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UPDATED: September 30, 2011 NO. 40 OCTOBER 6, 2011
Rebalancing Challenges

GLOBAL CURRENCY: The yuan has been rising rapidly in value against the U.S. dollar in recent months. Participants at the conference called for reforms to the financial sector, including interest rate and currency exchange rate regimes (GAO XINSHENG)

Sustainable growth drivers

Song Ligang, a senior researcher of Crawford School of Economics and Government, Australian National University

Thirty years of torrid growth has resulted in environment degradation and resource constraints in China. More disturbing though is domestic imbalance characterized by a current account surplus, income inequality, over-dependence on investments and exports, overcapacity in certain industrial sectors, as well as a shortage of service providers.

Now a key task for China is to alter the growth mode to rely more on productivity, instead of inputs. In a longer term, the goal is to transform the manufacturing and industrial powerhouse into a knowledge-based economy.

Enhancing productivity is a crucial component in shifting toward a low-carbon economy. Technological progress and innovation hold the key. There is huge potential for China to change the relationship between economic output and carbon emissions through the absorption, mass production and improvement of green technologies. The government can play a crucial role in ensuring that China reaches this potential, most importantly by facilitating the dynamic private sector's active engagement in this endeavor. A concerted effort to generate and commercialize green technologies would also enable China to quicken the pace of industrial upgrade.

Boosting domestic consumption will take time, but there are some clear reform options. For example, an effective way is to urbanize migrant workers by granting them urban residency, which would change their consumption behavior. Consumption can also be stimulated by deepening institutional reforms affecting labor mobility and the social security system.

Despite the current economic slowdown, the country has several long-term sources of growth, such as human capital and innovation and ideas.

Human capital is the asset that ultimately determines the wealth of China. As the Chinese people invest more in education and enterprises foster the creativeness of employees, the increased human capital will add to industrial productivity and economic vitality.

In the next decade, China will be of greater importance for the world economy. The reason is not that the country can contribute faster growth, but it can generate more ideas and innovations.

Insights from Japan

Ichiro Muto, director of the macro-modeling group, research and statistics department, Bank of Japan

China's growth has been heavily driven by investment, and excessive investments have side effects, which eventually may grow too large to control if the country fails to rebalance its growth pattern.

China is now roughly at the same stage of economic development as Japan during or prior to the early 1970s.

In the early 1970s, Japan transformed its growth mode from an investment-dependent one to one driven in a more balanced manner by investment, consumption and exports. The speed of capital accumulation decelerated while consumption continued increasing rapidly as a result of a steady rise in workers' wages. This shift laid the foundation for Japan to maintain a steady growth after the high-growth era in the 1960s.

Japan accomplished the rebalancing because its firms had less incentives to maintain high investment as returns on capital declined. There are a number of reasons for the decline, including a slowdown in technology advancement and the urbanization process. Moreover, the cost of capital increased as Japan raised interest rates in the 1970s, prompting companies to curtail investments.

In China, wage growth is accelerating due to reduction of surplus labor and a new labor law promulgated in 2008. But interest rates have been regulated far below the return on capital. If China fails to narrow the gap between the cost and return of capital, economic rebalancing will become even more difficult.

China also needs to address some unique problems hindering consumption. It must heighten welfare benefits and reform the household registration system to spur household consumption.

Japan's rebalancing was easier because its dependence on investments was much more modest. But China is more able to rebalance its economy while maintaining high growth. This will help China prevent many side effects such as a sluggish job market.

Reward and risks

Liu Ligang, Director of China Economic Research, ANZ Bank

As the U.S. dollar reels from increasing volatility, worries abounded about the safety of China's dollar assets, prompting the country to push forward internationalization of the yuan. To achieve that, China needs to open its capital accounts and strengthen convertibility of the yuan.

Opening capital accounts means removing restrictions on capital account-related transactions including FDI, portfolio equity investments, government and corporate bonds and financial derivatives.

Before China opens the capital accounts, it must first undertake domestic financial liberalization. Risks would emerge otherwise.

Domestic financial liberalization involves efforts to liberalize interest rates and reduce entry barriers into financial sectors.

Two possible risks may loom over the Chinese economy:

First, as China allows offshore renminbi deposits in Hong Kong to return to the mainland, the massive capital flows have the potential to complicate China's efforts to combat inflation.

Second, market-based interest rates in Hong Kong and state-controlled interest rates on China's mainland have provided arbitrage opportunities for speculators. This poses a daunting threat to the country's financial stability.

Controls on interest rates also have negative impacts on the growth momentum because households are not appropriately compensated for their savings. Moreover, banks become less motivated to improve their intermediary services and management efficiency. Moreover, market-determined interest rates could be an effective barometer of macroeconomic and liquidity conditions.

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