Three members of the Bush Cabinet are here today, trying to patch up economic relations. It's not going to be easy. In conversations in China this past week, I heard the muddle-through-uneasily forecast. And I heard the downward-spiral theory.
The downward spiral starts with China's cooling economy. Slower growth is expected to bring a tripling of China's trade surplus this year, triggering more friction with Congress. But the downward spiral is more than just a cyclical forecast. It's about Chinese savings and investment.
Right now China saves prodigiously, putting aside nearly 50 percent of gross domestic product. But it invests almost as much, plowing nearly all the savings back into its growth machine. The small gap between savings and investment drives China's global trade surplus. The downward-spiral theory holds that the gap will grow over the next five to 10 years, and the trade surplus will grow with it.
Why would the gap grow? Well, China's savings are driven by its demographics. Because of the one-child policy, people don't have enough kids to take care of them in old age; and life expectancy is rising. Public safety nets are full of holes, so people have to provide for themselves. All this means Chinese savings probably won't fall much. Supporting this theory, Japan and South Korea carried on saving furiously until they were a lot richer than today's China.
What about investment? Here there is scope for attrition. China's astonishing investment rate -- which is around 10 percentage points higher than South Korea's during its boom years -- is partly a good thing. China has twice as many miles of paved roads as its giant rival, India, and its booming coastal towns boast wonderful airports and broadband connections. Port cities such as Ningbo are sprucing up their downtown areas, landscaping the roadsides and restoring historical buildings. While here I visited the Bank of China, a vast government-owned lender, expecting to find a seedy communist building. Instead I found a futuristic atrium. "It's by I.M. Pei, so we have to pay," my host said laconically.
So you can see the fruits of China's high investment rate, and a lot of it is impressive. But part of it -- 5 percent of GDP, maybe? -- reflects the corruption and incompetence of the Chinese financial system. Until recently, at least, state-owned lenders allocated capital to no-hope state enterprises in order to keep them from firing everyone, so this so-called "investment" was really just welfare. These days, the bigger problem is that political bosses and their buddies bully state banks into financing deals that are designed to generate kickbacks. If China could squeeze this waste out of its system, its investment rate would fall, expanding the gap between investment and savings and driving up the trade surplus.
Well, China is squeezing. The regime campaigns loudly against the crony capitalists: Bosses who get caught face jail, and the communist ban on free and energetic journalism has been partially suspended for outfits that expose corruption. To promote non-cronyistic lending, the Bank of China has fired its workers and told them to reapply for their positions. It has brought in prestigious foreigners to instill Western lending practices. The bank's leaders know they need to enforce these reforms because next year Western competitors will be allowed into their market.
So although the financial system isn't anything like perfect, it is getting better. That means the allocation of capital will grow less wasteful, and China will be able to maintain miraculous growth while investing less frantically. As the widening savings-investment gap pushes up the trade surplus, China will accumulate huge piles of dollars. Its current takeover bids for Unocal and Maytag will prove to be the beginning of a coming avalanche of acquisitions in the United States and Europe.
Hence the downward spiral. Congress is already foaming at the mouth about China's existing trade surplus, and the administration has hit China's textiles with dumb quotas. If the trade surplus gets bigger, other U.S.-China frictions -- intellectual property disputes, the battle for influence in Asia -- will become impossible to manage.
Can this be avoided? The optimists -- those who believe that U.S.-China relations will remain troubled but not actually get worse -- pin their hopes on the government's ability to drive China's savings downward. The key here is to build social safety nets. The government would borrow to pay for pensions and public health care, forcing national savings down; the existence of those safety nets would encourage Chinese households to spend more freely. Yu Yongding, a smart economist who advises the government, talks bravely about reorienting the whole economy from export orientation to growth based on domestic consumption.
To anyone who heard Japanese economists advocate the same policy 10 or 15 years ago, Yu sounds a little hopeful. Investment-driven growth can be addictive, and the government borrowing needed to finance safety nets would be politically unpopular. But then this is China, where change is so rapid that nothing can ever quite be ruled out. Next time a U.S. economic team lands here, how to drive down China's savings rate should be part of the discussion.