the arms issue has been mentioned, both in terms of the US selling of arms to Taiwan and the arms embargo with Europe. I would not claim to be an expert on that. Also, energy was talked about earlier. There are quite a few areas where future tensions could be seen.
Q61 Chairman: Because of the growing development link between the EU and China?
Dr Lyons: And just the growing size of China. However, that should not be a surprise, in some respects.
Chairman: Can I thank you for your evidence this morning, it has been very helpful. I apologise for my absence for a while, but the Prime Minister called at the Liaison Committee so I had no option. Thank you very much.