For almost a decade now, China has followed a mercantilist growth strategy, which has involved maintaining a deliberately cheap exchange rate to boost exports and growth. Crucial to this policy has been China’s choice to keep the economy relatively closed to foreign financial flows. Had it not done so, foreign capital chasing the high returns in China would have put upward pressure on the Chinese exchange rate and undercut its ability to export. India, on the other hand, is steadily if stealthily dismantling its capital controls, foregoing the ability to emulate the Chinese growth strategy. Why so?

For reasons still unclear, the world, and hence Indian policy makers, are in thrall to the narrative of “imbalance” surrounding Chinese mercantilism. In this view, mercantilism has been a problem for China, creating distortions and reducing welfare, and a problem for the world. Now, Chinese mercantilism has not been costless, and these costs may well be rising.

But this imbalance narrative has obscured the first-order and potentially paradigm-shifting lesson about Chinese mercantilism: it promoted unprecedented growth, raised consumption dramatically, reduced vulnerability to risk, and facilitated China’s rise as an economic superpower.

Growth: plots the GDP performance of six of the fastest growing Asian countries during the period of stellar performance (the starting point is indicated in the legend). The period of Chinese mercantilism corresponds to the last ten years on the China line. The chart highlights that it is in this period that China’s performance literally went off the charts, compared to its own history and to that of other comparable countries.

Consumption: Critics of China’s policy argue that while mercantilism has been good for producers, it has imposed costs on Chinese consumers. In support they cite China’s consumption as a share of GDP, which has declined dramatically to about 35 per cent. But this is misleading, and shows why. It is in the period of mercantilism that China delivered the fastest growth rates of consumption for the average Chinese citizen — faster than that posted by the Asian economies during their miracle years. The reason is simple: even though the share of consumption in GDP was declining, GDP itself was rising so dramatically that absolute consumption levels surged.

Mitigating risk: Why is this experience potentially paradigm-shifting? Because it questions a fundamental tenet of development held since the 1950s: poor countries were poor because they did not have enough savings and hence investment. Escape from poverty through higher levels of investment required countries to be open to foreign capital flows. In macroeconomic terms, rapid growth required countries to run current account deficits as the counterpart of the foreign flows.

China did almost the opposite. It kept itself relatively closed to foreign financial flows (while allowing foreign direct investment) and despite doing so managed to increase investment dramatically and post humanity’s most dramatic economic transformation: indeed, it was able to generate so much domestic savings — far in excess of its investment needs — that it has been shipping them abroad for nearly 15 years now.

This conjunction of rapid growth and consumption and reduced reliance on foreign capital had the collateral benefit of reduced vulnerability to macroeconomic instability and crisis. Recall the pattern of classic balance-of-payments crises in emerging markets: in the build-up, foreign capital poured in which drove up domestic asset prices, increased consumption, worsened competitiveness, and fuelled large external deficits and imbalances. Then, some event or policy triggered the sudden stop, and capital headed for the exit, wreaking havoc in its wake.

This pattern has been notably and depressingly regular: Latin America in the 1970s, Asia in the 1990s, eastern Europe in the 2000s, and the PIGS (Portugal, Ireland, Greece and Spain) of Europe most recently. India ignores this pattern.

Power: Mercantilism not just reduced reliance on capital, it actually allowed China to become a large net creditor to the world. History suggests that economic superpowers are creditors. That was true of the British Empire and of the US, whose power has ebbed in recent years in part for having become a net debtor. Of course, China has incurred costs in accumulating its $3.2tr dollars of foreign reserves. But the world needs that cash and the borrower’s neediness is the creditor’s power, which China has exercised around the developing world and may do so in Europe too.

Now, how much of this combination of faster growth, rising consumption and savings surfeit was due to mercantilism and a closed capital account, as opposed to other factors, will be debated — but the strong correlation invites others to show that all these positive outcomes were not due to mercantilism, or that they were not so positive after all.

Acknowledging the success of Chinese mercantilism in the past is entirely consistent with arguing that China should gradually graduate from it in the future. The benefits are starting to be outweighed by the rising costs, including the costs that China is inflicting on others.

But if mercantilism has this beggar-thy-neighbour aspect, is it consistent with internationalism to advocate it for India? Yes. India should avoid egregious Chinese mercantilism, of deliberately and for long periods maintaining a cheap exchange rate. But there is no reason India should, by liberalising capital flows, deprive itself of the tools to prevent currency overvaluation, lower growth, and greater susceptibility to macroeconomic crises. There is a middle path between repelling capital inherent in Chinese mercantilism and recklessly embracing it as India has chosen.

When the history of this period is written, the irony will not go unnoticed that a government led by eminent macroeconomists exhibited uncharacteristic boldness in the one area — dismantling capital controls — where theory and the accumulating evidence screamed caution.

The views expressed in this article are the author's own and do not necessarily reflect 51勛圖’s editorial policy.

*[This article was originally published by Business Standard on January 25, 2012].

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Dear Madame Lagarde,

Europe is in deep trouble, possibly on the verge of catastrophe, and as a consequence so might be the world. You represent that world and you need to act quickly and decisively, and I am afraid somewhat solitarily. You need to quickly mobilize international resources to help address the problem in Europe, which in turn would help minimize the risks to the rest of the world.

You will have to fight and win this case on intellectual merits because most of the major powers will either explicitly resist you (Europe, especially Germany), subtly undermine you (the United States), or not support you enough (China and India).

Europe will keep telling you that they will call upon the Fund if and when they need it. You too keep echoing that by saying, “If Europe needs us…etc., etc.” You should stop taking your cues from Europe. Europe thinks it has the resources to avoid this Armageddon—maybe it does but it, or rather Germany and the European Central Bank, are behaving as if they do not have the money or are unable to mobilize the money. In any event, you and the world cannot afford to dance to the tune of European dithering and brinkmanship. The fact is there is some—non-trivial and rising—probability that Europe and the world will need the resources of those able to provide them in large quantities and quickly to avert meltdown or its aftermath. You need to mobilize those resources fast.

The fact is a tectonic shift has occurred in the global economy: The identity of potential international borrowers and creditors in the future has changed. More and more of the larger countries and yesterday’s creditors are today’s potential borrowers. Some have indeed started borrowing, and the queue of those with cap in hand outside your door is lengthening.

Today’s financial crises, like the 2008–09 crisis in the United States, requires invocation of the Powell doctrine: the application of overwhelming force. Calming markets requires occasionally reminding them that they can be reduced to irrelevance by enough firepower on the other side. Combine this doctrine with the prospect of many countries the size of Italy borrowing from the IMF in the years ahead, and you quickly realize that the IMF needs at least 1 if not 2 trillion dollars worth of resources, hopefully most of it serving as insurance. But if you actually do need to use the money, wouldn’t you be glad that you had mobilized it beforehand? The case for a bigger IMF is therefore both short-term—dealing with Europe—but also long term because of the nature of the countries that have become potential supplicants.

You cannot get these large sums of money right away, but you need to make a start right now.  You need to present a plan to that effect in the next few days and dare the G-20 finance ministers, who are due to meet soon, to overrule you. Remember, you have first-mover advantage. You propose. You define the default. You shape the status quo. Effort is required on the part of the others to defy or obstruct you.

I want to go through the depressing list of sources of opposition or lack of support for such a plan and how to deal with them. But let me offer advice on who you should have on your side in order to take on this weighty array of naysayers.

Brazil and Russia: Brazil and Russia have shown that they will support you. Brazil genuinely believes in the need for cooperation in times of trouble and has already offered to put up some cash. And Russia likes to flaunt its oil wealth and desperately wants to regain its Soviet-era seat at the table. Forget the motivation, take the cash and support. Hopefully, other oil exporters—such as Norway and Saudi Arabia—will also contribute.

China: Following the oil is generally a good strategy, but following China is essential. Only China has the kind of cash to make your initiative succeed. There are two ways to persuade China: the direct way and the manipulative way. The direct way is to say that China, for its contribution, will be given a much bigger say in the way the IMF is run.

I have written that China needs to be given power in the IMF equivalent to that of the United States and greater than that of Europe. You need to convince China that you will make that argument forcefully and if necessary take on your erstwhile French colleagues if they resist. That is key. On this you must speak with conviction and daring.

Remember, China’s leaders may not have to face voters periodically, but they are vulnerable to these telling questions domestically: why should we invest our billions to rescue much richer countries, banks, and individuals when there is poverty at home? Wouldn’t that be immoral hazard? The one way they can take their population along would be for Chinese leaders to say, “The returns for rescuing the rich are not just that we help ourselves because they buy our goods and we need to help them to continue doing so. The returns also are that the world has finally recognized that we the Chinese will have the same status as the United States in determining how to run the world. The world has now accorded us this status.” Tapping into that nationalist pride—wounded since Lord George Macartney set foot on Chinese soil in 1793–94—should not be underestimated. 

If that is not enough, play the Japan card. Get the Japanese—consistently underestimated for their qualities as good global citizens—to contribute another few hundred billion dollars to the IMF, and China will be shamed or goaded into matching its Asian rival. That dynamic has been at work in Asia, for example, in the context of the Chiang Mai initiative to set up an Asian Monetary Fund. Exploit it at the multilateral level.

And, of course, you might want to gently remind the Chinese that some of the resources they would be contributing to the IMF were acquired on the back of beggar-thy-neighbor exchange rate policies. Plowing them back for the collective good through the IMF would be partial redemption for those policies. 

Now for the naysayers.

United States: The United States will not support you in this effort. The United States has an incentive to believe that the IMF does not need more firepower because it knows that, fiscally compromised as it is, it cannot contribute to any extra resources and will therefore see your initiative—correctly—as leading to a reduction in its power and influence. No superpower will happily acquiesce in being stripped of such power, and the United States is no exception. Equally, though, if you do set this ball rolling, there are enough people with good sense and cosmopolitanism in this somewhat fading power who will come around to your position and be willing to make your case domestically.

Europe: Clearly, Europe will resist you not just because it thinks it can solve its problems on its own. As important, Europe, and especially France, projects its power internationally through the IMF in which it has acquired inordinate influence, and will be loath to give it up. But it will have to. You will have to remind the Europeans: In financial institutions, creditors have power, not debtors. And for several decades in the IMF, Europe has behaved like a powerful creditor. But now it is a debtor or at least forced itself into being a debtor.  You must stress that what was good for the European goose is now good for the Beijing duck.

But you should also tell your French friends this: An IMF that is seen to be involved in, and helping/rescuing Europe, should offend European pride enough for the Europeans to try and find more of the resources on their own. That is why many in Europe resisted IMF involvement in the sovereign debt crisis last year. This resistance applies in particular to Germany and the European Central Bank. Dangling the threat of outside help can elicit more European effort.

The moral hazard brigade: Then you will have to take on the moral hazard fetishists—notably Germany but also people on the far right in the United States—who will see a bigger fund as encouraging reckless behavior in the future. Your argument should be that countries—especially democratic ones—are less prone to moral hazard. Ask Prime Minister George Papandreou of Greece or even the soon-to-depart Prime Minister Silvio Berlusconi how pleasant it is to be a supplicant and to implement austerity measures dictated by outsiders. Or tell them about why the Asians will do their best never to borrow from the IMF because of the humiliation involved.

Germany: But in convincing Germany you must also outline how this crisis might damage Germany economically. If the euro area falls apart, it would reflect the failure of the core (Germany) to hold it together. Germany has potentially speeded that end because of its reluctance to finance Greece and stimulate its own economy, which would provide opportunities for Greece and other periphery countries to export. The consequence of a euro implosion would be the worst of all adverse competitiveness shocks for Germany. Once the euro collapses, and as the neo-drachma, nuovo-lira, nuevo-peseta, and even nouveau–French franc rise from its ashes, their values are likely to settle at levels producing a 50 percent real appreciation of the neue–Deutsche Mark. Germany would face collapsing exports, plummeting growth, and soaring unemployment—and not that much fiscal firepower to throw at these dire problems. These troubles could be seen as the payback for its miserliness today. Avoiding that outcome should make Germany rethink its domestic policies and its resistance to IMF involvement.

(As an aside, please do ask the Germans what model of political economy they had in mind when they offered the Greeks the deal of austerity for the next ten years so that they could reach a debt-to-GDP level in 2020 of 120 percent of GDP, a level which Italy today finds difficult to defend vis-á-vis markets.  How is austerity today, followed by more austerity tomorrow, an acceptable strategy for democratically elected politicians? In German, is there a different expression for “light at the end of the tunnel?”)

India: If India is not willing to contribute at least 25 percent of what China will, ask them why they deserve a seat at the high table. At least, tell them to stop complaining about the inequities of the international system if they do not exert themselves even a little to rectifying them.

Mme. Lagarde, yours is an unenviable task. But you have the bully pulpit, a fount of goodwill, the power of making a compelling argument, the first-mover advantage.

Greece is sinking, Rome is burning, and one of humanity’s most lofty projects—that strove to overcome difference for the sake of achieving a common ideal—is imperiled. Europe needs help to be saved from itself and the world needs to be saved from Europe too. Please stop taking the phone calls from Berlin, Brussels, Paris, and Frankfurt. Please be the internationalist that the world hopes and expects you to be. And please hurry.

*[This article was first published at on November 11, 2011 ]

The views expressed in this article are the author's own and do not necessarily reflect 51勛圖’s editorial policy.

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As the G-20 traveling road-show heads to Cannes, the coinage of international summitry risks becoming utterly debased. Restoring relevance to these events requires an agenda that must meet three criteria. The issues must be important, they must be truly international, and there must be some realistic scope for getting agreement on them. At Cannes, only one issue meets all these criteria: enlarging the size and revamping the governance of the International Monetary Fund (IMF). Consider why the others fail to meet these criteria.

Without doubt, the most important issues facing the G-20 are resolving the euro area crisis and the stance of US monetary and fiscal policies. Europe needs to get its house in order. And the United States needs a plan to increase demand and reduce unemployment in the short run while placing public debt on a sustainable medium-term footing.

But these are problems that can only be solved by governments building a political consensus at home. International and public hand-wringing at Cannes will have little role to play, not least because there is little intellectual consensus around some of them. How Sarkozy of France, Singh of India, and their colleagues can help bridge the divide between the Republicans and the Democrats within the United States eludes comprehension. Nor is it clear how the G-20 can broker a deal amongst the Europeans. At most, the imminence of the Cannes summit might be encouraging the Europeans to reach a consensus quickly. But even this effect must be marginal: Market pressure is clearly the decisive factor behind the flurry of Franco-German meetings.

Then there are issues such as China’s exchange rate policy. Certainly, this is an issue which is very directly international in nature and which would benefit from international cooperation. Under conditions of underutilization of resources in the United States and Europe, and because emerging market countries compete with China, an undervalued renminbi is a beggar-thy-neighbor policy with adverse effects on the rest of the world. The problem here is political feasibility. China today is beyond the ability of outsiders to threaten or cajole.

This is not an indictment of China because its behavior is far from atypical. Throughout the history of the IMF, large countries have never subordinated perceived self-interest to the collective good. Between 1946 and 1973, nearly all the major countries reneged on the pledge to maintain a fixed parity. The United States blew up the Bretton Woods system when it acted as a straitjacket on US policies. Europe would not brook interference by the IMF during its Exchange Rate Mechanism (ERM) crises of the early 1990s. The depressingly long list of failed attempts at cooperation, where the policies and interests of the large rich countries are involved, should give pause to efforts to deal with issues such as China’s exchange rate.

Another category comprises issues on the international reform agenda such as strengthening the Special Drawing Rights (SDR) and including the renminbi in the SDR basket. These are genuinely international issues and they may even hold some reasonable scope for getting international agreement. However, quite apart from the fact that the rise and fall of international reserve currencies are likely to be determined organically by market forces rather than by international collective action, strengthening the SDR is hardly likely to change the course of the global economy.

In contrast, increasing the lending capacity of the IMF meets all three criteria. It is truly an international issue and one of great potential value. One of the successes of the London G-20 summit in 2009 was the announcement of the increase in the size of the IMF which helped calm skittish markets. Today that need is even greater.

In 2008–09, the major countries had considerable scope for domestic action to respond to the crisis. Today, with interest rates close to the zero bound and fiscal positions considerably worse, the need for, and the magnitude of, international responses will be that much greater. One big change in the international landscape has been the fact that some of the large industrial countries in Europe—with a collective GDP of around $5 trillion—are now potential borrowers from the IMF. That calls for a large increase in the IMF’s lending capacity of about a trillion dollars, if only as insurance against a catastrophic turn of events.

Will it be possible to secure agreement on a much larger IMF? To be sure, there will be resistance from the status quo powers because the new creditors will rightly demand changes in IMF governance. In  today I describe the changes that will be required. Much of the additional resources will have to come from the emerging-market economies and oil exporters, but above all China must be given a considerably larger role in the IMF. Europe and the United States will, however, have to acquiesce to the governance changes once it becomes clear that China, as the key credible provider of additional resources, holds the cards.

At Cannes, a focus on strengthening the IMF would be the one step that would be seriously useful, genuinely cooperative, and potentially feasible. A focus on this measure could consequently help salvage the future of international cooperation. Otherwise, it will be yet again be a case of "words, words, words."

*[This article was first published by on October 28, 2011]

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Can a country that is also not amongst the richest in the world and not at the economic and technological frontier be a superpower? That is one of the most common questions raised against the central assertion in my recent that China’s economic dominance is more imminent, broader in scope and greater in magnitude than is currently imagined.

My projections suggest that by 2030, China will not be poor; indeed, its per capita GDP (in PPP terms) will be more than half that of the United States, and certainly greater than the average per capita GDP in the world.
China’s economic dominance will still be unique, because historically, the dominant powers (the United Kingdom and United States) have been rich, indeed amongst the richest relative to their competitors, when they have been dominant. In China’s case that will not be so. But neither will it be a case of a poor country wielding power. China will be a middle-income or upper-middle-income country. So, perhaps China’s future economic dominance should more aptly be described as that of a “precocious” rather than “premature” superpower as Martin Wolf of the Financial Times has described China.

But is precocious superpowerdom even possible? History is clearly on the side of those who believe that dominance requires a high standard of living. Why might this be the case?

First, a poor country might be inwardly focused because the tasks of maintaining internal stability and achieving a higher standard of living are the government’s major if not exclusive preoccupation. In this case, projecting power internationally will have to be subordinated to addressing more pressing domestic challenges. Internal fragility sits uneasily, or is just downright incompatible, with external dominance.

Second, a poor country might not be able to raise the resources — at least on a sustained basis —for the projection of power internationally. The classic example is military resources. These will have to be financed. But the poorer a country, the more difficult it might be to tax the people to raise resources. For example, tax revenues generally rise with the level of development. Russia sustained military dominance for some time beyond its underlying economic potential, but eventually economics caught up with geopolitics. North Korea is a more extreme example of external power being incommensurate with internal stability and wealth. North Korea can be a nuisance, a country that can cause trouble, but hardly one that can exercise international dominance.

A third reason why a poor country cannot project dominance is that it may not have the “soft power” attributes — such as democracy, open society, and pluralistic values — for dominance. Put differently, the leadership that comes with dominance is only really possible if it inspires followership. And followership comes when the dominant country stands “for” something that commands universal or near-universal appeal.

The fourth reason, related to the previous attribute, is that only a rich country — which by definition is at the frontier of economic and technological possibilities — can be a fount or source of ideas, technology, institutions, and practices for others to follow and absorb. A poor country is less likely to be such a model worthy of emulation and an inspiration to follow.

So, clearly, dominance is inconsistent with being extremely poor, but if one reflects on these points, it is worth noting that with some exceptions, neither does dominance necessarily require being among the richest countries. There is, for example, no reason why internal cohesion, the ability to raise resources for external purposes, the possibility of being democratic, or possessing some emulation-worthy national narrative or values or ideals is inconsistent with being a middle-income power, as China is likely to be by 2030.

Moreover, China’s current low standard of living is entirely consistent with different forms of the exercise of dominance. For example, China has used its surpluses to provide aid to and finance investments in Africa, extracting in return the closure of Taiwanese embassies. It has used its size to strengthen trade and financial relationships in Asia and Latin America. (China's offer to build an alternative to the Panama Canal to boost Colombia's prospects is one dramatic illustration of this phenomenon.) More recently, it is to China that the world will have to turn should things turn ugly in Europe and should additional resources be required to bail out some of the faltering European economies. (“China is Spain’s best friend,” effused Spanish Prime Minister José Luis Rodríguez Zapatero in April 2011, on the occasion of the Chinese president’s visit.)

Most strikingly, China has been following an exchange rate policy that has adversely affected not just the United States and Europe but a number of emerging markets that compete with China, including Brazil, Mexico, India, Turkey, Vietnam and Bangladesh. But the rest of the world has been powerless to change China’s policies. If this is not dominance, what is?

Even the mighty United States has repeatedly threatened action against China but has not been able to carry it through. It barks but cannot bite. The shift in the balance of power in the US-China relationship is especially striking given that it was only about a decade ago that the United States was able to muscle China into radically opening its agriculture, goods, and services market as part of China’s accession to the WTO.

So two possible conclusions suggest themselves. A form of dominance that naturally inspires followership and which might be necessary to create or build systems and institutions — as the United States did after World War II — might possibly elude China for some time, especially if it is unable to make the political transition to democracy. But other forms of dominance — to change the policies of other countries and resisting change to its own in a way that can result in systemically negative externalities — are already being exercised by China at low levels of income. As China becomes considerably bigger and richer over the next two decades, what should we expect?

*[This article originally appeared in on October 26, 2011]

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September 21, 2011

This testimony draws upon my forthcoming book, “,” my article in Foreign Affairs with Aaditya Mattoo, ” and my forthcoming paper with him, “A China Round of Trade Negotiations." Underlined text indicates links to supplementary material.

Summary and Recommendations

1. In the post-World War II period, open trade, by lowering prices, increasing consumer choice, and promoting exports, has been a force for economic prosperity for the United States. Creating and maintaining an open trading system, which has helped countries around the world to improve their living standards, has been one of the major achievements of the United States and its global leadership. Trade with China has also been, on balance, good for the United States, and overwhelmingly good for China.

2. But increased global integration can impose distributional costs domestically on certain relatively lower-skilled workers and certain communities. Certain aspects of China’s trade, notably its exchange rate policy, have also had adverse effects for the US which are pronounced in the current climate of high unemployment and under-utilization of resources.

3. For the United States, international competitiveness begins at home. For the medium run, this entails strengthening American technological capability and leadership, improving the education system, and creating a regulatory climate that fosters entrepreneurship and innovation. For the short run, the best way of coping with the adverse effects of trade is to strengthen the social safety net through assistance for those affected by trade and other technology-driven developments. This would also shore up political support for open trade at a time when this support is dwindling even amongst those traditionally in favor of free trade.

4. The United States must also engage internationally to maintain the current rules-based multilateral system. This is especially critical if the United States is to transition toward a growth model that is less reliant on consumption and more on investment and exports, and meet the export goals set by President Obama. Moreover, United States has substantial comparative advantage in tradable services, which could be further exploited through market opening abroad. 

5. China will be a critical part of this international engagement.  But China has become too economically dominant for the United States to engage with China on its own.  That is one of the major changes that have occurred in the world economy over the last decade. Fortunately, the desire and concern to ensure that China’s rise will remain a force for good is widely shared amongst other industrial and developing countries. This provides an opportunity for the United States to lead a collective effort—muscular multilateralism—to engage with China on trade issues. Moreover, because China’s economic development has benefited enormously from an open trade system, it will have a stake in preserving it.

6. A concrete way to realize this is to move beyond the Doha Round to start a new round of multilateral trade negotiations—a possible “China Round”—that would focus on the issues—exchange rates, government procurement, services, technology policy, commodities, and climate change—which are particularly crucial for China’s trade relations with the US and with other large trading nations. 

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