Beyond the bubble

February 7, 2012 / Andy Xie

Andy Xie urges the Chinese government to embrace the restructuring that is needed to sustain economic growth, instead of using its financial muscle merely to delay the inevitable - a painful transition



China's obsession with stability may lead to greater instability. A skilful person can keep a ball on a bigger ball only for so long. China's economy faces serious structural problems. Reshuffling liquidity to keep everything afloat for now will lead to a collapse later. The right way forward is to accept restructuring, deal with the pain, and be reborn into a more dynamic economy. This way, China could become the world's largest economy in 10 years.

China has experienced a tremendous economic boom, the result of it joining the World Trade Organisation, its demographic dividends, and its building of infrastructural networks. China's nominal gross domestic product has almost quadrupled over the past decade to an estimated 47 trillion yuan (HK$58 trillion) last year, with exports up more than seven times in US dollar terms, while electricity consumption, the best proxy for real growth, is up by over 200 per cent. Prosperity on such a vast scale has never occurred before. China should be proud of its achievement.

Amid the prosperity, two related forces have been sapping China's dynamism: the rise of the state sector and a vast financial bubble. Fixed-asset investment, dominated by government and state enterprises, rose from 2.8 trillion yuan to 31 trillion yuan, or from 30 per cent to 65 per cent of GDP, over the past decade. It is a symbol of the nationalisation of demand during the boom. Its two consequences are rising corruption and declining efficiency. The bubble, especially in property, has diverted the energy of businesses and households towards speculation to chase quick profits. Amid rising costs, China's businesses have tried to stay alive through speculation rather than by increasing efficiency and upgrading products.

China's bubble isn't a result of investors overreaching. In this system, every bubble-making opportunity is seized upon because it benefits the government and the people with influence. The productivity gains from joining the WTO, the demographic dividend and infrastructural build-up should go into raising profits and real wages. But, through rampant monetary expansion and government manipulation of the land market, the productivity gains have gone into supporting a giant credit-cum-land bubble.

The bubble has begun to deflate. Many blame the government's tightening measures, but they have merely brought forward the inevitable, because the bubble was already unsustainable. The WTO dividend is gone. The depressed global economy is turning China's export dependence into a weakness. Population ageing is causing labour shortages, shifting money from asset inflation to price inflation. And, the quantum benefits from building infrastructure have mostly been absorbed.

The right way forward is to: first, quickly deal with the bad debts from the bubble bursting; second, rebalance demand from the government to the people through tax cuts; and, third, to boost supply-side efficiency through industrial consolidation.

China's banking system has 110 trillion yuan in total assets or 234 per cent of GDP. While the reported loans are about half of those assets, a majority of the assets are loans to local governments and businesses, directly and indirectly. Much of the lending to businesses is also outside the banking system. And we know that most loans in mainland China go into property. China's property and land prices are likely to plummet from the peaks. Yet many more properties are under construction. China's bad debts could easily go into trillions of yuan.

China reported fiscal revenue at 22 per cent of GDP and industrial profit at 12 per cent of GDP in 2011. The household disposable income survey suggests household income was 40 per cent of GDP. Suffice it to say that China's income distribution is heavily skewed towards the government and state-owned enterprises; household disposable income is low, and this is why China's consumption is low.

On the supply side, China suffers extreme fragmentation and overcapacity. When labour and capital were cheap and supply was endless, such an industrial structure could survive. But, as China's demographic headwind pushes up wages and inflation pushes up capital costs, most businesses in China are having trouble. To survive, numerous companies have turned their core businesses into a fund-raising platform for property speculation. This strategy is backfiring as the property market heads south.

China's bubble has covered up many structural problems. The bubble worked when the benefits from other sources were available to sustain it. As the latter vanish, the bubble deflates. Obviously, it is painful to deal with all the problems at the same time.

The obsession with stability may be pushing China towards a stalling strategy. China's vast foreign-exchange reserves give it the freedom to maintain domestic liquidity regardless of the quality of the banking assets or hot-money outflows. The lack of liquidity pressure means China doesn't have to press bankrupt developers and inefficient businesses to sell out or liquidate. But that could lead to a Japan-style equilibrium with zombie banks, zombie companies, and zombie local governments.

Unlike Japan two decades ago, China's labour costs are still low. It is possible that, through multinational corporations and new companies at home, Chinese workers will become more productive, for example, by competing against their German and Japanese counterparts. The resulting rising tide could solve China's problems. But this strategy needs luck, and time, to work.

It would be far better to control one's own destiny through restructuring to become more productive on the supply side and more balanced on the demand side. But the prospect of that seems low for now. China's economy may take a long pause.



Andy Xie is an independent economist

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Posted in: China

Slow growth era may have arrived

January 16, 2012 / Andy Xie


Summary

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China's economy is slowing down due to export weakness and a bursting property bubble. Unless painful structural reforms are undertaken, the slow growth may be here to stay.

China has excessive debt in the corporate sector due to property speculation, excessive fragmentation of the supply side due to local government subsidies, and unsustainable dependency on investment on the demand side. Export slowdown and property bubble bursting expose their drag on growth. Unless structural reforms deal with these problems, China is entering an era of slow growth-GDP growth rate down by one third or more compared to the record in the last decade.

The structural problems are unlikely to be cured in the foreseeable future. China is likely to avoid widespread business bankruptcies, which is necessary for balance sheet cleansing and supply side consolidation, by forcing banks to prop up unprofitable businesses. This dynamic will suppress economic growth rate.

Fiscal or monetary stimulus couldn't revive growth. The stimulus money would go into government fixed investment, already excessive, inefficient, and inflationary.

China's per capita income reached $5,000 in 2011. It is less than half of the global average and one tenth of the OECD level. China has the potential to continue high growth rate until $15,000 per capita income. However, the will to embrace painful reforms, necessary to realize China's full potential, isn't here.



Too much debt

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China's debt is concentrated in the business sector and local governments. It appears that both are excessively in debt and will have trouble expanding through more debt. At a glance China's economy isn't excessively levered. The domestic credit at Rmb 65 trillion reported in October 2011 is about 145% of GDP. It is not alarmingly high by itself. But, the off-balance assets in the banking system and the lending activities outside of the formal financial system may add considerably to the country's indebtedness. The financial institutions have total assets of two times GDP. And the country's officially recognized financial assets are about 2.6 times GDP. These two numbers indicate that the lendings outside of the officially recognized financial system are considerable. China's total indebtedness of its non-financial sector is probably above 200% of GDP.

The concentration of China's debt in local governments and businesses is a big problem. Local governments usually have debts over three times revenue. There are examples of over ten times. Corporate debts in many coastal townships are above two times the local GDP. Such high leverage is difficult to sustain. It is quite likely that both sectors are having trouble paying off their debts.

Corporate debts usually go into property investments that in turn become revenues for local governments. As the property bubble bursts, the revenues for local governments will come under pressure. That increases the difficulties for local governments to pay off their debts.

The inability to pay off debts is not likely to lead to bankruptcy. The recent trend suggests that the banks will roll over the loans to governments or businesses despite their inability to repay.



Fragmentation of the supply side

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Most businesses in China seem to have a large number of companies, while similar industries in the rest of the world are consolidated into a few players. Low entry costs are the reason for China's fragmented industrial structure.

Local governments keep entry costs low to promote investment. Land is commonly free for industrial use. The environment protection cost is usually low. Until recently, credit and labor were cheap and plentiful. In an environment of low entry costs, market growth leads to more entries. Hundreds or even thousands of companies are doing the same thing across most industries.

The fragmented industrial structure is running into trouble due to rising labor and credit costs. A fragmented industry has no pricing power. When costs rise, only bankruptcies could shrink output, increase prices, and restore profitability. The logical ending in this process is the emergence of large players that develop brand, quality, intellectual properties, and economies of scale as entry barriers.

However, the consolidation process led by market force is unlikely to proceed normally. The lenders are under pressure not to pull the credit lines on struggling businesses. That means that the industrial sector couldn't improve efficiency to deal with rising costs.



Unbalanced demand

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Excessive investment, led by local governments and state-owned enterprises, has become the central pillar for demand management in China. As debts pile up, more investment with new debt has become the only option to keep liquidity positive. This dynamic of riding the tiger is leading the Chinese economy to become more and more skewered towards investment.

In 2001 the reported urban fixed asset investment ('FAI') was 25% of GDP. It surged to 43% in 2006, 60% in 2010, and an estimated 65% in 2011. The increase in the FAI over the past decade exceeded three quarters of GDP increase. The trend is simply crazy.

China's FAI is supply-driven, i.e., it starts with a government project. The government concerned then tries to raise revenues in whatever way at its disposal. As government power is unchecked, such dynamic inevitably leads to squeezing the household sector through whatever channels. High property price, inflation, taxes, or fees all lead to the same end: funding government projects.

The reported FAI could be exaggerated due to leakages in the expenditures. China's gray income could be one tenth of GDP. Much of it comes out of FAI. Such redistribution of income from the masses to a privileged few is not good for social stability. That is one reason that the FAI trend is bad for the country.

Leakages aside, some of the massive investment is just waste. The image projects are visible everywhere. China's per capita income is less than half of the global average. It doesn't make sense to waste money on such a scale.



Stimulus could backfire

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China's economy is slowing significantly since the summer of 2011. The eurozone debt crisis was the trigger. It appears that Europe is experiencing a deeper recession. It is the largest trading partner for China. The bursting property bubble at home is adding to the slowdown. The property bubble has been the liquidity machine turning bank loans to property developers and buyers into revenues for local governments that leverage up the receipts further with bank loans to fund FAI. The breakdown in this liquidity machine has forced many governments to stop FAI projects.

As the slowdown continues, there will be calls for monetary and fiscal stimulus. Such stimulus will merely go into FAI again, prolonging the problems in the economy. Inflation will follow such stimulus. It is just taxing the currency holders to finance inefficient FAI. While stimulus for propping up FAI isn't a good idea, it may happen anyway in 2012. The resulting inflation will cause public outcry and pullback of such stimulus.

China's current slowdown isn't just a cyclical phenomenon. The country's investment-and export growth model is running into a wall. Global trade isn't likely to return to high growth. Without export boom, there is no income to afford the inefficient FAI. Pure cyclical thinking in policy prescription isn't likely to get the economy out of the doldrums.



Structural reforms can revive high growth

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If China wants to revive growth, it should allow market force to function fully. Unviable businesses should shut down or be sold. China's cost structure will continue to rise due to labor and energy shortage and rising cost for environmental protection. Fragmented industrial structure is just not viable. Consolidation into the right hands could increase efficiency to offset the cost rise.

Further, China has to move up the value chain to deal with the rising costs. While China's exports are the biggest in the world, Germany and the US are not so far behind. Their labor cost is ten times China's. They are sustaining their exports by doing what China cannot. It is a big market out if China can upgrade and move into the same markets that Germany, Japan, and the US occupy now. The current industrial structure couldn't get China into the high value added market, as companies are too small and profits are too low to fund R&D. Consolidating the current fragmented industrial structure is a must if the country is to move its industrial base up the value chain.

The concentration of resources in the government sector has become a drag on the economy. This political force is the root cause for most of China's problems. The trend needs to be reversed if the economy is to move up the value chain. China should consider to decrease the government's stakes in the state-owned enterprises and to open up the industries that the SoEs now monopolize to private companies.

Demand support is worthwhile if it coincides with structural reforms. Otherwise, it would be just for propping up an inefficient and unsustainable economic structure. And, any stimulus should support consumption rather than investment to ease structural imbalance.

As I wrote in this page last time, cutting taxes is the best way to support demand. Monetary stimulus or increasing fiscal spending would only support inefficient FAI, making the situation worse down the road.



Stagnation for stability?

-------------------------------

The micro evidences suggest that China is trying to prop up the existing structure rather than to restructure the economy. Local governments are putting pressure on banks to support failing companies. The local government debts are likely to be rolled over too. While such actions preempt disruptive bankruptcies, businesses, banks, and local governments could all become zombies for a long time to come. Stability will be paid with stagnation.

China's attitude to the current economic challenges seems to be similar to Japan's two decades ago, emphasizing stability above all else. Japan essentially buried the consequences ot the bubble in the financial system. Businesses, banks, and local governments all became zombies. Of course, China is entering the phase at much lower per capita income. Stagflation will trap hundreds of millions of people in low income.

It is possible that China will emerge from the low growth phase on its own as businesses eventually learn to use China's labor for higher value-added activities. Import substitution and export expansion may follow, which would bring a rising tide again. But, it would be years away. Unless we see a coherent and comprehensive restructuring program soon, China may be stuck in low growth for years.



It doesn't have to be that way

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China's per capita income is only USD 5,000. The household consumption is merely one third of that due to over investment. China's living standard is still relatively low. It would be a trajedy for China to be stuck at such a low level.

Two decades ago, Japan was already enjoying per capita income similar to other developed economies'. Stagnation wasn't a bad prospect. Also, due to high cost, Japan wasn't in a position to revive high growth rate. One may argue that Japan made a rational choice to digest the consequences of the bubble over a long time.

The tradeoffs for China today are totally different from Japan's then. The country still has low cost. Through upgrading, high growth rate could be revived. The current per capita income is too low for most people.

Avoiding bankruptcies is very bad for the stock market. Failing businesses that are propped up by the banks will suppress profits for healthy companies. The banks will suffer terribly. Hence, the stock market will remain depressed due to low profitability. The government may try liquidity support for the stock market sometime this year. Its effect will be short-lived. Without a good environment for business profit, the stock market cannot perform.

As I wrote before, soft landing may not be good, hard landing may not be bad. Indeed, if China goes into a hard landing now, it will most likely push the country towards painful reforms. The economy will prosper for a long time afterwards. But, it doesn't look likely now. China's economy is slowing down in an orderly fashion, as the banks are not permitted to pull the plug on failing companies. When we celebrate the soft landing, we should remember the cost.

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Posted in: China

Start the international board now

A country becomes a financial center because it has succeeded in becoming the trade center.

Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money.

Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.

China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. When the bubble is big enough, China will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

2011-09-12  / Andy Xie


Summary

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China must effectively internationalize its surplus capital for the global economy and its own to function normally. Otherwise, the global economy would suffer bubbles and financial crisis again and again. It may lead to the rise of protectionism that would destroy the global economy.

Irresponsible borrowing by Southern European governments and Anglo-Saxon households and money hoarding by Germany, oil exporters, and East Asian manufacturing exporters planted the seeds for the current crisis. China's share among surplus countries is rising. If China keeps recycling its surplus into government bonds, the resulting distortion would hurt itself and others. The country could become the focal point in the international blame game.

Globalizing China's surplus labor has led to its economy rising over twentyfold in nominal dollar value and becoming the largest trading economy in just two decades. Globalizing the country's surplus capital would make China the largest economy in the world and the biggest financial center in another two. This action is in China and the world's best interest.

The first step in internationalizing China's surplus savings should be to start the international board of the country's stock market. It is a small downpayment but may produce a large effect on the global economy through inspiring multinational companies to expand production. As the global economy double-dips, this action would be China's contribution to supporting the global economy.

As the second largest economy, the largest trading nation with the largest trade surplus, China must take significant responsibility for the healthy functioning of the global economy. Its foreign assets of $4 trillion are overwhelming in government bonds. This lopsided allocation has created huge distortion in the relative price between bonds and stocks. This distortion is a destabilizing factor for the global economy. It should be remedied as soon as possible.



From labor surplus to capital surplus

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Globalizing China's surplus labor is the single most important factor in China's economic development over the past two decades. The surplus depressed China's labor cost to less than 5% of that in the developed economies two decades ago. But, China's labor quality was several times higher than the relative wage suggested. Opening up the country to FDI and building supporting infrastructure led to rapid export growth and industrialization. China has become so successful that it is now the largest trading nation and the second largest economy in the world.

The labor surplus is clearly gone. Indeed, the shortage of blue-collar labor is plaguing many industries. The wage for blue collar labor is rising at a double digit rate. In some industries like mining, it has doubled in the past three years. The wage level, however, is still one tenth of that in the developed economies. Cost isn't a barrier to China's industrialization yet. Upgrading is the right response to the labor shortage. In particular China must compete against Germany and Japan in the coming decade.

As China's surplus labor becomes fully integrated into the global economy, the country has migrated from capital shortage to surplus. China's trade surplus is at $200-400 per capita. This level is relatively low by East Asian standard. It could rise by five times or more. But, because China is so much bigger than other East Asian countries, if its trade surplus per capital reaches that level, the aggregate surplus would be huge relative to the global economy.

For example, if China's trade surplus reaches $1,000 per capita, a modest amount by East Asia standard, the total would reach $1.4 trillion, bigger than all the fund raisings in the stock market in the whole world. How this amount of money is deployed will hugely affect the global economy.



From trade to finance

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A country becomes a financial center because it has succeeded in becoming the trade center. London became the global financial center because the UK had overtaken other countries to be the largest in trading goods and services. The financial center moved to New York because the US replaced the UK as the top player in international trade. China is now the largest trading nation in the world. By 2020 China could dwarf anyone else in international trade, becoming twice as largest as the second largest. Could and should China become the global financial center? The answer to both is yes, I believe. If China doesn't take actions to do so, it would hurt itself and the global economy.

Finance followed trade because most of financial services were related to trade. And, profits were mostly derived from trade too. One could see the linkage by visiting Pingyao, the little town in Shanxi that dominated China's finance in the 19th century. It is a small and poor place bordering Mongolia. In the 19th century, the rise of the Russian Empire created a big market and a safe pathway for selling Chinese goods to it. The people in Pingyao had the advantage of bordering both worlds and could arbitrage the price difference between China and Russia. The profits from the trade and the need for trade finance turned Pingyao into a financial center. It later declined because the seabourn trade replaced the costly overland trade. China's financial center also migrated to Shanghai.

This story repeats on a large scale in the whole world. The United States didn't plot to supplant the UK to become the international financial center. It happened because the US replaced the UK as the biggest industrial power and trading nation. Finance just followed. The importance of the Wall Street is a consequence of the US's industrial success.

The most important economic development in the 21st century is China becoming the largest industrial nation. I have anticipated this for a long time. This is a consequence of globalization and China's cultural characteristics. The government has adopted supportive policies, i.e., not standing in the way. No other country is yet on the horizon to stop China's industrialization.

By one measurement-the industrial energy consumption China is already the biggest industrial economy in the world. The dollar value isn't there yet because Chinese goods are still cheap. China could raise prices to absorb the rising labor cost in this decade and still grow exports at above 10% per annum. By 2020 China could become twice as big as Germany in international trade.

The largest trading nation should become the global financial center. Some may argue that was in the past. Information technology has made where asset trading occurs irrelevant. Germany's plight today should remind everyone that, when the financial center and the source of money are disconnected, bad things happen to whoever has the money. Even though Germany amassed the biggest trade surplus in the past decade, its financial system was woefully underdeveloped and relied on London bankers to recycle its money into other countries. With the benefit of hindsight, it would be natural that the London bankers wanted to screw Germany, because they were paid to do so.

In a decade or two, Germany may become a poor country. When people look back then, they would conclude that its decline was due to the combination of a hyper competitive manufacturing sector and a woefully inadequate financial sector.



Foreign exchange reserves cannot substitute a financial center

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China has avoided Germany's fate by sending its surplus capital into government bonds, especially the US treasuries. This 'all eggs-in-one basket' strategy has worked so far. The government bonds of the major economies have held up in value, even though their economies are in shambles. But, government bonds cannot sustain value if the underlying economies are in constant crisis. At some point, either the government debt level is too high or its tax revenue is too low. Their central banks would be forced to bail out their governments by printing money. China would get its money back, but in severely depreciated currencies. Unless China changes its strategy, it cannot avoid Germany's fate.

China's net foreign assets have risen by twice as fast as its trade surplus. The main reason is capital inflow, especially from overseas Chinese, to avoid a depreciating dollar. The Chinese government is essentially taking on the currency risk for the whole overseas Chinese community. If China loses its foreign exchane reserves, the government may become bankrupt, and the country's financial foundation is gone.

In addition to asset safety, China's 'all eggs-in-one basket strategy' is creating distortion in the global economy. The sharp divergence between stock and bond prices is mostly due to the concentration of money among institutions that just buy government bonds. China is part of the picture. The oil export countries have even more money in the market. The low price of stocks discourages companies to invest and hire workers. While this isn't the only factor, it is a significant one in causing the instability in the global economy.

If a country makes a lot of money, it must be responsible for allocating the money effectively and efficiently to help the global economy. Otherwise, it would be worse off for everyone. In the past decade, China is just one player among several that have amassed money but done a poor job in allocating it. In the next decade, China would dwarf anyone else in amassing money. But, if China couldn't allocate the money effectively, the whole world would blame China for their ills.



China must become the biggest global financial center

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If China upgrades its industries successfully in response to its rising labor cost, as Japan did in the 1970s and Korea and Taiwan did in the 1990s, the country may increase its trade surplus to $1 trillion. The per capita level would still be a modest $715 by East Asia standard. The total, however, is above the total fund raisings in all the stock markets in the world. Unless the money is deployed efficiently, i.e., improving rather than impeding global growth, the global backlash would impede China's development, causing disasters for everyone.

An alternative to the trade surplus is running a massive asset bubble to exaggerate domestic demand. Japan did that in the 1980s. China is doing quite a bit now. Without the domestic asset bubble, China's trade surplus would be twice as big, I believe. Running a bubble just delays the inevitable and creates a financial crisis as the price. China's total property value, including work-in-progress and land banks, is already 5 times GDP. The bubble is about 100% above the sustainable level. The bubble can be bigger, twice as big, if the government tolerates it. When the bubble is big enough, the country will run trade deficit rather than surplus. But, it is artificial. When the bubble bursts, the currency gets devalued, the property value drops to 2.5 times GDP or less. It would lead to a huge trade surplus of above 10% of GDP. But, the world won't tolerate that. The resulting protectionism would shut down the global economy for everyone.

The only good way out is for China to develop a global financial center that would allocate China's trade surplus effectively and efficiently to boost global economic growth. If China can allocate its surplus capital into the global economy efficiently, it can continue to earn surpluses.



The international board is a downpayment

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China has a highly developed manufacturing sector but a backward financial sector. The later is dominated by state ownership and caged by a closed capital account and a fixed exchange rate. The mismatch between the two is the source of so many problems in China. The pressing issue is that the global economy cannot wait for China to go about its own pace. Unless China could allocate its surplus capital effectively and efficiently into the global economy soon, a global backlash against China's development is likely to emerge.

To develop a financial center, a country must have the rule of law, the strong protection for private property, and transparency. China lacks all three. It will take a long time to develop them. But, a downpayment in the form of an international board at China's Stock Exchange could help to jump-start the process.

The multinational companies need to expand in emerging economies. Their home countries don't have money surplus anymore. It makes sense for them to raise money in emerging economies for investments in them. While the market may start small, it would boost confidence among MNC's for future financing. They may become more willing to invest.

China should lay down the rules for the global top 500 hundred companies all to list in China. It should be a transparent process that won't require the aspiring companies to lobby the government individually. If the process is too tightly controlled, it won't have the impact on business confidence.

Many argue that the international board will weigh down the A-share market. This is just a petty excuse. The A-share market is already very low, because it is concerned about the growth at home and abroad. The international board will help the global economy. It would be good for China's economy too. The A-share market may rally on improving confidence.

To boost demand for stocks, the government could introduce new sources of demand. A 401K like retirement plan, for example, could boost stock demand greatly, possibly by over Rmb100 billion per annum. That would be sufficient to offset the fund raisings in the international board. Raising the stock investment ratio for insurance companies would be another source of demand. In short, there are many ways to increase demand to offset the fund needs of the international board. China runs a large trade surplus. Liquidity shouldn't be a problem. Appropriate policy adjustments can keep the liquidity for stock market.

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Posted in: China,finance,stock market

Supporting euro

2011-01-24 / Andy Xie,  The New Century Weekly

Summary

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China and Japan are supporting eurozone by purchasing government bonds that the market shuns today. Chin and Japan have $4 trillion in foreign exchange reserves and are capable of bridging liquidity problems that some eurozone economies are facing. What China and Japan can do is to stop market panic from leading some otherwise viable economies down a vicious spiral of rising interest rate, rising debt burden, and bankruptcy. The economies that are not viable in the first place shouldn't be helped.

China and Japan's action helps themselves in two ways. First, euro is the only alternative to the dollar for global trade, commodity pricing, and storing foreign exchange reserves. If the euro falls apart, the Federal Reserve will be further emboldened to pursue inflation to decrease the US's leverage or indebtedness at the expense of dollar holders. China and Japan hold vast dollar assets and have most lose from dollar devaluation.

Second, Europe is the largest trading partner for China and the third largest for Japan. It is in both's economic interest for Europe to avoid a vicious cycle and remain a healthy trading partner.



Stopping self-fulfilling vicious cycle

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The watchword for monitoring developed economies is debt and for developing economies inflation. In this article I want to discuss the debt situation in developed economies and the implications for their currency values. The market is panicking over the sovereign debt situation in some eurozone economies and is demanding high interest rates for rolling over their debts or providing new money for financing their deficits. When interest rate rises above some level, an otherwise healthy debtor can go bankrupt. This element of self-fulfilling prophesy is a major force in speculative attack against a company or country.

China has recently pledged to support the debt issuances by Spain and Portugal. Japan has committed to purchasing one fifth of the debt issuance by the European Financial Stability Facility ('EFSF'). China's actions were instrumental in the successful debt issuances by Spain and Portugal. Japan is taking risk behind the EFST that is guaranteed by strong economies like Germany and France. This is not enough. China and Japan should work closely together in their European Project. They have common interests.

If China and Japan stick together, they can play a critical role in preventing the eurozone from suffering unnecessary economic hardship due to financial market panic and, by extension, supporting euro as an alternative reserve currency to the dollar.



The developed economies must deleverage

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The developed economies suffered a massive credit bubble in the decade before the 2008 Financial Crisis. Their leverage rose roughly by 50%. Low interest rates and related rising asset prices powered the rising indebtedness, especially in household mortgage debt. McKinsey Global Institute published a comprehensive report on the phenomenon ('Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences'). Globalization brought low inflation, low interest rate, and low wage growth to the developed economies. As the supply side growth shifted to the developing economies, they used low interest rates to stimulate the demand side, which led to debt fueled asset bubbles.

When the Crisis hit, all infected countries pursued a similar strategy to stabilize the situation-extending government help to crashing financial institutions through capital injection, liquidity support, and sovereign guarantee. While it has mostly achieved its purpose, it has brought catastrophic consequences for some countries like Ireland. The resulting liability is bankrupting the Irish government that was quite frugal before the Crisis. The bailout cost has greatly increased government indebtedness in general, limiting their ability to help their economies in the future.

As the global credit bubble burst, we are seeing diverging trends in how the developed economies respond to it. The challenge is to bring down leverage. A good measurement for national indebtedness is the ratio of the total debt level of the real economy-government, non financial companies and households relative to GDP. For example, the US government debt is $14 trillion, the household sector 13.4, and the non-financial corporate sector 11. The total debt is $37.4 trillion. The US's nominal GDP in 2010 is probably $14.8 trillion. That would put the US's national indebtedness at 253%. The same indicator for the eurozone is about 250%, for the UK 280%, and Japan 370%.

In addition to the indebtedness of the real economy the financial system has leverage too. It is similar to borrowing money for buying stocks. It distorts asset prices but doesn't add to the indebtedness of the real economy. There is correlation between real economy indebtness and financial leverage. The later creates cheap money and incentivizes the real economy to gear up. One can assume that high real economy indebtedness has a financial counterpart. In the discussion here I will focus on the real economy leverage.

The real leverage in the developed economies increased by 50% in the decade before the financial crisis. Hence, one can argue that they need to decrease the leverage by one third to normalize. How fast it should happen depends on how dependent an economy is on foreign capital. And in what way it can be achieved is sometimes a policy choice.



Diverging deleveraging policies

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Some are behaving like nothing has happened. Australia stands out in that regard. Its household debt has surged by 20% since the Crisis hit and recently surpassed 100% of GDP. Its household debt to disposable income ratio at 156% is the highest among major economies in the world. Australia has had 4.5% of GDP in annual current account deficit for two decades, i.e., its household debt is funded by foreign capital inflow. Its property market is still booming. When you see rapidly rising household debt, big current account deficit, and booming property market, it is a credit-cum-property bubble for sure. Australia's bubble has survived the 2008 crisis because commodity prices came back on the back of the Fed's zero interest rate policy and China's massive credit growth. The Australian bubble is very likely to burst when commodity prices fall sharply. Either a substantial economic slowdown in China or spiking US interest rate would trigger it.

Australia is an exception. The booming commodity market is giving it the choice not to adjust. Some economies must adjust and fast, because they depend on foreign capital for financing. Iceland, Greece, and Ireland are small economies that depend on foreign capital to fund their fiscal deficits, i.e., they run large current account deficits and don't have sufficient domestic savings to fund their government deficits.

Japan is another economy that hasn't decreased its leverage; the belt tightening in the private sector has been offset by the government's deficit spending. Japan's debt level is truly frightening. But, it has been that way for two decades. The reason for its stability is due to its high domestic savings rate. Japan has been consistently running large current account surplus, i.e., sending its savings surplus abroad, for decades. Japanese people have extremely high home bias in deploying their savings. Japan's government can borrow at extremely low interest rate. Hence, it has no incentive to change its behavior.

Only sustained current deficit would change Japan's dynamics. An aging and declining population is slowly bringing down Japan's savings rate. But Japan's investment need is declining too. Hence, it is still running a significant current account surplus. The situation will change in a decade or so. Japan is unlikely to change without an external constraint. I suspect that Japan would look the same a decade from now.

Many economists think that Greece and Ireland are suffering because they don't have their own central bank. This is an erroneous observation. Small economies cannot use monetary policy to deal with a financial crisis with a large foreign debt component. When the crisis hits, foreigners want their money back. One must tighten belt to pay up or at least to demonstrate convincingly its ability to do so soon. Printing money will surely lead to currency collapse and foreign debt impossible to service, making bankruptcy inevitable.

Eurozone is pursuing belt tightening to address their debt overhang in general. It is not due to market pressure. The Maastrich Treaty of 1993 that laid the foundation for the euro implanted the DNAs of responsible fiscal and monetary policies in the eurozone. The up limit on fiscal deficit to 3% of GDP, though violated frequently, centers policy conversations on the 'right' level. Further, the mandate for the ECB is just price stability, unlike the dual mandate of price stability and employment maximization for the Fed.

The US is pursuing a different strategy to bring down its leverage. It is trying to grow out of it. It is adding more and more monetary and fiscal stimulus to accelerate the economy. Even though the approach leads to rising indebtedness, its advocates believe that the economy would grow faster on its own and bring the leverage down and employment up on its own.

The US's approach hasn't worked well so far. Its government debt has risen to $14 trillion now from $8 trillion in the third quarter of 2008 when the Crisis hit. The increase is equal to 40% of last year's GDP. The Federal Reserve's balance sheet has bloomed to $2.6 trillion from $900 billion during the same period and is likely to rise to $3.2 trillion on QE 2 early next year. Yet, the US's unemployment rate is at 9.4%. If including the people who stopped looking for job or are underemploymend, one sixth of the US's labor force is unemployed.



Euro is better than dollar

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The dollar has been firm since the Obama Administration introduced a new tax cut package. The dollar index ('DXY') has hovered tightly around 80 lately. It was as low as 74 mid last year. Its long cycle high was over 120 in 2002 and low was 71 in 2008. The dollar's strength is due to market's optimism over the US's economic growth outlook for 2011. The double kick from QE 2 and the Obama tax cut could lead to strong growth.

I do believe that the US's economy would have a growth spurt in the first half of 2011. But it would sputter later on. Beyond the government stimulus the economy doesn't have an engine to sustain fast growth. The household sector has 100% of GDP in debt and cannot support consumption through borrowing like before. The US's corporate sector is sitting on record cash. Hence, the Fed's QE 2 is unlikely to change their investment behavior. Indeed, they are investing aggressively in emerging economies. They would invest aggressively in the US when either its consumption grows on a sustainable basis or the US becomes a low cost producer. Neither is likely in the foreseeable future.

When this round of stimulus-inspired growth spurt peters out, the US doesn't have room for more fiscal stimulus. The Federal government already borrows $4 for every $10 that it spends. If it wants to increase the deficit, it runs into two constraints. First, the treasury market could get spooked. The government is adding $1.5 trillion to its $14 trillion debt stock. When the interest rate normalizes, the short-term policy rate should be 5% and 10Y treasury 6%. The interest payment for the government could rise to over $1 trillion in five years. The government finance would be in a vicious cycle. Hence, the market would pull back from more financing for the deficit spending.

The Federal Reserve would be left to support the economy on its own soon. It has only one instrument-printing money to devalue the debt and cheapen the dollar. The former works through inflation. But, it is a high risk strategy. When the market panics, the treasury market may crash, causing the US's interest rates to spike, defeating the benefit of inflation for bringing down the debt burden. A cheap dollar may generate more income through boosting exports. But, a cheap dollar can generate inflation that offsets the dollar weakness in cutting cost.

The Fed probably wants to pull off an impossible task-creating enough inflation to cut debt burden and weakening dollar enough for boosting exports but without panicking the treasury market. I call it an impossible task because the US depends on foreign capital to fund its deficit. The US is likely to run 4-5% of GDP in current account deficit for the foreseeable future, i.e., half of its fiscal deficit needs to be funded by foreign capital. It would be insane for foreigners to continue to buy the treasuries while the Fed is trying to weaken the dollar. It is working now because the dollar is the dominant currency in the global economy. Hence, the US can abuse the dollar and get away with it.

Even if the Fed pulls off the impossible, it wouldn't be rewarding for the dollar. The current dollar strength is likely to be short-lived. When the Fed starts to talk about QE 3, possibly late in the year, the dollar would resume its decline.

Eurozone is pursuing belt tightening to decrease its indebtedness or leverage. It is painful in the short term. The risk to growth scares away euro buyers and attracts short sellers. Hence, euro has been under pressure. But, short-term growth difference has no bearing over the long term value of a currency. Competitiveness and money supply ultimately determine a currency's value. Japan's economy has stagnated for two decades. But, yen against dollar has appreciated from 140 to 80.

In today's world an economy's competitiveness derives from technology, resource endowment, and brands. While the whole world is focusing on technology, its benefits tend to spread out quickly and don't bring much competitiveness to the country of its origin. The US is very strong in mobile internet. Its benefits, however, have quickly spread around the world. The technology may have boosted productivity globally but without conferring a unique advantage to the US.

We need to distinguish between corporate and national competitiveness. The two no longer overlap closely. Apple is highly competitive. It reaps billions in profits from global sales. In terms of unique benefit to the US, it is to the small number of programmers based in the US and Apple's US shareholders. The US is full of companies that are very competitive but don't benefit the US much. This is why I'm optimistic on the US corporate earnings, but not the US economy or the dollar.

Brands and resources, on the other hand, are sticky relative to the countries of their origins. French luxury brands, German cars, and Italian tourist attractions bring benefits mostly to themselves. Southern European countries have lost their competitiveness in labor intensive manufacturing. The rest of eurozone's tradeable sector is quite sticky.

The eurozone has stronger macro fundamentals than the US's also. Its current account deficit is about 1% of GDP and fiscal deficit 6.5%, compared to 4.5% and 10% for the US. The ECB is worried about inflation, as the eurozone's CPI is increasing above its up limit of 2%, while the Fed is explaining away energy and food inflation by focusing on the so-called core CPI. The former is more likely to tighten than the later. It would be good news for euro. Indeed, without short selling euro would be quite strong today.



China and Japan are right to support euro

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While euro's fundamentals are much better than dollar, market panic could push the eurozone down a vicious cycle and make euro crash self-fulfilling. Eurozone doesn't have a central fiscal authority. The small economies in the zone are vulnerable to market pressure. When market panics, it pushes interest rate sky high and makes the borrower bankrupt. If some buyer is willing to step in to replace the market, it gives the borrower time to restructure. The result could be a happy situation for both borrowers and lenders.

IMF exists for that purpose. But, it is clearly not big enough for eurozone's problem. China and Japan have $4 trillion foreign exchange reserves and are much more powerful than the IMF in steadying the market's nerves. Of course, if a country isn't viable, it shouldn't be supported. Debt restructuring-a form of bankruptcy should be pursued. I suspect that Greece falls into this category. Ireland may need some restructuring too

Spain is undoubtedly the key battle. It is large, suffering from 20% unemployment rate, and, if given time, capable of paying off its debts. As long as enough resources are marshaled to maintain liquidity for Spain's debt market, euro is quite safe. China and Japan can play a decisively role in the area. China is already providing direct support. Japan should too.

Supporting euro is in China and Japan's best interest. They hold more dollar assets than anyone else and have strong vested interest to safeguard the dollar's value. The only viable alternative to the dollar is euro. If it is discredited, the Fed would be emboldened to print more money. Euro's value in that regard is worth enough support from China and Japan to provide sufficient liquidity to Spain.

Down the road, China and Japan should work with the OPEC countries to prepare for the post-dollar world. The three hold most dollar assets in the world. If they don't prepare an alternative, they are always at the Fed's mercy. When the Fed stimulates the economy by printing money, it dilutes their wealth. If they prepare a credible alternative, the Fed will have to think twice before it starts the print press.

The key step for replacing the dollar is for oil to be priced in a different currency. For now euro is the only possibility. China, Japan, and the OPEC should begin to discuss on trading oil in euro. Oil is mostly traded in London and New York now. Euro-denominated trading systems could be created in Dubai, Shanghai and Tokyo.


It's time to prepare for the post-dollar world.

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Posted in: China,EURO,Japan

Why China and Japan Need an East Asia Bloc

Withering exports and asset bubbles have forced Asians – especially China and Japan -- to work harder at free trade pacts.

Andy Xie 2009-11-10

(Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.)

(Caijing Magazine) All kinds of proposals have been floated about creating an Asian bloc a la European Union. Bilateral and multilateral free trade agreements (FTA) have been suggested for various combinations of Asian countries. Lately, there's been a flurry of new ideas as Japan's recently installed DPJ government seeks to differentiate from the ousted LDP.

By promoting ideas that lean toward Asia, DPJ's leadership is signaling that Japan wants less dependence on the United States. This position offers a hope for the future to Japanese people, whose economy has been comatose for two decades. Closer integration with Asian neighbors could restore growth in Japan.

Whenever global trade gets into trouble, Asian countries talk about regional cooperation as an alternative growth driver. But typically these talks die out as soon as global trade recovers. Today's chatter is following the same old pattern, although this time global trade is not on track to recover to previous levels and sustain East Asia's export model. Thus, some sort of regional integration is needed to revive regional growth.

Which regional organization is in a position to lead an integration movement? Certainly not ASEAN, which is too small, nor APEC, which is too big. Something more is needed – like a bloc rooted in a trade pact between Japan and China.

ASEAN's members are 10 countries in Southeast Asia with a population exceeding 600 million and a combined GDP of US$ 1.5 trillion in 2008. The group embraced an FTA process called AFTA in 1992, which accelerated after the 1997-'98 Asian Financial Crisis and competition with China heated up. When AFTA began, few gave it much chance for success, given the region's huge disparities in per capita income and economic systems. Today AFTA is almost a reality, which is certainly a miracle.

ASEAN has succeeded beyond its wildest dreams. These days China, Japan, and South Korea join annual meetings as dialogue partners, while the European Union and United States participate in regional forums and bilateral discussions.

China and ASEAN completed FTA negotiations last year, demonstrating that they can function as an economic bloc. Now, China is ASEAN's third largest trading partner. Indeed, there is a great upside for economic cooperation between the two.

Before the Asian Financial Crisis, the ASEAN region was touted as a "miracle" by international financial institutions for maintaining high GDP growth rates for more than two decades. But some of that growth was built on a bubble that diverted business away from production and toward asset speculation. This developed after credit expansion, driven by the pegging of regional currencies to the U.S. dollar, encouraged land speculation. ASEAN's emerging economies absorbed massive cross-border capital due to a weak dollar, which slumped after the Federal Reserve responded to a U.S. banking crisis in the early 1990s by maintaining low interest rates.

Back then, I visited companies in the region that produced goods for export. I found that, despite all the talk of miracles, many were making money on financial games -- not business. At that time, China was building an export sector that had started exerting  downward pressure on tradable goods prices. Instead of focusing on competitiveness, the region hid behind a financial bubble and postponed a resolution. Indeed, ASEAN's GDP was higher than China's before the Asian financial crunch; now China's GDP is three times ASEAN's.

China today faces challenges similar to those confronting ASEAN before the crisis. While visiting manufacturers in China, I've often been discovering that their profits come from property development, lending or outright speculation. While asset prices rise, these practices are effectively subsidizing manufacturing operations – an asset game that can work wonderfully in the short term, as the U.S. experience demonstrates. When property and stock markets are worth more than twice GDP, 20 percent appreciation would be equivalent to four years of business profits in a normal economy. You can't blame businesses for shifting their attention to the asset game in a bubbly environment. Yet as they focus on finance rather than manufacturing, their competitiveness erodes. And you know where that leads.

I digress from the main focus for this article -- regional integration, not China's bubble challenge.

So let's look again at ASEAN's success. In part, this reflects its soft image: Other major players do not view ASEAN as a competitive threat. Rather, the FTA with China has put pressure on majors such as India and Japan to pursue their own FTAs with ASEAN. Another dimension is that the region's annual meetings have become important occasions for representatives from China, Japan and South Korea to sit down together.

In contrast to ASEAN's success, APEC has been an abject failure.
Today, it's simply a photo opportunity for leaders of member countries from the Americas, Oceania, Russia and Asia. APEC was set up after the Soviet bloc collapsed, and served a psychological purpose during the post-Cold War transition. It was reassuring for the global community to see leaders of former enemy countries shaking hands.

However, APEC is just too big and diverse to provide a foundation for building a trade structure. So general is the scope that anything APEC members agree upon would probably pass the United Nations. Now, two decades after end of the Cold War, APEC has clearly outlived its usefulness and is withering, although it may never shut down. APEC's annual summit still offers leaders of member countries a venue for meetings on the sidelines to discuss bilateral issues. Maybe the group is useful in this way, offering an efficient venue for multiple summits concurrently.

Although ASEAN has succeeded with its own agenda, and achieved considerable success in relation to non-member countries, it clearly cannot assume the same role as the European Union. Besides, should Asia have an EU-like organization? Asia, by definition, clearly cannot. It's a geographic region that includes the sub-continent, Middle East and central Asia. Any organization that encompasses Asia as a whole would be as unwieldy as APEC.

I am always puzzled by the word "Asia," which the Greeks coined. In his classic work Histories, it seems ancient Greek historian Herodotus primarily referred to Asia Minor -- today's Turkey, and perhaps Syria -- as Asia. I haven't read much Greek, but I don't recall India being included in ancient Greek references. So as far as I can determine, there is no internal logic to treating Asia as a region. It seems to encompass all places that are neither European nor African. Africa is a coherent continent, and Europe has a shared cultural past. Asia belongs to neither, so it shouldn't be considered an organic entity.

Malaysia's former prime minister Tun Mahathir bin Mohamad Mahathir was a strong supporter of an East Asia Economic Caucus (EAEC) which would have been comprised of ASEAN nations plus China, Japan and South Korea. But because Japan refused to participate in an organization that excluded the United States, the idea failed.

Yet there is some logic to Mahathir's proposal. East Asia has a shared history, and intra-regional trade goes back centuries. Population movements have been significant, and as tourism takes off, regional relations should strengthen. One could envision a future marked by free-flowing capital, goods and labor in the region.

Yet differences among the region's countries are much greater than in Europe. ASEAN's overall per capita income is US$ 2,000, while it's US$ 3,500 in China and US$ 40,000 in Japan. China, Japan, South Korea and Vietnam share Confucianism and Mahayana Buddhism, while most Southeast Asian countries embrace Islam or Hinayana Buddhism, and generally are more religious. I think an EU-like organization in East Asia would be very hard to establish, but something less restrictive would be possible.

Because Japan turned down Mahathir's EAEC idea, there was a lot of interest when recently elected Prime Minister Yukio Hatoyama's proposed something similar – an East Asia Community -- at a recent ASEAN summit. Hatoyama failed to clarify the role of the United States in any such organization. If the United States is included, it would not fly, as it would be too similar to APEC. Nor could such an organization be like the EU. But if Japan is fully committed, the new group could assume substance over time.

The Japanese probably proposed the community idea for domestic political reasons. Yet the fundamental case for Japan to increase integration with the rest of Asia and away from the United States grows stronger every day. Despite high per capita income, Japan remains an export-oriented economy, having missed an opportunity to develop a consumption-led economy in the 1980s and '90s. In the foolish belief that rising property prices would spread wealth beyond the industrial heartland in the Tokyo-Osaka corridor, the government of former Prime Minister Kakuei Tanaka pursued a high-price land policy, discouraging the middle class from pursuing a consumer lifestyle as they saved for property purchases.

Even more seriously, high property prices have been a major reason for Japan's rapidly declining birth rate, as land prices inflated living costs. Now, facing a declining population and public debt twice GDP, Japan has few options for rejuvenating the economy by promoting domestic demand. It needs trade if it hopes to achieve any growth at all. Without growth, Japan will sooner or later suffer a public debt crisis.

Japan's property experience offers a major lesson for China. Every Chinese city is copying the Hong Kong model -- raising money from an increasingly expensive land market to fund urban development, leading to rapid urbanization. But this is borrowing growth from the future. Rising land prices lead to rising costs and, hence, slower growth and the same rapid decline in the birth rate that Japan experienced. Unless China reverses its high-land price policy, the consequences will be even more disastrous than in Japan or Hong Kong, as China shifted to the asset game much earlier in its development.

Yet I digress again. The point is that Japan has a strong and genuine case that favors more integration with East Asia. The United States is unlikely to recover soon and with enough strength to feed Japan's export machine again. There is no more room for fiscal stimulus. Devaluing the yen to gain market share is not an option as long as Washington pursues a weak dollar policy. Without a new source of trade, Japan's economy is doomed. Closer integration with East Asia is the only way out.

In addition to Hatoyama's EAC proposal, a study jointly sponsored by China, Japan and South Korea is considering the possibility of a FTA. Of course, ASEAN could offer a template for any new East Asian bloc. ASEAN has signed an FTA with China and is talking with Japan and South Korea. If they all sign, regional integration would be halfway completed.

Whatever proposals for East Asian integration, the key issue is a possible FTA between China and Japan. Adding other parties avoids this main issue. China and Japan together are six times ASEAN's size and 10 times South Korea's. Without a China-Japan FTA, no combination in East Asia would truly support regional integration.

Five years ago, I wrote an op-ed piece for the Financial Times entitled China and Japan: Natural Partners. At the time, a prevailing sentiment was that China and Japan were antithetical: Both were still manufacturing export-led economies and could only gain at the other's expense. I saw complementary demographics and capital: Japan had a declining labor force and China needed to employ tens of millions of youths migrating to cities from the countryside. China needed capital and Japan had surplus capital. And their trade relations indeed tightened, as Japan had increased the Chinese share of its overall trade to 17.4 percent in 2008 from 10.4 percent in '04.

Today, the situation has changed. China has a capital surplus rather than a shortage. Demographic complementarity is still good and could last another decade. As China shifts its development model from resource intensive to environmentally friendly, a new complementarity is emerging. Japan has already made the transition, and its technologies that supported the transition need a new market such as China's. So even without a new trade agreement, bilateral trade will continue growing.

An FTA between China and Japan would significantly accelerate their trade, resulting in an efficiency gain of more than US$ 1 trillion. Japan's aging population lends urgency to increasing the investment returns. On the other hand, as China prepares to make a numerical commitment to limiting greenhouse gas emissions at the upcoming Copenhagen summit on global warming, heavy investment and rapid restructuring are needed for its economy. Japanese technology could come in quite handy.

More importantly, a China-Japan FTA would lay a foundation for an East Asian free trade bloc. The region has a population of 2.1 billion and a GDP of US$ 13 trillion, rivaling the European Union and United States. Blessed with a low base, plenty of capital, sound technology and a huge market, the region's GDP could easily double in a decade.

Trade and technology are twin engines of growth and prosperity. No boom is sustained without one or the other. And when they come together, the boom can be massive. Prosperity seen over the past decade, for example, is due to information technology along with the opening up of China and other former planned economies. But these factors have been absorbed, forcing the world to find another engine. An integration of East Asian economies would be significant enough to play this role.

The best approach would be for China and Japan to negotiate a comprehensive FTA that encompasses free-flowing goods, services and capital. This task may appear too difficult, but recent changes have made it possible. The two countries should give it a try.

It would be wrong to begin by working out an FTA that includes China, Japan and South Korea. That would triple the task's level of difficulty, especially since South Korea doesn't have a meaningful FTA with any country. To imagine that the Seoul government would cut a deal with China or Japan is naive. China and Japan should negotiate bilaterally.

A key issue is that China and Japan should put economics before politics. If the DPJ government wants to gain popularity by increasing international influence rather than boosting the economy, then all the current speculation and discussion about an East Asia bloc would be for nothing. But if DPJ wants to sustain power by rejuvenating Japan's moribund economy, chances for a deal are good.

While Japan is talking, China should be doing. China should aggressively initiate the FTA process with Japan. Regardless of China's current difficulties, its growth potential and vast market are what Japan will never have at home nor anywhere else. Hence, China would be able to compromise from a position of strength.

Some may say a free trade area for East Asia is beyond reach. However, history belongs to the daring. The world has changed enough to make it possible. China and Japan should seize the opportunity.

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Posted in: China,Japan