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The Paradox of China’s Reform
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Jamie F. Metzl
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18 May 2012

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NEW YORKThe compelling drama of former Chongqing Communist Party chief Bo Xilai’s ouster amid allegations of corruption and murder, and of blind Chinese human-rights advocate Chen Guangcheng’s dash to safety in the US Embassy in Beijing, are more than just fascinating narratives of venality and courage. Unless China can purge the thousands of corrupt Party leaders like Bo, and empower peoplelike those Chen represents – who have been left behind or harmed by rapid growth, its economy will increasingly suffer.


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Like the Asian Tiger economies before it, China has excelled in the first phase of capitalist economic growth, benefiting from massive infusions of capital, low-cost labor, intellectual-property theft, and centralized planning. And, like many of them, China is now facing a “middle-income trap”: as wages rise, its low-end manufacturing is losing global competitiveness while government policies, endemic corruption, and dominant state-owned enterprises are stifling the type of private-sector innovation that China needs most to generate products and services with higher added value.


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China’s leaders understand this, which is why the government’s 12th Five-Year Plan calls for a gradual opening up of the Chinese economy. Likewise, a Chinese government think tank worked with the World Bank to produce the China 2030report, which outlines the structural reforms needed to strengthen the foundations of the country’s market-based economy and create a climate of open innovation.


.But if China’s national imperative today is reform, the greatest threat to that goal is the massive influence and institutionalized corruption of the country’s entrenched elites. For years, senior Chinese officials and their families have received a cut of countless major investments throughout China. They and their families have become multimillionaires by exploiting the close association of business and politics, as well their strong links with China’s state-owned enterprises.

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The resulting rise in inequality has been exacerbated by China’s capital controls and mandated low interest rates on savings. For lack of other options, poor people put their money in banks which then lend to more privileged people to fund state-owned enterprises or much higher-yielding real-estate investments.

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This system worked to drive overall economic growth and financial rewards in the first phase of China’s post-reform growth, but the incomes of ordinary Chinese have stagnated over the past decade, their interests have been neglected, capital has been misallocated, and major negative environmental and social side effects have emerged. Now those who have benefited most from the current system are blocking badly needed reforms.


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For example, years of imbalanced incentives have led China to overbuild premium residential real-estate, which should cause prices to fall dramatically. But, although the government is trying to take some of the air out of the market, the authorities cannot easily take the more aggressive action that is required, because Chinese officials and other elites store so much of their wealth in real estate, which also comprises much of the collateral of state-connected banks. Similarly, although state-owned enterprises are sucking too much oxygen out of China’s economy, reforming them would require taking on China’s most powerful business and government leaders.


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This is why the Chinese government’s dance around the Bo scandal has been so complicated. Bo may have lost an internal political struggle, and may have crossed a line after the murder of British businessman Neil Heywood, for which Bo’s wife is under arrest; but vilifying him is a double-edged sword for the government. On one hand, the authorities need to pursue him aggressively to justify the purge of someone who was so recently lauded. On the other hand, many of the accusations against Bo could be leveled at an extremely large number of senior officials across China who, like Bo, have amassed multimillion-dollar family fortunes.

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In highlighting Bo’s misdeeds, the Party is trying to demonstrate that it alone can and should be responsible for addressing official corruption. But given that the people who have benefited so much from the current system are unlikely to clean it up, the only other way to generate reform would be to empower the people getting the short end of the stickpeople like Chen and those he has helped.


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The crackdown on Chen for representing villagers who have been abused by the authorities follows the same pattern as the silencing of parents who protested shoddy school construction after the 2008 Sichuan earthquake, and of opponents of the environmentally damaging Three Gorges Dam. If China is serious about reform, it will need armies of people like these, fighting for their rights, in order to balance the overwhelming political power of its entrenched elites.


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China’s reform process can succeed only if it is pushed from the top and the bottom. The Party needs to find every possible way to get rid of the Bo’s in its midst. Instead of threatening people like Chen, the Party should give them recognition and support. None of this will be easy, but the future of China’s economy depends on it.

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Jamie Metzl served on the National Security Council in the Clinton Administration and is Co-Chairman of Partnership for a Secure America and a former Executive Vice President of the Asia Society.
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Who is Responsible for the Greek Tragedy?
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Mohamed A. El-Erian
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17 May 2012



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SEATTLEGreece is following the road taken by several other crisis-ridden emerging economies over the past 30 years. Indeed, as I argued earlier this year, there are stunning similarities between this once-proud eurozone member and Argentina prior to its default in 2001. With an equally traumatic implosioneconomic, financial, political, and socialnow taking place, we should expect heated debate about who is to blame for the deepening misery that millions of Greeks now face.


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There are four suspectsall of them involved in the spectacular boom that preceded what will unfortunately prove to be an even more remarkable bust.



Many will be quick to blame successive Greek governments led by what used to be the two dominant political parties, New Democracy on the right and PASOK on the left. Eager to borrow their country to prosperity, they racked up enormous debts while presiding over a dramatic loss of competitiveness and, thus, growth potential. Some even sought to be highly economical with the truth, failing to disclose the true extent of their budgetary slippages and indebtedness.



Having borrowed far too much after joining the eurozone in 2001, New Democracy and PASOK let their citizens down when adjustments and reforms were needed after the 2008 global financial crisis. An initial phase of denial was followed by commitments that could not be met (indeed, that some argued should not be met, owing to faulty program design). The resulting erosion in Greece’s international standing amplified the hardship that citizens were starting to feel.



Hold on, I hear you say. For every debt incurred there is a credit extended. You are right.




Greece’s private creditors were more than happy to pour money into the country, only to shirk their burden-sharing responsibilities when the artificial boom could no longer be sustained. The over-lending was so widespread that at one point it drove down the yield differential between Greek and German bonds to just six basis points – a ridiculously low level for two countries that differ so fundamentally in terms of economic management and financial conditions.



Overeager creditors willingly underwrote this absurd risk premium. Yet, when it became abundantly clear that Greece’s debt burden had been taken to insolvency levels, creditors delayed the moment of truth. They dragged their feet when it came to the critical agreement on orderly burden-sharing (that is, acceptance of a “haircut” on private-sector claims on Greece). And the longer they did that, the more money left Greece without any intention of returning.



But neither the Greek government nor its private creditors acted in a vacuum. Both took comfort from the political cover provided by the European unification effort – an historic initiative aimed at securing the continent’s well-being through closer economic and political integration on the basis of credible rules and effective institutions.



On both countsrules and institutions – the eurozone fell short of what was required. Remember, the large core economies (France and Germany) were among the first members to breach the budgetary rules that were established when the euro was launched. And European institutions proved toothless when it came to enforcing compliance. All of this served to sustain the fantasy world that both Greece and its creditors happily inhabited for far too long.



Europe also failed to react properly when it became obvious that Greece was starting to teeter. European government counterparts failed to converge on a common assessment of the country’s problems, let alone cooperate on a proper response. While they grudgingly loosened their purse strings to support Greece, the underlying motives were too shortsighted, and the resulting approach was strategically flawed and abysmally coordinated.



Finally, there was the International Monetary Fund, the institution charged with safeguarding global financial stability and being a trusted adviser to individual countries. It appears that the IMF succumbed too easily to political pressures during both the boom and the bust. Political expediency seems to have trumped analytical robustness, undermining both the Fund’s direct beneficial role and its function as a policy and financial catalyst.



On the surface, each of the four suspects has an individual case for arguing that the finger of blame should be pointed elsewhere. They could even argue that, at worst, they were uninformed accomplices. But that is not really right.



None of the four can avoid the reality that Greece’s collapse would not have occurred had they not been complacent during the boom and, subsequently, fulfilled their responsibilities during the bust so poorly. They sucked each other into a sense of false prosperity, only to trip each other up during the inevitable downturn. Now, one hopes, all four will be held properly accountable by their stakeholders and undertake serious self-evaluation.



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Most likely, they will end up getting off too easy, especially compared to the real victims of this historic tragedy – the most vulnerable segments of the Greek population, who will become much worse off, today and for many years to come, as jobs disappear, savings evaporate, and livelihoods are destroyed. And they may not be alone. Millions of others may experience collateral damage, as financial contagion risks spreading to other European countries and to the global economy as a whole.



In a fairer world, these vulnerable citizens would be entitled to claw back the salaries, official privileges, and bonuses that the four parties to blame enjoyed for too long. In the world as it is, they are a compelling lesson for the future.



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Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment compamy PIMCO, with approximately $1.4 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, and 2011. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by the Economist.


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Copyright Project Syndicate - www.project-syndicate.org


Why is the eurozone different? Part 2
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Martin Wolf
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May 19, 2012 12:58 am




I have noted in the first part of this blog that the debts of countries in the eurozone have suffered a very different fate from those outside the eurozone during the crisis. This is evident when one compares the yields on sovereign bonds of the UK with those of France, Italy and Spain, countries that on the face of it, have governments at least as solvent, if not more so.



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So why has the experience of the eurozone members been so different and so painful and what can be done to remedy the problem?



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There are two possible explanations, which are not mutually exclusive.


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The first explanation is that a country with its own currency enjoys access to the captive savings of its private sector. The reason why people keep most of their financial assets in the domestic currency is that this is also the currency of most of their spending and of course, of the taxes they pay. Currency mismatches are also very dangerous in a world in which the currency might shift a large amount in a short time.



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After a crisis, the private sector will also often (though not always) have a large financial surplus – that is, an excess of income over spending. This must be spent either on the liabilities of the government or on foreign assets. The former purchases fund the government directly. The latter drive down the external value of the currency, which will result in improved prospects for the economy and strengthening the public finances.




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The position of eurozone members is very different. A Spanish resident may buy German bunds, instead of Spanish bonds, with no currency risk or to the extent such risk exists, it is only on the upside. The same is true for any other euro-based person. Thus, the debt of the government of Germany – both the largest country and one with a strong creditor position – has emerged as the safest asset in the system. Its price has risen as its yields tumbled. It should be grateful, but does not seem to be. Meanwhile, the debt of sovereigns deemed less secure than that of Germany risks being turned into junk.



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Suppose that the interest rates on the bonds of the weaker sovereigns soar. Suppose, too, that there is limited official support for those bonds from the central bank (that is, the European Central Bank) or other governments. Then the government of the weaker sovereign will be forced into fiscal austerity. Quickly, the nominal rate of interest will become far higher than the prospective growth of nominal gross domestic product.


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The government will find itself in a debt trap. It will need a large primary surplus (before interest payments) to constrain the growth of its stock of debt relative to GDP. But the weakness of the economy will limit its ability to achieve such a surplus. Awareness among investors of the trap will automatically make it deeper. This is why deflating a government back into solvency is so hard once interest rates become high.



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The point is made below. The picture is particularly striking for Spain. Between 1995 and 2007, Spain’s nominal GDP grew on average 7.4 per cent a year. Between 2010 and 2014, this average is forecast by the International Monetary Fund to be just 1.2 per cent a year. For Italy, the corresponding average growth of nominal GDP was 4.5 per cent between 1995 and 2007, but again, the forecast average rate is 1.2 per cent a year between 2010 and 2014. Nominal interest rates on government bonds of 5-6 per cent will not work with such depressed growth of nominal GDP.

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The second explanation for the high bond yields of governments in the eurozone is that a member of a currency union does not have a central bank of its own. This then creates liquidity and default risk in the market for government bonds.


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Investors in government bonds should know that they have no collateral. So expectations of repayment depend on the ability of the government to refinance debt, since the latter can never pay it off: the market for government debt is lifted by its own bootstraps. Without a central bank, a time may arrive when the government is unable to refinance its debt. That creates tail risk – the likelihood of being trapped in debts whose maturity will be forcibly extended or on which the government will default.



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These risks will come to investors’ minds during a crisis. Liquidity will then dry up and investors flee. Only the central bank can halt such a “run” or market panic. But, by assumption, the latter will refuse to take the needed action.



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Paul de Grauwe, who now teaches at the London School of Economics has put the point forcefully.




In a nutshell the difference in the nature of sovereign debt between members and non-members of a monetary union boils down to the following. Members of a monetary union issue debt in a currency over which they have no control. It follows that financial markets acquire the power to force default on these countries. This is not the case in countries that are no part of a monetary union, and have kept control over the currency in which they issue debt. These countries cannot easily be forced into default by financial markets.


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Another way of looking at the absence of a central bank is as follows. The yield on a bond with no default risk should be the weighted average of expected short rates of interest. Thus for an economy in deep recession, with no serious risk of inflation over the relevant horizon, expected short-term interest rates will be low and so, as a result, will be the yields on bonds. This then explains the UK’s very low bond yields, since it has (next to) no default risk.



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Yet bonds of eurozone member states do have default risk, since in effect, they borrow in a foreign currency, as have many emerging economies in the past. Investors now know of this risk not just from theory, but from what has happened in Greece. The expectation of ultra-low official short-term rates will not, in these cases, determine the yield on bonds, because the possibility of default will also enter the calculation. Worse, the probability of default is a function of the interest rate on the bonds: the higher is the rate, the greater is the probability of default. So yet again, governments may enter a trap in which the higher the interest rates they have to pay the smaller is their perceived likelihood of avoiding default.


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What then could be done to reduce this dangerous fragility inside the eurozone? That will be the subject of my next post.