"China has made great progress in opening to the outside world," and industrialized nations should maintain their policy of engagement with Beijing, said James Dorn, vice president for academic affairs at the Cato Institute.

For its part, China should "recognize its responsibility as a rising great power" and implement various reforms, including the introduction of a floating exchange rate regime and capital freedom, Dorn told the symposium organized by Keizai Koho Center on Oct. 28 under the theme, "Japan-U.S.-China Relations in East Asia."

	James Dorn and Albert Keidel (bottom) discuss changes in Chinese economic system and their implications from Japan and the United States, during the Oct. 28 symposium at Keidanren Kaikan in Tokyo.

But Albert Keidel, a senior associate at the Carnegie Endowment for International Peace, said China needs to avoid a rapid financial liberalization, including the opening of its capital account.

Keidel warned that China -- without a proper regulatory system -- could fall into a crisis if its financial system is liberalized or privatized too quickly.

They were among the five experts from U.S.-based think tanks who discussed China's economic and military issues, and their implications for Japan and the U.S. before the audience at Keidanren Kaikan.

Dorn expressed concern over what he called a "disturbing coalition between China hawks and protectionists" in the U.S. Congress.

One example, he said, was the failure earlier this year of the bid by Hong Kong-based CNOOC Ltd., a subsidiary of China National Offshore Oil Co., for control of the California-based Unocal Corp. Citing what it perceived as a U.S. economic and national security threat over the purchase of an American energy company by a Chinese firm, Congress intervened and CNOOC eventually dropped its $18.5 billion bid for Unocal.

Dorn said China -- often criticized for manipulating the value of its yuan currency unfairly low to maintain its export competitiveness -- is not chiefly to blame for the huge U.S. trade imbalances. Given that China accounts for only 13.5 percent of total imports to the U.S., even a 20 percent revaluation of the yuan would have negligible impact on the overall U.S. trade balance, he noted.

"The real problem is imbalances in the global economy between savings and investment, and excessive U.S. government spending," Dorn said.

"It's much easier to blame China than face our problems at home. Thus we see what (Federal Reserve Chairman) Alan Greenspan called 'creeping protectionism,' " he told the audience.

While Congress seems to take an increasingly confrontational approach toward China, Dorn said Washington should not stray from its policy of engagement with Beijing. A deviation from the policy, he warned, would be "very costly and would jeopardize our national security in the long run."

Freeing capital
Dorn said he expects the yuan's exchange rate to appreciate by 3 percent to 5 percent during the next eight months. There will also be a gradual liberalization of China's interest rate regime, and banking and capital controls are being relaxed step by step, he said. "The direction of the change is clear, but the speed of change will depend on the political climate," he added.

Dorn described China's economy -- despite the continuing rapid growth with dramatic increases in foreign direct investment -- as "half healthy and half sick."

He said China "needs to move from a system of financial repression to capital freedom." People should be able to freely move their capital because "it's their property" and the government "should not be telling them what they can do and limit their alternatives," he argued.

"Development is really just not about increasing physical output . . . but giving people a wider range of choices. That's why I think capital freedom would mean real development in China," he said.

Dorn said China is aware of the problems in its financial system. "If they want to be an international financial capital at some point -- Shanghai for example -- they're going to have to make a firm decision about having a floating exchange rate, along with an independent monetary policy, and capital freedom," he said.

Lack of capital freedom in China has allowed a huge waste of capital, and interest rate controls lead to a massive corruption and politicization of investment decisions, Dorn said.

Dorn deplored what he called excessive savings in China. "People save roughly 40 percent of their income. They put it mostly into state-owned bank deposits, because they don't have very many alternatives," he said. "So it goes right into the state's pocket. Some of it may be used on productive investments, but a lot of it is wasted."

"The nonstate sector in China accounts for about 70 percent of industrial output value, but the nonstate sector, especially the private sector, is starved of capital and relies on foreign direct investment," he said. "The state sector captures most of the capital, but it does not produce much of the output. There's a big leaky bucket there."

Chinese 'myth
' Keidel of Carnegie Endowment meanwhile said he disagrees with Dorn over financial liberalization in China. Keidel said it is an often repeated "myth" that China's financial sector is unhealthy and insolvent, with its nonperforming loan woes posing a serious obstacle to economic growth. "China has nonperforming loans on its books but it has huge contingent assets, and the government has repeatedly indicated it will use those assets to back up the financial system," he said.

"The only real danger to the financial system would be policy blunders. If they liberalized or privatized the financial system too quickly you could have crisis and chaos," Keidel told the audience.

"Similarly, capital account opening would be a disastrous blunder anytime in the next 20 or maybe even 30 years. They do not have the (necessary) regulatory system at the micro level," he said. "Capital controls are the first line of regulatory defense in a world of volatile capital flows."

Keidel brushed aside the often repeated view that China keeps the value of the yuan unfairly low and that its currency exchange regime is a barrier to growth.

He lashed out against a "characterization" often heard in Japan -- that China's political system is a barrier to its economic growth, or that its Maoist communist regime is fundamentally inconsistent with a market economy.

"The Chinese system is not a Maoist philosophy nor some high-school version of what communism is all about," he said as he explained how China is dramatically changing in terms of freedom of speech, assembly and the press.

Japan and the U.S. should "find ways to muffle the demonizing of China," Keidel told the audience.

"It's so easy when it's not an ally, not a friend, to solve our problems by blaming them on China," he said as he urged Tokyo and Washington to "build an image of China that is more complex than the demonizing image of China as a bad actor, a bad player and a cheater."

He urged Japan and the U.S. to engage in more cultural exchanges with China -- to go there and learn about China and "understand its complexity and the process that economic development has to take . . . so that we don't live with ghosts or images, or myths of how the other side thinks."

Workforce problems
As one of the real challenges confronting China, Keidel cited restructuring an economy "in which much of the labor force is doing the wrong jobs in the wrong place." Transformation of the labor force is a "key test of reform success," he said. "If it stumbles, the reforms will stumble."

Today, much of China's labor force is in rural interior locations "where they are cut off from centers of transport and communication," Keidel noted.

The transformation, he said, takes moving people from one location to another -- to have them leave their place of longtime residence and employment. "This process is well under way over the last 10 years" as employment at state-owned enterprises has been cut by tens of millions, he added.

How do you encourage reluctant rural workers to move to new jobs in urban areas?

"The only real way is to introduce incentives through degrees of inequality -- rich places and poor places. If you don't introduce significant degrees of inequality, you don't have incentives for people to move voluntarily to locations where they actually earn a real income -- where they deserve to have a better standard of living," he said.

"So it's not surprising that we see in China a major increase in inequality in many dimensions. And I would say this, to the degree it's been handled by China, is a sign of economic reform success, not failure."

Also key to this labor transformation is urbanization, a process that will require an "extremely high level of investment" in basic infrastructure such as transport, water supply and sewerage, Keidel observed. Improved basic infrastructure will pave the way for growth of the private sector, because it creates freedom of movement, he added.

China simultaneously needs large-scale investments in basic industries that would compete for funds, he said.

"This requires reforms in the whole investment process for public investments -- competitive bidding, cost control and smart planning," he said. "China is making a great deal of progress, but it has a long way to go."