FROMLET - June 1310

Presentation at the Global Interdependence Center’s (GIC, Philadelphia) Conference in Prague at the Czech National Bank on June 14, 2010

“Post-crisis relations between China and EU”

Hubert Fromlet Linnaeus University / Sweden & Jönköping International Business School (JIBS)

hubert.fromlet@lnu.se hubert.fromlet@jibs.hj.se

1.Introduction China, the U.S. and Europe (European Union, EU) are the economic powerhouses of the world. Much is regularly written about the relations between the U.S. and China, focusing both on political and on economic ties between the two countries. Relations between EU and China are discussed less frequently in the daily and weekly media.

There are several reasons for this emphasis on the relations between the U.S. and China. First, the U.S. and China are two powerful independent countries with their own decision-making. Second, Congress appears to hold more openly discussed views on China than officials within EU. Third, U.S. officials have in the past years expressed their irritation about China’s undervaluation of the renminbi much more clearly and frequently than leading representatives of the EU have done. In particular the currency issue has frequently made headlines, partly because of China’s various strong reactions against foreign (American) verbal exchange rate interventions.

On the other hand, the Chinese see the European Union – we discuss Europe in this context as the EU – as an economic organization rather than a political one.1 This is an important distinction to keep in mind. Furthermore, the EU is regarded as a very complex organization, quite hard to deal with. The Chinese hardly understand why national interests dominate EU meetings in these very difficult times.

In Asia there is instead a desire for more harmony in the region when international problems are on the rise, but also more respect for the largest economy (i.e. China) – contrary to what Germany is currently experiencing.

Limited tensions between China and the EU are usually caused by (smaller) trade frictions, sometimes also by varying interpretations of free trade and environmental improvements. But more interesting issues regarding China and the EU show up currently and will continue to do so in the (forthcoming) aftermath of the global and European crisis. This may concern both microeconomic and macroeconomic developments.

China manifests itself as a country that increasingly has to be watched by means of interdisciplinary research. Politics, sociology, the environment and even psychology should be included in a future economic analysis. Pure macroeconomic analysis cannot capture China’s economic future.

This should be said despite the methodological difficulties that exist in interdisciplinary economic modeling. The current economic crises in some EU countries tell us, for example, that reasonable forecasts on European growth and financial markets for at least some years ahead cannot be made without including the political ability of reducing large fiscal deficits. And getting back to China: What will the new Chinese political leadership go for when it comes into power only a few years from now? China’s economy is – as we well know - very closely linked to the political leadership of the country.

A technical assumption: “Post crisis” is defined in this paper as “from now onwards”, even if the current problems in parts of Euroland also can be related to the global economic and financial disaster that started with the subprime crisis in the U.S. Conclusion 1: The Chinese economy cannot be analyzed without a modern interdisciplinary approach, including politics, sociology, psychology, the environment, etc.

2. Europe and China today China and Europe (EU) nowadays have quite good or at least satisfactory relations, even if minor tensions – as already mentioned – occur occasionally, particularly when it comes to trade relations and the insufficient Chinese protection of intellectual property. Compared to the U.S., the EU keeps quite a low profile when it comes to criticism of China’s exchange rate policy. The Chinese definitely do not appreciate foreign comments on what they call “purely domestic matters”. However, China certainly plays an important role in global economic rebalancing.

Foreigners still have difficulties in understanding the Chinese economic system. Is it already a kind of market capitalism or – using the official term – a “socialist market economy” with non-capitalist basics? Or is there a special Chinese system without comparable examples from other countries?

I would plead for the third alternative, i.e. that China is evolving its own system from the historical dominance of state-owned planned economy - via gradual state-privatization and marketization - to what will eventually be a kind of state-determined capitalism, at least in the medium or longer run.

Characteristic of China is the planned development of a kind of state capitalism. Thus, the emergence of a market economy and capitalism in China is not the result of preceding political reforms and an “automatic” dispersion over the whole country as we have seen in Eastern Europe – but the result of cautious governmental strategic planning towards a new production model.

Of course, one may ask whether the Chinese model will be sustainable in the future. In the forthcoming years – or maybe even much longer than this, a special question may be motivated: How will political leaders continue with the marketization of the Chinese economy, e.g. on financial markets 2 - rather than asking the usual foreign question: For how long can China’s marketization be brought in line with the current political system?

If this main scenario of China’s way into the future proves to be wrong, a number of long-term assumptions on China will not come true either. More distorted or chaotic developments would be the consequence. In particular the corporate sector in Europe, the U.S. and the rest of the world should regularly consider this strategic long-term issue of the Chinese leaders’ road towards their special state capitalism.

A general observation - which not only affects Europe but also the rest of the world – should be added.

In line with the increasing number of economic Chinese top rankings in the world (in terms of exports, imports, car registrations, IPOs, FDI, etc.) and the achievement of global organizational top positions (at G20, IMF, World Bank, etc.), China’s self-confidence has been growing visibly in the past few years. This indicates that future negotiations between China and EU and other countries/global institutions will gradually become tougher. A new kind of Western- China diplomacy must be developed.

China’s increasing activities in other emerging market economies should not be neglected either. So far China’s future supply of commodities seems to be the main motive for its well-visible global expansion in the third world (and other commodity-producing countries). Whether China in a longer perspective wants to increase its political influence in these emerging countries cannot be determined today.

Conclusion 2: China’s own economic system needs improved understanding abroad and continuous analysis.

3. China and Europe in the short term Chinese/European economic relations in the short run are all about the European financial crisis – more precisely: the budget crises in some E(M)U-member states and the exchange rate of the euro.

China is obviously not very happy about the latest economic developments in Europe because they create additional uncertainty in the aftermath of the global economic and financial crisis.

The Chinese are absolutely aware of the possible negative implications of the fiscal crises in a number of EU countries in terms of both economic growth in Europe and the euro. Many Chinese people are really angry with Greece because the country has provoked this new imbalance in the world economy.

In my opinion, the Chinese are more concerned with the current weakness of the euro than is generally believed (the euro is down around 15 percent down against the USD since the beginning of this year, and, consequently, against the RMB as well because of China’s fixed rate policy vis-à-vis the USD since summer 2008; but recent exchange rate trends in some appreciating EU-member states with floating currencies are more favorable for China if we use the Chinese perspective). Furthermore, the EU is an extremely important region for Chinese exports. Weak European economic growth may even have an impact on Chinese exchange rate policy.

On the other hand, expectations in Europe are that China can maintain its current strong growth rates in the short run (and also in the medium and the longer run). Chinese imbalances - such as in real estate markets in major cities - are hardly taken seriously in Europe or are simply neglected. Only when the central bank (PBoC) tightens credit rules – which still happens softly – some brief reactions can be seen on the Western (European) stock exchanges. By the way, there are also an increasing number of Chinese experts with growing concerns about their real estate markets. Authorities try to tighten these markets – but will they succeed this time and will it happen in time?

From a European point of view it would be shocking if China faced markedly slower growth in the near future (even if China in a macroeconomic and macrofinancial stability perspective cannot continue to experience growth rates in GDP of around 12 percent as it did in the first quarter of 2010).

What should concern Europeans is the fact that China does not have the appropriate instruments for a calculable downsizing of economic growth. European market analysis on China usually does not consider this issue.

Published price changes on the real estate market are not a matter of discussion in the old world either.

Even Chinese experts question the official statistics on price changes in the real estate market. It would be interesting to know why European analysts have this benign – or possibly malignant – neglect of the quality of Chinese statistics.

Market reactions to the PBoCs attempts to cool down the real estate market in the past quarters were mostly negative because of growth concerns. Less short-sighted players on the market, however, should feel a little bit more comfortable after each little step of tightening of credit policy.

Conclusion 3: The two examples in this chapter from the exchange rate and growth problems in European countries burdened by deficit show clearly that China is not immune to European problems. However, China can also be affected by good European GDP growth and a gradually appreciating euro once European developments improve again (which also depends on China’s own exchange rate policy).

China is really waiting for a normalization of the global economy – with contributions from Europe.

4. China and Europe in the longer term In the longer run - i.e. around a decade from now – China should have a share of global GDP that will be in line with global GDP contributions from the U.S. and Europe. Around 2030 China will probably run away from the U.S. and Europe. Thus, economic and even political power will increasingly move to Asia, in particular China. As Joseph Cohen and Brad de Long nicely describe in their new book “The End of influence” (2010) 3, power will move to where the money is. And the money will be mainly in China (Asia), according to the forecasting capacity we have today. This expected development calls for stronger global rules and institutions, including a re-vitalization of WTO. Cohen/deLong add: “When you have the money – and you are a big, economically and culturally vital nation – you get more than just a higher standard of living for your citizens. You get power and influence…” – at the expense of the U.S. and probably Europe. In order to tackle this challenge Europe certainly needs more outstanding political and corporate leaders – and less mediocracy.

Cohen’s/deLong’s long-term forecast for China assumes that the current global creation of savings will not be reversed dramatically. Most reflections – I refuse to apply the word “forecasts” when looking at such a long-term horizon – point to such a continuing trend. However, nobody can really be sure about trends twenty years or more in the future. Can China manage all its future political, social and economic challenges? Can China still run surpluses in the current account balance once private consumption really gains much more momentum than it has today, and the creation of more sophisticated production may become more difficult (even if “Go-West” activities within China and import substitution should give new opportunities to strengthen China’s current account balance)? Is the U.S. condemned to remain a deficit-producing country forever - as nearly all experts foresee? Can Europe finally stick to necessary structural changes? This seems at least theoretically achievable in a longer perspective.

It is, of course, from a political, economic and corporate point of view preferable to assume the more probable scenario that China and Asia will become much more powerful and (probably) more successful in the forthcoming decades. This may accelerate certain necessary steps in the West. This conclusion should be made despite China’s big future challenges when it comes to social security, domestic migration, income distribution, the opening of the current account, the marketization of the financial system, excess capacity in certain sectors, insufficiently functioning innovation systems, the partly corrupt and partly highly endebted university system, the environment, health, institutions, etc.

– challenges that can lead to temporary distortions.

Trying to foresee China’s future economic policy and the future challenges that corporate China will place on corporate Europe and on companies in the whole OECD area should be taken more seriously.

Competition from China is expected to become really tough, influencing an increasing share of the European (Western) corporate sector. It should not be forgotten that China will also have a growing impact on areas and companies in our part of the world that today (almost) no one regards as likely to be challenged.

An approach from economic history may support the expected future progress of China – and certainly of India as well - and, thus, of Asia as a whole. Looking briefly at the so-called big innovation waves in modern industrial history, a total of three have taken place during the past 200 to 250 years (first the steam machine, then electricity/the electrical motor and other industrial machinery, and finally electronics and IT applications). Within each and one of these big waves there have been two special structural eras that have given the more general long-term big waves a more visible face (Kondratieff

cycles). The current stage of the long wave has brought an enormous new supply of labor from China and India to the global economy which will lead to continuous pressure on relative prices on labor.4 Thus, Europe and the U.S. have to innovate - which may also create a big opportunity. Reduction or changes in energy production, environment-friendly products, better food production, nanotechnology, biotechnology, commodity substitution and a modern service sector will be the melody of the future for Western producers. Again: Progress in these areas means urgent large (new) incentives for education, research and entrepreneurship, i.e. areas that only provide improvements in the longer run.

Therefore early action is needed.

China certainly wants to advance in these areas as well. But China also still has vast other fields for improvements and an enlarged supply of more products in the low tech and mid tech areas – which Europe and the U.S. only have to a limited extent. There is enough room for a future reasonable division of labor and products between the old industrial countries and the advancing emerging countries – if Europe and the U.S. take the opportunity of leading advanced product development in the recently started or forthcoming era within the current long wave.

Economic history also tells us that China led the economic development in the world from the year 1000 to 1500 and finally lost much speed during and after the first industrial revolution in the latter part of the 18thcentury. China was sleeping after the first industrial revolution. That this will not happen again can often be heard in China. Many Chinese people know about their history. Europe should be regularly reminded of this important historical understanding by the Chinese.

Conclusion 4: China’s impact on the European and the whole global economy will gradually increase in the forthcoming years and decades, both in terms of positive and possible negative developments. This growing influence of China will come from both microeconomic (see next chapter) and macroeconomic events and trends. The U.S. and particularly Europe have to do much in order to become technological driving horses during the future era in the current long wave of industrial development. But the opportunity is still there. China would benefit from positive Western trends in this direction as well.

5. China and Europe on the corporate level There is no doubt that corporations in EU played an important role in the economic development of China. The EU’s economic production patterns fitted in well with the Chinese growth model which is still valid despite theoretical Chinese and foreign debate on the sustainability of the model’s main components: the rapid growth of exports, domestic investment and FDI in China. This happened, of course, at the expense of mainly private consumption. Private consumption could have grown faster in the past years. However, high personal savings as the main consequence of households’ uncertainty about future social security impede the Chinese from consuming even faster than they have been doing in the past few years.

Corporate ties between China and EU are already now developing and changing much faster than the macroeconomic and political relations between the two economic powerhouses. Quite a number of new trends and observations can be singled out. In this context, a separation of Chinese corporate activities in EU (Europe) and of European companies in China is necessary.

Chinese companies’ activities in Europe have recently accelerated or have become more visible. The very strongly debated takeover of one the Swedish industrial crown jewels – the car producer Volvo – this year by the far less exclusive Chinese and relatively small car producer Geely seems to be obvious evidence that Chinese strategists are openly interested in participating more actively in European technological achievements and development.

However, certain tensions in this respect cannot be ruled out in the future, particularly when the Chinese close down factories in Europe or move R&D and production to China. There was a lively discussion on this issue during the takeover discussions about Volvo.

Another interesting question concerns the future role of Central/Eastern European companies in Western Europe. Will Chinese companies benefit from the problems that exist in some of the new member and candidate states? There is no clear answer today. The only thing we know is that a) Central/Eastern European countries– on average – have to work more on structural improvements, both with regards to short-term and long-term competitiveness and stability, and that b) more Chinese companies with good or improved product quality will come to Europe.

European companies’ operations in China on the other hand will also face a tougher reality over time – despite China’s still weak innovation systems. Many European companies are already now confronted with new, more demanding conditions – and complain about this through their organizations or chambers, one example being the frequent violation of intellectual property. An increasing number of European companies report weakening profit margins because of increased competition from domestic companies in China. This beginning trend will certainly become more general during the next decade. Other companies from the old world feel uncomfortable about certain conditions on the labor market.

At the same time, there are still lots of European companies which feel that it’s only just begun.

Volkswagen, for instance, seems to be increasingly deeply involved in business with China. On the one hand, the quarterly and annual results of the German car producer are increasingly influenced by the performance in China which may lead to a result overexposure at some point. On the other hand, Volkswagen is making great efforts to become the leading electrical car label on the world’s largest car market. Visions are high and challenging – like at other headquarters of European companies that

still look more at the potential of the huge Chinese markets than at certain obvious risks. A lack of transparency is – rightly or wrongly - rarely seen as an argument for staying at home.

The huge size of the Chinese market can be marketed in almost all European board rooms. But this does not rule out that foreign companies in the future will be facing tougher conditions on the Chinese market.

Conclusion 5: The trend is obvious in a Chinese/European corporate perspective: Chinese companies will become much more active in Europe, including by acquisitions. And European companies will face a tougher reality in China, partly caused by increased competition with domestic companies. This calls for an ambitious European concentration on innovation and new products.

6. Summary – risks and challenges ¤ The objective of this short paper is to show that Europe and the whole Western hemisphere will be confronted with a continuously strengthening China (Asia), even if the future may bring a number of truly unforeseeable events and developments in the Middle Kingdom. ¤ Despite the assumption of continued good domestic growth, the Chinese market will not become easier for corporate Europe and America. Many developments remain unpredictable - despite expected slow progress in transparency. 5 ¤ Chinese companies will become much more active abroad, both in marketing, sales and in acquisition terms. At the same time, one must be aware of the Chinese strategy of gradually substituting more imported goods with domestic production. This catching-up process in the production chain will probably become much more ambitious than we can observe and predict today.

This means that many European, American, Japanese, Korean companies, etc., in the future will face a much tougher competitive reality than today. ¤ It also appears probable that China on its own will launch important innovations for energy production - cars included - the environment, pharmaceuticals, etc., despite its lagging innovative ability. But there are also many foreign investors who can put China forward. Having Europe as the region that is mainly addressed in this paper about post-crisis external relations with China, Europe’s need for improved education, innovation incentives, entrepreneurship, and other structurally growthsupporting strategies and policies becomes increasingly urgent. ¤ China is a very ambitious country. Maddison’s 6research shows that China was the leading economy in the world between the year 1000 and 1500 – and lost particularly after the first industrial revolution.

The Chinese do not want this to happen again during the current innovation period and its geographical shifts of big parts of industrial production from OECD countries to emerging economies. ¤ The late Paul Samuelson described globalization to me about ten years ago as follows: “Globalization means that there is no longer room for comfortable ineffectiveness.“ Neither EU (Europe) nor the U.S. can afford “comfortable ineffectiveness” in their future competition with China and Chinese companies. Something to remember in the forthcoming years and decades! ¤ Finally: Also from an analytical point of view China is about to become more and more interesting.

Usually it’s not very smart to give the Chinese recommendations on what they should or should not

do. But I want to repeat what I have been writing and saying many times before (also in China): China should improve its statistical standards and transparency – particularly in economic policy and financial markets - as soon as possible. China and the rest of the world would benefit from such a development.5

References 1. Grant, Charles. 2008. Can Europe and China Shape a New World Order? CER Paper. May. 2. Fromlet, Hubert. 2008. Marketization of Chinese Financial Markets. CASS Conference Celebration of the 30th of Chinese Opening-up and Reform Policy. December.

3. Cohen, Joseph/DeLong, Bradford. 2010. The End of Influence. Basic Books.

4. Schön, Lennart. 2009. Technical Waves and Economic Growth – Sweden in an International Perspective 1850-2005. Circle WP 06.

5. Fromlet, Hubert. 2010. Increased Transparency on Chinese Financial Markets: Benefits for China, Europe, and the Whole Global Economy. Paper presented at the SNEE Conference in Mölle/Sweden. May 18.

6. Maddison, Angus. Statistics on World Population, GDP and Per Capita GDP. 1-2006 AD. http://www.ggdc.net/Maddison and also several OECD publications written by Angus Maddison.