At the very heart of the American idea is the notion that, unlike in other places, we can start from nothing and through hard work have everything. That nothing we can imagine is beyond our reach. That we will pull up stakes, go anywhere, do anything to make our dreams come true. But what if that's just a myth? What if the truth is something very different? What if we are…stuck?

I. What does it mean to be an American?

Full disclosure: I'm British. Partial defense: I was born on the Fourth of July. I also have made my home here, because I want my teenage sons to feel more American. What does that mean? I don't just mean waving flags and watching football and drinking bad beer. (Okay, yes, the beer is excellent now; otherwise, it would have been a harder migration.) I'm talking about the essence of Americanism. It is a question on which much ink—and blood—has been spent. But I think it can be answered very simply: To be American is to be free to make something of yourself. An everyday phrase that's used to admire another ("She's really made something of herself") or as a proud boast ("I'm a self-made man!"), it also expresses a theological truth. The most important American-manufactured products are Americans themselves. The spirit of self-creation offers a strong and inspiring contrast with English identity, which is based on social class. In my old country, people are supposed to know their place. British people, still constitutionally subjects of Her Majesty Queen Elizabeth, can say things like "Oh, no, that's not for people like me." Infuriating.

Americans do not know their place in society; they make their place. American social structures and hierarchies are open, fluid, and dynamic. Mobility, not nobility. Or at least that's the theory. Here's President Obama, in his second inaugural address: "We are true to our creed when a little girl born into the bleakest poverty knows that she has the same chance to succeed as anybody else because she is an American; she is free, and she is equal, not just in the eyes of God but also in our own."

Politicians of the left in Europe would lament the existence of bleak poverty. Obama instead attacks the idea that a child born to poor parents will inherit their status. "The same chance to succeed as anybody else because she is an American…."

Americanism is a unique and powerful cocktail, blending radical egalitarianism (born equal) with fierce individualism (it's up to you): equal parts Thomas Paine and Horatio Alger. Egalitarian individualism is in America's DNA. In his original draft of the Declaration of Independence, Thomas Jefferson wrote that "men are created equal and independent," a sentiment that remained even though the last two words were ultimately cut. It was a declaration not only of national independence but also of a nation of independents.

The problem lately is not the American Dream in the abstract. It is the growing failure to realize it. Two necessary ingredients of Americanism—meritocracy and momentum—are now sorely lacking.

America is stuck.

Almost everywhere you look—at class structures, Congress, the economy, race gaps, residential mobility, even the roads—progress is slowing. Gridlock has already become a useful term for political inactivity in Washington, D. C. But it goes much deeper than that. American society itself has become stuck, with weak circulation and mobility across class lines. The economy has lost its postwar dynamism. Racial gaps, illuminated by the burning of churches and urban unrest, stubbornly persist.

In a nation where progress was once unquestioned, stasis threatens. Many Americans I talk to sense that things just aren't moving the way they once were. They are right. Right now this prevailing feeling of stuckness, of limited possibilities and uncertain futures, is fueling a growing contempt for institutions, from the banks and Congress to the media and big business, and a wave of antipolitics on both left and right. It is an impotent anger that has yet to take coherent shape. But even if the American people don't know what to do about it, they know that something is profoundly wrong.

II. How stuck are we?

Let's start with the most important symptom: a lack of social mobility. For all the boasts of meritocracy—only in America!—Americans born at the bottom of the ladder are in fact now less likely to rise to the top than those situated similarly in most other nations, and only half as likely as their Canadian counterparts. The proportion of children born on the bottom rung of the ladder who rise to the top as adults in the U.S. is 7.5 percent—lower than in the U.K. (9 percent), Denmark (11.7), and Canada (13.5). Horatio Alger has a funny Canadian accent now.

It is not just poverty that is inherited. Affluent Americans are solidifying their own status and passing it on to their children more than the affluent in other nations and more than they did in the past. Boys born in 1948 to a high-earning father (in the top quarter of wage distribution) had a 33 percent chance of becoming a top earner themselves; for those born in 1980, the chance of staying at the top rose sharply to 44 percent, according to calculations by Manhattan Institute economist Scott Winship. The sons of fathers with really high earnings—in the top 5 percent—are much less likely to tumble down the ladder in the U. S. than in Canada (44 percent versus 59 percent). A "glass floor" prevents even the least talented offspring of the affluent from falling. There is a blockage in the circulation of the American elite as well, a system-wide hardening of the arteries.

Exhibit A in the case against the American political elites: the U. S. tax code. To call it Byzantine is an insult to medieval Roman administrative prowess. There is one good reason for this complexity: The American tax system is a major instrument of social policy, especially in terms of tax credits to lower-income families, health-care subsidies, incentives for retirement savings, and so on. But there are plenty of bad reasons, too—above all, the billions of dollars' worth of breaks and exceptions resulting from lobbying efforts by the very people the tax system favors.

So fragile is the American political ego that we can't go five minutes without congratulating ourselves on the greatness of our system, yet policy choices exacerbate stuckness.

The American system is also a weak reed when it comes to redistribution. You will have read and heard many times that the United States is one of the most unequal nations in the world. That is true, but only after the impact of taxes and benefits is taken into account. What economists call "market inequality," which exists before any government intervention at all, is much lower—in fact it's about the same as in Germany and France. There is a lot going on under the hood here, but the key point is clear enough: America is unequal because American policy moves less money from rich to poor. Inequality is not fate or an act of nature. Inequality is a choice.

These are facts that should shock America into action. For a nation organized principally around the ideas of opportunity and openness, social stickiness of this order amounts to an existential threat. Although political leaders declare their dedication to openness, the hard issues raised by social inertia are receiving insufficient attention in terms of actual policy solutions. Most American politicians remain cheerleaders for the American Dream, merely offering loud encouragement from the sidelines, as if that were their role. So fragile is the American political ego that we can't go five minutes without congratulating ourselves on the greatness of our system, yet policy choices exacerbate stuckness and ensure decline.

In Britain (where stickiness has historically been an accepted social condition), by contrast, the issues of social mobility and class stickiness have risen to the top of the political and policy agenda. In the previous U.K. government (in which I served as director of strategy to Nick Clegg, the deputy prime minister), we devoted whole Cabinet meetings to the problems of intergenerational mobility and the development of a new national strategy. (One result has been a dramatic expansion in pre-K education and care: Every 3- and 4-year-old will soon be entitled to 30 hours a week for free.) Many of the Cabinet members were schooled at the nation's finest private high schools. A few had hereditary titles. But they pored over data and argued over remedies—posh people worrying over intergenerational income quintiles.

Why is social mobility a hotter topic in the old country? Here is my theory: Brits are acutely aware that they live in a class-divided society. Cues and clues of accent, dress, education, and comportment are constantly calibrated. But this awareness increases political pressure to reduce these divisions. In America, by contrast, the myth of classlessness stands in the way of progress. The everyday folksiness of Americans—which, to be clear, I love—serves as a social camouflage for deep economic inequality. Americans tell themselves and one another that they live in a classless land of open opportunity. But it is starting to ring hollow, isn't it?

III. For black Americans, claims of equal opportunity have, of course, been false from the founding.

They remain false today. The chances of being stuck in poverty are far, far greater for black kids. Half of those born on the bottom rung of the income ladder (the bottom fifth) will stay there as adults. Perhaps even more disturbing, seven out of ten black kids raised in middle-income homes (i.e., the middle fifth) will end up lower down as adults. A boy who grows up in Baltimore will earn 28 percent less simply because he grew up in Baltimore: In other words, this supersedes all other factors. Sixty-six percent of black children live in America's poorest neighborhoods, compared with six percent of white children.

Recent events have shone a light on the black experience in dozens of U. S. cities.

Behind the riots and the rage, the statistics tell a simple, damning story. Progress toward equality for black Americans has essentially halted. The average black family has an income that is 59 percent of the average white family's, down from 65 percent in 2000. In the job market, race gaps are immobile, too. In the 1950s, black Americans were twice as likely to be unemployed as whites. And today? Still twice as likely.

From heeding the call "Go west, young man" to loading up the U-Haul in search of a better job, the instinctive restlessness of America has always matched skills to work, people to opportunities, labor to capital.

Race gaps in wealth are perhaps the most striking of all. The average white household is now thirteen times wealthier than the average black one. This is the widest gap in a quarter of a century. The recession hit families of all races, but it resulted in a wealth wipeout for black families. In 2007, the average black family had a net worth of $19,200, almost entirely in housing stock, typically at the cheap, fragile end of the market. By 2010, this had fallen to $16,600. By 2013—by which point white wealth levels had started to recover—it was down to $11,000. In national economic terms, black wealth is now essentially nonexistent.

Half a century after the passing of the Civil Rights Act, the arc of history is no longer bending toward justice. A few years ago, it was reasonable to hope that changing attitudes, increasing education, and a growing economy would surely, if slowly, bring black America and white America closer together. No longer. America is stuck.

IV. The economy is also getting stuck.

Labor productivity growth, measured as growth in output per hour, has averaged 1.6 percent since 1973. Male earning power is flatlining. In 2014, the median full-time male wage was $50,000, down from $53,000 in 1973 (in the dollar equivalent of 2014). Capital is being hoarded rather than invested in the businesses of the future. U. S. corporations have almost $1.5 trillion sitting on their balance sheets, and many are busily buying up their own stock. But capital expenditure lags, hindering the economic recovery.

New-business creation and entrepreneurial activity are declining, too. As economist Robert Litan has shown, the proportion of "baby businesses" (firms less than a year old) has almost halved since the late 1970s, decreasing from 15 percent to 8 percent—the hallmark of "a steady, secular decline in business dynamism." It is significant that this downward trend set in long before the Great Recession hit. There is less movement between jobs as well, another symptom of declining economic vigor.

Americans are settling behind their desks—and also into their neighborhoods. The proportion of American adults moving house each year has decreased by almost half since the postwar years, to around 12 percent. Long-distance moves across state lines have as well. This is partly due to technological advances, which have weakened the link between location and job prospects, and partly to the growth of economic diversity in cities; there are few "one industry" towns today. But it is also due to a less vibrant housing market, slower rates of new business creation, and a lessening in Americans' appetite for disruption, change, and risk.

This geographic settling is at odds with historic American geographic mobility. From heeding the call "Go west, young man" to loading up the U-Haul in search of a better job, the instinctive restlessness of America has always matched skills to work, people to opportunities, labor to capital. Rather than waiting for help from the government, or for the economic tide to turn back in their favor, millions of Americans changed their life prospects by changing their address. Now they are more likely to stay put and wait. Others, especially black Americans, are unable to escape the poor neighborhoods of their childhood. They are, as the title of an influential book by sociologist Patrick Sharkey puts it, Stuck in Place.

There are everyday symptoms of stuckness, too. Take transport. In 2014, Americans collectively spent almost seven billion hours stuck motionless in traffic—that's a couple days each. The roads get more jammed every year. But money for infrastructure improvements is stuck in a failing road fund, and the railophobia of politicians hampers investment in public transport.

Whose job is it to do something about this? The most visible symptom of our disease is the glue slowly hardening in the machinery of national government. The last two Congresses have been the least productive in history by almost any measure chosen, just when we need them to be the most productive. The U. S. political system, with its strong separation among competing centers of power, relies on a spirit of cross-party compromise and trust in order to work. Good luck there.

V. So what is to be done?

As with anything, the first step is to admit the problem. Americans have to stop convincing themselves they live in a society of opportunity. It is a painful admission, of course, especially for the most successful. The most fervent believers in meritocracy are naturally those who have enjoyed success. It is hard to acknowledge the role of good fortune, including the lottery of birth, when describing your own path to greatness.

There is a general reckoning needed. In the golden years following World War II, the economy grew at 4 percent per annum and wages surged. Wealth accumulated. The federal government, at the zenith of its powers, built interstates and the welfare system, sent GIs to college and men to the moon. But here's the thing: Those days are gone, and they're not coming back. Opportunity and growth will no longer be delivered, almost automatically, by a buoyant and largely unchallenged economy. Now it will take work.

The future success of the American idea must now be intentional.

Entrepreneurial, mobile, aspirational: New Americans are true Americans. We need a lot more of them.

There are plenty of ideas for reform that simply require will and a functioning political system. At the heart of them is the determination to think big again and to vigorously engage in public investment. And we need to put money into future generations like our lives depended on it, because they do: Access to affordable, effective contraception dramatically cuts rates of unplanned pregnancy and gives kids a better start in life. Done well, pre-K education closes learning gaps and prepares children for school. More generous income benefits stabilize homes and help kids. Reading programs for new parents improve literacy levels. Strong school principals attract good teachers and raise standards. College coaches help get nontraditional students to and through college. And so on. We are not lacking ideas. We are lacking a necessary sense of political urgency. We are stuck.

But we can move again if we choose.

In addition to a rejuvenation of policy in all these fields, there are two big shifts required for an American twenty-first-century renaissance: becoming open to more immigration and shifting power from Washington to the cities.

VI. America needs another wave of immigration.

This is in part just basic math: We need more young workers to fund the old age of the baby boomers. But there is more to it than that. Immigrants also provide a shot in the arm to American vitality itself. Always have, always will. Immigrants are now twice as likely to start a new business as native-born Americans. Rates of entrepreneurialism are declining among natives but rising among immigrants.

Immigrant children show extraordinary upward-mobility rates, shooting up the income-distribution ladder like rockets, yet by the third or fourth generation, the rates go down, reflecting indigenous norms. Among children born in Los Angeles to poorly educated Chinese immigrants, for example, an astonishing 70 percent complete a four-year-college degree. As the work of my Brookings colleague William Frey shows, immigrants are migrants within the U. S., too, moving on from traditional immigrant cities—New York, Los Angeles—to other towns and cities in search of a better future. Entrepreneurial, mobile, aspirational: New Americans are true Americans. We need a lot more of them.

This makes a mockery of our contemporary political "debates" about immigration reform, which have become intertwined with race and racism. Some Republicans tap directly into white fears of an America growing steadily browner. More than four in ten white seniors say that a growing population of immigrants is a "change for the worse"; half of white boomers believe immigration is "a threat to traditional American customs and values." But immigration delves deeper into the question of American identity than it does even issues of race. Immigrants generate more dynamism and aspiration, but they are also unsettling and challenging. Where this debate ends will therefore tell us a great deal about the trajectory of the nation. An America that closes its doors will be an America that has chosen to settle rather than grow, that has allowed security to trump dynamism.

VII. The second big shift needed to get America unstuck is a revival of city and state governance.

Since the American Dream is part of the national identity, it seems natural to look to the national government to help make it a reality. But cities are now where the American Dream will live or die. America's hundred biggest metros are home to 67 percent of the nation's population and 75 percent of its economy. Americans love the iconography of the small town, even at the movies—but they watch those movies in big cities.

Powerful mayors in those cities have greater room for maneuvering and making an impact than the average U. S. senator. Even smaller cities and towns can be strongly influenced by their mayor.

There are choices to be made. Class divisions are hardening. Upward mobility has a very weak pulse. Race gaps are widening.

The new federalism in part is being born of necessity. National politics is in ruins, and national institutions are weakened by years of short-termism and partisanship. Power, finding a vacuum in D. C., is diffusive. But it may also be that many of the big domestic-policy challenges will be better answered at a subnational level, because that is where many of the levers of change are to be found: education, family planning, housing, desegregation, job creation, transport, and training. Amid the furor over Common Core and federal standards, it is important to remember that for every hundred dollars spent on education, just nine come from the federal government.

We may be witnessing the end of many decades of national-government dominance in domestic policy-making (the New Deal, Social Security, Medicare, welfare reform, Obamacare). The Affordable Care Act is important in itself, but it may also come to have a place in history as the legislative bookend to a long period of national-policy virtuosity.

The case for the new federalism need not be overstated. There will still be plenty of problems for the national government to fix, including, among the most urgent, infrastructure and nuclear waste. The main tools of macroeconomic policy will remain the Federal Reserve and the federal tax code. But the twentieth-century model of big federal social-policy reforms is in decline. Mayors and governors are starting to notice, and because they don't have the luxury of being stuck, they are forced to be entrepreneurs of a new politics simply to survive.

VIII. It is possible for America to recover its earlier dynamism, but it won't be easy.

The big question for Americans is: Do you really want to? Societies, like people, age. They might also settle down, lose some dynamism, trade a little less openness for a little more security, get a bit stuck in their ways. Many of the settled nations of old Europe have largely come to terms with their middle age. They are wary of immigration but enthusiastic about generous welfare systems and income redistribution. Less dynamism, maybe, but more security in exchange.

America, it seems to me, is not made to be a settled society. Such a notion runs counter to the story we tell ourselves about who we are. (That's right, we. We've all come from somewhere else, haven't we? I just got here a bit more recently.) But over time, our narratives become myths, insulating us from the truth. For we are surely stuck, if not settled. And so America needs to decide one way or the other. There are choices to be made. Class divisions are hardening. Upward mobility has a very weak pulse. Race gaps are widening. The worst of all worlds threatens: a European class structure without European welfare systems to dull the pain.

Americans tell themselves and the world that theirs is a society in which each and all can rise, an inspiring contrast to the hereditary cultures from which it sprang. It's one of the reasons I'm here. But have I arrived to raise my children here just in time to be stuck, too? Or will America be America again?

Editor's note: This piece originally appeared in Esquire.

      

Baltimore police officer Edward Nero, one of six being tried separately in relation to the arrest and death of Freddie Gray, has been acquitted on all counts. The outcome for officer Nero was widely expected, but officials are nonetheless aware of the level of frustration and anger that remains in the city. Mayor Stephanie Rawlings Blake said: "We once again ask the citizens to be patient and to allow the entire process to come to a conclusion."

Since Baltimore came to national attention, Brookings scholars have probed the city’s challenges and opportunities, as well addressing broader questions of place, race and opportunity.

• In this podcast, Jennifer Vey describes how, for parts of Baltimore, economic growth has been largely a spectator sport: "1/5 people in Baltimore lives in a neighborhood of extreme poverty, and yet these communities are located in a relatively affluent metro area, in a city with many vibrant and growing neighborhoods."
• Vey and her colleague Alan Berube, in this piece on the "Two Baltimores," reinforce the point about the distribution of economic opportunity and resources in the city:
  

  In 2013, 40,000 Baltimore households earned at least $100,000. Compare that to Milwaukee, a similar-sized city where only half as many households have such high incomes. As our analysis uncovered, jobs in Baltimore pay about $7,000 more on average than those nationally. The increasing presence of high-earning households and good jobs in Baltimore City helps explain why, as the piece itself notes, the city’s bond rating has improved and property values are rising at a healthy clip."

• Groundbreaking work by Raj Chetty, which we summarized here, shows that Baltimore City is the worst place for a boy to grow up in the U.S. in terms of their likely adult earnings:

• Here Amy Liu offered some advice to the new mayor of the city: "I commend the much-needed focus on equity but…the mayoral candidates should not lose sight of another critical piece of the equity equation: economic growth."
• Following an event focused on race, place and opportunity, in this piece I drew out "Six policies to improve social mobility," including better targeting of housing vouchers, more incentives to build affordable homes in better-off neighborhoods, and looser zoning restrictions.
• Frederick C. Harris assessed President Obama’s initiative to help young men of color, "My Brother’s Keeper," praising many policy shifts and calling for a renewed focus on social capital and educational access. But Harris also warned that rhetoric counts and that a priority for policymakers is to "challenge some misconceptions about the shortcomings of black men, which have become a part of the negative public discourse."
• Malcolm Sparrow has a Brookings book on policing reform, "Handcuffed: What Holds Policing Back, and the Keys to Reform" (there is a selection here on Medium). Sparrow writes:
  

  Citizens of any mature democracy can expect and should demand police services that are responsive to their needs, tolerant of diversity, and skillful in unraveling and tackling crime and other community problems. They should expect and demand that police officers are decent, courteous, humane, sparing and skillful in the use of force, respectful of citizens’ rights, disciplined, and professional. These are ordinary, reasonable expectations."

Five more police officers await their verdicts. But the city of Baltimore should not have to wait much longer for stronger governance, and more inclusive growth.

      

“A society of equals is a society in which disadvantages do not cluster,” say Jonathan Wolff and Avner de-Shalit in their book Disadvantage. Low income matters greatly in itself, of course. But it also matters because it brings other difficulties along with it, like poor health and/or a lack of health insurance. An important goal of policy is to “de-cluster” these disadvantages.  

Increased health insurance coverage has had a modest impact on access

In recent years, the State of Colorado, embracing and going beyond the Affordable Care Act, has increased health insurance coverage, especially among low-income residents. Between 2009 and 2015, the proportion of Coloradans with annual family incomes below $30,000 who were uninsured fell from one in four to one in ten.

Clearly this is good news. But the expansion of insurance has so far had a modest impact on healthcare utilization, at least according to the Colorado Health Access Survey. The Survey includes questions such as, “Have you visited a health care professional or health care facility in the past 12 months?,” and “Was there any time that you did not get doctor care that you needed because of cost?” On these and similar questions, there was relatively little change between 2009 and 2015.

Why didn’t improved health insurance coverage lead to increased use of health care resources? It may be that the survey questions simply aren’t capturing improvements in utilization rates. A more detailed study of the ACA expansion in Oregon did find an increase in utilization, along with improvements on a number of financial hardship indicators. The Colorado survey does seem to suggest financial improvement: the share of low-income white residents that reported trouble paying medical bills fell by just over 3 percentage points from 2009 to 2015; for minority residents the figure was just over 6 percentage points. It’s hard to know, however, how much of this trend is driven by the stronger economy, and how much is driven by the ACA expansion. It is also possible that people are now able to access more appropriate care, for instance using primary care, rather than resorting to the emergency room.

Dental care coverage means most low-income Coloradans now visit the dentist

Utilization rates have clearly increased in one area, however: dental health. Medicaid covers dental care for children, so Colorado’s Medicaid expansion increased the number of children in the state with government-sponsored dental insurance. In 2014, Colorado also became one of the few states to introduce limited adult dental coverage. As a result of these policy reforms, the share of low-income Coloradans with insurance for dental care has increased sharply:

Over the same time period, the proportion of low-income Coloradans who visited a dentist—especially minorities—increased, too:

Better living through dentistry

Dentistry is an important part of the health care system, and dental disease is a serious health issue. Four in ten poor Americans suffer from untreated tooth decay, according to some researchers. Better dental care helps low-income people in a range of ways, from avoiding emergency rooms, to having healthier pregnancies, and even succeeding in the job market. The dramatic improvements in dental coverage and dental care in Colorado show that the connection between policy reforms and improved quality of life can sometimes be quite straightforward. 

      

As every good teacher knows, education is not just about academics. It is about broadening horizons and discovering passions. (The root of education is the Latin e ducere, meaning “to draw out.”) From this perspective, extra-curricular activities count for a great deal. But as Robert Putnam highlights in his book Our Kids, there are growing class gaps in the availability of music, sports, and other non-classroom activities.

Fewer field trips?

Schools under pressure may also cut back on field trips outside the school walls to parks, zoos, theaters, or museums. In the 2008-09 school year, 9 percent of school administrators reported eliminating field trips, according to the annual surveys by the American Association of School Administrators (AASA). That figure rose through the recession:

Just 12 percent of the administrators surveyed about 2015-16 said they had brought back their field trips to pre-recession levels. Museums around the country report hosting fewer students, from Los Angeles and Sarasota, to Minneapolis, and Columbia, Missouri. None of this is definitive proof of a decline in field trips, since we are relying on a single survey question. But it suggests a downward trend in recent years.

Museums help with science tests

If some children are missing out on field trips, does it matter? They may be nice treats, but do they have any real impact, especially when they take time away from traditional learning? There is some evidence that they do.

Middle school children with the chance to go on a field trip score higher on science tests, according to a 2015 study by Emilyn Ruble Whitesell.

She studied New York City middle schools with teachers in Urban Advantage, a program that gives science teachers additional training and resources—as well as vouchers for visiting museums. In some schools, the Urban Advantage teachers used the field trip vouchers more than others. Whitesell exploits this difference in her study, and finds that attending a school with at least 0.25 trips per student increased 8^th grade scores by 0.026 standard deviations (SD). The odds of a student passing the exam improved by 1.2 percentage points. There were bigger effects for poor students, who saw a 0.043 SD improvement in test scores, and 1.9 percentage point increase in exam pass rates.

Art broadens young minds

Students visiting an art museum show statistically significant increases in critical thinking ability and more open-minded attitudes, according to a randomized evaluation of student visits to the Crystal Bridges Museum in northwest Arkansas. One example: those who visited the museum more often agreed with statements like: “I appreciate hearing views different from my own” and “I think people can have different opinions about the same thing.” The effects are modest. But the intervention (a single day at the museum) is, too. Again, there were larger effects for poor students:

All this needs to be put in perspective. In comparison with the challenge of closing academic gaps and quality teaching, field trips are small beer. But schools create citizens as well as undergraduates and employees. It matters, then, if we have allowed field trips to become a casualty of the great recession.

      

The Horatio Alger ideal of upward mobility has a strong grip on the American imagination (Reeves 2014). But recent years have seen growing concern about the distance between the rhetoric of opportunity and the reality of intergenerational mobility trends and patterns.

The related issues of equal opportunity, intergenerational mobility, and inequality have all risen up the agenda, for both scholars and policymakers. A growing literature suggests that the United States has fairly low rates of relative income mobility, by comparison to other countries, but also wide variation within the country. President Barack Obama has described the lack of upward mobility, along with income inequality, as “the defining challenge of our time.” Speaker Paul Ryan believes that “the engines of upward mobility have stalled.”

But political debates about equality of opportunity and social and economic mobility often provide as much heat as light. Vitally important questions of definition and motivation are often left unanswered. To what extent can “equality of opportunity” be read across from patterns of intergenerational mobility, which measure only outcomes? Is the main concern with absolute mobility (how people fare compared to their parents)—or with relative mobility (how people fare with regard to their peers)? Should the metric for mobility be earnings, income, education, well-being, or some other yardstick? Is the primary concern with upward mobility from the bottom, or with mobility across the spectrum?

In this paper, we discuss the normative and definitional questions that guide the selection of measures intended to capture “equality of opportunity”; briefly summarize the state of knowledge on intergenerational mobility in the United States; describe a new microsimulation model designed to examine the process of mobility—the Social Genome Model (SGM); and how it can be used to frame and measure the process, as well as some preliminary estimates of the simulated impact of policy interventions across different life stages on rates of mobility.

The three steps being taken in mobility research can be described as the what, the why, and the how. First, it is important to establish what the existing patterns and trends in mobility are. Second, to understand why they exist—in other words, to uncover and describe the “transmission mechanisms” between the outcomes of one generation and the next. Third, to consider how to weaken those mechanisms—or, put differently, how to break the cycles of advantage and disadvantage.

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• Download "Modeling Equal Opportunity"

      

Feminism needs fathers. Unless and until men and women share the responsibilities of parenting equally, gender parity in the labor market will remain out of reach.

As Isabel Sawhill and I argued in our piece on “Men’s Lib” for the New York Times, “The gender revolution has been a one-sided effort. We have not pushed hard enough to put men in traditionally female roles—that is where our priority should lie now.”

Dads on the home front: Paternity leave

An important step towards gender equality is then the provision of paternity leave, or at least forms of parental leave that can be taken up by fathers as well as mothers. Right now the U.S. is one of the few advanced nations with no dedicated leave for fathers:

But there are reasons to be hopeful. More companies are offering paternity leave or, like Amazon, a “leave bank” that parents can share between them. Hillary Clinton is promising to push for paid family leave if she wins in November. Recent studies of California’s paid leave scheme, introduced in 2004, suggest that there are significant benefits for fathers.

The number of fathers taking leave while the mother is in paid work rose by 50 percent, according to an analysis of the American Community Survey by Ann Bartel of Colombia and her colleagues.

Fathers of sons are more likely to take leave than those with daughters, suggesting that parents particularly value father-son bonding. Fathers were also very much more likely to take leave if they worked in occupations with a high share of female workers, indicating that workplace culture is also a big factor.

Men are more likely to take leave when it is exclusively available to them—with a so-called “use it or lose it” design—and when the period of leave is paid. The Quebec Parental Insurance Plan, for instance, which offers fathers three to five weeks at home with a child, resulted in a 250 percent increase father’s participation in parental leave.

Benefits of paternity leave

Of course, there are costs. Paid leave has to be funded: either through payroll taxes (as most Democrats including Senator Kirsten Gillibrand want), taxes on the wealthy (Clinton’s preferred approach), or tax breaks for firms (as Marco Rubio has suggested).

So what are the upsides? Among the potential benefits from paternity leave are:

• A more equal division of labor in terms of parenting and childcare
• More equal sharing of domestic labor, including housework
• Less stress on the family
• Closer father-infant bonding
• Higher pay for mothers (according to a study in Sweden, future income for new mothers rises by 7 percent on average for every month of paternity leave taken by the father)

More than a day

Gender roles have evolved rapidly in recent decades, especially in terms of the place and status of women. But the evolution of our mental models of masculinity, and especially fatherhood, has been slower. Helping fathers to take time to care for their children will help children, families, and women. Fathers need more than a day.

       

British politics is starting to resemble a bowling alley. One after another, political figures are tumbling–including the leading lights of the Brexit campaign. They sowed the wind and now are reaping the whirlwind.

First to topple was the prime minister. After the referendum, David Cameron announced that he would step down. Last week fellow Conservative Boris Johnson, the leading light of the Brexit campaign, said he would not run to succeed Mr. Cameron after his ally Michael Gove, the justice secretary, concluded, in quintessentially British style, that Mr. Johnson lacked “the team captaincy” required. Then Nigel Farage stepped down as leader of the UK Independence Party, saying “I want my life back.” Labour Party leader Jeremy Corbyn has lost the support of his parliamentary colleagues and may be next to fall.

The exit of the leading Brexiteers is a relief. The skills required to run a populist, fact-averse campaign are not the same skills needed to lead a nation. For all his mercurial talents, on full display during his colorful stint as mayor of London, Boris Johnson would have been a disastrous prime minister. The alternatives–especially Mr. Gove and Home Secretary Theresa May–are steadier souls. Both are also better positioned to unite Conservative members of Parliament and hold on until the next scheduled general election, in 2020.

Mr. Corbyn is likely to go; the question really is when. It he doesn’t, the Labour Party will break apart. In his case the departure will be only slightly about the vote to remain in or leave the European Union. Broadly, his fellow Labour MPs didn’t want him as their leader in the first place; it was the votes of more left-wing party members that propelled him to the leadership, and many see him as an electoral liability. (He is.)

There is no direct connection between Brexit and Donald Trump. But a few things can still be deduced on this side of the pond. First, Mr. Trump may succeed in making the connection tighter. His immediate announcement that the vote was about “declaring independence” reflected his sharpening political instincts. The day after the vote, Mr. Trump said: “The people of the United Kingdom have exercised the sacred right of all free peoples. They have declared their independence from the European Union. … Come November, the American people will have the chance to re-declare their independence. Americans will have a chance to vote for trade, immigration and foreign policies that put our citizens first.”

Independence is a powerful populist theme, one Mr. Trump is likely to exploit it to its fullest.

Brexit and the economic and political chaos it has already sparked are proof that no matter how crazy or far-fetched an electoral outcome appears, it can happen. Right up to the last minute, many believed that even if the vote were close, it would be to remain in the EU. At some level we just couldn’t imagine the alternative. Maybe Mr. Cameron and Mr. Corybn felt the same, which is why they were so complacent. Not so, the other side.

All this suggests the wisdom of treating every poll with a fistful of salt. Electorates are becoming more volatile and more visceral. Pollsters are getting it wrong as often as they get it right. The last general election in the U.K. is another case in point. Populist sentiment wrecks standard political models. When people are angry, they don’t weigh the costs and benefits of their actions in the usual way; that’s true in life and it’s true in voting.

It’s also why it’s risky to allow populist campaigners near the levers of power. I’ve written in this space before about the dangers of injecting direct democracy in a parliamentary political system. Think of referendums as akin to Ming vases: something rare, to be handled with great care. The British Parliament is now acting as a firebreak. The leading populists will not get the keys to 10 Downing Street.

But the United States holds direct elections for president. If Donald Trump wins in November, he will assume the most powerful office in the world. There is no firebreak, no buffer, no second chance.

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Editor's note: This piece originally appeared on the Wall Street Journal's Washington Wire blog.

       

China's economy sailed through the financial crisis unscathed — at least in the short run.

When the global crisis hit, the country's government-owned banks started lending out lots more money. The money came largely from the savings accounts of ordinary Chinese people. It went largely to finance big construction projects, which helped keep China's economy growing.

"It sort of explains why China recovered so quickly," Hu Angang, an economist at Tsinghua University, told us. Indeed, China's strong showing through the crisis was seen by some as a vindication of the large role Chinese government plays in steering the country's economy.

But if it turns out China doesn't need all that new stuff it's building, the country will face an economic reckoning, says Michael Pettis, who teaches finance at Peking University in Beijing.

For Pettis, China's economic miracle is just the latest, largest version of a familiar story. A government in a developing country funnels tons of money into construction. This increases economic activity for a while, but the country ultimately overbuilds — and the loans start going bad.

"In every single case it ended up with excessive debt," Pettis says. "In some cases a debt crisis, in other cases a lost decade of very, very slow growth and rapidly rising debt. And no one has taken it to the extremes China has."

The counterpoint to Pettis's argument: China is extreme. It's a country of a billion people, growing at an incredible rate. The country needs to build lots of new stuff — new roads, new power plants, new buildings.

It's been this way for decades, says Arthur Kroeber, who runs the Chinese research firm Dragonomics. When he first arrived in Beijing in 1985, the city had just finished building a new ring road — a highway that runs in a loop circle around the city center. It was so empty that he and his wife rode their bikes down the middle of the highway.

Listen to the full interview on npr.org»

      

Editor's Note: In the coming decade, China’s economic growth is projected to slow from its long-run average annual rate of 10 percent, sustained over the past three decades. The imminent slowdown also reflects a variety of specific structural challenges. Arthur Kroeber argues that responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets.

In the coming decade, China’s economic growth will certainly slow from the long-run average annual rate of 10% sustained over the past three decades. In part this is a natural slowdown in an economy that is now quite large (around US$7 trillion at market exchange rates) and solidly middle-income (per capita GDP of about US$7,500, at purchasing power parity). Despite the certainty of this slowdown, China’s potential growth rate remains high: per-capita income is still far below the level at which incomes in the other major northeast Asian economies (Japan, South Korea and Taiwan) stopped converging with the US level; the per-capita capital stock remains low, suggesting the need for substantial more investment; and the supply of low-cost labor from the traditional agricultural sector has not yet been exhausted. All these factors suggest it should be quite possible for China to achieve average annual real GDP growth of at least 7% a year through 2020.[1]

But the imminent slowdown also reflects a variety of specific structural challenges which require active policy response. Inadequate policies could result in a failure of China to achieve its potential growth rate. Three of the most prominent structural challenges are a reversal of demographic trends from positive to negative; a substantial secular decline in the contribution of exports to growth; and the very rapid increase in credit created by the 2009-10 stimulus program, which almost certainly led to a substantial reduction of the return on capital. Responding effectively to these challenges requires a broad set of reforms in the financial sector, fiscal policy, pricing of key factors such as land and energy which are now subject to extensive government manipulation, and the structure of markets. This paper will argue that financial sector reform is the best and most direct way to overcome these three major structural challenges.

1. China’s growth potential

There are several strong reasons to believe that China has the potential to sustain a fairly rapid rate of GDP growth for at least another decade. We define “fairly rapid” as real growth of 7% a year, which is a very high rate for an economy of China’s size (US$7 trillion), but substantially below the average growth rate since 1980, which has been approximately 10%.

The most general reason for this belief is that China’s economic growth model most closely approximates the successful “catch-up” growth model employed by its northeast Asian neighbors Japan, South Korea and Taiwan in the decades after World War II. The theory behind “catch-up” growth is simply that poor countries whose technological level is far from the global technological frontier can achieve substantial convergence with rich-country income levels by copying and diffusing imported technology. Achieving this catch-up growth requires extensive investments in enabling infrastructure and basic industry, and an industrial policy that focuses on promoting exports. The latter condition is important because a disciplined focus on exports forces companies to keep up with improvements in global technology; in effect, a vibrant export sector is one (and probably the most efficient) mechanism for importing technology.

A survey of 96 major economies from 1970 to 2008 shows that 14 achieved significant convergence growth, defined as an increase of at least 10 percentage points in per capita GDP relative to the United States (at purchasing power parity). Eight of these countries were on the periphery of Europe and so presumably benefited from the spillover effects of western Europe’s rapid growth after World War II, and from the integration of eastern and western Europe after 1990. The other six were Asian export-oriented economies: Japan, South Korea, Taiwan, Malaysia, Thailand and China. Most of these countries experienced a period of very rapid convergence with US income levels and then a sharp slowdown or leveling off. On average, rapid convergence growth ended when the country’s per capita GDP reached 55% of the US level. The northeast Asian economies that China most closely resembles were among the most successful: convergence growth in Japan, Taiwan and South Korea slowed at 90%, 60% and 50% of US per capita income respectively. In 2010 China’s per capita income was only 20% of the US level. Based on this comparative historical experience, it seems plausible that China could enjoy at least one more decade of relatively rapid growth, until its per capita income reaches 40% or more of the US level.[2]

So China’s growth potential is fairly clear. But realizing this potential is not automatic: it requires a constant process of structural reform to unlock labor productivity gains and improve the return on capital. The urgency of structural reform is particularly acute now. To understand why, we now examine three structural factors that are likely to exert a substantially negative effect on economic growth in coming years.

2. Challenges to growth

When considering China’s structural growth prospects, it is necessary to take account of at least three major challenges to growth. Over the past three decades, rapid economic growth has been supported by favorable demographics, a very strong contribution from exports, and a large increase in the stock of credit. The demographic trend is now starting to go into reverse, the export contribution to growth has slowed dramatically in the last few years, and the expansion of credit cannot be safely sustained for more than another year or two at most.

Demographics. From 1975 to 2010, China’s “dependency ratio”—the ratio of the presumably non-working (young people under the age of 15 and old people above the age of 64) to the presumably working (those aged 15-64) fell from approximately 0.8 to 0.4. Over the same period the “prime worker ratio”—the ratio of people aged 20-59 to those 60 and above—stayed roughly stable at above 5. Both of these ratios indicate that China’s economy enjoyed a very high ratio of workers to non-workers. This situation is favorable for economic growth, because it implies that with a relatively small number of dependent mouths to feed, workers can save a higher proportion of their incomes, and the resulting increase in aggregate national saving becomes available for investment in infrastructure and basic industry.

Over the next two decades, however, these demographic trends will reverse. The dependency ratio will rise, albeit slowly at first, and the prime worker ratio will decline sharply from 5 today to 2 in the early 2030s. These demographic shifts are likely to exert a drag on economic growth, for two reasons.

The first impact, which is already being felt, is a reduction in the supply of new entrants into the labor force—those aged 15-24. This cohort has fluctuated between 200m and 230m since the early 1990s, and in 2010 it stood at the upper end of that range. By 2023 it will have fallen by one-third, to 150m, a far lower figure than at any point since China began economic reforms in 1978. Because the supply of new workers is falling relative to demand for labor, wage growth is likely to accelerate above the rate of labor productivity growth, which appears to be in decline from the very high levels achieved in 2000-2010. As a result, unit labor costs will start to rise (a trend already in evidence in the manufacturing sector since 2004) and inflationary pressures will build. In order to keep inflation at a socially acceptable level, the government will be forced to tighten monetary policy and reduce the trend rate of economic growth.

The second impact will be the large increase in the population of retirees relative to the number of workers available to support them. This is the effect described by the prime worker ratio, which currently shows that there are five people of prime working age for every person of likely retirement age. As this ratio declines, the overall productivity of the economy slows, and the health and pension costs of supporting an aging population rise. The combination of these two effects can contribute to a dramatic slowdown in economic growth: during the period when Japan’s prime worker ratio fell from 5 to 2 (1970-2005), the trend GDP growth rate fell from 8% to under 2% (though demographics, of course, does not explain all of this decline). Over the next 20 years China’s prime worker ratio will decline by exactly the same amount as Japan’s did from 1970-2005.

Export challenge. Another element of China’s extraordinary growth was its rapidly growing export sector. Exports are a crucial component of catch-up growth in poor economies because, as explained above, they act as a vector of technology transfer: in order to remain globally competitive, exporters must continually upgrade their technology (including their processes and management systems) to keep up with the continuous advance of the global technological frontier.

Precisely measuring the impact of exports on economic growth is tricky, because what matters is not headline export value (which contains contributions from imported components and materials), but the domestic value added content of exports. In addition, a dynamic export sector is likely to have indirect impacts on the domestic economy through the wages paid to workers, the long-run effect of technological upgrading and so on. If we ignore these second-round impacts and focus simply on the direct contribution to GDP growth of domestic value added in exports, we find that exports contributed 4.6 percentage points to GDP growth on average in 2003-07. In other words, exports accounted for about 40% of economic growth during that period.[3]

Such a high export contribution to growth is on its face unsustainable for a large continental economy like China’s, and in fact the export contribution has slowed substantially since the 2008 global financial crisis. In 2008-11 the average contribution of export value added to GDP growth was just 1.5 percentage points – about one-third the 2003-07 average. It is likely that the export contribution to growth will fall even further in coming years.

Credit challenge. China responded to the global financial crisis with a very large economic stimulus program which was financed by a large increase in the credit stock. The ratio of non-financial credit (borrowing by government, households and non-financial corporations) rose from 160% in 2008 to over 200% in 2011. While the overall credit/GDP ratio remains lower than the 250% that is typical for OECD nations, a rapid increase in the credit stock in a short period of time, regardless of the level, is frequently associated with financial crisis. In China’s case, it is evident that the majority of the increase in the credit stock reflects borrowing by local governments to finance infrastructure projects which are likely to produce economic benefit in the long run but which in many cases will result in immediate financial losses.[4] To avert a potential banking sector crisis, therefore, it would be prudent for government policy to target first a stabilization and then a decline in the credit/GDP ratio.

The good news is that China has recent experience of deflating a credit bubble. In the five years after the Asian financial crisis (1998-2003), the credit/GDP ratio rose by 40 percentage points (the same amount as in 2008-11) as the government financed infrastructure spending to offset the impact of the crisis. Over the next five years (2003-08), the credit/GDP ratio fell by 20 points, as nominal GDP growth (17% a year on average) outstripped the annual growth in credit (15%). This experience suggests that, in principle, it should be possible to reduce the annual growth in credit significantly without torpedoing economic growth.

The bad news is that the 2003-08 deleveraging occurred within the context of the extremely favorable demographics, and unusually robust export growth that we have just described. Not only are these conditions unlikely to be repeated in the coming decade, both these factors are likely to exert a drag on GDP growth. Given this backdrop, any reduction in the rate of credit growth must be accompanied by extensive measures to ensure that the productivity of each yuan of credit issued is far higher than in the past.

3. The role of financial sector reform

The three growth challenges described above are diverse, but they are reflections of a single broader issue which is that China’s ability to maintain rapid growth mainly through the mobilization of factors (labor and capital) is decreasing. Much of the high-speed growth of the last decade derived from a rapid increase in labor productivity which was in turn a function of an extremely high investment rate: as the amount of capital per worker grew, the potential output of each worker grew correspondingly (“capital deepening”). But the investment rate, at nearly 49% of GDP in 2011, must surely be close to its peak, since it is already 10 percentage points higher than the maximum rates ever reached by Japan or South Korea. So the amount of labor productivity gain that can be achieved in future by simply adding volume to the capital stock must be far less than during the last decade, when the investment/GDP ratio rose by 10 percentage points.

The obvious corollary is that if China’s ability to achieve rapid gains in labor productivity and economic growth through mobilization of capital is declining, these gains must increasingly be achieved by improved capital efficiency. More specifically, the tightening of the labor supply implied by the demographic transition means that unit labor cost growth will accelerate; all things being equal this means that consumer price inflation will be structurally higher in the next decade than it was for most of the last. This in turn means that nominal interest rates will need to be higher. As the cost of capital rises, the average rate of return on capital must also increase; otherwise a larger share of projects will be loss-making and the drag on economic growth will become pronounced.

On the export side, the dramatic slowdown in the contribution to economic growth from exports means the loss of a certain amount of “easy” productivity gains. Greater productivity of domestic capital could help offset the deceleration in productivity growth from the external sector. Finally, as just noted, the need to arrest or reverse the rapid rise in the credit/GDP ratio means that over the next several years, a given amount of economic growth must be achieved with a smaller amount of credit than in the past—in other words, the average return on capital (for which credit here serves as a proxy) must rise.

Conceptually this is all fairly straightforward. The problem for policy makers is that measuring the “productivity of capital” on an economy-wide basis is not at all straightforward. In principle, one could measure the amount of new GDP created for each incremental increase in the capital stock (the incremental capital output ratio or ICOR). But in practice calculating ICOR is cumbersome, and depends heavily on various assumptions, such as the proper depreciation rate. Moreover, in an industrializing economy like China’s, the ratio of capital stock to GDP tends to rise over time and therefore the ICOR falls; this does not mean that the economy misallocates capital but simply that it experiences capital deepening. Sorting out efficiency effects from capital deepening effects is a vexing task.[5]

A more practical approach is simply to examine the ratio of credit to GDP. There is no one “right” level of credit to GDP, since different economies use different proportions of debt and equity finance. But the trends in the credit to GDP ratio in a single country (assuming there is no major shift in the relative importance of debt and equity finance), which are easily measured, can serve as a useful proxy for trends in the productivity of capital, and provide some broad guidelines for policy.

Figure 1 shows the ratio of total non-financial credit to GDP in China since 1998 (all figures are nominal). Total non-financial credit comprises bank loans, bonds, external foreign currency borrowing, and so-called “shadow financing” extended to the government, households and non-financial corporations; it excludes fund-raising by banks and other financial institutions. This measure is similar to the measure of “total social financing” recently introduced by the People’s Bank of China. 

This shows, as noted previously, that the credit to GDP ratio rose sharply from 160% of GDP in 2008 to 200% in 2010. The current ratio is not abnormally high: many OECD countries have credit/GDP ratios of 250% or so, and Japan’s is around 350%. But it is obvious that the trend increase is worrying: if credit/GDP continues to rise at 20 percentage points a year then by 2015 it would hit 300%, a level much higher than is normal in healthy economies. It seems intuitively clear that to ensure financial stability, policy should target a stabilization or decline in the credit/GDP ratio. Success in this policy would imply that the productivity of credit, and capital more generally, improves.

The large increase in the credit/GDP ratio in 2008-10 is not unprecedented. Following the Asian financial crisis of 1997-98, the total credit stock rose from 143% of GDP in 1998 to 186% in 2003, an increase of 43 percentage points in five years, as a result of government spending on infrastructure and the creation of new consumer lending markets (notably home mortgages). During this period the credit stock grew at an average annual rate of 15.9%, but nominal GDP grew at just 10% a year.

Over the next five years, 2004-08, the average annual growth in total credit decelerated only slightly, to 14.8%. But thanks to a gigantic surge in productivity growth—caused by a combination of the delayed effect of infrastructure spending, deep market reforms (such as the restructuring of the state owned enterprise sector), and a boom in exports—nominal GDP growth surged to an average rate of 18.3%. As a consequence, the credit/GDP ratio declined to 160% in 2008, a decline of 26 percentage points from the peak five years earlier.

This experience shows that, in a developing country like China, it is quite possible to deflate a credit bubble relatively quickly and painlessly. To do so, however, two conditions must be met: the projects financed during the credit bubble must, in the main, be economically productive in the long run even if they cause financial losses in the short run; and structural reforms must accompany or quickly follow the credit expansion, in order to unlock the productivity growth that will enable deleveraging through rapid economic growth rather than through a painful recession. These conditions were clearly met during the 1998-2008 period: the expanded credit of the first five years mainly went to economically useful infrastructure such as highways, telecoms networks and port facilities; and deep structural reforms improved the efficiency of the state sector, expanded opportunities for the private sector, and created a new private housing market. This combination of infrastructure and reforms helped lay the groundwork for the turbo-charged growth of 2004-08.

The credit expansion of 2008-10, following the global financial crisis, was about the same magnitude as the credit expansion of a decade earlier: the credit/GDP ratio rose 40 percentage points, from 160% to 200%. But the expansion was much more rapid (occurring over two years instead of five), and while the bulk of credit probably did finance economically productive infrastructure, there is evidence that the sheer speed of the credit expansion led to far greater financial losses. A large proportion of the new borrowing was done by local government window corporations, often with little or no collateral and in many cases with no likelihood of project cash flows ever being large enough to service the loans. A plausible estimate of eventual losses on these loans to local governments is Rmb2-3 trn, or 4-7% of 2011 GDP.

Furthermore, whereas in the late 1990s restructuring of the state enterprise sector and creation of the private housing market took off at the same time the government began to expand credit, the 2008-10 credit expansion occurred without any significant accompanying structural reforms. In sum we have significantly less reason to be confident about the foundations for economic growth over the next five years than would have been the case in 2003.

On the assumption that the trend rate of nominal GDP growth over the next five years is likely be quite a bit less than in 2003-08, just how difficult will it be for China to stabilize or better yet reduce the credit to GDP ratio? For the purposes of analysis, Figure 1 proposes two scenarios. Both assume that nominal GDP will grow at an average rate of 13% in 2012-2015 (combining real growth of 7.5% a year with economy-wide inflation of 5.5%). The “stabilization” scenario assumes that total credit grows at the same 13% rate, stabilizing the credit/GDP ratio at around 200%. The “deleveraging” scenario assumes that credit growth falls to 9.5% a year, enabling a reduction in the credit/GDP ratio of 25 percentage points to 175%--about the same magnitude as the reduction of 2003-08.

A quick glance suggests that achieving either of these two outcomes will be far more difficult than in the previous deleveraging episode. In 2003-08, the average annual rate of credit growth was just one percentage point lower than during the credit bubble of 1998-2003. In other words, the work of deleveraging was accomplished almost entirely through economic growth, rather than through any material constraint on credit.

In the three years following the global financial crisis, by contrast, total credit expanded by 22.7% a year, generating nominal GDP growth of 14.1% on average. The required drop in average annual credit growth is 10 percentage points under the stabilization scenario and 13 points under the deleveraging scenario, while nominal GDP growth declines by only a point. In other words, this episode is likely to be the reverse of the 2003-08 episode: deleveraging will need to come almost entirely from a constraint on credit, rather than from economic growth.



Another way of looking at this is to examine the relationship between incremental credit and incremental GDP—that is, how many yuan of new GDP arise with each new yuan of credit. This calculation is presented in Figure 2. This shows that in 1998-2003 each Rmb1 of new credit generated Rmb0.39 of new GDP; this figure rose to 0.72 in 2003-08, an 84% increase in the productivity of credit. The GDP payoff from new credit in 2008-10 was far worse than in 1998-2003. Simply to stabilize the credit/GDP ratio at its current level will require a 73% increase in credit productivity. To achieve the deleveraging scenario, a 150% improvement will be required.

The good news is that under the deleveraging scenario, the average productivity of credit in 2011-2015 only needs to be the same as it was in 2003-08. In principle, this should be achievable. But as previously noted, the mechanism of improvement needs to be quite different this time round. In 2003-08, the productivity of credit rose because credit growth remained roughly constant while GDP growth surged, thanks to structural reforms that accelerated returns to both capital and labor. Over the next several years, by contrast, the best that can be hoped for is that GDP growth will remain roughly constant. Consequently any improvement in credit productivity must come from constraining the issuance of new credit, while substantially raising the efficiency of credit allocation and hence the returns to credit.

What are the main mechanisms for improving the efficiency of credit, and of financial capital more generally? Broadly speaking, there are two: diversification of credit channels, and more market-based pricing of credit. Historically most credit has been issued by large state-owned banks, which are subject to political pressure in their lending decisions, and the majority of credit has gone to state-owned enterprises. Diversifying the channels of credit to include a broader range of financial institutions, a more vigorous bond market, and even by encouraging the creation of dedicated small- and medium-size enterprise lending units within the big banks, should improve credit allocation by giving greater credit access to borrowers who were previously shut out simply by virtue of a lack of political connections. Over the past decade government policy has been broadly supportive of the diversification of credit channels: specialized consumer credit, leasing and trust companies have been allowed to flourish, and there is some anecdotal evidence that SME lending at the state owned banks has begun to pick up steam.

The government has been far more reluctant, however, to embrace systematic measures for improving the pricing of credit. Bank interest rates remain captive to the policy of regulated deposit rates. Guaranteed low deposit rates means that banks have little incentive to seek out and properly price riskier assets, and are content to earn a fat spread on relatively conservative loan books. Bond markets, which in more developed economies form the basis for pricing of financial risk, are in China large in primary issuance, but small in trading volumes. The majority of bonds are purchased by banks and other financial institutions and held to maturity, make them indistinguishable from bank loans. Active secondary market trading by a wide range of participants is the essential mechanism by which bond prices become the basis for financial risk pricing.

4. Conclusions and recommendations

China still has potential for another decade of relatively high speed growth, but a combination of structural factors means that “high speed” in future likely means a trend GDP growth rate of around 7%, well below the historic average of 10%. Moreover, a combination of negative trends in demographics and the external sector, and the need to constrain credit growth after the enormous credit expansion of 2008-2010, mean the obstacles to realizing this potential growth rate are quite large. In order to overcome these obstacles, the efficiency of credit, and of capital more generally, must be improved. A large increase in credit efficiency was achieved in the previous economic deleveraging episode of 2003-08, but that increase in efficiency resulted mainly from an acceleration in GDP growth due to capital deepening, rather than from a constraint on credit. Over the next several years, the best that can plausibly be achieved is a stabilization of nominal GDP growth at approximately the current level. Any increase in credit efficiency must therefore come from a constraint on credit growth and direct improvements in credit allocation, rather than from capital-intensive economic growth.

In order to achieve this improvement in credit efficiency, three improvements to China’s financial architecture are urgently needed. First, the diversification of financial channels should continue to be expanded, notably through the acceptance and proper regulation of so-called “shadow financing” activities, which reflect market pressure for higher returns to depositors and greater credit availability (at appropriate prices) for riskier borrowers. Second, the ceiling on bank deposit rates should gradually be lifted and ultimately abolished, in order to give banks incentives for increased lending at appropriate prices to riskier borrowers who (it is to be hoped) will deliver a higher risk-adjusted rate of return than current borrowers. Third, steps should be taken to increase secondary trading on bond markets, in order to enable these markets to assume their appropriate role as the basis of financial risk pricing. Particular stress should be laid on diversifying the universe of financial institutions permitted to trade on bond markets, to include pension funds, specialized fixed-income mutual funds and other institutional investors with a vested interest in active trading to maximize both short- and long-term returns.

 

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Following the global financial crisis of 2008, China’s authorities took a number of steps to internationalize the use of the Chinese currency, the renminbi. These included the establishment of currency swap lines with foreign central banks, encouragement of Chinese importers and exporters to settle their trade transactions in renminbi, and rapid expansion in the ability of corporations to hold renminbi deposits and issue renminbi bonds in the offshore renminbi market in Hong Kong.

These moves, combined with public statements of concern by Chinese officials about the long-term value of the central bank’s large holdings of U.S. Treasury securities, and the role of the U.S. dollar’s global dominance in contributing to the financial crisis, gave rise to widespread speculation that China hoped to position the renminbi as an alternative to the dollar, initially as a trading currency and eventually as a reserve currency.

This paper contends that, on the contrary, the purposes of the renminbi internationalization program are mainly tied to domestic development objectives, namely the gradual opening of the capital account and liberalization of the domestic financial system. Secondary considerations include reducing costs and exchange-rate risks for Chinese exporters, and facilitating outward direct and portfolio investment flows. The potential for the currency to be used as a vehicle for international finance, or as a reserve asset, is severely constrained by Chinese government’s reluctance to accept the fundamental changes in its economic growth model that such uses would entail, notably the loss of control over domestic capital allocation, the exchange rate, capital flows and its own borrowing costs.

This paper attempts to understand the renminbi internationalization program by addressing the following issues:

1. Definition of currency internationalization

2. Specific steps taken since 2008 to internationalize the renminbi

3. General rationale for renminbi internationalization

4. Comparison with prior instances of currency internationalization, notably the U.S. dollar after 1913, the development of the Eurodollar market in the 1960s and 1970s; and the deutsche mark and yen in 1970-1990

5. Understanding the linkage between currency internationalization and domestic financial liberalization

6. Prospects for and constraints on the renminbi as an international trading currency and reserve currency

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• China’s Global Currency: Lever for Financial Reform

      

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In recent years, China has increasingly confronted new challenges in economic policy, including rising labor costs, low household consumption, rapid urbanization and inefficient domestic investment. While it is now widely acknowledged in Beijing that major structural adjustments are needed to address these issues, implementing serious reforms pose major challenges for the newly installed leadership.

On April 16, the John L. Thornton China Center at Brookings and China’s Caixin Media Group hosted a conference to examine the daunting challenges confronting China’s new leaders. The morning panels featured a discussion of the financial sector as well as the relationship between the domestic agenda for financial reform and China’s evolving strategy for outbound investment. The afternoon panels took a close look at the political obstacles to implementing major economic reform in areas such as tax policy, the household registration system and land transfers, as well as explore the impact of environmental and natural resource constraints on China’s economic growth.

Audio

• Part 1 - The Road Ahead for China’s Economy
• Part 2 - The Road Ahead for China’s Economy

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20130416_china_economy

      

The recent gyrations in the Chinese interbank market underscore that the chief risk to global growth now comes from China. Make no mistake: credit policy will tighten substantially in the coming months, as the government tries to push loan growth from its current rate of 20% down to something much closer to the rate of nominal GDP growth, which is about half that. Moreover, in the last few months of the year the new government will likely start concrete action on some long-deferred structural reforms. These reforms will bolster China’s medium-term growth prospects, but the short-term impact will be tough for the economy and for markets.

The combination of tighter credit and structural reforms means that with the best of luck China could post GDP growth in 2014 of a bit over 6%, its weakest showing in 15 years and well below most current forecasts. A policy mistake such as excessive monetary tightening could easily push growth below the 6% mark. Banks and corporations appear finally to be getting the message that the new government, unlike its predecessor, will not support growth at some arbitrary level through investment stimulus.

The dire performance of China’s stock markets in the past two weeks reflects this growing realization among domestic investors, although we suspect stocks have further to fall before weaker growth is fully discounted.

Slower growth… but no Armageddon

But the China risk is mainly of a negative growth shock, not financial Armageddon as some gloomier commentary suggests. Financial crisis risk remains relatively low because the system is closed and the usual triggers are unavailable. Emerging market financial crises usually erupt for one of two reasons: a sudden departure of foreign creditors or a drying-up of domestic funding sources for banks. China has little net exposure to foreign creditors and runs a large current account surplus, so there is no foreign trigger. And until now, banks have funded themselves mainly from deposits at a loan-to-deposit ratio (LDR) of under 70%, although the increased use of quasi-deposit wealth management products means the true LDR may be a bit higher, especially for smaller banks. The danger arises when banks push up their LDRs and increasingly fund themselves from the wholesale market. So a domestic funding trigger does not exist—yet.

The People’s Bank of China clearly understands the systemic risk of letting banks run up lending based on fickle wholesale funding. This is why it put its foot down last week and initially refused to pump money into the straitened interbank market. Interbank and repo rates have dropped back from their elevated levels, but remain significantly above the historical average. The message to banks is clear: lend within your means. This stance raises confidence that Beijing will not let the credit bubble get out of control. But it also raises the odds that both credit and economic growth will slow sharply in the coming 6-12 months.

If the economy slows and local stock markets continue to tumble, doesn’t this mean the renminbi will also weaken sharply? Not necessarily. Beijing has a long-term policy interest in increasing the international use of the renminbi, which can only occur if the currency earns a reputation as a reliable store of value in good times and bad. Allowing a sharp devaluation now runs against this interest, and also would be a sharp break from a long-established policy of not resorting to devaluation to stimulate growth, even at moments of severe stress (as in 1997-98 and 2008-09). So while our call on China growth has been marked down, our call on the renminbi has not.

Short-term pain is better than long-term stagnation

From a broader perspective, the biggest China risk is not that the country suffers a year or two of sharply below-trend growth. If that slowdown reflects more rational credit allocation and the early, painful stages of productivity-enhancing reforms, it will be healthy medicine. And even a much slower China will still be growing faster than all developed markets and most emerging ones.

The real risk is rather that the new government will show a lack of nerve or muscle and fail to push through financial sector liberalization, deregulation of markets to favor private firms, and fiscal reforms to curtail local governments’ ability to prop up failing firms, overspend on infrastructure, and inflate property bubbles. The old government wasted the last three years of its term doing none of these things despite the obvious need. The new leaders are talking a better game, but they have a year at most to articulate a clear reform program, begin implementation (liberalizing interest rates and freeing electricity prices would be a good start), and ruthlessly removing senior officials who stand in the way. If they fail to deliver, then the short-term slowdown could become a long and dismal decline.

       

The much anticipated Third Plenum of the Chinese Communist Party’s 18^th Congress closed its four-day session last Tuesday. A relatively bland initial communiqué was followed today by a detailed decision document spelling out major initiatives including a relaxation of the one-child policy, the elimination of the repressive “re-education through labor” camps, and a host of reforms to the taxation and state-owned enterprise systems. Today’s blizzard of specific reform pledges allays earlier concerns that the new government led by party chief Xi Jinping and premier Li Keqiang would fail to set major policy goals. But is this enough to answer the three biggest questions analysts have had since Xi and  Li ascended a year ago?

Those questions are, first, do Xi and his six colleagues on the Politburo standing committee have an accurate diagnosis of China’s structural economic and social ailments? Second, do they have sensible plans for addressing these problems? And third, do they have the political muscle to push reforms past entrenched resistance by big state owned enterprises (SOEs), tycoons, local government officials and other interest groups whose comfortable positions would be threatened by change? Until today, the consensus answers to the first two questions were “we’re not really sure,” and to the third, “quite possibly not.”

These concerns are misplaced. It is clear that the full 60-point “Decision on Several Major Questions About Deepening Reform”[1] encompasses an ambitious agenda to restructure the roles of the government and the market. Combined with other actions from Xi’s first year in office – notably a surprisingly bold anti-corruption campaign – the reform program reveals Xi Jinping as a leader far more powerful and visionary than his predecessor Hu Jintao. He aims to redefine the basic functions of market and government, and in so doing establish himself as China’s most significant leader since Deng Xiaoping. Moreover, he is moving swiftly to establish the bureaucratic machinery that will enable him to overcome resistance and achieve his aims. It remains to be seen whether Xi can deliver on these grand ambitions, and whether his prescription will really prove the cure for China’s mounting social and economic ills. But one thing is for sure: Xi cannot be faulted for thinking too small.

Main objective: get the government out of resource allocation

The four main sources we have so far on Xi’s reform strategy are the Plenum’s Decision, the summary communiqué issued right after the plenum’s close,[2] an explanatory note on the decision by Xi,[3] and a presumably authoritative interview with the vice office director of the Party’s Financial Leading Small Group, Yang Weimin, published in the People’s Daily on November 15, which adds much useful interpretive detail.[4] Together they make clear that the crucial parts of the Decision are as follows:

• China is still at a stage where economic development is the main objective.
• The core principle of economic reform is the “decisive” (决定性) role of market forces in allocating resources (previous Party decisions gave the market a “basic” (基础）role in resource allocation.
• By implication, the government must retreat from its current powerful role in allocating resources. Instead, it will be redirected to five basic functions: macroeconomic management, market regulation, public service delivery, supervision of society (社会管理), and environmental protection.

In his interview, Yang Weimin draws a direct comparison between this agenda and the sweeping market reforms that emerged after Deng Xiaoping’s southern tour in 1992, claiming that the current reform design is a leap forward comparable to Deng’s, and far more significant than the reform programs of Jiang Zemin and Hu Jintao.

This a very bold and possibly exaggerated claim. But the basic reform idea – giving the market a “decisive” role in resource allocation – is potentially very significant, and should not be dismissed as mere semantics. Over the last 20 years China has deregulated most of its product markets, and the competition in these markets has generated enormous economic gains. But the allocation of key inputs – notably capital, energy, and land – has not been fully deregulated, and government at all levels has kept a gigantic role in deciding who should get those inputs and at what price. The result is that too many of these inputs have gone to well-connected state-owned actors at too low a price. The well-known distortions of China’s economy – excessive reliance on infrastructure spending, and wasteful investment in excessive industrial capacity – stem largely from the distortions in input prices.

Xi’s program essentially calls for the government to retreat from its role in allocating these basic resources. If achieved, this would be a big deal: it would substantially boost economic efficiency, but at the cost of depriving the central government of an important tool of macro-economic management, and local governments of treasured channels of patronage. As a counterpart to this retreat from direct market interference, the Decision spells out the positive roles of government that must be strengthened: macro management and regulation, public service delivery, management of social stability, and environmental protection. In short, the vision seems to be to move China much further toward an economy where the government plays a regulatory, rather than a directly interventionist role.

Keep the SOEs, but make them more efficient

Before we get too excited about a “neo-liberal” Xi administration, though, it’s necessary to take account of the massive state-owned enterprise (SOE) complex. While Xi proposes that the government retreat from its role in manipulating the prices of key inputs, it is quite clear that the government’s large role as the direct owner of key economic assets will remain. While the Decision contains a number of specific SOE reform proposals (such as raising their dividend payout ratio from the current 10-15% to 30%, and an encouragement of private participation in state-sector investment projects), it retains a commitment to a very large SOE role in economic development. The apparent lack of a more aggressive state-sector reform or privatization program has distressed many economists, who agree that China’s declining productivity growth and exploding debt are both substantially due to the bloated SOEs, which gobble up a disproportionate share of bank credit and other resources but deliver ever lower returns on investment.

The communiqué and the Decision both make clear that state ownership must still play a “leading role” in the economy, and it is a very safe bet that when he retires in 2022, Xi will leave behind the world’s biggest collection of state-owned enterprises. But while privatization is off the table, subjecting SOEs to much more intense competition and tighter regulation appears to be a big part of Xi’s agenda. In his interview, Yang Weimin stresses that the Plenum decision recognizes the equal importance of both state and non-state ownership – a shift from previous formulations which always gave primacy to the state sector. Moreover, other reports suggest that the mandate of the State-owned Assets Supervision and Administration Commission (Sasac), which oversees the 100 or so big centrally-controlled SOE groups, will shift from managing state assets to managing state capital.[5] This shift of emphasis is significant: in recent years SOEs have fortified their baronies by building up huge mountains of assets, with little regard to the financial return on those assets (which appears to be deteriorating rapidly). Forcing SOEs to pay attention to their capital rather than their assets implies a much stronger emphasis on efficiency.

This approach is consistent with a long and generally successful tradition in China’s gradual march away from a planned economy. The key insight of economic reformers including Xi is that the bedrock of a successful modern economy is not private ownership, as many Western free-market economists believe, but effective competition. If the competitive environment for private enterprises is improved – by increasing their access to capital, land and energy, and by eliminating regulatory and local-protectionist barriers to investment – marginal SOEs

must either improve their efficiency or disappear (often by absorption into a larger, more profitable SOE, rather than through outright bankruptcy). As a result, over time the economic role of SOEs is eroded and overall economic efficiency improves, without the need to fight epic and costly political battles over privatization.

Can Xi deliver?

Even if we accept this view of Xi as an ambitious, efficiency-minded economic reformer, it’s fair to be skeptical that he can deliver on his grand design. These reforms are certain to be opposed by powerful forces: SOEs, local governments, tycoons, and other beneficiaries of the old system. All these interest groups are far more powerful than in the late 1990s, when Zhu Rongji launched his dramatic reforms to the state enterprise system. What are the odds that Xi can overcome this resistance?

Actually, better than even. The Plenum approved the formation of two high-level Party bodies: a “leading small group” to coordinate reform, and a State Security Commission to oversee the nation’s pervasive security apparatus. At first glance this seems a classic bureaucratic shuffle – appoint new committees, instead of actually doing something. But in the Chinese context, these bodies are potentially quite significant.

In the last years of the Hu Jintao era, reforms were stymied by two entrenched problems: turf battles between different ministries, and interference by security forces under a powerful and conservative boss, Zhou Yongkang. Neither Hu nor his premier Wen Jiabao was strong enough to ride herd on the squabbling ministers, or to quash the suffocating might of the security faction. By establishing these two high-level groups (presumably led by himself or a close ally), Xi is making clear that he will be the arbiter of all disputes, and that security issues will be taken seriously but not allowed to obstruct crucial economic or governance reforms.

The costs of crossing Xi have also been made clear by a determined anti-corruption campaign which over the last six months has felled a bevy of senior executives at the biggest SOE (China National Petroleum Corporation), the head of the SOE administrative agency, and a mayor of Nanjing infamous for his build-at-all-costs development strategy. Many of the arrested people were closely aligned with Zhou Yongkang. The message is obvious: Xi is large and in charge, and if you get on the wrong side of him or his policies you will not be saved by the patronage of another senior leader or a big state company. Xi’s promptness in dispatching his foes is impressive: both of his predecessors waited until their third full year in office to take out crucial enemies on corruption charges.

In short, there is plenty of evidence that Xi has an ambitious agenda for reforming China’s economic and governance structures, and the will and political craft to achieve many of his aims. His program may not satisfy market fundamentalists, and he certainly offers no hope for those who would like to see China become more democratic. But it is likely to be effective in sustaining the nation’s economic growth, and enabling the Communist Party to keep a comfortable grip on power.

Editor's Note: Arthur Kroeber is the Beijing-based managing director of Gavekal Dragonomics, a global macroeconomic research firm, and a non-resident fellow of the Brookings-Tsinghua Center. A different version of this article appears on www.foreignpolicy.com.

       

A year after he and his colleagues took control of China’s government, Xi Jinping has emerged as an extraordinarily powerful leader, with a clear and ambitious agenda for remaking the Chinese governance system. Economic, social and foreign policy are now on a far more clear and decisive course than they were during the drifting and unfocused last years under president Hu Jintao and premier Wen Jiabao.

Xi arguably wields more personal authority than any Chinese leader since Mao: he has subdued the fragmented fiefdoms that arose under Hu; has arrogated all key decisions to himself, unlike Jiang Zemin who delegated much economic policy power to his premier Zhu Rongji; and does not have to deal with the cabal of conservative patriarchs that often hemmed in Deng Xiaoping.

Perhaps the biggest surprise of Xi’s first year was the speed with which he consolidated his power and signaled his policy intentions. He achieved this through two big house-cleaning drives. First was an anti-corruption campaign that neutralized a powerful political enemy (former security boss Zhou Yongkang), brought to heel a powerful vested interest (state oil giant China National Petroleum Corporation, much of whose senior management was arrested) and signaled the costs of opposing his reform agenda by sweeping up 20,000 officials at all levels of government. The other was the so-called “mass line” campaign that involved party, government and military officials engaging in “self-criticism” sessions and getting marching orders from party central.

So there is no question that Xi has power. What does he intend to do with it? The Decision document that emerged last November from the Communist Party plenum made clear that his aim is comprehensive governance reform. This does not mean eroding the party’s monopoly on power; quite the reverse. The intention is to strengthen the party’s grip by improving the administrative system, clarifying the roles of the market and the state (resulting in a more market-driven economy but also in a more powerful and effective state), and permitting a wider role for citizen-led non-governmental organizations—so long as those NGOs effectively act as social-service contractors for the state and do not engage in advocacy or political mobilization.

And at the recent National People’s Congress (NPC) we got additional detail on Xi’s economic program, which is the most comprehensive structural reform agenda since the late 1990s. (Xi’s propagandists make the bolder claim that it is the most sweeping reform program since Deng’s original “reform and opening” drive of the late 1970s.) Much commentary has focused on the Plenum Decision’s emphasis on giving the market a “decisive role,” and this shift is indeed important. But Xi is not some Chinese version of Ronald Reagan or Margaret Thatcher: for him and his colleagues, the market is a tool, not an end in itself. The respective roles of state and market need to be clarified, but the state role will remain very large. Xi’s economic agenda is not just about deregulation and improving the environment for private enterprise; it is also about fixing the state-enterprise and fiscal systems so that they become more effective instruments for achieving state aims.

If Xi succeeds, the result will be a China with a more efficient economy, a better run and somewhat more transparent government—and a Communist Party with enhanced legitimacy and tighter control of all the crucial levers of power. But there are also two less rosy potential outcomes. One is that his reforms fail, and China is left with a debt ridden, slow-growing economy with an overbearing state sector and an increasingly dissatisfied population. Another is that he succeeds—but either becomes a permanent dictator himself, or establishes the belief that China only be ruled by a strongman, thereby retarding the development of a more open and participatory political system.

It’s the economy, and we’re not stupid

On the immediate economic policy questions, a gulf has opened between foreign and many non-official domestic analysts on the one hand, and the apparent stance of the government on the other. According to the prevalent outside view, China’s biggest problem is the huge increase in leverage since the 2008 global financial crisis: total non-financial credit rose from 138 percent of GDP in 2008 to 205 percent last year. Unless this spiraling leverage is brought under control, the argument goes, China risks some sort of financial crisis. To stabilize the credit/GDP ratio, annual credit growth must fall from its current rate of around 17 percent to the trend rate of nominal GDP growth, which now appears to be around 10 percent. But such a dramatic fall in credit growth must almost certainly cause a drop in real GDP growth, at least in the short run. The conclusion is therefore that if Beijing is serious about controlling leverage, it must accept significantly lower growth for at least a couple of years. If on the other hand the leaders insist on keeping economic growth at its current pace, this means they cannot be serious about controlling leverage and imposing structural reform, and a train wreck is more likely.

As far as we can tell from the agenda laid out at the Plenum and the NPC, Xi and his colleagues do not agree with this analysis. Their priorities are to restructure the state-owned enterprises (SOEs) and the fiscal system, and maintain real GDP growth at approximately its current rate of 7.5 percent. The leverage problem, by implication, can be sorted out over several years.

The argument in favor of this approach is that SOE and fiscal reform strike at the root causes of the debt build-up. Local governments have borrowed because their expenditure responsibilities exceed their assigned revenues, they have an implicit mandate to build huge amounts of urban infrastructure, and they face no accountability for the return on their investments. SOEs have borrowed because their return on capital has deteriorated sharply. Improving SOEs’ return on capital and cleaning up local government finance, should greatly reduce the demand for unproductive debt, and hence bring credit and economic growth back into alignment—eventually. In the meantime credit will flow at whatever rate permits real GDP to keep humming at 7 percent or more, meaning that leverage will continue to rise.

In other words, the government thinks the debt build-up is merely a symptom, and it intends to attack the underlying disease while letting the symptoms take care of themselves. One can feel comfortable with approach this on two conditions: first, that the government is right that the debt buildup does not itself pose an immediate threat to economic health; and second that the government is serious about tackling the structural problems.

Debt – what, me worry?

The safety of the current debt trajectory is a judgment call. On the plus side, the last several months have seen a steep decline in year-on-year credit growth, with very little apparent impact on economic activity. Growth in broad credit (including activity in the “shadow” financing sector) peaked at 23.5 percent in April 2013 and declined continuously to 17 percent in February, while GDP growth remained basically steady in both real and nominal terms. If this pattern holds, it suggests that leverage will continue to increase, but at a slower rate than in the past two years, so the runaway-train risk is reduced.

The government’s own case for the safety of the present debt situation implicitly rests on a report by the National Audit Office (NAO) in late December, which found the debt position of local governments to be poor but manageable. Total liabilities of local governments as of 30 June 2013 were found to be Rmb18 trn (US$3 trn), or approximately 31 percent of GDP; of these liabilities 40 percent were guarantees and contingencies (and thereby not an imminent risk to local finances). NAO’s estimate of consolidated public debt, including the central government, came in at about 53 percent of GDP, well below the levels of public borrowing in most OECD countries.

Another basis for the sanguine view on debt was an extensive national balance-sheet analysis published in December by the Chinese Academy of Social Sciences (CASS), the party’s main think-tank. CASS’s calculation methods differ from NAO’s, so the two sets of figures are not directly comparable. CASS found that total government debt was 73 percent of GDP in 2011, and that broad public-sector liabilities (including the debt of SOEs and policy banks) were 151 percent of GDP. This sounds scary until you inspect the asset side of the balance sheet, which comes in at a more cheerful 350 percent. This figure is almost certainly too rosy: nearly three-quarters of it represents the land holdings of local governments and SOE assets, whose reported values are probably well above their true market values. But even discounting these values substantially, it is still possible to conclude that the public sector’s assets comfortably cover its liabilities.

Whether one agrees with these estimates or not, it is clear that policy makers accept the central conclusion that the nation’s debt problem is serious but manageable, and that direct efforts to deleverage immediately are not warranted. The important question then becomes whether Beijing’s efforts to tackle the underlying structural problems are bearing fruit.

Rolling back the SOE tide

So what are those efforts? The agenda on SOE reform is now clear. SOEs will be compelled to focus on improving their return on capital, rather than expanding their assets; private capital will be permitted to enter previously restricted sectors; direct private investment in SOEs and in state-led investment projects will be encouraged; and most likely (although government officials have been coy on this point), a swathe of underperforming locally-controlled SOEs in non-strategic sectors will be privatized or forced into bankruptcy.

In essence, this revives the zhuada fangxiao (grasp the big, release the small) SOE reform strategy of the late 1990s. The idea was that the state would retain control, and try to improve the operational efficiency, of a relatively small number of very large enterprises in strategic sectors such as railways, aviation, telecoms, power and petrochemicals, while privatizing most activity in competitive consumer goods and services sectors. This strategy was successful: in the decade ending in 2008, the number of SOEs fell from 260,000 to 110,000, the private sector’s share of national fixed investment rose from less than a quarter to 58 percent, the profitability and return on assets of state firms rose dramatically and came close to matching the returns in private firms, and the proportion of SOE assets in “strategic” sectors rose to an all-time high of 62 percent.

Thanks to the Hu/Wen leadership’s lack of enthusiasm for state sector reform, and their mandate that state firms support the massive 2009 economic stimulus, some of these gains have been reversed. Crucially, the return on assets in SOEs plummeted to less than half the private-sector average, and state firms began to re-colonize sectors from which they had previously retreated: by 2011, half of SOE assets were in these non-strategic sectors.

Now the reformers are back in charge and aim to complete the zhuada fangxiao objective. This does not mean eliminating the state sector, or privatizing the core centrally-owned firms on the economy’s commanding heights. But it does mean a determined push to shed non-core SOEs and assets, abandon consumer-facing sectors in favor of private firms, and improve the operational efficiency of the remaining SOES. The headline efforts in this direction so far have been an announcement by the Guangdong provincial government that it aims to move 80 percent of provincial SOEs to a mixed-ownership structure, with no predetermined minimum state shareholding; and an announcement by petrochemicals giant Sinopec that it will seek private investment for an up to 30 percent share of its downstream gasoline and diesel distribution operations.

Funding the unfunded mandates

SOE reform was a surprisingly strong component of the Third Plenum decision; fiscal reform took center stage in the recent NPC session. China’s central fiscal problem is unfunded mandates for local governments. Localities control less than half of revenues but are responsible for 85 percent of government expenditure. In theory, the gap is supposed to be bridged by transfers from the central government, but in practice the transfers often do not match up well with localities’ actual needs. Not surprisingly, they respond to this structural deficit by resorting to a variety of off-budget funding schemes, a lot of which involve grabbing land and selling it to developers at a big markup.

A mismatch between local expenditure and revenue was a deliberate feature of the landmark 1994 tax reform (in whose design finance minister Lou Jiwei was involved as a junior official). But until the early 2000s, localities’ expenditure share was roughly stable at around two-thirds of the total; unfunded mandates and chronic deficits have grown dramatically in the past decade.

The centerpiece of Lou’s fiscal reform strategy is a recentralization of expenditure responsibility and a more flexible transfer system, reducing incentives for local-government rapacity. But in his budget speech he outlined a host of other detailed reforms, whose combined effect would be curb over-investment in real estate and heavy industry, permit fiscal policy to become more countercyclical and increase budget accountability. The main items include:

• Revenue estimates “are now seen as projections instead of tasks to accomplish.” This aims to discourage the current practice of trying to increase tax collections during economic downturns.
• Adoption of a three-year budget cycle and accrual accounting.
• Increase local government borrowing authority (from a small base), via provincial and municipal bonds.
• Make budgets at both the central and local level more open and transparent.
• Clean up the maze of local government tax breaks.
• Impose the long-delayed tax on property values, establish an environmental protection tax and hike the resource tax on coal.

Good diagnosis, but will the cure cause more harm?

All in all the reform agenda is a strong one: its diagnosis of China’s economic ills is compelling, and the proposed cures seems sensible. There are three concerns. First, there is the worry that the government has underestimated the financial risks of the burgeoning debt burden and a rapidly-changing financial system. The only clear promise of stronger financial regulation so far is Lou’s statement that a deposit insurance system will be launched later this year. This would reduce moral hazard by clarifying for investors which financial assets are guaranteed and which are risky. But more action to cut debt and restrain the “shadow banking” sector may be needed.

Second, it is possible that reforms may be thwarted by powerful bureaucratic and business interests: some reforms (like the property tax) have been proposed in the past but gone nowhere. On the whole, Xi’s success at whipping officialdom into line by the anti-corruption and mass line campaigns suggests he will be more effective than his predecessor, but there is no guarantee. Finally, there is the worry that Xi’s program succeeds, and validates highly centralized and authoritarian style of governance that could harm China’s long-term prospects for development into a more open and liberal society.

       

In the last two months China has executed a decisive change in its policy for managing its currency, the renminbi. Ending an eight-year period of slow but relentless appreciation against the U.S. dollar, the People’s Bank of China (PBOC) engineered a swift devaluation of about 3 percent, and doubled the size of the currency’s daily trading band. These moves took financial markets by surprise and sowed confusion. Was Beijing simply trying to re-ignite export growth by making its currency cheaper? Or was it making a more fundamental shift?

The answer is straightforward. China has taken a huge step towards making its exchange rate more flexible and market determined. In doing so, the authorities have clearly signaled their intention to switch from a monetary policy that mainly targets the exchange rate, to one that mainly targets domestic interest rates. The change in renminbi policy is thus part of a broad and ambitious financial reform strategy, reflecting the agenda laid out last November in the “Decision” published following the Third Plenum of the 18th Party Congress. It is all about improving China’s macroeconomic management, and has little or nothing to do with boosting exports.

Four Phases of China’s Exchange Rate Management

To understand the significance of the new renminbi policy, some background is helpful. The history of China’s exchange rate management can be divided into four phases. In the first, from 1979 to 1994, there was a steady depreciation in order to wean the country off the artificially overvalued exchange rate inherited from the previous period of Communist autarky. During this period Beijing maintained a dual exchange rate system. This consisted of an official rate, still overvalued, but gradually converging toward reality, which essentially applied to the capital account; and a more market based “swap rate” which was available to exporters. The purpose of this arrangement was to enable a competitive (though rudimentary) export economy to develop while still keeping the local price of imported capital goods relatively low, and avoiding the collapse in living standards that a full-on depreciation would have caused.

The second phase was a brief transition period in 1994-1995 when the two exchange rates were combined and the currency was allowed to float more or less freely in order for fair value to be established. In late 1995 the value of the renminbi was fixed at a rate of 8.3 against the U.S. dollar, initiating the third phase—a hard peg against the U.S. dollar—which lasted until July 2005.

It’s important to recall that the first test of this regime was the refusal to devalue in 1998 in the wake of the Asian financial crisis, when the currencies of the countries with whom China was then competing for export orders all fell dramatically. Rather than devaluing to help out exporters, Beijing hardened its peg. This was costly: China’s exports flatlined in 1998, and arguably the relatively strong currency played a role in the deflation that China suffered for the next four years. One reason the government hardened the peg, rather than devaluing, was to establish that China was a dependable player in the world system and that its currency could be relied on as a store of value. The short-term hit to exports was more than offset by the strategic gain in China’s reputation as “responsible stakeholder” and a safe place for foreign direct investment.

The hard peg against a declining U.S. dollar led eventually to a depreciation of the trade-weighted, inflation-adjusted exchange rate (known as the real effective exchange rate, or REER) that contributed to the exploding exports and ballooning trade surpluses of the early 2000s. This in turn prompted the fourth phase of Chinese currency policy: a crawling peg against the U.S. dollar, starting in July 2005. Each day, the PBOC fixed a reference rate for the renminbi against the dollar, and permitted the currency’s value to fluctuate within a narrow band around the reference. The daily trading band was initially set at 0.3 percent (in either direction), and subsequently widened to 0.5 percent in 2007 and 1 percent in April 2012. Over eight years, the crawling-peg system delivered a 35 percent appreciation against the U.S. dollar and a 40 percent appreciation of the REER.

In light of the vociferous criticism China endured for its undervalued exchange rate, it is striking in retrospect how swift Beijing was to change its currency regime once a serious external imbalance appeared. As late as 2004, China’s merchandise trade balance was around 2.5 percent of GDP, just slightly above the 15-year average. In 2005 it jumped to 5.5 percent, and the decision to let the currency rise was immediate. At first the rise was too timid, and the trade and current account balances continued to expand. But by mid-2007 the appreciation pace picked up to 5 percent a year. The ultimate result of the crawling-peg regime was a reduction in the current account surplus from its peak of 10 percent of GDP in 2007 to the measly 0.8 percent recorded in the first quarter of 2014.

As the above account makes clear, mercantilist motives historically played a secondary role in China’s exchange rate policies—and after 2007 China pursued an anti-mercantilist policy of deliberately shrinking its trade surplus. Beijing’s bigger concerns were the exchange rate’s role in facilitating a broad shift from administered to market prices (1978-1995), as an anchor for monetary policy (1995-2013) and as instrument for correcting an external imbalance and promoting a shift in favor of domestic demand (2007-2013). Lying in the background was the idea that a relatively stable exchange rate was strategically beneficial. After the Asian crisis, foreign investors were reassured that China was a safe place for direct investment; and after the 2008 global crisis the case for the renminbi as an international trade-settlement and portfolio investment currency was strengthened.

Given this history, we can safely rule out the theory that this year’s devaluation is a tactic to boost exports at a time of flagging domestic demand. An explanation that better fits both the recent facts and the historical context is that, in line with the Third Plenum Decision, Beijing wanted to make the exchange rate more flexible and market-determined. But it faced a problem: for almost 18 months from September 2012, the daily market rate of the renminbi was at or near the top of the 1 percent trading band, because investors assumed (rightly) that the Chinese currency would always go up: it was a “one-way bet.” The one-way bet caused large-scale capital inflows that were routinely much larger than the monthly trade surplus. Under these conditions, if the central bank had simply widened the daily trading band, traders would quickly have pushed the value of the currency to the top of the new band, and even more capital would have flowed in. To prevent this outcome, the PBOC in late February starting pushing down its daily fixing, and ordered Chinese state-owned banks to sell renminbi and buy dollars. In mid-March, when the “one-way bet” psychology had been chased out of the market, PBOC doubled the daily trading band to 2 percent.

Welcome to the Managed Float

It is clear that China has entered a new phase of currency management, and the rulebook that has worked well since 2005 must be heavily revised. Two observations inform this judgment. First, the main aims of the strong renminbi policy have been achieved. The current account surplus has been virtually eliminated, and at least one serious technical study of the currency (by Martin Kessler and Arvind Subramaniam of the Peterson Institute for International Economics), the structural undervaluation of the renminbi has been eliminated.

Second, the adoption of a 2 percent daily trading band means that, on a day-to-day basis, the renminbi rate can now be determined mainly by the market most of the time (since only at times of extreme stress do currencies move more than 2 percent in a day). This newfound capacity seems consistent with the broad aim articulated in the Communist Party’s reform agenda last November, of having market forces play a “decisive role” in resource allocation. A willingness to let the currency float more freely is also consistent with the apparent agenda to liberalize deposit interest rates within in the next two years, which implies shifting from a monetary policy that mainly targets the exchange rate to one that mainly targets a domestic money-market interest rate.

It is also clear, however, that the renminbi will not simply be left to its own devices: the float will be a heavily managed one. Mechanically, it will likely operate much like the Singapore dollar “basket, band and crawl,” or BBC system, with an undisclosed trade-weighted index target, a 2 percent daily trading band puts a limit on extreme movements and a periodic readjustment of the slope of the policy band to prevent a major misalignment of the currency emerging (as it did at the end of China’s hard-peg era).

Strategically, the two most important aims of Beijing’s exchange rate regime will be maintaining stability of both the current and capital accounts, and providing support for the emergence of the renminbi as a serious international currency. (For an analysis of the renminbi-internationalization drive, see China’s Global Currency: Lever For Financial Reform.)

The first factor basically means that when capital flows (in or out) threaten to become destabilizing, the PBOC will use the exchange rate to reverse those flows; the same applies to extreme movements in the current account. In effect, Beijing will try to keep both parts of the balance of payments in roughly neutral position, while it undertakes deep reforms of the domestic economy.

The second aim means that sustained depreciation is unlikely to be tolerated, since as the new kid on the block the renminbi still must convince global investors that it is a reliable store of value over the medium to long term. Yet intolerance for sustained depreciation is perfectly compatible with significant short-term depreciations lasting several months or more, to correct current or capital account imbalances. The days of the one-way bet are over.

The bottom line is that Beijing has made a decisive commitment to a much more flexible and far more market-driven exchange rate—exactly what the U.S. Treasury Department and the International Monetary Fund have been suggesting for years. This commitment means that the exchange rate will cease to be a major point of friction between China and its trading partners. The interesting question now is how quickly China will follow up with the even bigger task of liberalizing its domestic financial system.

       

After the enthusiasm which greeted the launch of Chinese President Xi Jinping’s landmark reform blueprint at the Third Plenum of the 18th Central Committee in November 2013, the mood among observers of China’s economy has gradually soured. A common view is that progress on economic reforms has been slow, bogged down not only by the opposition of vested interests but also by the government’s own distraction with its endless anti-corruption campaign, and by its anxiousness to support short-term growth through easy monetary policy.

This popular take misses the mark in three respects. First, the top priority of Xi’s reform is not about economics; it is to remake China’s system of governance. Successful reform of government and administration, along with more specific market reforms, will, in turn, enable more sustainable economic growth. Second, China’s leaders clearly reject the view that to be serious about structural economic reform, they must accept a sharp cyclical slowdown. Instead, they believe that maintaining relatively rapid growth in the short term will give them more breathing room to push through their complex economic agenda. Finally, a tally of economic reform measures this year shows that progress has in fact been impressively brisk.

Governance, Not Economics, Tops the Agenda

Understanding the primacy of governance reform is essential to grasping the role of the anti-corruption campaign, which has resulted in the investigation or disciplining of over 70,000 officials at all levels of government in virtually every province, and has now spread to senior levels of the People’s Liberation Army. This campaign is often portrayed as a cynical effort by Xi Jinping to consolidate power, eliminate his enemies and curtail the influence of retired senior leaders, notably former Presidents Jiang Zemin and Hu Jintao. These motives no doubt play a large role, but the campaign is too far-reaching, and has gone on for too long, for them to be a full explanation.

It is now apparent that the campaign’s central goal is to sharply reduce the system’s tolerance of corruption, which has been quite high since the beginning of economic reforms in the late 1970s. This, in turn, suggests a desire to renegotiate the basic bargain between the central and local governments that has held throughout the reform period. In essence, that bargain tasked local officials with maximizing economic growth, in exchange for which they were tacitly permitted to skim off part of the financial gains from that growth. Central authorities only cracked down when the graft reached grotesque proportions (as with smuggling scandals in Xiamen and other coastal cities in south China in the late 1990s), or when political and policy interests converged in an exemplary prosecution (as in the purge of Shanghai party Secretary Chen Liangyu in 2005, which both removed a Politburo rival to Hu Jintao and sent a message to cities to rein in property speculation).

This bargain proved effective in stimulating sustained rapid growth while China was still a low-income country. But the nation’s economy has now matured and with a per capita national income of $6,560, China now qualifies as an upper-middle income country, by the World Bank’s definition. To sustain high growth at this income level, China needs better governance, a more reliable legal system and considerably less corruption. Thus, the anti-graft campaign is not incidental to or a distraction from the main reform agenda—it is an essential part of the foundation of a more successful economic and political system.

Similarly, the legal system reform outlined at the Fourth Plenum in October, while disappointing many Western observers because it sanctified the Communist Party’s position above the laws that apply to everyone else, is in fact a significant step towards a more consistent, predictable, rules-based system. As Cheng Li has pointed out, the very act of devoting a Plenum to legal issues has made possible a discussion about how to create rule of law in China (see “Fourth Plenum Has Opened Discourse on Constitutionalism, Governance”). And the specific reforms that legal scholars believe are likely—creation of circuit courts to limit the influence of parochial interests, more consistent publication of court decisions, prohibition on Party interference in most cases and the creation of limited avenues for public-interest litigation against polluting industries—have the potential to make Chinese governance fairer, more transparent and more responsive to citizens' concerns. As with the anti-corruption drive, a key theme is to readjust the balance of power in favor of the central government at the expense of the localities.

A final element in the governance reform agenda is the important but often-overlooked fiscal program adopted by the Politburo on June 30. By 2016, China will complete its first major overhaul of the nation’s taxation and government spending system in two decades. Key items include the elimination of land-based local government financing and its replacement by provincial bond issues; restructuring of taxes to reduce local governments’ revenue shortfalls and encourage them to promote consumer services, rather than heavy industry; and stronger resource and environmental taxes to arrest environmental degradation and promote more efficient energy use. Once more, much of the focus is on redefining the core role of local governments: their main mission will shift from promotion of economic growth to effective provision of public services.

Cyclical Economic Management Supports the Reform Agenda

Once we understand the primary role of governance, the sequencing of reform measures becomes more evident, and the relative tardiness of more narrowly economic reforms becomes more understandable. But skeptics have another concern: that the government is losing sight of its long-term structural reform goals in a desperate effort to keep short-term gross domestic product (GDP) growth above seven percent. The premise of this worry is that unless the authorities are willing squeeze out inefficiencies and curb the rapid rise in debt—measures which inevitably require a sharp slowdown in growth—then the structural reforms have little chance of success. In short, the economic model cannot change unless the old, bad habits are punished by clear failure.

Two pieces of recent evidence support this view. First, early in 2014, Beijing relaxed monetary policy and started removing long-standing administrative restrictions on house purchases, in order to prop up a property market that seemed on the brink of collapse. These measures reversed the tight monetary policy of the second half of 2013, which succeeded in bringing credit growth down from 23 percent in April to around 16 percent by the end of the year. Second, the new, looser policy meant that the country’s aggregate debt-to-GDP ratio continued to rise in 2014. After rising from 145 percent of GDP in 2008 to 220 percent in 2013, this ratio continued to climb in 2014 and now exceeds 230 percent of GDP. In absolute terms, this figure is not alarming—most developed countries, including the United States, have significantly higher ratios. But the rapid increase in leverage in a short time is usually a harbinger of financial problems.

It is a mistake, however, to assume that the continued increase in leverage shows that Beijing is incurably addicted to its old debt-fueled growth model, or that the authorities have decided to prioritize growth over reform. First of all, the credit stimulus used to support the property market this year was extremely modest: the year-on-year growth rate of credit ticked up only about one percentage point for a few months, and quickly dropped again once stimulus was withdrawn. The removal of administrative restrictions on house purchases arguably played a larger role in the property stabilization than did easy credit.

More important, Beijing’s approach to deleveraging is a deliberate policy choice driven by the conviction that growth and reform are partners, rather than antagonists. A relevant comparison is the debate between U.S. and European policymakers after 2008 about the appropriate response to the global financial crisis, which left the rich economies stuck with low growth and big debts. Washington argued that policy must focus on sustaining growth (through ultra-easy monetary policy and large fiscal deficits), and that fiscal consolidation should take a back seat. European officials, especially in Germany, argued that fiscal consolidation and debt reduction had to be a top priority, even if it harmed growth. Beijing obviously favors an American-style approach to deleveraging and structural adjustment. Given the superior performance of the U.S. economy (relative to Europe) since the global crisis, this is a defensible choice.

Economic Reforms are Proceeding Smartly

The last point is that, in fact, China’s rollout of specific reform measures over the past year has been impressive. In addition to the fiscal reform package, whose significance has been severely underrated by the market-obsessed international financial media, achievements of 2014 include:

• Abolition of registered capital requirements for new firms, which caused growth in new-company registrations to surge to over 20 percent, the highest rate in a decade.

• Switching the resource tax on coal from a volume to a value basis, a long-delayed measure which should discourage excessive investment and promote energy efficiency.

• Publication of a plan to deregulate all pharmaceutical prices beginning in 2015.

• Publication by virtually all provinces of plans for “mixed-ownership” reform of state enterprises.

• A significant opening of the capital account via the Shanghai-Hong Kong Connect program which permits investors in those two financial hubs to put money directly in each others’ stock markets.

• The publication of draft rules on deposit insurance, paving the way for implementation next year, followed by full liberalization of deposit interest rates.

Clearly these are just initial steps and much work needs to be done to broaden these reforms in ways that will have material impact on China’s $8 trillion economy. But it is hard to think of another major world leader whose government has accomplished so much in such a short period of time. Japanese Prime Minister Shinzo Abe, for instance, came to office two years ago promising “three arrows” of monetary easing, expansive fiscal policy and deep structural reform. So far he has delivered only one—monetary easing, which has driven the yen down and the stock market up—but structural reform is missing in action and fiscal policy was disastrously captured by Ministry of Finance hawks, whose consumption-tax increase drove the country into a needless recession. The U.S. government is gridlocked and is still fighting over a health care reform law passed five years ago. Six years after the global crisis, Italy has just begun to put in place long-overdue reforms to its labor market, and France, under its last two presidents, has done nothing at all to address its structural economic malaise. Xi Jinping can certainly be criticized on many issues, but failure to deliver on his reform agenda is not one of them.

       

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While countless factors have contributed to China’s dramatic economic transformation, the groundbreaking economic reforms instituted by Premier Zhu Rongji from 1998 to 2003 were critical in setting the stage for China to become one of the world’s dominant economic powers. From combatting corruption and inefficient state-owned enterprises at home to engineering China’s ascension to the World Trade Organization, Zhu left behind a legacy on which successive administrations have sought to build. What similarities, differences or parallels can be drawn between Zhu’s time and today? And what lessons can China’s current leaders learn from Zhu’s reforms?

On January 9, the John L. Thornton China Center at the Brookings Institution launched the second English volume of Zhu Rongji: On The Record (Brookings Press, 2015), which covers the critical period during which Zhu served as premier between 1998-2003. In addition to highlighting Zhu’s legacy, this event also featured public panel discussions outlining the past, present and future of Chinese economic reform and its impact domestically and internationally.

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• Chinese Economic Reform: Past, Present and Future - Part 1
• Chinese Economic Reform: Past, Present and Future - Part 2

Transcript

• Transcript (.pdf)

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• 20150109_china_economic_reform_transcript

       

Just how much economic trouble is China in? To judge by global markets, a lot. In the first few weeks of the year, stock markets around the world plummeted, largely thanks to fears about China. The panic was triggered by an 11 percent plunge on the Shanghai stock exchange and by a small devaluation in the renminbi. Global investors—already skittish following the collapse of a Chinese equity-market bubble and a surprise currency devaluation last summer—took these latest moves as confirmation that the world’s second-biggest economy was far weaker than its relatively rosy headline growth numbers suggested.

In one sense, markets overreacted. China’s economy grew by 6.9 percent in 2015; financial media headlines bewailed this as “the lowest growth rate in a quarter century,” but neglected to mention that this is still by a good margin the fastest growth of any major economy except for India. Even at its new, slower pace, China continues to grow more than twice as fast as developed economies. Some doubt the reliability of China’s economic statistics, of course, but most credible alternative estimates (based on hard-to-fake indicators of physical output) still suggest that China is growing at around 6 percent, and that if anything there was a slight pickup in activity in late 2015.

It’s true that construction and heavy industry, which drove China’s growth from 2000 to 2013, are now nearing recession levels. But services—which now account for over half of China’s economy—and consumer spending remain strong, underpinned by solid employment and wage gains. The latest Nielsen survey of consumer confidence ranked China eighth of 61 countries in consumer optimism, and confidence actually increased in the last quarter of 2015. All in all, another year of 6 percent-plus growth should be achievable in 2016.

Markets also exaggerate the risk of financial crisis, with their breathless talk of capital fleeing the country. Most of this so-called “capital flight” is simply a matter of companies prudently paying down foreign-currency debts, or hedging against the possibility of a weaker renminbi by shifting their bank deposits into dollars. In the main, these deposits remain in the mainland branches of Chinese banks. Domestic bank deposits grew by a healthy 19 percent in 2015 and now stand at $21 trillion—double the country’s GDP and seven times the level of foreign exchange reserves. The continued fast rise in credit is an issue that policymakers will need to address eventually. But they have time, because lending to households and companies is backed one-for-one by bank deposits. By contrast, the United States on the eve of its crisis in 2008 had nearly four dollars of loans for every dollar of bank deposits. As long as China’s financial system stays so securely funded, the chance of a crisis is low.

Yet while we should not worry about an imminent economic “hard landing” or financial crisis, there are reasons to be seriously concerned about the country’s economic direction. The core issue is whether China can successfully execute its difficult transition from an industry- and investment-intensive economy to one focused on services and consumption, and how much disruption it causes to the rest of the world along the way. History teaches us that such transitions are never smooth. And indeed, China’s transition so far has been much rougher than the gradual slowdown in its headline GDP numbers suggests.

Remember that when China reports its GDP growth, this tells you how much its spending grew in inflation-adjusted renminbi terms. But to measure China’s impact on the rest of the world in a given year, it is better to look at its nominal growth—that is, not adjusted for inflation—in terms of the international currency: the U.S. dollar. This is because nominal U.S.-dollar figures better show how much demand China is pumping into the global economy, both in volume terms (buying more stuff) and in price terms (pushing up the prices of the stuff it buys).

When we look at things this way, China’s slowdown has been precipitous and scary. At its post-crisis peak in mid-2011, China’s nominal U.S.-dollar GDP grew at an astonishing 25 percent annual rate. During the four-year period from 2010 to 2013, the average growth rate was around 15 percent. By the last quarter of 2015, though, it had slowed to a tortoise-like 2 percent (see chart). In short, while investors are wrong to complain that China distorts its GDP data, they are right to observe that, for the rest of the world, China’s slowdown feels far worse than official GDP numbers imply.

This dramatic fall in the growth of China’s effective international demand has already hit the global economy hard, through commodity prices. In the past 18 months, the prices of iron ore, coal and oil, and other commodities have all fallen by about two-thirds, thanks in part to the slowdown in Chinese demand and in part to the glut of supply built up by mining companies that hoped China’s hunger for raw materials would keep growing forever. This has badly hurt emerging economies that depend on resource exports: Brazil, for instance, is now mired in its worst downturn since the Great Depression. The slowdown also hurts manufacturers in rich countries like the United States and Japan, which rely on sales of equipment to the mining and construction industries.

This helps explain why markets react so fearfully at every hint the renminbi might fall further in value: A weaker currency reduces the dollar value of the goods China can buy on international markets, creating more risk of a further slowdown in an already languid world economy.

There is a silver lining: The flattening of its commodity demand shows China has turned its back on an unsustainable growth model based on ever-rising investment. The question now is whether it can succeed in building a new growth model based mainly on services and consumer spending. As we noted above, growth in services and consumer spending is solid. But it is still not strong enough to carry the whole burden of driving the economy. For that to happen, much more reform is needed. And the pace of those reforms has been disappointing.

The crucial reforms all relate to increasing the role of markets, and decreasing the role of the state in economic activity. China has an unusually large state sector: OECD researchers have estimated that the value of state-owned enterprise assets is around 145 percent of GDP, more than double the figure for the next most state-dominated economy, India.[1] This large state sector functioned well for most of the last two decades, since the main tasks were to mobilize as many resources as possible and build the infrastructure of a modern economy—tasks for which state firms, which are not bound by short-term profit constraints, are well suited.

Now, however, the infrastructure is mostly built and the main task is to make the most efficient use of resources, maximize productivity, and satisfy ever-shifting consumer demand. For this job, markets must take a leading role, and the government must wean itself off the habit of using state-owned firms to achieve its economic ends. And the big worry is that, despite the promises in the November 2013 Third Plenum reform agenda, Beijing does not seem all that willing to let markets have their way.

The concerns stem from the government’s recent interventions in the equity and currency markets. Last June, when a short-lived stock market bubble popped, the authorities forced various state-controlled firms and agencies to buy up shares to stop the rout. This stabilized the market for a while, but left people wondering what would happen when these agencies started selling down the shares they had been forced to buy. To enable these holdings to be sold without disrupting the market, the authorities instituted a “circuit breaker” which automatically suspended stock-exchange trading when prices fell by 5 percent in one day. Instead of calming the market, this induced panic selling, as traders rushed to dump their shares before the circuit breaker shut off trading. The government canceled the circuit breaker, and the market remains haunted by the risk of state-controlled shareholders dumping their shares en masse.

Similarly, Beijing got into trouble in August when it announced a new exchange-rate mechanism that would make the value of the renminbi more market determined. But because it paired this move with a small, unexpected devaluation, many traders assumed the real goal was to devalue the renminbi, and started pushing the currency down. So the People’s Bank of China (PBOC) intervened massively in the foreign exchange markets, spending down its foreign-currency reserves to prop up the value of the renminbi. This stabilized the currency, but brought into question the government’s commitment to a truly market-driven exchange rate. 

Then, in December, PBOC made another change, by starting to manage the renminbi against a trade-weighted basket of 13 currencies, rather than against the dollar as in the past. Because the dollar has been strong lately, this in effect meant that PBOC was letting the renminbi devalue against the dollar. Again, PBOC argued that its intention was not to devalue, but simply to establish a more flexible exchange rate. And again, it undermined the credibility of this intention by intervening to prevent the currency from falling against the dollar.

One could argue that these episodes were merely potholes on the road to a greater reliance on markets. This may be so, but investors both inside and outside China are not convinced. The heavy-handed management of the equity and currency markets gives the impression that Beijing is not willing to tolerate market outcomes that conflict with the government’s idea of what prices should be. This runs against the government’s stated commitment in the Third Plenum decision to let market forces “play a decisive role in resource allocation.”

Another source of unease is the slow progress on state enterprise reform.  Momentum seemed strong in 2014, when provinces were encouraged to publish “mixed ownership” plans to diversify the shareholding of their firms. This raised hopes that private investors would be brought in to improve the management of inefficient state companies. Yet to date only a handful of mixed-ownership deals have been completed, and many of them involve the transfer of shares to state-owned investment companies, with no private-sector participation. Plans to subject the big centrally controlled state enterprises to greater financial discipline by putting them under holding companies modeled on Singapore’s Temasek have been incessantly discussed, but not put into action. Meanwhile the number of state firms continues to grow, rising from a low of 110,000 in 2008 to around 160,000 in 2014.

So long as Beijing continues to intervene in markets to guide prices, and fails to deliver on the key structural reforms needed to create a sustainable consumer-led economy, markets both inside and outside China will continue to be nervous about the sustainability of growth, and we will see more “China scares” like the one we endured in January. A clearer sense of direction is required, as is better communication.

For three decades, China sustained fast economic growth by steadily increasing the scope of markets, even as it preserved a large role for the state. Because investors were confident in the general trend towards more markets and more space for private firms, they were happy to invest in growth. Today neither private entrepreneurs in China, nor traders on global financial markets, are confident in such a trend. By the end of 2015 growth in investment by non-state firms had slowed to only about two-thirds the rate posted by state-owned firms, ending nearly two decades of private-sector outperformance.

Doubts are amplified by the government’s failure to communicate its intentions. During the last several months of confusion on foreign exchange markets, no senior official came forth to explain the goals of the new currency policy. No other country would have executed such a fundamental shift in a key economic policy without clear and detailed statements by a top policymaker. As China prepares for its presidency of the G-20, the government owes it both to its own people and to the global community of which it is now such an important member to more clearly articulate its commitment to market-oriented reforms and sustainable growth.

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[1] P. Kowalski et al., “State-owned Enterprises: Trade Effects and Policy Implications,” OECD Trade Policy Papers No. 147 (2013). http://dx.doi.org/10.1787/5k4869ckqk7l-en

       

       

       

       

       

       

What makes the Trans-Pacific Partnership (TPP) consequential?

Since the onset of the 21st century, countries from every corner of the world have vigorously negotiated free trade agreements (FTAs) based on the principle of preferential market access (as opposed to the most-favored nation obligation of the WTO). This has resulted in a veritable avalanche of such trade deals, with close to 400 FTAs notified to the WTO in the past 20 years. If the negotiation of preferential trade agreements is now the dominant trend in the trading regime, and almost no country has escaped contagion from the FTA syndrome, why does one agreement in particular—the TPP—remain the focal point of policy debates on trade?

Chart 1. Multilateral trade regimes and FTA proliferation

The TPP generates most attention because it has spurred the emergence of mega trade agreements (as compared to the mostly small bilateral trade deals that had characterized the FTA wave), and has offered a new platform to advance the trade agenda as negotiations on the Doha Round continue gridlocked. The TPP has come a long way from its humble beginnings as a trade grouping of four small open economies (Brunei, New Zealand, Chile, and Singapore). Today, it comprises 12 nations, covers 26 percent of world trade, and is expected to generate global income gains in the neighborhood of $492 billion by 2030.

Chart 2. From humble beginnings to mega trade deal

But the significance of the TPP is not to be grasped by numbers alone. Consider the following defining traits of this trade agreement:

1. Its high level of ambition for tariff liberalization vowing to disallow sectoral carve-outs. While it is true that sensitive sectors asserted their political weight by deferring or limiting tariff elimination (e.g., autos for the United States and five agricultural commodities for Japan), the commitment of TPP countries to eventually eliminate 99-100 percent of tariff rates is indeed impressive. Japan does stand out for a lower level of committed tariff elimination (95 percent); but again this is the highest level of liberalization that Japan has ever committed to in any trade negotiation.
2. Its comprehensive set of rules to target non-tariff barriers by introducing disciplines on issues such as regulatory coherence, state-owned enterprises, competitiveness, supply chains, etc. With 30 chapters and over 5,000 pages of text, grasping the reach of TPP rules will certainly take time. However, a quick glance does reveal novel, and needed, disciplines in important areas of the economy. For example, the e-commerce chapter establishes a binding obligation for governments to allow free data flows, disallows forced localization of data servers (except for the financial sector), and mandates that all countries must provide a legal framework to protect personal information. Another important innovation is the TPP provision that governments cannot require the transfer of source code from private companies operating in their market.
3. Its expansive vision as an Asia-Pacific platform with aspirations to set global standards. Its open architecture with a docking mechanism to encourage further member expansion and its explicit aim to establish a trans-regional platform that bridges Asia and North and South America are strong selling points for the TPP. It undercuts the oft-mentioned fear of using preferential trade agreements to create closed-off regions, and it gives its rules and standards the opportunity to disseminate far and wide.
4. Last but not least, the TPP has emerged as a central policy priority for both the U.S. and Japan to hone their international economic competitiveness and achieve broader foreign policy goals. In the area of foreign economic policy, the TPP is one of the most compelling frameworks to encourage China to deepen its market reforms and sign on to more ambitious liberalization commitments. The TPP, therefore, has emerged as a central arena for the interaction of the three giants of the world economy.

The TPP’s effect for the United States and Japan

The United States as a Pacific power

The U.S. expects to reap important economic benefits from the TPP. It is a trade agreement that taps into the areas of competitive strength of the American economy: agricultural exports, trade in services, the digital economy, to name a few. Econometric studies put the expected income gains of the TPP for the U.S. in the order of $131 billion per year, and to the extent that the TPP becomes a global standard, these gains will grow. Indeed, the TPP is the centerpiece of the American trade agenda. Its success is required for continued momentum in the on-going trans-Atlantic trade negotiations, but it could also influence other important trade initiatives. For example, TPP disciplines on services and state-owned enterprises are expected to influence deliberations on the Trade in Services Agreement, a plurilateral trade negotiation carried out under the aegis of the WTO.

From the point of view of global governance, the TPP is a litmus test of the U.S. ability to provide leadership at a time of great complexity in the world economic order: one where supply chains have emerged as a main driver of production and trade, where emerging economies are increasingly vocal in the management of the global economy, and where the test of updating Bretton Woods institutions looms large. Through the TPP, the U.S. can display its convening power to negotiate novel trade rules, to devise new institutional forms that complement and spur on the multilateral regime, and to be proactive and not just reactive to initiatives from rising economic powers.

But the TPP is also a pillar of U.S. Asia policy, one that solidifies the U.S. commitment to remain an engaged Pacific power. This trade agreement increases the appeal of the rebalancing policy by defining it not just as a reorientation of military resources toward a region undergoing a significant power transition; but also as the pursuit of a common endeavor: furthering economic interdependence with rules that match the realities of the 21st century economy, and potentially establishing a bridge toward China with the prospect of TPP membership.

Japan is an essential partner for the U.S. to achieve these important goals. Japan came late to the TPP negotiations (in the summer of 2013), but it transformed the economic and political significance of this deal. Japan’s participation allowed the TPP to qualify as a mega trade agreement. For the U.S. alone, the projected economic gains with Japan on board tripled. This is not surprising given the size of the Japanese market and the fact that the U.S. and Japan do not have a bilateral trade agreement; nor has Japan ever accepted these levels of liberalization. Moreover, prior to Japan joining the TPP there were doubts as to whether this could indeed become an Asia-Pacific platform of economic integration since no major Asian economy was participating. Japan’s entry put those objections to rest.

Japan as a reviving power

For Japan as well, the TPP negotiations have had salutary effects on its trade diplomacy and on the pursuit of central domestic and foreign policy priorities. Prior to joining the TPP, Japan’s trade strategy had achieved modest results: it lagged behind its peer competitors in negotiating an FTA network that covered a substantial share of its trade, it had faced difficulty in persuading Southeast Asian countries to adopt many WTO+ rules, it had received the cold shoulder from the U.S. and Europe as it proposed the negotiation of trade agreements, and remained deadlocked with China over the membership configuration of an East Asian trade grouping. The TPP altered the parameters of Japanese trade policy. It allowed the country to negotiate preferential access to main markets of destination, to disseminate next frontier trade rules, and to undertake concurrent mega trade negotiations. As a reaction to Japan’s courting of TPP membership, China recalibrated its trade policy to speed up the launch of trilateral trade negotiations in Northeast Asia and was now amenable to a 16-member trade grouping upholding the principle of ASEAN centrality (Regional Comprehensive Economic Partnership or RCEP), and the Europeans also came to the negotiation table.

As a full participant in the mega FTA movement, Japan can aim high in order to pursue signature objectives such as:

• Negotiate deep integration FTAs that enhance the international competitiveness of Japanese global supply chains. An assessment of Japan’s core competencies in the 21st century should start with the recognition that a significant share of industrial capacity has been relocated overseas. On-shoring of manufacturing operations is not a viable goal given projected demographic trends. Rather, the aim should be to sustain and strengthen Japan’s role in global supply chains (the leading force of international production and trade today). Japan’s international diplomacy has a role to play here by negotiating deep FTAs that meet the needs of fragmented production chains. Additionally, deep FTA commitments will also help Japan address its own domestic inefficiencies such as the modest liberalization of the services sector.
• Lock-in structural reforms. One of the main benefits of linking the domestic structural reform agenda to international trade commitments is that it will be harder to roll back the reforms if and when political circumstances change (this is indeed a major lesson of the failure to institutionalize Prime Minister Junichiro Koizumi’s reforms). Importantly, the TPP negotiations do not conform to the old-style gaiatsu pattern where a reluctant Japan would deflect U.S. pressure for it to change its ways. This time Japan has eagerly sought to be at the TPP table and has—of its own accord—identified the synergies between the new trade commitments and its own efforts to reform the domestic economy.
• Manage the transition from “regime-taker” to “regime-maker.” With the stagnation of the WTO, we have moved to a system of decentralized competition whereby different clusters of countries seek to define the standards for economic integration. The costs of a passive trade policy are much higher today than in a most favored nation (MFN) world where preferential trade agreements were the exception and not the rule. The expectation of steady liberalization benefits through successive multilateral trade rounds has been sharply revised. Therefore, countries that want to avoid the discriminatory effects of existing preferential trade deals and to improve access to important markets through additional elimination of tariffs and the adoption of rules that address behind-the-border barriers have resorted to an active FTA diplomacy. More broadly, Japan has much to win from displaying leadership in international economic governance, in a manner that resonates with the goals of the Abe administration to play a proactive role in world affairs.

Conclusion of TPP talks: Significance and impact

For all the shared interests between the U.S. and Japan in the TPP project, negotiations over long divisive market access terms proved difficult and frustratingly long. Of course, a host of other issues also kept the larger TPP membership apart. Biologics especially was the last topic to close in the final TPP ministerial held in Atlanta in October 2015, and negotiations went to the wire. Despite all these difficulties, the ability to strike a TPP deal last fall represents a big win for the trade regime which has not seen a success of this magnitude in two decades. Since its creation, the WTO has not updated the rules of international trade and investment, and the Doha Round lingers on life support. Many were skeptical that a major trade negotiation tackling front and center the complex and unwieldy behind-the-border agenda could succeed. This is the most powerful message coming from Atlanta: it can be done.

With a TPP deal in hand there is greater hope that we can manage the tectonic changes in international trade governance. The transformation of the trade agenda (increasingly about regulatory matters) and the limitations of the WTO as a negotiation forum, have called into question the pure multilateral ideal—one set of binding rules for 150+ countries. Instead, the center of action is now on what we call “variable geometry” arrangements where subsets of countries negotiate next-frontier rules: the plurilaterals in the WTO and the preferentials through mega trade agreements. The emerging system for trade governance is not risk-free, and much effort will be required to forestall potential dangers: fragmentation (if TPP-like standards do not disseminate widely) and exclusion (if less developed countries are bypassed by the FTA wave).

Moreover, the TPP deal opens a new and promising chapter in U.S.-Japan relations. It is certainly more than a U.S.-Japan trade agreement—it represents the ability of 12 countries at varying levels of development and with very different regulatory regimes to agree on the most substantive trade liberalization to date. But it is also true that at the core of the TPP, the U.S. and Japan as the largest and most developed economies have acted as an engine of negotiations. The TPP marks a milestone in U.S.-Japan relations, as an effective instance of cooperation to upgrade the international economic architecture. In the TPP, the U.S. and Japan are on close alignment on the rules area of the talks and were able to reach an agreement on market access issues that in the past had proven intractable.

Ratification, reform, and reach

None of these effects will be long lasting nor will they reach their full potential, if TPP countries (and the U.S. and Japan in particular) do not double down on the next crucial steps. For simplicity sake, these can be dubbed the three “Rs” of ratification, reform, and reach.

Ratification

Ratification rules in the TPP require that six countries representing 85 percent of combined GDP approve the agreement before it enters into force. Therefore, to meet this numerical requirement both the U.S. and Japan must ratify. However, for the U.S., TPP ratification will represent a steep political battle in the midst of an American presidential election year. Despite public opinion polls showing that most Americans see in international trade an opportunity, the politics of trade agreements are fractious. Long-standing opposition by environmental groups and unions to trade agreements has resulted in their active mobilization against the TPP. And the debate on the merits of trade agreements has only become more heated as critics suggest that trade globalization is to be blamed for growing income inequality and the erosion of state regulatory powers.

For both national parties, the TPP is a divisive issue. While President Barack Obama has made TPP negotiation and ratification a central priority of his administration, Democrats in Congress have not backed his trade initiative in large numbers, in part due to the opposition of the party’s traditional base, labor unions. The internal dynamics of the Republican Party have shifted dramatically, complicating the odds for the TPP. The Republican Party has become less cohesive with the emergence of the Tea Party wing determined to deny Obama a legacy-making trade agreement. The support of key Republican figures in the Senate has also waned due to dissatisfaction over the tobacco carve-out from investor-state dispute settlement and the exclusivity period for biologics. And the business community has also criticized these provisions, offering only qualified support for the TPP deal.

The U.S. has yet to fail in ratifying a negotiated trade agreement. And a vote down on the TPP would be singularly costly for the credibility of U.S. foreign policy and the evolution of the international trade regime.

Reform

One of the most powerful benefits of trade agreements is the ability of governments to use them as commitment devices to implement needed economic changes. Reform is in fact the crucial issue for Japan as it tries to leave behind stagnant growth. Economic revitalization certainly goes beyond agricultural reform, to encompass the host of productivity-enhancing measures across all areas of the economy, the internationalization of services, the promotion of inward direct investment, and the further upgrading of regional and trans-regional production networks.

Yet, farming countermeasures adopted in the wake of the TPP deal have raised doubts about the government’s resolve to transform its agricultural sector. Japan’s TPP market access commitments do include a 56,000-ton import rice quota (to grow eventually to 78,400 tons). But the government promptly announced an increase in stockpiling purchases to match the TPP quota, effectively preventing a drop in the price of rice and market adjustment. This artificial support preempts the modernization of the agricultural sector since it enables part-time farmers to continue operating in tiny plots, hindering the emergence of commercial farming. The government also submitted a generous 2016 supplementary budget with 312 billion yen earmarked for agricultural TPP countermeasures. But informed experts question its impact in boosting farming competitiveness since public works allocations still loom large (30 percent of outlays will go to land reclamation projects).

Just as the electoral cycle has not facilitated TPP ratification in the U.S., the looming Japanese Upper House election in July is not conducive to moving past prior trade compensation practices.

Reach

The release of the TPP text has clarified a very important point: membership can be extended not only to APEC economies but also to other countries that are willing to meet TPP disciplines. Enlargement will be critical to avoid the above-mentioned risks of fragmentation and exclusion by helping disseminate TPP standards. In the short and medium term, the conclusion of the TPP talks is expected to have two main effects: increase the list of potential applicants, and encourage a higher level of ambition among on-going trade negotiations.

The number of economies expressing an interest in joining the TPP has grown to include South Korea, Taiwan, Indonesia, Thailand, the Philippines, Colombia, and Costa Rica, among others. Regarding the second wave of accession the key issue will be readiness to undertake the ambitious liberalization commitments of the TPP, and the list of prospective applicants shows wide variation on this score. The conclusion of TPP talks also creates an incentive for the updating of existing FTAs and/or scaling up the level of ambition in ongoing trade negotiations, as countries outside the TPP want to secure export markets, attract foreign direct investment, and embed their companies in global supply chains.

In the long run, the key challenge will be to devise an effective strategy to engage emerging economies, such as China, India, and Brazil. This is still the gaping hole in the U.S. plans to develop trans-Pacific and trans-Atlantic trade groupings. Certainly, putting in place the TPP and the Transatlantic Trade and Investment Partnership is the first step in such strategy since it changes the incentive structure for these countries to entertain further market liberalization. But at the end of the day, these emerging economies must reach the determination that it is in their national interest to abide by these economic standards, and find the political will to tackle vested interests. This is a tall order indeed.

The most pressing question may well be how China will position itself vis-à-vis the TPP. Can we expect it to act on past precedent and seek TPP accession just as in the past it used WTO membership to advance economic reforms? Or will it choose instead to champion the negotiation of a Free Trade Area of the Asia-Pacific (FTAAP) after both the TPP and RCEP materialize, in order to play a more proactive role in the international economic architecture—more in conformance with the recent launch of the Asian Infrastructure Investment Bank?

The recently struck TPP agreement underscores the potential of furthering U.S.-Japan cooperation to supply needed international economic governance. However, the overview of remaining challenges also shows that clinching a TPP deal is just the first step.

This article originally appeared in the March/April 2016 issue of Economy, Culture & History Japan SPOTLIGHT Bimonthly.

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In an era of fluid geopolitics and geoeconomics, challenges to the global order abound: from ever-changing terrorism, to massive refugee flows, a stubbornly sluggish world economy, and the specter of global pandemics. Against this backdrop, the question of whether leader summitry—either the G-7 or G-20 incarnations—can supply needed international governance is all the more relevant. This question is particularly significant for East Asia this year as Japan and China, two economic giants that are sometimes perceived as political rivals, respectively host the G-7 and G-20 summits. 

On April 18, the Center for East Asia Policy Studies and the Project on International Order and Strategy co-hosted a discussion on the continued relevancy and efficacy of the leader summit framework, Japan’s and China’s priorities as summit hosts, and whether these East Asian neighbors will hold parallel but completely separate summits or utilize these summits as an opportunity to cooperate on issues of mutual, and global, interest.

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Introduction

Reaching education goals in the coming years will require sharp increases in funding and better delivery. Despite a global focus on improving access to education, nearly 60 million children in developing countries remain out of primary school and increased investments have not translated to better education quality or improved learning outcomes (UNESCO 2015a). Even with an increase in domestic public expenditure, UNESCO estimates that the financing gap for delivering good quality universal education from pre-school through junior secondary levels by 2030 in low-income countries will be $10.6 billion, on average, between 2015 and 2030—over four times the level currently provided by official donors ($2.3 billion) (UNESCO 2015b).

Closing acute financing and delivery gaps that prevent access to quality education will be a major challenge, requiring all hands on deck. Domestic governments and foreign donors will need to step up their game substantially, but fiscal and capacity constraints are likely to prevent them remedying resource deficits on their own in the short term. Non-state actors—mainly religious and charitable organizations, private (“foundation”) schools, and a small number of for-profit schools—are already partially filling the gaps, although the precise extent of their services and their impact is unknown.

Determining the appropriate role of non-state actors in education is a contentious topic among specialists. Disagreements have revolved around serious normative issues, including such basic questions as whether non-state provision is consistent with the principle of education as a human right, and serious empirical questions relating to quality and equity implications. This discussion has been blurred by definitional issues (i.e., what is non-state and private education?); lack of clarity over distinctions between ownership, delivery, and financing; a lack of accurate data on current and potential provision rates; and an insufficient base of evidence from which to draw clear conclusions on the effectiveness of non-state engagement in education. These problems have made it difficult to generate comparisons across empirical studies, leading to significant variation in the interpretation of evidence. For some observers, evidence has fueled concern that non-state education is violating human rights principles (e.g., the report by the United Nations Rapporteur on Education),1 while for others it has provided encouragement that non-state engagement can help address financing and delivery challenges (e.g., Tooley 2009).

Our goal is to provide a neutral background to this debate and identify areas of common ground. Beginning with some big picture facts, this paper develops a detailed language around non-state actors in education. We then outline current issues and poles of debate around engagement of non-state actors in education and provide an assessment of the depth of available data and evidence. To close, we establish a typology and propose a framework for discussions around the role of non-state actors in basic education and how these actors can best contribute to the achievement of Education for All and the Sustainable Development Goals (SDGs). Our paper refers largely to basic education, including pre-primary, primary, and lower-secondary, as this is the main focus of much recent discussion around the role of non-state actors in education and an area of strong growth in developing countries.

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