How to tame a dominant China

The mighty West, led by the mighty US, is suddenly looking to China for help in rescuing debt-ridden Europe. But China has not just arrived as a global economic power. It is going to eclipse the US and become the dominant economic power in the world, according to a fascinating, highly-readable and often brilliant new book by Arvind Subramanian, Eclipse: Living in the Shadow of China\’s Economic Dominance.

US economic dominance has long been eroding, but it has remained resilient to challengers – notably Japan till 1990 – and has huge inherent strengths. In today\’s troubled times, investors have flooded into the dollar: the US still looks a safe haven in stormy times.

Hold on, says Subramanian. After making various statistical adjustments – which remain controversial – for the undervaluation of China\’s currency (renminbi or RMB), he calculates that China\’s GDP in 2010 was $14.8 trillion, ahead of the US\’ $14.6 trillion. China remains far poorer in per-capita income. Both matter for economic dominance, but GDP matters more.

In a book combining deep scholarship with wit, his key innovation is an Index of Economic Dominance based on three parameters: GDP, trade strength and external financial strength. These three helped Britain dominate the 19th century and the US the 20th century.

Using IMF weights, his index shows China almost catching up with the US in 2010. Using reserve currency weights, China was just ahead at No. 1 in 2010. By 2020, it will be so well ahead – using either set of weights – that it could be called dominant. By 2030, that should not be in doubt at all.

How credible are the projections? Subramanian says China\’s rise will be driven by demography and convergence – the tendency of poorer, low-tech countries to catch up with rich, hi-tech ones provided they have reasonable policies and institutions. He assumes that Chinese GDP growth will slow dramatically to 6.9% while the US will grow at 2.5% – conservative, plausible assumptions.

Yet, as Subramanian admits, forecasting is a hazardous business. Past trends rarely predict future ones. Who would have thought a year ago that the US would lose its AAA rating and three European countries would be reduced to junk-bond status? As Mohammed El-Erian said at a Peterson Institute book discussion, the unthinkable now happens constantly.

China is not exempt from this rule. Like the Arab Spring, one day, we will have a Chinese Spring. Nobody knows when. But when it comes, all past projections could quickly look ridiculous.

Martin Wolf of the Financial Times pooh-poohs the notion that the RMB will become a reserve currency by 2020. To achieve that status, China will have to open its capital account, allow private sector banks and financial institutions to become dominant, and develop bond markets so deep and liquid that they can determine interest rates. Wolf says this will not be acceptable to the Chinese leadership, which is paranoid about staying in control.

Whether or not China becomes a dominant power, it certainly is rising fast. Economic clout translates into military clout. Subramanian sticks to economic dominance and does not consider the political and military consequences. Yet, these are of paramount interest to most readers.

However, his analysis on how to control China in the economic side has clear lessons on how to control its political ambitions too. First, there are many positive aspects of China\’s rise. It has helped the world economy survive a terrible Western recession, reduced the global prices of goods – especially low-end manufactures used by the poor – lowered the cost of capital, and financed infrastructure and other investment across the world, including much-neglected Africa. The world needs these strengths even while guarding against the risks that will arise from dominance.

Subramanian says that the best way to bind China is through multilateral institutions and agreements. China\’s trade-GDP ratio (almost 50%) is far above the US ratio in the 20th century. China is a very big importer as well as exporter, especially of raw materials and food. This is very unlike the US, which was an exporter or self-sufficient in most commodities till World War II, and remains far less dependent on imports.

China needs the rest of the world in ways that post-War US did not. The US chose not to rely on its own muscle and, instead, helped create multilateral institutions like the UN, World Bank, IMF and Gatt. This was essential to end economic anarchy and lack of international rules between the two World Wars. China is a keen student of economic history, and can be persuaded that multilateralism is better for a superpower: it produces world order, yet leaves lots of space for superpower bullying.

Hopefully, the same strategy can be used by the rest of the world to channel China into multilateralism in the political and military arenas. Hopefully, Iraq and Afghanistan have taught China that foreign military adventures are disastrous for even economic superpowers, and spark huge political resentments at home.

Toady, China claims virtually the entire South China Sea, disregarding the Law of the Sea and claims of other littoral states like Vietnam and the Philippines. China has not unambiguously accepted all international norms on sharing river waters, such as the Brahmaputra\’s. We need a China that agrees to international rules set by multilateral institutions, in both political and economic matters.