Razeen Sally on Protectionism, International Trade, and China

Razeen Sally is an associate professor at the Lee Kuan Yew School of Public Policy at the National University of Singapore and formerly taught at the London School of Economics. He is also the Chairman of the Institute of Policy Studies, the main economic policy think tank in Sri Lanka and a senior advisor to Sri Lanka’s Minister of Finance. He joins Macro Musings to discuss the state of international economic affairs and how it specifically relates to Asia. Razeen explains why he believes the U.S. should stay engaged within Asia and also shares his thoughts on China’s demographic problem as well as the effects of the Trump administration’s increased protectionism.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Razeen, welcome to the show.

Razeen Sally: Thank you.

Beckworth: It's a real treat to have you on. Like I do with all my guests, I would like to know, how did you get into economics?

Sally: The first broadly economic book I read was Robert Heilbroner's Worldly Philosophers, which got me interested in the basic ideas. And then I went to the London School of Economics. That was my initial interest. I was always interested in the political side of economics, political economy. And that came from my experience as a child in Sri Lanka. My family had pretty severe political problems in the 1970s. My father was in jail for a while. So I acquired political consciousness at the age of six. The economics came later.

Beckworth: Wow, very interesting. We're grateful you took this journey into economics. You've done a lot of interesting work, written on Asia and you're doing policy work there now. And in this show, I want to take an on the ground look at what's happening up close. And we'll step back to the 30,000 foot macro perspective, because you've written some interesting pieces on that. What is happening in Asia and what role does America have to play still in the region. But I want to first, again, look at some of the facts on the ground. You've written about some of these. And I want to begin with the apparent global trade slowdown. I know that maybe recent indicators say it may have picked up again. But tell us about that. What happened, and how do we interpret it?

The Global Trade Slowdown

Sally: What happened was until the global financial crisis hit, in the 30 years or so before that, international trade grew twice as fast as world GDP, which was a good indication that trade was an engine of growth. Then trade crashed with the crisis. It fell 10% or thereabouts, the worst since the depression. And there was a rebound after that, but for a period of about four or five years, until a year ago or a year and a half ago, trade didn't shrink. But it grew much more slowly than it did before the crisis. And barely kept pace with world GDP growth. Now, the reasons for that, there were several reasons given, some cyclical, some structural. But I think with hindsight, the best reason given for it is that it was because growth slowed down such a lot. Particularly fixed investment. That fed into lower trade volume growth around the world. That's a cyclical explanation. In other words, if we can get growth back up, and levels of fixed investment up, then trade growth will follow. And that's probably what's happened just in the last to a year and a half.

Sally: We've seen a global economic revival. The three major centers of the global economy have all been firing more than since the crisis. That's led to more investment. And that's translated into better trade growth than we saw before. That's I think the central explanation. Other explanations are probably over-egging the pudding. Namely that we were entering a period of secular stagnation. We know who thought up that term recently.

Beckworth: Larry Summers.

Sally: Indeed.

Beckworth: Past guest on the show.

Sally: And that translates into a secular slowdown in GDP and trade and so on. I think that's way too premature. There was an argument that global supply chains had delivered the big trade growth they did before the crisis, much less after that. There was an argument that protectionism was affecting trade. We haven't seen, until recently, a significant increase in protectionism since the crisis. It hasn't made that big a dent into international trade.

Beckworth: That's interesting you mention protectionism, because trade appears at least to be increasing. The latest IMF World Economic Outlook report is out, and it's showing some sign of recovery. And yet here we are, 2018, and Donald Trump is doing his best to disrupt that progress. And I just want to run through a few headlines. And this gets us to this next point. There seems to be a growing wave of protectionism, at least rhetoric, some actual policy following that. But I have here just a collection of headlines I found, one from CNN. They put together... They detailed Trump's decisions, his policies. So April 2017, soon after his election, he comes into office. He launches investigations into steel imports. August 2017, he has his trade representative look at China's unfair trade practices with regards to intellectual property issues. They estimate the US is losing between $225 billion and $600 billion because of intellectual property to China. It's quiet for a few months.

Beckworth: Then in January 2018, we have the first major trade action against China with 30% tariffs on imported solar panels. And China expresses strong dissatisfaction. And in February, the Commerce Department proposes tariffs on steel and aluminum. Trump follows through in March, recently, steel imports at 25%, aluminum at 10. Of course, we exempt our NAFTA partners. There's so much going on here. I could go on, but Trump has imposed tariffs. China responds. Little tit-for-tat. And it hasn't probably escalated into what we would probably call a trade war. But there's a lot of rumblings going on. And this raises a bunch of questions. Let me start with the first one. Why now? Why has this all come to a head now? Is it just because of Donald Trump, or is he part of a bigger trend or phenomenon that someone else would have done if it hadn't been Trump?

Breakdown in US-China Trade Relations

Sally: He's clearly responding or taking advantage of cracks here in the United States and elsewhere in the west. Yes, there is a sort of anti-globalization backlash. It's wound up with a general upsurge of populism. It's neuralgic points seem to be a combination of trade and immigration. And if Hillary Clinton had been president, maybe she would have responded to some of these pressures as well. And we would have seen a moderate increase in protectionism. But I think this is much more a Trump phenomenon here in the United States. We have similar pressures in Europe, particularly against migrants, to a lesser extent against trade. But we haven't seen the kind of protectionist upsurge that we've seen in the United States. And that I think points to a Trump phenomenon. So we have a president who is the most isolationist since at least Herbert Hoover. And this is not an aberration. So what he's doing is not surprising given his public pronouncements over 30 years or more. He's clearly an isolationist in his gut, protectionist in his gut. He talks a crude mercantilist language.

Sally: And so we have things coming through the pipeline now that are far worse than they would have been with a Clinton presidency on trade and probably on immigration as well. I think we are now at a tipping point. What we've seen so far is a kind of creeping protectionism since the crisis, which hasn't damaged the world economy too much. It's been kept within fairly narrow bounds. But now when the leading economy in the world seems to be on the verge of implementing major acts of protectionism rather than minor ones, starting with the steel and aluminum tariffs, then going on to that $50 billion or $100 billion. Maybe much bigger restrictions on Chinese investment coming into the United States going beyond narrow national security concerns. Then I think we might be entering new territory, because this is not something that's going to be contained. The Chinese will retaliate.

Sally: The Europeans will retaliate. And then small and medium sized economies will start copy catting as well. And all around the world, interest groups favoring protection against imports will gain succor from it. And they will have more lobbying clout with their governments. In the process, the WTO will be severely weakened. So all of that I think is bound to translate into a bigger impact on international trade and the world economy. So unless the start of this process is contained, I fear that we are going to enter a period of creeping protectionism accelerating and then having an impact on bigger chunks of international trade. So far, protectionism hasn't really harmed this network of global supply chains that have come to dominate trade in the past generation. But I fear that this process will start to make inroads into those global supply chains in manufacturing and services. And then we will see an appreciable impact on GDP. Now of course, any macroeconomist will say there are all kinds of other macroeconomic factors at play, not least the recent tax reform, which is giving a stimulus to the American economy and the world economy.

Sally: So you have to consider all these factors into play. But I think on trade, there are worrying things going on that could easily get out of control.

Beckworth: Okay, so we have a Trump bump in the road now, but it could be an inflection point if things don't change. It could be a true change in direction for trade policy. This is interesting. It speaks to the importance of personalities, leadership. Some people argue history is shaped by movements, others by people. But you can have a bit of both. In this case, as you mentioned, Trump has been pretty consistent on his view on trade going several decades back.

Sally: Yes, and I think there are still grounds for some optimism. I don't want to lay the darkness on too thickly. I still have faith in your Constitution and in the institutions that have been developed over more than two centuries, the decentralization of power that it involves, the checks and balances that it involves. So we see that at play. There are companies, American companies in global supply chains who are pushing back, because consumers and producers here in the United States will be affected. There are key agricultural exporters in key swing states. There are Republicans in Congress. There are individuals within the administration who are trying to limit the damage and work in a different direction to countervail the president and some of the dangerous people around him.

Sally: And that in combination with pro-globalization interests in the rest of the world. All of those countervailing forces are more powerful than they were a generation or two generations ago. So we should have some faith in all of that. That may not be enough to arrest these worrying short-term movements.

Beckworth: Okay. But I think your point is, the global supply chains are so interwoven through our economy... I'm from the south. I live near Nashville, and there's factories around there. There's factories in Alabama, South Carolina, these auto plants are there. The global supply chain will really hit home if this trade dispute gets taken farther down the road and it affects jobs. And you'll see political feedback. So we have that optimism, I guess, is what I'm hearing from you, that there will be some kind of check.

Sally: Yes. It's not automatic. This is where ideas matter. It's important that we have individuals, institutes, thought leaders who make the case for free markets and free trade and for the right kind of government to provide the framework for all of this to happen, rather than the wrong kind of government. And that needs to work, as John Stuart Mill said, in season with other things out there. The word in season is very important.

Beckworth: All right. So there's several aspects of Trump's trade concerns. One part of that I think is just pure confusion. He's worried about bilateral trade deficits without thinking about multilateral trading patterns. He mis-understands what a trade deficit is. The flip side of that is we're exporting lots of financial assets. Give me 15 minute with President Trump and I'll tell him, we've won the trade war in terms of exporting financial assets. So he gets that wrong, and I think that's just a question of him hanging on to his cherished beliefs. But there is a legitimate concern he raises, and that's the intellectual property right issue we mentioned earlier. And he's addressing that, it would have been addressed by any other president. But there is a better approach to take than going down this path. Wasn't the TPP part of the original push to handle that? Can you speak to that alternative approach?

The TPP and Addressing Intellectual Property Concerns

Sally: Sure. I think that there are two options on the table to deal with this ascendant Chinese mercantilism, which includes infringements of intellectual property rights all the way to outright theft. The Trumpian option, which is the raw, crude mercantilist option, is to threaten trade sanctions. So you put up the barriers at home as a bargaining chip to get the Chinese to make the concessions they wouldn't make otherwise. Of course by doing that, as Joan Robinson once famously said, because other people are throwing rocks into their harbors, you're throwing rocks into yours. But clearly the president doesn't get that and is not amenable to persuasion, to reasoned argument at that front.

Sally: The alternative option is not to use that kind of stick. In other words, not to raise your own barriers to what the Chinese are doing. Because by doing so, you are harming your consumers and producers and fundamentally, you are harming the competitiveness of the home base, which is the foundation for your international success economically and politically. Throwing rocks into your harbor, as it were. The alternative option is to strengthen alliances with like-minded countries who have the same concerns vis a vis China, with the Europeans, with the EU, other European countries, and indeed some emerging markets as well to join the TPP, because there you have an alternative framework for market rules to compete with what the Chinese are offering, which is an attractive magnet for many developing countries.

Sally: To join with others to take cases more robustly to the World Trade Organization, not to destroy the World Trade Organization in the process, as this administration seems to be trying to do. To buttress NAFTA rather than undermine it. So that kind of alliance building, FTAs, WTO, alongside keeping the border open at home and improving competitiveness at home, I think is the viable alternative option to put pressure on China to move in a different direction. Now even that might not work. It is clear to me that the Chinese government, particularly under President Xi, is serious about a mercantilist strategy for development. The China 2025 program is at the heart of it. I don't think they're going to stray from that too far, whatever pressure they might come under internationally. It'll affect them at the margin. But we can live with that. Yes, it's a threat, but the answer is not to batten down the hatches at home in a zero sum world. The answer is to strengthen the home base in an open world as the riposte to Chinese mercantilism.

Sally: And then let the market sort it out and show which model is superior. In other words, we have to have faith in markets and in the appropriate role for government, rather than adopt a soft form of Chinese mercantilism.

Beckworth: Now the TPP, just for the listeners who don't know, is Trans Pacific Partnership. If I understand correctly, had the US followed through and joined it, it would have represented roughly 40% of world GDP, is that right?

Sally: Yes.

Beckworth: So you would have gone to China with 40% of world GDP and said, hey. This is what we want to change. You need to be more honest with your use of intellectual property rights, you need to treat these firms that come into your country evenhandedly. And we've squandered that opportunity. Do you think that's the reason Trump is reconsidering the TPP? At least he's mentioned it. He may have dismissed it again, but at least he tinkered with the idea of going back to it.

Sally: Who knows what goes through the president's mind at three in the morning. Your guess is as good as mine. It could be that. It could be pressure from Midwestern states exporting soybeans and what have you. A channel through the vice president. Who knows? But yes it was a major strategic blunder for the United States to withdraw from the agreement it had led. It's an American agreement.

Beckworth: And how many years in the making was this? This is many years.

Sally: It started as a negotiation among a few small countries in Asia Pacific. Others joined and then the Americans and the Japanese joined, which made all the difference, because America and Japan together make up the bulk of the TPP's GDP. And at the heart of the Trans Pacific Partnership is basically a free trade agreement between the United States and Japan, but in a pluri-lateral setting. So the United States absenting itself from the agreement is a strategic blunder all round, because it's economically damaging. It also means the US has less bargaining clout with China on the very issues we're discussing. But it's also very bad for the geopolitics of Asia, because it sent a very clear signal that the US was retreating even more from Asia, not just economically but way beyond that. Perhaps a harbinger of military retreat. And the Chinese have taken that signal to push further in their newfound assertiveness in the broader region, not just economically but also militarily.

Beckworth: I want to come back to that point in a minute, because you have a nice article on that. But before we do that, one other on the ground observation or development. And that has been the tightening of financial conditions around the world. Central banks have been winding down, or at least the Federal Reserve has been winding down its large scale asset purchase program. There's talk of other central banks slowing down. The Fed's been raising interest rates. Just this week, the 10-year Treasury yield rose above 3%. And there's talk about all this dollar denominated debt outside the US, which is going to be affected by this. Do you see this as something that could also adversely affect trade flows going forward? Could we have a perfect storm brewing here for global trade?

Debt and the Perfect Storm for Global Trade

Sally: I'm not sure. I think that the tightening of monetary policy, starting with the major central banks, the Fed, perhaps the ECB in due course, will have an effect, a serious effect on some developing countries more than others. Take my own Sri Lanka as an example. Sri Lanka is highly indebted. Government debt is 80% plus of GDP. A bigger percentage of that is actually debt owed to foreigners through private commercial borrowing. So we're at the mercy of global interest rates to service a bigger chunk of our debt at a time when domestic public finances are precarious. So a country in that position, I think, feels these swings very keenly. Other countries in the region are better equipped to deal with it. It's a largely unsung success story, but many east Asian countries actually worked themselves out of the Asian crisis 10 years before the global financial crisis very well.

Sally: So what we've seen across southeast Asia in particular are countries with very healthy reserves, with much less dependence on foreign commercial borrowing, more reliance on long term foreign investment rather than short term commercial borrowing, which of course was the trigger for the Asian crisis, with more flexible exchange rates and with better run central banks. Generally better macroeconomic management, so there are those buffers in the region. Like many skeptics of the way monetary policy has been run since the global financial crisis, I am worried about the kind of artificial monetary stimulus we've had in a prolonged fashion around the world, led by the leading central banks, and the seeming addiction of players around the world to loose money.

Sally: And the unwinding of that is going to cause problems. Whether that will lead to a perfect storm, I wonder.

Beckworth: I guess I worry some, and maybe I shouldn't be too worried, because the dollar has gone down in value, has depreciated some. But there's a recent study by Ethan Ilzetzki, Carmen Reinhart and Ken Rogoff. We had Ethan on the show. And they went back and they traced the number of countries that have their currency in some form tied to the dollar, whether it's loosely, dirty float, or real tight, like a currency board. But they traced it to 60% of all countries or 76% of world GDP. I do worry that when the Fed moves, it affects other countries. But what you're suggesting is that other countries are better insulated for a shock like that.

Sally: Some.

Beckworth: Some of them are. They have reserves built up. Let's move then and let's step back. Those are things that are happening, facts on the ground. Let's pull back and take the 30,000 foot perspective and talk about Asia. And you have an article that came out last year. And the title is, Why Global Order Still Needs America and Asia. And it's very fascinating. I want to just read the first paragraph or so and then have you respond for that. I have some questions based off of this. But here it goes.

Beckworth: Asia has a gathering conventional wisdom about the impending end of a 70-year- old US-led global order and China's inevitable rise to regional leadership. The US will no longer provide the public goods necessary for a stable and open global order. It will disengage from Asia, on both security and economic fronts. Donald Trump's election heralds a marked acceleration of US withdrawal from leadership, globally and in Asia. To pessimists, this threatens a collapse into a 1920s and 1930s scenario of global disorder. To Asian optimists, US decline is China's opportunity to rise to Asian, if not global, leadership. A regional 'Pax Sinica' will replace a global 'Pax Americana'. I fear US disengagement will result in a more unstable and a less open world, but I do not think a regional 'Pax Sinica' is either inevitable or desirable.

Beckworth: All right. Walk us through that reasoning. Why is it important for the US to stay engaged in Asia?

Sally: At bottom, it's about freedom. It's about liberty.

Beckworth: Who doesn't love that?

Sally: In Asia, we have had that combination of stability and openness for the last 70 years. Yes, there have been local problem, some big local problems like the Vietnam War and the Korean War. But in a macro sense, we've had that combination of stability and openness, and the United States has been the indispensable nation, because it's provided that leadership for those public goods over that long time frame. On the security front, by essentially being the balancing power in Asia with its naval presence, with its network of alliances. And on the economic front, by leading the cause of an open world economy. And all of that has provided the macro context for the extraordinary success that we've seen first in east Asia, spreading to other parts of Asia. The Asian miracle, if you like.

Sally: Without those macro conditions, the kind of Asian success that we're not accustomed to probably wouldn't have happened. Those weren't sufficient conditions, but they were probably necessary conditions for other things to happen. What worries me is that combination of stability and openness is now under threat, coming from a variety of fronts. But one of those is seeming American decline and retreat. So geopolitically, we've seen the United States retreating from Asia. We've seen that happening on the economic front, not least with the TPP. We see a weaker United States at home, translating into a diminished willingness to lead abroad. And at the same time, of course, this mercantilist China is ascending and becoming more assertive, particularly in its Asian back yard.

Sally: The kind of future I'd like to see for Asia, a future based on more freedom, more prosperity through a more advanced form of capitalism, more political liberalism, more open societies, is going to need those external enabling conditions. A Pax Sinica will not provide those conditions. Quite the reverse. Because a Pax Sinica will have different rules and privilege different players. It will be, yes, about the market. The market will continue to function. But it will be a more constrained market with a bigger role for the state, following the leadership or guidance of the Chinese state. I think that will be bad for prosperity, bad for political health, and bad for social health. An even worse scenario is that in this power transition between a Pax Americana and a Pax Sinica, we'll just have a very dangerous vacuum in which all kinds of things could go wrong, including the prospect of surprise wars here and there.

Sally: So for me, who would like to see a more liberal Asia, a freer Asia, a more prosperous Asia with stronger political institutions and with more open societies, the external enabling condition for that is a continuation of the Pax Americana. In that sense, I still see the United States as the indispensable nation, because no one else is out there who will provide that kind of leadership for those public goods of stability and openness. So that leads us back to willingness and ability here in the United States to lead internationally.

Beckworth: That's a little bit disheartening given what's going on in the US we talked about earlier. President Trump's pulling out, disengagement with TPP. I know from his perspective, he's probably thinking he's strengthening America's hand. But what you're suggesting is it's actually putting us on a path to make the world less stable, maybe even a weaker hand down the road for America. If we stay engaged overseas and via the TPP or some framework like that, then we have a better chance of providing these public goods to the world.

Sally: Yes. The way it looks from Asian vantage points is very much of an America in retreat. Now, this was happening before Donald Trump. So the general feeling in Asia was that the United States was neglecting Asia because of the Iraq War and this obsession with the Middle East. And then with fighting lots of fires in the Middle East. And then of course, President Obama seemed to psychologically lead from behind, wary of being assertive in other parts of the world. So this has a lead up. But now we have this incredibly isolationist and viscerally protectionist president. And the way it looks from Asian vantage points is that this is all a sign of American decline and weakness.

Sally: America would not be acting this way, threatening all these tariffs on China and having this obsession about bilateral trade deficits and talk of building walls against foreigners, if America were strong at home. It's a sign of American weakness that's only getting worse. And some people read it as a sign of something inevitable. America is heading in this direction. President Trump is its present incarnation. But it's going to continue to happen in the future. So we in Asia need other forms of protection. It's no longer going to come from the United States. We can't bank on it in the future. America's word is not followed by action. Words are cheap and empty. So we have to look elsewhere, and we have to look elsewhere where power is rising and where power counts. So people are looking more to China. And so some people think that this Pax Sinica is inevitable, that there will be an inevitable transition from American leadership to Chinese leadership.

Beckworth: Let's talk a little bit more about China. You've mentioned elsewhere how the Chinese model cannot survive the medium to long term. Its mix of state intervention and markets is creating distortions that eventually may result in a crisis, a crash. And is it fair to say that America's engagement in Asia is important, not only for regional stability for China's own well being, to keep it on the proper reform paths?

The Importance of US Engagement in Asia

Sally: It would help to provide an alternative future that the Chinese and others can look up to. But it's not going to make the crucial difference. Ultimately, China's future is going to be decided within China, not by the United States or others. Yes, a United States that retreats from Asia, that becomes more mercantilist and isolationist, will probably only accelerate China's retreat to an even more illiberal political system, and a more mercantilist economic system. An America that reengages with Asia with other liberal things going on in Asia would provide more of a counterpoint to where the regime is heading in China at the moment, more countervailing pressure. But ultimately, I think this is about what happens in China itself. At the moment, we have a combination of Mao and markets. We have an immobile political system, a political system that's becoming more dictatorial, alongside an economy that for the past almost 40 years now has marketized and globalized.

Sally: Clearly that's worked so far. That might continue to work for some years to come. But I wouldn't bet on it surviving in the medium to long term. I think it's fundamentally unviable. A basic catch up economy is compatible with different kinds of political systems, including authoritarianism. But an economy that is on the way to becoming a rich economy, a sophisticated economy, I think really depends on free individuals and a liberal political system and a broadly open society. China is not heading in that direction. So I do see a contradiction between political China and economic and social China, on the other hand. And I think those contradictions are only going to get worse. And there may come a time when there will be a collision, and something gives.

Sally: It's true, many commentators have predicted the collapse of China. There've been several books with titles like that. It hasn't happened so far, clearly. But I think there are far too many optimists around, optimists about the Chinese political system and its future viability. Optimist about Chinese mercantilism as the path to prosperity in China and elsewhere in Asia. I think they're far too Panglossian about the state of institutions in China, not attentive to their underlying weaknesses. By comparison, for all the weaknesses that one sees in the United States at the moment, I think fundamentally your institutions are so much stronger than Chinese institutions. You have a much healthier civil society here, still, than China has given the convulsions of its history over the last two centuries in particular.

Sally: And that I think stands you in much better stead for the longer term.

Beckworth: Do you see any parallels between China today and the Soviet Union leading up to its demise?

Sally: Up to a point. I think part of China's hubris at the moment is to believe that a centralized state can somehow or other gather all these forces in the market economy and channel them to superior outcomes than we have in the west. Particularly with new fourth industrial revolution technologies, so called. So that state direction can make China win the race on 5G and telecoms, on AI, robotics, super computers, and other things besides. And then gain those supernormal rents in a game of strategic trade policy that Paul Krugman and others talked about. And that to me echoes some of the hubris of the Soviet Union and its fellow travelers in the west going back to the 1950s. People who never had faith in liberal institutions in the west, but who were probably closet authoritarians themselves. Who just loved the idea of a central plan engineering superior outcomes. They got it spectacularly wrong, because they fundamentally misunderstood the preciousness of human freedom and the magic of markets.

Sally: And I think there are people in power in China today, and there are many, many, many fellow travelers outside China. Many of the fellow travelers, some of them useful idiots for the regime, many useful idiots for the regime, who now make the same argument. And just as I think the John Kenneth Galbraiths of this world were wrong one or two generations ago, I think these people are wrong today. Because that kind of planning is probably not the recipe for a superior technological or economic outcome. I think the superior recipe is very much free individuals in open societies. That tends to be when innovation flourishes most. I said up to a point, in terms of analogies with the Soviet Union, because there are some important differences. The Soviet Union was much more of a command economy.

Sally: It had much more of a genuine central plan than China has had since 1978 And therefore failed more spectacularly. China since 1978 has become a much more marketized and globalized economy than the Soviet Union ever was. It's a very complicated hybrid. It has residual command economy elements, but it has these expanding market economy elements, not least in its high tech sector, with companies like Alibaba and Tencent. They are plugged in to what's happening in the rest of the world. So there are those countervailing market forces in China which complicate the picture somewhat.

Beckworth: Is it wrong for me to look at some of the state-owned enterprises, the subsidies to certain industries, the growth of government debt, or private debt, as a manifestation of these concerns? Lots of commentators have remarked about how much debt has accumulated since the crisis in China in part because they have these policies from the government that support that expansion. And that could be setting up the stage for a crisis down the road. Is this one potential manifestation?

Setting the Stage for a Potential Economic Crisis

Sally: Yes, I think so. China's gross debt is now getting up to 300% of GDP. A lot of it is off the balance sheet. It is part of the old model of pump priming factors of production, in this case, capital, to generate as much growth as possible. And the system has just become addicted to it. And it's preventing the government from shifting model as it were, from input led growth based particularly on capital accumulation, to growth that's based much more on efficient combining of factors of production. To growth based on productivity gains. But it's difficult to see how the government can wean itself off this type of growth. It provide a short term fix. It prevents growth from getting to unacceptably low figures while the system becomes more efficient. But it's not a sign of a crisis or an implosion tomorrow or the day after tomorrow.

Sally: Yes, there is potential of the banking system crashing in China, because of this explosion of debt, much of it as I said off the balance sheet. But the government has the wherewithal to clean it up.

Beckworth: All the reserves it has.

Sally: As they've done before. The last time-

Beckworth: But that would come at a cost, right? If you use reserves to clean up the banking system, that's wealth that can't be used for something else, right?

Sally: Sure. It's not being used for something else now. It's parked in Treasury [crosstalk 00:46:59]. But they have the wherewithal to write off huge amounts of debt, particularly with the state-owned banks and also accumulated by state-owned companies. And it's a closed financial system, of course, which means that there's much less risk of contagion beyond the border. But they're not doing what they need to be doing to move to a more efficient model of capitalism, which is to use their factors of production more efficiently, to rely less on fixed investment and more on service and consumption. To do that, they need to free up the banking system. But freeing up the banking system is politically very difficult, because it gets to the heart of the party state. The links between the state-owned firms, the state-owned banks, and the party all the way up to the family networks around the key members of the Politburo, are just too strong. It's the linch pin of the system. Once you start interfering with that, you then start compromising the monopoly power of the Communist party.

Beckworth: Sounds like it will take a crisis to really address some of the systemic problems.

Sally: Possibly.

Beckworth: Let's move on to another observation about China, and that's its demographic problem. First, describe what it is, and then second, do you see that as a potential concern down the road for China's economic model?

China’s Demographic Problem

Sally: Yes. China is aging fast. I think the popular adage is that China will grow old before it grows rich. So up until just about a year or two ago, China had a population which was adding younger people into the labor market. And that was part of its model of catch up growth. So it was just pushing a lot of labor, young, often unskilled people into manufacturing jobs. It accelerated China's industrialization and catch up growth. But given rising levels of prosperity, people naturally having fewer children, and then in addition to that the one child policy, we have suddenly or very quickly come to a demographic transition.

Sally: So China seems to be prematurely aging. The dependency ratio of the over 65s on the working population is increasing very quickly. I think the population about plateaued in 2015 or 2016. We're going to see, if memory serves me right, possibly a doubling of numbers of senior citizens in China between now and 2030. You have a sort of inverted pyramid now with many Chinese families, with a smaller number of individuals aged between in their 20s and their late 50s, supporting increasing numbers of elderly parents and grandparents while having just one child or two children at most themselves.

Sally: So China's approaching a real crunch. For one thing, it doesn't now have the labor to plug into this catch up growth model. Real wage are increasing as a result. So it can't compete in the kind of labor-intensive stages of production it has done for the last three decades plus. So like other countries that have faced this demographic transition, it needs to move to productivity led growth in which higher real incomes move alongside with more efficient work and more efficient output. And of course provide the safety nets for this burgeoning population of elderly, which are still rudimentary in China. But it's going to have to do that in a much shorter space of time than other countries have done, starting in the west. That's the challenge.

Beckworth: Big hurdle. Let me ask a related question to the demographics, also related to the reserves. So the government is the purchaser of all these reserves, right? So private citizens themselves don't go out and buy Treasuries, am I correct on that?

Sally: Yes.

Beckworth: Let me ask this. What if the government were not buying these Treasury securities? Would you still see individual Chinese searching for a safe asset like Treasuries on their own? Is the government effectively doing what the citizens would do on their own? And I bring this up because we've got an aging population. They may want to invest in fixed income securities, thinking about retirement.

Sally: The problem is they can't. In China, you have a combination of restrictions in the domestic capital market and then, of course, pretty stringent restrictions on capital inflows and to some extent outflows. A friend of mine has a very useful metaphor for this. The Chinese financial system is the forbidden city surrounded by a moat. Outside is the market economy in China. But at the heart of it is this forbidden city surrounded by a moat. And that's the financial system. The financial system still largely operates on command economy lines. It's dominated by the state-owned banks, whose CEOs I think carry vice ministerial status in the government. They're appointed by the party.

Sally: So these are not normal commercial organizations. These are appendages of the Communist party. They don't take normal business decisions. They do take decisions to favor particular state-owned enterprises in particular industries that are targeted by the government. There are all sorts of family connections involved in these networks. Now, the textbook thing to do for China to have a financial system that does a better job at translating savings into investment, is to gradually free up the domestic financial system. And once that job is largely done, then open China up to international capital markets and allow the exchange rate to float.

Sally: Now doing that, starting with liberalizing the domestic financial system, will give Chinese savers the opportunities they don't have at the moment. One reason why China has this ongoing property bubble is that people have very few avenues in which to invest their savings at home, let alone abroad. There are limits to the way they can legally invest anything abroad. But at home, it's often a case of either putting cash under the bed if you're somewhere in the countryside, or just buying apartments, one apartment after the other. But the domestic equity market and bond market are both very under developed. So those need to be liberalized, not least to liberate the savings of Chinese, and they do save a lot, not least for their old age, for their children's education, for healthcare and so on.

Sally: But this is where it hits the political system, because the government is wary of opening up the state-owned banks in particular to competition from new entrants, whether it be foreign banks or new arrivals, new local private sector banks, and diversifying the equity market and the bond market. So it's about power.

Beckworth: There's been some liberalization, right?

Sally: Very little. It's hardly made a dent. It was announced in outline with big fanfare five years ago. There was hope then on the basis of a report that the World Bank did with one of the main think tanks in China, the DRC, called China 2030. It was the brain child of Bob Zoellick when he was president of the World Bank and the previous Hu–Wen administration in China. And that fed into the report of the fifth plenum, which announced these reforms in outline over the next decade for China to shift decisively to the market economy. And decisive was the adjective actually used. And financial reforms were supposed to be part of that. They had a pilot scheme in Shanghai but hardly any serious reforms have actually happened. We've seen baby steps in one direction, but at the same time, whenever things seem to have got out of hand, draconian steps in the other direction, including some pretty stringent financial controls a couple of years ago.

Beckworth: I bring it up because there's been discussion of illicit outflows of capital, but also the macroeconomic trilemma, right? If you try to do all three, and some argued the recent financial stress in China a few years ago, capital was leaving, China was fixing it own domestic interest rates. It was also trying to peg to the dollar. There was some leakage out, right, that makes the maintenance of this exchange rate regime very challenging.

Sally: There still is. It is testament to China's domestic instability and the almost total lack of trust in public situations in China beyond the immediately family that the Chinese elite seem to be doing their very best to park their billions abroad. Whether it be in the property market in Hong Kong or here in the States or elsewhere. And that continues to happen in big numbers.

Beckworth: That's the rot in the system there. Okay, our time is up. Our guest today has been Razeen Sally. Razeen, thank you so much for coming on the show.

Sally: My pleasure.