The international community, and particularly policy makers in the United States, put great expectations on the contribution that China can make to global economic recovery by rebalancing its economy through promoting consumption growth.

The Chinese authorities broadly accept this priority and have put in place a number of policy measures that aim to achieve it.

Piecing together a complete picture of Chinese consumption by drawing on both official and unofficial data reveals some interesting detail about how far China is along the way to boosting domestic consumption.

China’s consumption share of GDP was probably underestimated by an average of 3.1 percentage points during the past decade, as it declined steadily from 64 per cent in 2000 to 50 per cent in 2008, in line with official statistics, but recovered afterwards to 54 per cent in 2010.

These figures could mean that China’s long-awaited economic rebalancing has already begun, especially if the sharp decline in the country’s trade surplus from 7.5 per cent of GDP in 2007 to 2.1 per cent in 2011 is taken into account. If these changes continue, the Chinese economy may transition from an economic ‘miracle’ toward more normal development, as growth slows, inflation rises, industrial upgrading accelerates and economic cycles become more dramatic.

Boosting China’s domestic consumption has been a key government policy in trying to rebalance the economy. But according to official statistics, the consumption share of GDP declined persistently from 62 per cent in 2000 to 47 per cent in 2010, highlighting a serious policy failure.

Even more surprising is the widening gap between retail sales growth and total consumption growth in recent years. The fact that consumption-related retail sales grew increasingly faster than total consumption indicates the relative weakness of components of consumption unrelated to retail sales. This weakness is mainly in China’s services sector. But this is at odds with common sense, as normally the income elasticity of demand for service goods is much higher than that for other consumer goods.

The Chinese National Bureau of Statistics derives consumption data from household survey data. If household income was significantly underreported, as various studies have suggested, then it is quite possible that household consumption was also grossly underestimated, and likewise for consumption growth rates in general.

A re-estimation of China’s consumption share of GDP, taking into account these distortions, suggests that China’s consumption share of GDP actually declined from 64 per cent (with official statistics recording only 62 per cent) in 2000 to 50 per cent (officially 48.4 per cent) in 2008, but then recovered to 54 per cent (officially 47 per cent) in 2010.

What could have driven the improvement?

There is a strong argument that both China’s ‘growth miracle’ and its economic imbalances during the country’s reform period are attributable to widespread distortions in factor markets. These distortions generally repress factor costs and, therefore, are like subsidies to producers, investors and exporters. At the same time, they also tax households. This explains both the increasing dominance of investment and exports in Chinese growth and weakening consumption during the past decade. This implies that the key to rebalancing China’s economy lies in further liberalising its factor markets and removing cost distortions.

Anecdotal evidence suggests that the climate for increased consumption has started to improve in recent years. This seems to have been mainly triggered by changes in factor costs and returns, but more importantly, the changes are by and large natural market responses, instead of deliberate policy adjustments. The government certainly took steps to reform pricing mechanisms for factor markets, most clearly in energy prices and exchange rates. But a rapid growth in wages and the increased role of market-based interest rates were still the most significant changes.

While the People’s Bank of China has not taken concrete steps to liberalise interest rates, those that are market-based have started to play an increasingly important role in China’s financial intermediation. Changes in both labour and capital markets are also positively impacting on consumption in at least two ways. First, they increase household income, while also reducing ‘subsidies’ to Chinese enterprises. And second, rising wages and interest income advantage low-income households, and should help improve income distribution.

This analysis has encountered both disbelief and scepticism.

Some critics have argued that retail sales are a poor proxy for consumer demand, since China’s figures must incorporate wholesale business, and government and business procurement. But Chinese retail sales figures do not include wholesale business, and the analysis does not use retail sales as a proxy for consumption.

Others object to the analysis because China’s undervalued currency, relatively low wage growth and repressed interest rates show little sign of reversal — and these are crucial factors in repressing household income growth.

But with a decreasing trade surplus, declining foreign exchange reserves and even occasional expectations of a currency depreciation, estimates of the renminbi’s undervaluation have been significantly re-evaluated downwards. Wages have in fact grown rapidly, and while regulated interest rates did not change much, the proportion of financial intermediation subject to market-based interest rates has risen sharply. These are exactly the types of changes that are driving a rebalancing of the Chinese economy and recovery of consumption.

Reports of China’s declining consumption share are exaggerated, and the official statistics are partly to blame. Rather, the opposite appears to be true, with China’s consumption share already starting to expand.

Yiping Huang is Professor of Economics at Peking University and Professor at the China Economy Program, the Australian National University. He is also Chief Economist for Asia at Barclays Bank, Hong Kong and co-authored the report The Great Wave of Consumption Upgrading (January, 2012).

1. Rebalancing China’s economic structure
2. Sustaining economic growth in China
3. Malaysia’s New Economic Model as a rebalancing strategy

This year presents a new set of challenges for Chinese energy endeavours, and nowhere more so than in oil.

Despite analysts bemoaning China’s ‘cavalier’ approach to risk as it strikes upstream deals in exotic locations, Beijing always knew it would have to cash in some of its chips when geopolitical cards were put on the table. And while some of the bigger cards will be called this year, other options will open up for China — and not where most people would commonly think.

Beijing’s biggest problem for 2012 is Iran. US and EU pressure is mounting via sanctions as rapidly as the Iranian bluster over the Strait of Hormuz is pushing benchmark prices higher. The structural hedge currently being played out in Tehran is the fight for nuclear enrichment against the threat of a major oil price spike. The game will keep being played until someone makes a wrong — or rash — move. Forget Beijing buckling to Western pressure over sanctions — what matters here is the regional dynamics of the Middle East. Unless China can convince the bulk of Middle Eastern producers that its close ties with Iran can help constrain Tehran’s nuclear ambitions, China’s core suppliers in the Gulf will call time on Iran and expect Beijing to comply accordingly. If Iran thinks Saudi Arabia is already tightening the screw by covering prospective Persian supply gaps, it will be turned even harder when the Saudis withhold oil from global markets to force assertive international action on Iran. As painful as this reality is for China, it knows that Arab output will always trump Persian production; of China’s 5.5mb/d of imports in 2011, 2.3mb/d were source from Saudi Arabia, Iraq, the UAE and Kuwait, with Iran only accounting for 550,000b/d. ‘Chirabia’ rather than ‘Chiran’ is the key relationship Beijing needs to get right.

Uncertainties surrounding Iraq also feed into the regional dynamics. Baghdad has little political glue to hold the country together following the US withdrawal. Oil has been at the epicentre of secessionist Kurdish claims. And Sunni–Shia schisms remain ingrained as Baghdad’s core weakness — and these schisms will continue to grow as external power vacuums unfold. The upshot is that regional players will use Iraq to advance their own ambitions, which in turn points toward the real interest for Iran. Disrupting Iraq to buy more nuclear time would do far more harm to the US’s international credibility — and presidential election campaigns — than short-term blockages from the Strait of Hormuz.

This is all bad news for China. Beijing’s overriding energy interests are to secure and maintain steady energy supplies to fuel the Chinese economy and to keep benchmark prices within a ‘stable range’. Even if suspicion over Iranian nuclear weapons had not been raised and uncertainties surrounding Iraq’s future were not a concern, the Arab Spring and prospective ‘Eurasian and African Summers’ pose major questions as to whether China is prepared to do the heavy lifting required to keep global hydrocarbon provisions online. Beijing needs to get its strategy right so that its political risks abroad do not translate into political instability at home.

At the very least, Beijing should start reflecting upon which energy policies to keep and which to trade in at ‘reasonable energy prices’. This logic should not only apply to key producers like Iran, but also to more marginal players in Central and Eastern Africa, not to mention the Gulf of Guinea reserves. China cannot fill all these geopolitical gaps overnight, which means the global power transition from West to East will be intrinsically fraught for energy.

But it will not be all bad news for Beijing in 2012. Political risk — or rather a lack thereof — holds the key for China’s bright future; despite endless hype over US energy independence, China’s energy aces will be found in the Americas this year (most notably Canada, the US and Latin America), and the reason for this is simple. American markets like the colour of Beijing’s money and have the infrastructure in place to harness reserves and investment to ramp up production. True, issues of ‘resource nationalism’, ‘tax hikes’ and ‘fiscal fiddles’ will flare up from time to time in these more mature markets, but they will not be in the same ballpark as problems in the Middle East, West Africa or Central Asia. The prospect of state implosion (or explosion) in these regions will clearly have dramatic implications for global energy provision.

China’s strategic play should therefore see Beijing hedging its stakes in the global energy system by buying into the Americas. Beijing is well aware that it needs to invest geopolitically to secure supplies from some of the world’s key energy producers — and that this will remain a long-term project. Investing in the Americas now, will come in handy for China later, when the truly serious energy bets are cashed in — namely, the US ceding ground in the Middle East in return for Chinese concessions handed back in the Americas. As this ‘neat’ division of hydrocarbon labour plays out, China must be ready to take up the security slack. The year 2012 will thus provide some painful, but very valuable, lessons for China as to how an Asian hydrocarbon century will pan out.

Matthew Hulbert is Lead Analyst at the European Energy Review, Amsterdam.

1. Threat to Asia’s energy security
2. Common ground in US-China energy relations
3. Dealing with China’s energy and resource insecurities – Weekly editorial

As bright as the future may seem for China, crucial reforms are needed in order to maintain its current rate of economic growth and prevent the Chinese economy from falling over like a house of cards.

Some of the most imminent challenges that China faces in the near future include environmental pollution, income inequality, uneven development between rural and coastal areas, and a risky financial system. The central government has already identified these problems, and reforms are now in place — including those contained within China’s twelfth five-year plan announced in March 2011. But widespread corruption continues to undermine the effectiveness of any potential reform.

China’s domestic wealth has increased dramatically. But for some, the limits of transformative growth already seem to have been reached. Even conservative estimates suggest that the 54 million people currently unable to find work will remain in this position for at least another four years. China also runs on a risky financial system. Its banks are hiding piles of non-performing loans — piles built on the prediction that growth will continue to increase indefinitely. Income disparity, unbalanced growth and the need to reform the financial system were issues the IMF emphasised in their Chinese sustainability report. China also faces a grim battle against pollution. The price of rapid economic development is high; water, soil and air contamination puts the health of countless people at risk.

With the Twelfth Five-Year Plan, the Chinese government is setting out an ambitious proposal to put more money in the pockets of the poor and provide incentives to increase domestic consumption. It is also addressing economic restructuring, and tackling pollution by conserving energy and cleaning up the environment.

But corruption has the power to essentially nullify the government’s reform efforts. It is hindering development in remote areas and marginalising the poor. Often, money tagged for environmental programs disappears without making any noticeable impact. Corrupt officials are also obstructing individuals and groups reporting on pollution, and state-owned commercial banks are at the disposal of bureaucrats who exploit their position to benefit themselves. Above all, the biggest danger of corruption is that it undermines the very legitimacy of the government and key reformers.

One of Hu Jintao’s first addresses to party leaders in 2012 included an order to fight harder against corruption. The fight is crucial, but a poor record of success gives little reason for optimism. There are different views on why this battle is not being won. While some say it comes hand in hand with the benefits of an otherwise successful system, others say it is the legacy of extreme poverty during the Cultural Revolution. And others just believe it to be a part of Chinese culture. Be that as it may, the corrosive effects of corruption on government reforms, the economy and the reputation of the party are undeniable.

China’s previous efforts to curb corruption have focused on toughening related penalties, even resorting to capital punishment. But this approach has proved unsuccessful. Rather, transparency and public accountability are more effective in fighting corruption. And while China’s authoritarian leadership provided fast and comprehensive reforms, which turned the impoverished state into a superpower, accountability has little place within authoritarian regimes. This is why reform in China is so difficult.

China does not have to become a Western-style democracy; it should find a way to implement the idea of public accountability within its own system to allow for public scrutiny and expose corruption where it thrives. Channels that encourage credible and accurate reporting without fear of being labelled ‘anti-government’ have to be built. China will need to implement these reforms without forgoing the very characteristics that allowed for its economic development.

Failure to effectively curb corruption risks widespread public dismay with the country’s political leadership. Corruption is skimming away the resources allocated for China’s urgently needed reforms, and while it may not be the country’s biggest problem, it is seriously hindering efforts to tackle more-imminent ones. Consequently, success in curbing corruption is vital not only for China but also for the rest of an increasingly China-dependent world.

Michel May is a MEXT scholar and a Masters student in international relations and Asia-Pacific studies at the Graduate School of Asia-Pacific Studies, Waseda University.

1. Indian corruption: Time to fight back
2. Markets and corruption in Indonesia
3. Vietnam’s endless corruption campaign

As developed countries struggle to recover after the global recession and try to confront the looming sovereign debt crisis in Europe, big emerging markets are now driving global growth.

Given the slow down in developed countries, emerging economies are trying to boost domestic demand to sustain growth — and this is particularly the case in China. But in recent months these developing economies have started to feel the pressure from the slowdown in the West, leading the G20 to put global growth high on its agenda.

Emerging economies have managed to keep up their growth rates and exports, and have thus experienced a trade surplus, while developed countries are facing huge trade deficits and have come to favour protectionism. The importance of recovering growth and jobs in the US, for example, and efforts to sustain export-led growth in China are now creating trade and currency friction between these two countries. For several decades there has also been a consistent increase in the trade deficit between the two — in favour of China — and this imbalance reached over US$200 billion per annum in 2010. The US kept quiet over this for a long time, as the trade deficit helped contain inflation due to cheap imports from China, and the unemployment level was still manageable. But as soon as the US realised this trade friction with China was affecting employment and there was no level playing field for its domestic industries, the Americans resorted to protectionism.

A major allegation against China is that its exchange rate is fixed and is not allowed to appreciate — all in the name of stability. As a result, China’s currency is undervalued, making its exports particularly competitive in the international market. The US has adopted several measures to counter the growth of Chinese exports and boost its own domestic economy. First, it has upped the number of anti-dumping cases against China. And second, the US government passed legislation to punish Chinese exports, as it believes that China is heavily subsidising its export items to the US. There have also been instances of tariff hikes on several import items from China.

The currency friction between China and other developed and developing economies is a matter of concern for the G20. China and the US are not only the world’s biggest economies, but they are highly dependent on each other for their growth — and of course the rest of the world also depends on them. China has nearly US$1.5 trillion worth of dollar-denominated assets, and it will be problematic for the US if China stops buying US government bonds. The US is equally dependent on China for its exports of primary commodities such as meat and fruit, and many US companies are based in China in the hope that domestic demand will rise and they will make profits. But Chinese domestic demand is still largely suppressed, meaning the US is not able to obtain sufficient market access. Meanwhile, China depends largely on the US market to sell its labour-intensive manufactured items. Nearly five per cent of China’s GDP comes from exports to the US. So, the trade friction continues.

The world’s two largest economies must work together toward solving this trade friction and to help avoid a currency war. China must allow its currency to be market determined, while the US must do away with its harsh protectionist measures.

India is an active member of the G20 and works alongside China and other developing countries on major international issues, including the restructuring of global financial architecture, and achieving progress on climate change and the Millennium Development Goals. India is aware the trade and currency friction between the US and China will not only hurt the G20’s agenda and the world economy, but will also affect its own future growth prospects. The US and China are India’s major trading partners, and any slowdown in these two countries would affect India as well. So Delhi has been opposing any protectionist measures adopted by developed countries, and pushing for market reforms by phasing out wasteful and distorting subsidies in countries like China.

India also understands the impact of China’s undervalued currency on its exports and expects China to understand the fair principles of trade. India believes there are bigger and more pressing problems that need the attention of the G20. Its member countries need to focus on solving the European debt crisis, help countries resolve trade and currency friction and give fresh impetus to the Doha Round. Against this backdrop, India needs to play a proactive role in the G20 to make it an effective body for dealing with these issues.

Dr Geethanjali Nataraj is a Fellow at the National Council of Applied Economic Research, India.

1. India losing ground to China on trade with Bangladesh
2. The India-China Strategic Economic Dialogue
3. India, China and Asian economic integration

Since China’s reform and opening-up policies began in the 1970s, the country’s average annual economic growth rate has hovered around 10 per cent.

Currently, China’s gross domestic product is second only to the United States; it is the world’s largest exporter and importer and the largest holder of foreign exchange reserves. Along with China’s remarkable economic rise comes an increase in China’s role in both regional and global development and governance.

With the economies of the US, the EU and Japan reeling from weak growth and burdensome debt levels, China is a key driver of global economic growth, contributing, along with other major emerging economies, nearly two-thirds of new global economic output. According to many projections, China will surpass the US as the largest economy in the world by 2030.

As its power emerges China will naturally become a more important player in shaping regional and global development and governance. Likewise, with its economy moving into a new phase through steady technological innovation and an explosion of domestic demand, China will play a bigger role as a major market and capital resource for regional and global economic growth.

China’s economy is highly integrated into the global market, so the country should participate actively in initiatives to reform the international economic system. While a stable and evolutionary reform process is important to China, the desired outcome should see structural changes that produce a new, more effective international system.

China is active in promoting efforts to improve regional governance through various forums involving the Asia Pacific region as a whole, East Asia, Central Asia and Northeast Asia. The goal is clear: to help create a favourable environment for economic cooperation, enhanced political trust and regional security.

It is significant that China’s strategy is focused broadly, encompassing more than just economic issues. An important part of these efforts are free trade agreements, whether bilateral or sub-regional, such as the FTA between China and the Association of Southeast Asian Nations (ASEAN). They are different from market-driven integration, because in addition to being compliant with the rules of the World Trade Organization, they provide a broader framework for cooperation among governments of different countries. Experience shows that FTAs can have a profound impact on improving governance in individual economies and regional systems.

In the past decade, China took the initiative to establish the China-ASEAN Free Trade Agreement (CAFTA) and played a leading role in the feasibility study for the East Asia Free Trade Agreement. China also actively sought to promote trilateral cooperation with Japan and South Korea. For China, CAFTA is more than just a trade agreement. It helps to provide a comprehensive framework for cooperation between China and the ASEAN countries. China is now the largest market for ASEAN exports, but relations go well beyond trade to include infrastructure, connectivity and capacity building for human development.

Although China participates in all regional arrangements, it views ASEAN +1 as its core regional relationship followed by ASEAN+3. China worries that the recent enlargement of the EAS from ASEAN+6 to include the US and Russia may weaken the cooperative spirit of East Asia because of different strategic interests.

Recently, the Trans-Pacific Partnership (TPP) led by the United States has received a lot of attention. Although China is the second-largest economy in this region, it is excluded from the TPP negotiations. China’s view is that the Asia Pacific Economic Cooperation (APEC) forum is the more appropriate for regional issues of the kind envisioned for the TPP.

While the United States is touting the TPP as a kind of high-level FTA for the 21st century, it will fundamentally change the nature of the APEC approach to regional relations. It can also be seen as a move by the United States to weaken East Asian integration and co-operation. This should worry ASEAN for two reasons. First, many member states aren’t included in the TPP. And second, it could have a negative impact on ASEAN’s central role in building an East Asian community.

In this context, a great concern is how China manages its relations with the US. That relationship today encompasses both economic prosperity and political security. By focusing on common goals such as global growth and prosperity, China and the US can establish and promote a partnership that will benefit both countries, as well as the rest of the world.

But promoting economic interdependence requires creating common interests and reducing incentives for conflict or instability. This is difficult in the current climate, where structural trade imbalances between China and the US are fuelling tensions. The US is pushing hard for China to allow the renminbi to appreciate quickly, while China is insisting on a gradual appreciation of the currency. With the US now part of the East Asia Summit, hopefully the two countries can use this framework to manage their interests and relations in a collaborative way.

The rise of China will end the current Western-dominated world order, but it will not end the Western world, as some alarmists in the West fear. In a highly interdependent world, human society’s future rests on true co-operation from all sides.

Zhang Yunling is Professor of International Economics, and Director of International Studies, Chinese Academy of Social Sciences.

1. Asia’s global responsibilities: Delivering through global and regional arrangements
2. A regional solution to global imbalances: We need a Beijing Accord
3. China’s Soft Power v America’s Smart Power

China’s vice president, Xi Jinping, is set to make a hugely important visit to the US next week, prior to succeeding President Hu Jintao as China’s next president later this year.

The visit will set the stage for interaction between the next generation of Chinese leaders and American political leadership and help to shape how the most important bilateral relationship in the world will be managed over the medium-term future.

In recent times, the political-security dimension of the Sino-American relationship has received increasing attention, as the US ‘pivots’ toward Asia. But core and immediate challenges concern the economic relationship and how rapid change in the Chinese economy plays into US and global interests. These matters will be at the forefront of Mr Xi’s meetings when he visits Washington.

In a recent interview in the Wall Street Journal Nick Lardy argues that ‘if China does not accelerate the pace of reforms that support rebalancing, when global growth resumes a more normal pace, China’s external surplus likely would expand again. That would mean that China again would be subtracting from economic growth in the rest of the world, including the United States. That would make it more difficult for the United States to reduce its budget deficit to put its government debt on a more sustainable path’.

Lardy’s lead essay this week reflects the view set out in his new book that correcting the numerous imbalances is necessary to propel China toward a new and sustainable growth path.

Among the problems, Lardy says, are: a low share of private consumption expenditure and a super-elevated share of investment in GDP; an outsized manufacturing sector and a diminutive service sector; an unprecedentedly large hoard of official holdings of foreign exchange; and an increasingly high and probably unsustainable rate of investment in residential property. Mitigating these imbalances will require fundamental market-oriented reforms. The pace of reform will need to be accelerated to achieve sustainable, domestically driven growth and harmonious relationships in the international economy, notably with the United States.

Chinese economists, such as Yiping Huang at Peking University, have made the same point about the distortions in Chinese markets that need to be addressed to correct imbalances in the economy.

Lardy worries about the tardy pace of reform in China. ‘Market-oriented interest rate liberalisation, eliminating the under-pricing of energy and other factor inputs used predominantly in manufacturing, greater flexibility of the exchange rate and an even more rapid expansion of the social safety net are essential to moving China onto a consumption-driven growth path. Many of these reforms have been on the agenda for a decade or more’, he says, ‘yet with the exception of increased social expenditures, progress has been painfully slow’.

According to Lardy, the explanation is that financial repression, the undervaluation of the currency, and factor price distortions advantage some sectors and regions of China at the expense of others. The benefits of unbalanced growth flow to export- and import-competing industries (which enjoy elevated profits at the expense of firms in the service sector), coastal provinces (which have enjoyed supercharged economic growth at the expense of inland regions), the real estate and construction industries (which have benefitted from interest rate policies that have made residential property a preferred asset class), and China’s banks (which enjoy lofty profits that come with the high spread between deposit and lending rates set by the central bank) who have acquired disproportionate influence over economic policy. And to date they have been able to block much-needed policy reforms. These reforms are necessary if China is to move toward a more balanced, sustainable growth path.

Lardy also argues that there are immediate dangers to strong growth in China from excessive investment in housing and real estate. The share of residential investment in GDP has doubled to more than 10 per cent between 2003 and 2010, a share far higher than that in countries with comparable per capita incomes. This was induced, Lardy argues, in part by households channelling their savings into housing in the face of negative real deposit rates in the state-owned banking system.

While Huang sees less immediate risk of collapse in the housing market, residential housing has become the single most important driver of China’s economic growth since the middle of the last decade. Lardy is right in observing that this cannot last indefinitely, although how long it lasts is a very important question.

Peter Drysdale is Editor of the East Asia Forum.

1. Sustaining economic growth in China
2. Reform in China: Experience with economic system reform
3. Chinese economic risks

China’s 2009-10 stimulus program was quite successful: growth ticked down only slightly in 2009 while the rest of the world suffered its sharpest decline in 60 years.

But the stimulus program was not intended to address the longer-term structural problems that in 2007 led China’s premier, Wen Jiabao, to characterise the country’s growth as ‘unsteady, imbalanced, uncoordinated and unsustainable’.

Numerous imbalances have emerged in the Chinese economy in recent years: a low share of private consumption expenditure and a super-elevated share of investment in GDP; an outsized manufacturing sector and a diminutive service sector; an unprecedentedly large hoard of official holdings of foreign exchange; and an increasingly high and probably unsustainable rate of investment in residential property. Mitigating these imbalances will require fundamental market-oriented reforms. Continuing the modest, incremental reforms of recent years will not be sufficient to propel China toward a new growth path.

Perhaps the most important source of China’s economic imbalances is financial repression, most apparent in the negative average real return on one-year deposits in Chinese banks since 2003. This is in sharp contrast with the years 1997-2003 when the average real rate was 3 per cent. Negative real deposit rates have had a double-barrelled adverse effect on private consumption expenditures. First, negative rates have depressed the growth of household income, leading to lower consumption. Second, in response to sustained negative real deposit rates, households have sharply increased the share of their after-tax income that goes to savings, further depressing the share of private consumption expenditure in China’s GDP.

Also in response to negative deposit rates, households have increasingly funnelled their savings into alternative investments, notably housing. Since 2003, returns from owning property have far exceeded the interest rate on bank deposits. Housing investment accounted for 5 per cent of GDP in 2003; by 2010 that share had doubled to 10 per cent. This is far in excess of the average share of residential housing investment in other countries with a comparable level of per capita income. This sharp rise accounts for nearly half of the increased share of investment in GDP between 1997-2003 and 2004-10. In short, residential housing has become the single most important driver of China’s economic growth since the middle of the last decade.

But this is not likely to continue indefinitely. First, the share of household wealth held in the form of property has doubled over the past decade; at some point households are likely to seek greater diversification. Second, bank exposure to property, in the form of mortgages to individuals and loans to property developers, has roughly doubled in the past five years. At some point China’s banks may decide the risk of extending even more property loans exceeds the potential returns. Third, household debt relative to income has doubled in the past few years. Household indebtedness in China as a share of GDP is again half as great as households in countries at comparable levels of economic development. With real estate prices now falling, Chinese households may soon decide the risk of incurring even more debt outweighs the potential returns from additional investments in housing. Any of these developments would lead to a slowdown in the pace of property investment, which could potentially have a negative impact on China’s economic growth.

Market-oriented interest rate liberalisation, eliminating the under-pricing of energy and other factor inputs used predominantly in manufacturing, greater flexibility of the exchange rate and an even more rapid expansion of the social safety net are essential to moving China onto a consumption-driven growth path. Many of these reforms have been on the agenda for a decade or more, yet with the exception of increased social expenditures, progress has been painfully slow. The explanation is that financial repression, the undervaluation of the currency, and factor price distortions advantage some sectors and regions of China at the expense of others.

The beneficiaries of imbalanced growth — including export- and import-competing industries (which enjoy elevated profits at the expense of firms in the service sector), coastal provinces (which have enjoyed supercharged economic growth at the expense of inland regions), the real estate and construction industries (which have benefitted from interest rate policies that have made residential property a preferred asset class), and China’s banks (which enjoy lofty profits that come with the high spreads between deposit and lending rates set by the central bank) — have acquired disproportionate influence over economic policy. And to date they have been able to block much-needed policy reforms. But these reforms are necessary if China is to ever move toward a more balanced, sustainable growth path.

Nicholas Lardy is Anthony M. Solomon Senior Fellow at the Peterson Institute for International Economics. He is the author of Sustaining Economic Growth in China after the Global Financial Crisis.

1. Chinese economic reform, full front and centre
2. India: sustaining high growth needs new reform momentum
3. Low-consumption China needs serious reforms

On 14 January, Taiwan’s incumbent president, Ma Ying-jeou, won a second term in office, obtaining 51.6 per cent of the popular vote while Tsai Ing-wen, his Democratic Progressive Party (DPP) opponent, managed 45.6 per cent.

Ma’s party, the Kuomintang (KMT), thus retained control of the Legislative Yuan, securing 64 of the 113 seats. Based on the numbers, President Ma will be able to govern with both a clear majority of popular support and legislative freedom over the next four years. Beijing and Washington were also visibly relieved by the KMT’s success, as Tsai’s appointment may have created a new source of instability in East Asia that neither the US nor China was keen to face — given the current state of their own domestic politics. In autumn 2012, China will undergo a leadership succession during the 18th Party Congress, and in November, the US will face its own presidential elections.

The election campaign and results in Taiwan highlight two emerging dynamics. First, figures from Taiwan’s Central Election Commission reveal that although President Ma won, the total number of votes he received dropped by more than 767,000 compared to 2008, when he received 58.45 per cent of the total vote. Conversely, votes for the DPP’s presidential candidate increased by 648,000, a growth of 4.05 per cent. The KMT coalition also lost 18 seats in the Legislative Yuan, a significant portion of its majority, while the opposition DPP coalition gained 16 seats. These gains signify that the KMT’s second term may not be as smooth as the first; President Ma will likely be constrained by increased opposition in the legislature, and this is likely to limit how much he can offer Beijing in enhanced cross-strait relations.

Second, the voting landscape looks to be evolving beyond the generational colour-coded political divisions, which have traditionally divided Taiwanese society into Pan-Blue (pro-unification) and Pan-Green (pro-independence) camps. This was illustrated by the addition of James Soong’s orange-coloured People First Party, which focused on campaigning in the ‘neglected’ central provinces and to Taiwan’s rapidly aging population. Moreover, socio-economic concerns dominated the campaign more so than in previous elections. Consequently, the issue of cross-strait relations became inseparable from the question of Taiwan’s economic security.

Ma’s economic policies — in particular the 2010 signing of the Economic Cooperation Framework Agreement — were juxtaposed with Taiwan’s slow economic growth, regressive taxation system, declining public investment, reduced job opportunities for new graduates, and a widening income gap between rich and poor. On the one hand, Ma argued that Taiwan’s future prosperity and greater regional stability both required a reduction in cross-strait tensions — and this would be achieved by promoting pragmatic economic and socio-cultural ties with the mainland. On the other hand, Tsai argued that further integration should be approached with caution; that it will lead Taiwan down the path of becoming a Chinese ‘special administrative zone’ and threaten its de facto independence.

As such, Ma’s slipping popularity and the increased public concern over his cross-strait economic policies suggest that many Taiwanese remain suspicious of Ma’s ties with mainland China. So while the election may not have reconfigured cross-strait relations, the risk remains that Beijing could become impatient with its limited influence over Taiwan’s democratic government, especially with the re-election of a pro-China KMT-dominant legislature.

Ma’s victory has almost certainly raised Beijing’s expectations; China’s leaders may pressure Ma to begin formally discussing Taiwan’s political future, and among other measures, Beijing may call upon Taiwan to halt the purchase of arms from the US and phase out its military ties with Washington. Rather than stabilising the cross-strait status quo, the KMT’s election victory may usher in a new period of instability — not one in which Taiwan calls for de jure independence and recognition as a sovereign nation — but one in which China may intensify its demands on Taiwan.

Sheryn Lee is Project Officer and Research Assistant at the Languages of Security in the Asia-Pacific project, and Research Assistant at the Strategic and Defence Studies Centre, Australian National University.

1. Taiwan and Hu Jintao’s end-year overtures
2. Taiwan, China, and the WHO
3. Taiwan: The Democratic Progress Party’s ‘China Syndrome’

Since the fourth quarter of 2010, the global economy has faced serious uncertainty and a turbulent outlook.

Both the US and Europe have gloomy growth prospects due to a lack of credible medium-term plans for debt reduction in the US and the sovereign debt crisis in southern Europe.

Against the downside risk to growth in the West, Asia’s recovery and growth in the past three years has been exceptional. China and India recorded the highest growth rates in the world with 10.3 and 10.1 per cent in 2010, respectively, while Indonesia, Thailand, Malaysia, the Philippines and Vietnam (ASEAN-5) grew 6.9 per cent. Asia, with a solid global market and a large pool of foreign exchange reserves, has proven to be the shining light of the world economy.

Asia’s future prospects are likely to be affected by the West, yet ‘rising Asia’ also appears able to help save the sinking world economy. Even with weaker demand from the West, Asian growth in 2012 is expected to remain strong on the back of solid domestic demand. But for robust, sustainable and balanced world growth, Asia needs to shift from its conventional extra-regional export orientation to intra-regional demand as a way to help advanced economies recover and to ensure its growth sustainability.

How can Asian governments accomplish these twin objectives amid the current global turbulence? First, they must continue to shift to more domestic demand-based growth in the short and medium term and accelerate ongoing regional economic integration to allow freer intra-regional trade and more cross-border investment. This policy shift will result in two things: greater self-propelled growth and more imports from Western economies, especially the US, which would help correct chronic trade imbalances and raise the growth potential of America and Europe.

Second, Asian governments must minimise external financial contagion and expand intra-regional FTAs to spur sustainable economic growth.

How can they do this? One effective means would be to create a cross-border free trade regime in East Asia. At present, there is a relatively low degree of intra-regional trade share in East Asia. Intra-regional trade among ASEAN+3 countries has increased steadily since 1998, when the Asian financial crisis was subsiding, but slowed a little after 2005. In 2008, the East Asian intra-regional trade ratio, at about 37 per cent, was lower than that of the North American Free Trade Agreement (NAFTA), and far lower than the euro zone’s ratio, with 60 per cent. Considering that the euro zone and NAFTA are free trade blocs, it seems plausible that East Asia could find significant growth sources from its own regional domestic demand if it established an East Asia-wide FTA.

Given the ongoing hub-and-spoke issues around intra-regional FTAs, East Asia should adopt a strategy of ‘doing easy things first’. A good example of such an approach is the Chiang Mai Initiative, which is already under way. The Asian Bond Market Initiative could also be accelerated to provide a viable cross-border financing scheme to small and medium enterprises. In this regard, a cross-border regional cooperation mechanism among sub-regions and mega-cities such as the Pan-Yellow Sea Circle and Greater Mekong Sub-Region could be a starting point.

Northeast Asian integration has great potential to build a robust regional community of peace and prosperity. It is encouraging that China, Japan and Korea in May 2010 agreed to establish a secretariat office in Seoul to address trilateral regional issues. Apart from FTA talks in Northeast Asia, Asian governments in ASEAN+6 need to pay attention to many proposals in cultivating diverse ‘public goods’ such as cross-border oil and gas pipelines and railways to enhance connectivity. Dynamic benefits resulting from a cross-border, bottom-up approach could also be derived from establishing common standards for production technology, product regulations, distribution and after-sales services.

By accumulating success stories for open Asian regionalism, major Asia Pacific economies can work together toward an Asia Pacific Economic Community, which the APEC forum has long addressed. Though it may take time to nurture mutual trust and confidence, Asia should be eager to establish open regionalism which a variety of external stakeholders, including the US, India, Canada, Australia and New Zealand, can join. Asian open regionalism needs to be translated into an Asia Pacific Economic Community to ensure it will be a building block toward viable multilateralism, not a stumbling block.

At this critical juncture of the world economy, East Asian integration must be pursued to increase its own growth momentum internally. Asia must move aggressively to shift its focus to the region’s 3.5 billion consumers so that its intra-regional demand-led growth can contribute to balanced and sustainable global growth. The Greek debt crisis clearly showed that no country can overcome the emerging economic malaise without a strong manufacturing base. Consequently, Asian economies need to strengthen the already existing global ‘manufacturing house’ through intra-regional trading. But Asia is diverse and still not free from historical rivalries. For both its own growth and the good of the global economy, Asia needs visionary political leadership to put historical legacies behind and look toward a long-term vision for an Asia Pacific Economic Community.

Choong Yong Ahn is Distinguished Professor at the Graduate School of International Studies, Chung-Ang University, Seoul.

This is an abridged version of an article that originally appeared here in Global Asia.

1. The DPJ: Sacrificing the economy to ‘save’ agriculture
2. World economy not quite out of the woods yet
3. Economic integration: Will Asia go regional?

The year 2011 proved fascinating for Asia, with the region consolidating its role as the essential player driving global economic recovery.

But 2012 promises to be more fraught as domestic politics take command amid new challenges to growth. A number of risks, opportunities and emerging patterns will shape Asia during the next 12 months and beyond.

One lesson of Europe’s current struggles is that politics matters deeply to choices about the EU’s economic and financial future. Asia is not Europe, of course, but its politics will matter greatly in 2012. Electoral outcomes and succession arrangements are likely to roil markets, bring to power governments more (or less) committed to institutional, regulatory and trade-related reforms, and possibly yield greater international tension. Three elections — in the US, South Korea and recently in Taiwan — feature candidates and parties with distinct policies and priorities. China will also complete a scheduled leadership change. And North Korea’s elite, whose members aim above all to preserve their own power, must now navigate an earlier-than-expected transition that could yet produce infighting and vast new challenges for Pyongyang’s neighbours.

Thailand also bears watching, as former Prime Minister Thaksin Shinawatra looks to return from exile. Such political risks will likely intensify well into 2014, when India and Indonesia hold elections. A possible return to Golkar rule in Indonesia, in particular, could slow institutional and policy reforms there. The year 2012 should be another rough time for Afghanistan, Central Asia and Pakistan. War, terrorism, narcotics and weak political institutions continue to steal headlines. But the region’s future will depend as much on whether governments improve their poor macro- and microeconomic fundamentals and expand opportunity, although economic change will remain elusive unless these states better cooperate in 2012. Meanwhile, Pakistan’s economy has considerable potential. But the country lacks a credible growth strategy. Islamabad will remain burdened by a high debt-to-GDP ratio that crossed 60 percent in 2010, painful debt service obligations to its creditors, a large fiscal deficit, double-digit inflation, a depreciating rupee and a trade deficit worsened by high global commodity prices. These economic realities will compound intensifying political risks in Pakistan.

Much was made in 2011 of Washington’s supposed strategic ‘pivot’ to Asia. A bigger issue for Washington’s partners in Asia is that the US, for all its strengths, still does not have its economic act together. Thus the principal strategic issue for most in Asia is whether America restores its economy and addresses its fiscal deficit and growth outlook. The weaker America’s fiscal and economic position becomes in 2012, the less relevant the US will be to Asia’s future.

Asia even managed to sustain robust growth amid austerity in Europe and sluggish growth in the US. But new challenges are emerging for the region’s most export-dependent economies. The markets will watch China especially closely — along with the US and the EU — because the world economy can hardly afford to have its three principal growth engines facing a crisis simultaneously. Beijing’s landmark Twelfth Five-Year Plan deliberately aims to achieve slower but more balanced growth. But such structural adjustments will come only gradually, and, in the meantime, China’s economy continues to rely on exports and investment in fixed assets. Others, such as South Korea, will also be vulnerable in 2012. They have relied, in part, on Chinese demand to power their economies, so even a modest slowdown in China will have contagion effects elsewhere in Asia.

India will grow robustly, but more slowly, in 2012. This is only one of many sources of gloom. Tax, pension and FDI reforms have all stalled, and parliamentary business has been tied up in knots as the leading national and regional parties squabble. Mumbai’s SENSEX stock index was the world’s worst major performer in 2011, declining from 20,561.05 on 3 January to 15,175.08 on 19 December. And bellwether state elections, especially in Uttar Pradesh, are almost certain to make the major parties even more cautious when considering any major reforms. Similarly, slow progress on economic reform may limit other countries in Asia in 2012. In Vietnam and Indonesia, FDI, regulatory or financial reforms have largely stalled and show little sign of revival. Still, one bright spot in 2012 may be Malaysia, which has begun to shed elements of its 1970s-era ‘New Economic Policy’.

By far the biggest question mark about reform though is China, with resistance to change anchored in interest group politics. Chinese leaders, as cautious technocrats, tend to split the difference between competing groups in China’s increasingly pluralistic polity. The result has been a strong bias toward incremental policy change rather than bold reforms. We will also learn much more in 2012 about the sincerity of reforms in Burma. Another question mark will be ASEAN’s response to Burma’s apparent change of direction. Balancing the role of great powers to the north — China and Japan — has long provided an impetus to ASEAN community building, with founding members hoping for a cohesive force to help balance China in particular. But Burma has stubbornly resisted ASEAN ways. With Naypyidaw now scheduled to assume the ASEAN chairmanship in 2014, regional heavyweights will face tough decisions about how hard to push the regime.

In recent years, Preferential Trade Agreements (PTAs) have proliferated in Asia. The US entered the trade fray in 2011 by more fully embracing the Trans-Pacific Partnership (TPP). In my view, the TPP has considerable potential. Beijing has criticised the TPP as part of a US strategy to ‘contain’ China. Yet it has also promoted its own brand of PTAs across the region — with ASEAN, Pakistan, Singapore and others.

While protectionist pressures will likely rise in 2012, so too will the tolerance for trade conflict, particularly in Washington and Beijing. China has grown more comfortable with the WTO’s dispute-resolution procedures. And, having learnt to leverage the system to its own advantage, Beijing is vigorously fighting US suits in many areas. For their part, US political and business elites are certain to complain ever more loudly about Chinese currency, intellectual property, procurement and cyber-related practices. Most in Asia will watch warily, fearing greater protectionism. But some will jump on the bandwagon: India has already initiated 149 anti-dumping cases against China.

Politics, economics and security are increasingly in collision in Asia. The US continues to provide Asia’s principal security-related public goods through its forward-deployed military presence and role as a strategic balancer. But Asian economies will increasingly provide one another with their principal economic-related public good — namely, the demand that can provide a pathway to sustained economic growth. This collision between economics and security may well intensify in 2012.

Evan A. Feigenbaum is Adjunct Senior Fellow for East, Central and South Asia at the Council on Foreign Relations.

A version of this article was first published here on the Council on Foreign Relations Asia Unbound blog.

1. Will Asia step up to the global challenges of 2012?
2. Asia, Europe and regional cooperation in 2012
3. Russia in the Asia Pacific: a bleak outlook