VZCZCXRO4965
PP RUEHCN RUEHGH RUEHVC
DE RUEHBJ #1556/01 1610708
ZNR UUUUU ZZH
P 100708Z JUN 09
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 4435
RHMFIUU/DEPT OF ENERGY WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPT OF COMMERCE WASHDC
INFO RUEHOO/CHINA POSTS COLLECTIVE
RHEHNSC/NSC WASHDC

UNCLAS SECTION 01 OF 04 BEIJING 001556 
 
SIPDIS 
SENSITIVE 
 
TREASURY FOR OASIA/DOHNER 
USDOC FOR 4420, 5130 and 6510 
STATE PASS USTR FOR STRATFORD 
 
E.O. 12958:  N/A 
TAGS: ECON ETRD EINV EDEV CH
 
SUBJECT:  China/Economic Rebalancing: New Growth 
Model Needed to Avoid Stagnation 
 
This cable is Sensitive but Unclassified (SBU) and 
for official use only.  Not for transmission outside 
USG channels. 
 
¶1. (SBU) SUMMARY.  China's export-dependent growth 
model has served it well, but that model has now 
reached its limits, according to locally-based 
foreign economists. Domestic consumption could fuel 
future growth but it will take many years -- even 
decades -- to achieve the fundamental economic 
reforms necessary, including provision of a 
comprehensive social safety net, achieving increased 
rural incomes, developing a middle-class that 
extends beyond the major cities, and building a much 
larger services sector. Increasing productivity 
through competition and financial sector reform 
could help China avoid economic stagnation in the 
medium term.  While Chinese policymakers are aware 
of the need for such reforms, there is some question 
as to whether they have the political ability and 
will necessary to realize such fundamental changes. 
Certainly at the moment, Beijing appears more 
concerned with stimulating short-term growth through 
government-led investment.  The economists expressed 
concern that the very success of the stimulus plans 
in restoring growth could lead to complacency and 
slow--or possibly even stymie--vital reforms.  With 
reform, China could be able to achieve growth rates 
in the 7 percent range; much slower than over the 
past decade, but fast enough to preserve social 
stability.  END SUMMARY. 
 
¶2. (SBU) On May 4, 2009, World Bank Director David 
Dollar, Dragonomics Managing Director Arthur 
Kroeber, and Peking University's Guanghua School of 
Management Professor Michael Pettis participated in 
a roundtable at the Embassy during the annual 
Economic Reporting Conference and discussed the 
economic challenges China faces following the global 
economic downturn. 
 
Domestic Consumption Must Drive Future Growth 
-------------------------------------- 
¶3. (SBU) Dollar commented that China had done well 
using the "Asian" development model, where state- 
encouraged investment in industrial capacity created 
excess production that was absorbed by foreign 
markets through exports.  In part, this model 
succeeded because U.S. consumption had been driving 
rapid import growth.  Now, however, due to the 
financial crisis, U.S. import demand has declined, 
presenting a dilemma for China's economic planners. 
 
¶4. (SBU) Pettis agreed that U.S. consumption will 
grow more slowly than GDP, causing the overall U.S. 
trade deficit to fall -- although it was hard to 
determine the short-term impact on the bilateral 
U.S.-China trade balance.  At the moment, China's 
trade surplus remains high.  This, according to 
Pettis, is not sustainable.  As foreign trade 
deficits contract and global demand declines, 
China's trade surplus must also contract.  He 
estimated that the United States' ability to absorb 
China's excess production was "dead for the next six 
years," nor could Europe be counted on as an 
importer of last resort if China continues to 
produce more than it can consume.  Pettis, 
therefore, proclaimed "the death of the Asian 
economic development model" for China. Pettis stated 
that future Chinese growth must be driven by 
domestic consumption. 
 
Income Redistribution and Liberalization Important 
------------------------------------ 
¶5. (SBU) All three commentators noted that China 
needs basic social safety nets to encourage 
consumption, but noted that other reforms were also 
important.  Kroeber explained that Chinese consumers 
were still poor, with the per capita GDP of around 
USD 3,000 per year.  He noted that the returns from 
economic and productivity growth fell 
disproportionately to corporations; this money 
 
BEIJING 00001556  002 OF 004 
 
 
needed to be redistributed to households for 
consumption.  Dollar too stated that, although the 
household saving rates were high, the big change 
came from increasing enterprise savings, and 
household income as a share of GDP had been 
declining.  For China to develop a more consumption- 
driven growth model, incomes as a portion of GDP 
needed to rise. 
 
¶6. (SBU) Kroeber and Dollar added that in a 
consumption economy, producers must be able to move 
goods efficiently within the country.  They 
advocated major reform and opening up of the 
distribution, logistics, and transportation sectors. 
Dollar emphasized the need to remove regulatory and 
local monopoly barriers to internal movement of 
goods. 
 
¶7. (SBU) Beyond increasing consumption, the 
observers noted that China needs to find a way to 
increase productivity without relying on investment 
in production.  Dollar commented that China needed a 
more developed, open services sector.  Kroeber added 
that China needs more competition in non-competitive 
sectors such as services, but also in certain 
resource and energy sectors.  He said 2008 was the 
year in which China's manufacturing peaked as a 
share of GDP.  Pettis argued that reform of the 
financial sector was necessary to increase China's 
productivity.  China's stock market is not good at 
allocating capital because the lack of transparency 
and structure of the market encourages speculation; 
a solid governance framework and sound financial 
data do not exist. Kroeber agreed that China must 
liberalize its financial sector, eliminating 
restrictions on capital flow among provinces. 
 
Transition Politically Difficult 
------------------------------------ 
¶8. (SBU) Kroeber said that, although policymakers in 
Beijing increasingly accept that Chinese growth can 
no longer rely on external demand, unfortunately 
there is currently little evidence of serious action 
by Beijing to transition the economy to one driven 
by domestic consumption. 
 
¶9. (SBU) Kroeber opined that China's leaders had 
accepted somewhat lower efficiency implied by a 
large state-owned sector as the price for 
maintaining social control over certain politically- 
important sectors.  He acknowledged that significant 
political barriers to reform and deregulation exist 
in a state-run economy. Pettis pointed out, for 
example, that significant financial reform implied 
significant political reform. Control of the 
financial system allows wider control of the 
economy. 
 
¶10. (SBU) Dollar noted that leaders at the central 
and local levels are more concerned with public 
opinion, leading to what he called the 
"democratization" of policy making. He noted that 
earlier leaders were bolder risk takers, offering as 
an example Zhu Rongji's reform of the state sector 
in the late 1990s.  Now, he said, the leadership 
bases their decisions on broad public opinion, 
making bold reform initiatives less likely. 
 
Moving in the Wrong Direction? 
---------------------- 
¶11. (SBU) Pettis noted that when the U.S. faced the 
need to devolve away from a heavy reliance on 
exports in the 1920s, the transition took twenty 
years and was not smooth.  China, like the United 
States before it, is responding to the drop in 
external demand by increasing investment and 
retaining workers, rather than decreasing production 
capacity as necessary. 
 
¶12. (SBU) Pettis thought that China's massive new 
lending was being misallocated.  In part, these 
loans might go to increased production capacity. 
 
BEIJING 00001556  003 OF 004 
 
 
Alternatively, the misallocation of funds would 
significantly increase non-performing loans (NPLs), 
he thought.  He offered the example of the large 
state-owned enterprise AVIC, which reportedly has 
taken out loans worth USD 35 billion, but has no 
immediate need for the money and now has to find 
projects.  Because the cost of failed corporate 
loans would ultimately be assumed by the taxpayers 
(through government bailouts) or small depositors 
(through suppressed deposit rates), these NPLs would 
suppress domestic consumption in the future.  Pettis 
predicted a difficult decade: "not the hard landing, 
not the soft landing, but the long landing." 
 
¶13. (SBU) Dollar was less concerned about 
overinvestment as a result of the stimulus plan.  He 
agreed that investment -- and in particular 
government-led infrastructure investment -- was 
currently driving economic growth.  However, he said 
the infrastructure projects were aimed at improving 
consumption, such as high-speed passenger rail and 
urban public transport.  Dollar, however, was 
concerned that the state sector was crowding out the 
private sector and predicted that this will not 
create an environment for productive private 
investment. 
 
Disagreement on Future Prospects 
------------------------------- 
¶14. (SBU) Dollar's main concern was that the early 
results from China's stimulus plan were so good that 
Beijing could lose enthusiasm for further reforms. 
To increase the share of household income as a 
portion of GDP, China must reform many sectors, but 
Dollar commented that he was not impressed with 
progress and was concerned about complacency.  He 
thought if Beijing relied exclusively on its fiscal 
stimulus and monetary loosening, China might face a 
"W" shaped double-dip recession.  Further, attempts 
to recapture the past and stimulate exports would be 
a detrimental approach for China.  Dollar saw a 
decade of stagnation if China did not reorient its 
economy towards domestic demand. 
 
¶15. (SBU) Kroeber shared the same concerns about the 
Chinese government becoming complacent due to a 
fairly successful stimulus program.   Kroeber 
thought the stimulus program was in part a 
propaganda exercise to support consumer confidence 
in the face of a fundamental external shock.  He was 
fairly confident moving forward that Beijing would 
find a way to muddle through the transition.  He 
highlighted the fact that there already has been a 
shift towards a consumer-driven economy, that the 
government has made a commitment to a national 
healthcare program, and that the percentage of the 
budget directed at social services should increase. 
Although confident that Beijing would reorient the 
economy in the next few years, Kroeber noted that 
future growth rates would be much lower, probably 
around seven percent.  This was because, without 
exports and foreign investment, China's productivity 
growth rate would decline, while Beijing's reliance 
on the state-owned sector further hinder efficiency. 
Mitigating this somewhat was the government's 
recognition of the benefits of competition for 
productivity growth and long term economic growth. 
In addition, the downturn was weeding out weaker 
companies, particularly in the export sectors, which 
should be good for future growth.  Kroeber stated, 
"at the end of the day, they will come around to 
keep growth and to keep growing at a solid clip." 
 
¶16. (SBU) Pettis offered the most pessimistic 
assessment of China's future growth.  He said that 
Beijing's central bankers and Ministry of Finance 
officials knew what needed to be done but didn't 
have the power to effect the necessary changes.  He 
suggested that reasonable academics also knew that 
China needs to appreciate the Remminbi, liberalize 
markets, and allow workers to organize, but remained 
pessimistic that the government could implement such 
 
BEIJING 00001556  004 OF 004 
 
 
reforms.  According to him, China has needed to 
reduce its demand on export-led growth by increasing 
domestic demand for years, and yet Beijing has not 
proactively addressed these problems.  Pettis also 
expressed concerns that China's policies would 
result in trade friction, which would 
disproportionately hurt China. 
 
Social Stability Not an Issue 
------------------------------- 
¶17. (SBU) None of the commentators felt that the 
current economic downturn would result in social 
instability.  Pettis shared his opinion that social 
instability does not stem from unemployment, but 
rather it usually occurs when there is a significant 
split in the leadership.  He stated that the current 
economic crisis has brought factions together. 
 
¶18. (SBU) Kroeber agreed, stating that lower growth 
-- for example in the achievable range of seven 
percent -- was all that was necessary to meet China's 
employment needs.  He said that, although Chinese 
citizens and policymakers were accustomed to 
ridiculously high growth rates, the country would 
operate a perfectly successful society at a lower 
growth rate. 
 
Comment 
----------------------------- 
¶19. (SBU) Most foreign observers and a growing 
majority of Chinese economists and policymakers 
concede that China has outgrown an export economic 
model and needs to reorient its economy towards 
domestic-demand driven growth.  The current debate 
within China is over the reforms necessary to 
achieve this fundamental reorientation of the 
economy, with some advocating state-led growth and 
others pressing for more market-oriented reform. 
Complicating matters are the large and powerful 
special interest groups that have grown up around 
the current investment- and export-oriented regimes, 
seeking to preserve jobs and profits within these 
formerly-favored sectors.  We are seeing signs that 
the government, while not moving boldly, would like 
to enact the policies necessary to create a strong, 
self-propelling domestic economic system.  The 
question for most outside observers remains whether 
China can realize the necessary level of reform with 
enough speed to prevent a prolonged period of below- 
potential growth. 
 
PICCUTA