Asia and the Global Economy
It's a pleasure to be back in Vancouver. I'm especially honoured to be able to address faculty and students here at the University of British Columbia. UBC and the Bank of Canada have a long-standing relationship. Professor Mick Devereux was one of the first recipients of the Bank's research Fellowship, Professor Angela Redish was a Special Adviser at the Bank in 2000-01, and Professor John Helliwell is our current Special Adviser. As well, David Dodge was on the faculty here, in the Commerce Department, in 1997-98. And, of course, there have been numerous UBC graduates who have joined the Bank over the years.
Let me now turn to my topic for today: Asia and the global economy.
To state the obvious, Canada is a very open economy, heavily dependent on foreign trade. What goes on in the rest of the world can have a substantial impact on our domestic economy.
Naturally, we tend to focus on the United States because roughly 80 per cent of our trade is with that country. But nowadays, the world for Canada is not just the United States. This was made very clear to us during the Asian crisis of 1997-98. At that time, events on the other side of the globe, in countries that were not even our major trading partners, had significant consequences for Canada's economy. The most important of these was the collapse of Asian demand for commodities, which led to a sharp decline in the world prices of major Canadian exports and to downward pressure on our currency.
These days, Asia is once again in the news—although for different reasons. Today, I would like to talk about the increasing importance of that region, particularly China and India, in the global economy. I will also talk about the implications for policy in industrialized countries and in the emerging-market economies of Asia. I will then conclude my presentation with a few words on the Bank's outlook for the economy and inflation in Canada.
New International Economic Players
To begin, let me just point out that what we are witnessing today is not a new phenomenon. Since the early nineteenth century, many countries have, at different times, emerged as major forces on the international economic scene. During the 1830s, productivity gains associated with the Industrial Revolution launched the United Kingdom as an economic powerhouse. Germany and the United States followed in the latter part of the nineteenth century, by adopting the new technology of the time, as did Russia for a while before the First World War.
Through the 1950s and 1960s, Japan emerged from the Second World War to become a major economic power. Then Korea took off in the 1970s, followed by other so-called "Asian tigers" during the 1980s and 1990s. Now, it's China's turn. And India is not far behind.
What differentiates China and India from these other countries is their sheer size. Together, these two countries represent close to 40 per cent of the world's population. By comparison, Japan accounted for only 3 per cent of the world's population at the time of its emergence as an economic force.
What's also breathtaking is the speed of China's rise to economic prominence. In 1980, the Chinese economy produced less than 3 1/2 per cent of global output, measured on a purchasing power parity basis. By 2003, this share had risen to more than 13 per cent, roughly half that of the United States. In fact, China is now the fourth-largest exporter in the world, having surpassed Canada in 2001 and the United Kingdom and France in 2002.
As for India, while its economy is also very large, equivalent to about a quarter of that of the United States, it is not yet a major global exporter. But, with advancements in communications and with a large number of well-educated workers, India is establishing itself as a significant and growing presence in the international service industry.
The Asian Challenge: What Does It Mean?
Not surprisingly, many perceive the growing competition from China and India as a significant threat. And some are wondering how anyone can compete against countries that have such huge pools of cheap labour and access to the latest technologies.
To be sure, China's rising production of manufactured goods and India's rapidly growing services industry represent a serious competitive challenge to other producers around the world. And, in an environment in which firms everywhere are under constant pressure to lower costs, many are finding that China and India are attractive places to establish production facilities and service centres. Indeed, a significant percentage of China's export companies are subsidiaries or affiliates of multinationals from industrialized countries. The same is true of the many call centres and software manufacturers that have located in India.
The loss of jobs in the home countries of those companies can be a sensitive social and political issue and can contribute to protectionist pressures, especially during periods of relative economic weakness and subdued employment growth. In the United States, outsourcing has become a major issue in the political debate leading up to this year's presidential election.
The perceived threat to jobs and domestic production from the growing integration of the emerging Asian economies into the global economy is one point of view. But, to put things in perspective, there is another viewpoint. Increased competition is beneficial, even if somewhat painful at times. Competition spurs innovation. And efforts to increase productivity benefit consumers everywhere.
In industrialized countries, lower prices for goods and services mean that consumers and firms have more money to spend on other goods and services. This, in turn, contributes to increased overall demand in the economy. Competition is also part of the normal market process of "creative destruction," which sees dated, low-productivity activities replaced by more innovative, dynamic enterprises. Let us not forget that higher productivity leads to durable increases in real incomes. And while jobs may be lost in sectors facing heightened competition, others are being created elsewhere.
It is also important to keep in mind that international trade is based on comparative advantage. A country will tend to specialize in, and export, those goods and services that it can produce at a relatively low, not an absolutely low, cost. Put another way, even if a country has an absolute advantage in producing all goods and services, it and its trading partners would still be better off by focusing on the products they can produce more efficiently and importing those they can produce less efficiently.
Robust economic growth in Asia, which is lifting hundreds of millions of people out of poverty, is creating more demand for goods and services from the industrialized countries, thus providing a much-needed boost to global economic growth. Indeed, preliminary data for 2003 suggest that China may have vaulted into third place among the world's most important importers, behind only the United States and Germany. We in Canada have certainly benefited from sharply higher U.S.-dollar commodity prices, which again reflect strong demand from Asia, notably China.
Clearly, the growing integration of the Asian economies into the global economy presents challenges to policy-makers everywhere—in industrialized countries that are their principal markets, in other developing countries that may be losing market share in certain products to Asian competition, and in the Asian economies themselves.
This integration process is being complicated by large external imbalances among major countries. Most importantly, a large U.S. current account deficit has its counterpart in large surpluses elsewhere. While China's overall current account surplus narrowed in 2003, its trade share of the U.S. market has been rising rapidly in recent years, reflecting its growing specialization within Asia. China is increasingly becoming an "assembly platform" for firms from other countries in the region: it is essentially importing materials from its neighbours for assembly and for final export to the United States. Collectively, the Asian economies are running a very large current account surplus with the rest of the world.
The flip side of these imbalances has been a sharp rise in the net foreign liability position of the United States and a massive accumulation of foreign exchange reserves by the Asian countries. China has amassed more than US$400 billion of reserves, mainly because of efforts to maintain a fixed exchange rate against the U.S. dollar in the face of a persistent current account surplus and large capital inflows. India has permitted a modest appreciation of its currency against the U.S. dollar; but it, too, has seen a marked rise in international reserves, to roughly US$100 billion. Even more striking, as of the end of 2003, all of Asia (including Japan) had accumulated US$1.9 trillion in foreign exchange reserves.
How these global imbalances will be corrected is currently a major topic of debate in international policy circles.
Now, what does all this mean for policy-makers around the world?
First, let me be clear about one thing: market forces will come to bear on these imbalances. The external indebtedness of a country, even a country as big as the United States, cannot grow indefinitely as a proportion of its GDP. At some point, investors will begin to balk at increasing their exposures to the United States. Similarly, the buildup of foreign exchange reserves in countries with balance-of-payment surpluses cannot be sustained indefinitely without repercussions for their domestic economies.
So, market forces will, in the end, bring about an adjustment. But appropriate policy action by national authorities around the world can help to address these global imbalances and facilitate an orderly adjustment process. What we need is a multifaceted policy approach.
Let's start with policy-makers in the industrialized countries. What can they do?
Above all, they should resist the siren song of protectionism. Trade—whether in goods or services—is a positive-sum game. That is to say, in the end, all countries can be winners. If countries yield to protectionist pressures, everyone in the international community will be worse off in the long run. Moreover, protectionist actions that focus on bilateral imbalances will not reduce the size of a country's overall current account deficit. If the underlying cause of that deficit is not addressed, say, through efforts to increase domestic savings, protectionism would only result in trade flows being diverted to other countries.
Policy-makers everywhere can certainly take steps to improve their domestic economic situations through appropriate national policies. Macroeconomic policies should aim to promote sound, sustained economic growth—that is, growth at an economy's production capacity. Fundamentally, this means a fiscal policy that keeps the public debt-to-GDP ratio on a sustainable track, and a monetary policy that is directed towards low, stable, and predictable inflation. Structural policies designed to make product and labour markets more flexible are also key to facilitating the movement of labour and resources from sectors that are shrinking to those that are expanding. Finally, social policy has an important role to play in spreading the cost of adjustment more evenly.
Here in Canada, federal and provincial governments have done a great deal to clean up their balance sheets over the past decade. And we at the Bank of Canada have kept inflation low. We have done this by working within an inflation-targeting framework, supported by a flexible exchange rate that allows us to respond symmetrically to shocks that threaten to take inflation above or below the 2 per cent target. In addition, Canada has made progress in improving its economic flexibility through structural reforms. We have seen the payoff from these investments in sound policies. That payoff is solid underlying economic growth and an improved ability to adjust to changing circumstances and adverse shocks and to take advantage of new global opportunities.
Emerging-market economies in Asia could also contribute to the orderly and timely adjustment of global imbalances through greater policy flexibility. First of all, greater exchange rate flexibility would help to head off growing protectionist pressures among their major trading partners. More importantly, such flexibility is likely to be in their best domestic interest. As I said before, the persistent accumulation of reserves, stemming from official efforts to preserve a "competitive" nominal exchange rate, will eventually have repercussions for their economies.
Although, in theory, a country can accumulate reserves indefinitely, in practice, this can be difficult. Often, it leads to a loss of monetary control and to rapid credit expansion, which can set in motion a boom-bust cycle. It was precisely this kind of cycle that contributed to the financial crises in some Asian economies in 1997-98.
It is possible that history may be repeating itself in China. Bank lending is growing rapidly, contributing to overinvestment in certain areas of that economy—most notably property development. The fixed exchange rate itself may also be encouraging a misallocation of resources, with too much investment going into export-oriented industries.
It is well known that China faces serious challenges in strengthening its financial system. And many argue that financial sector reform is a prerequisite for greater exchange rate flexibility. But the risks of adopting that view are twofold: one, macroeconomic instability, in the form of higher inflation, and two, financial instability, in the form of an increased number of bad loans due to excessive credit expansion.
The Chinese authorities are aware of these risks. Indeed, late last year, the central bank raised the reserve requirements of commercial banks in an effort to slow bank lending and moderate the torrid pace of economic growth that topped 9 per cent in 2003. And last week, additional measures were announced to tighten monetary policy.
Ultimately, rapid money growth and credit expansion would lead to higher inflation in China and thus to an appreciation of the real exchange rate of the Chinese currency, even as the nominal exchange rate remains fixed. Remember, it is the real exchange rate that matters when it comes to international trade.
Greater exchange rate flexibility would help to mitigate the risk of China's economy overheating. It would also help the adjustment to rising productivity, by facilitating an upward movement in real wages.
But one needs to go one step further and think about how greater exchange rate flexibility fits into an overall framework for monetary control. Policy-makers in China, as well as in other Asian countries, might want to think about adopting a monetary policy framework similar to Canada's. An explicit inflation target to anchor expectations, combined with a flexible exchange rate, enables monetary authorities to maintain price stability in the face of domestic and external shocks. Such a framework would provide the Chinese authorities with an effective approach for addressing the needs of their economy.
With China being a linchpin of the Asian economy, greater exchange rate flexibility in that country would probably encourage similar moves by other countries in the region. Together with actions by countries on other policy fronts—especially policies to promote strong domestic demand and sustainable fiscal positions—we would be looking at a powerful, multifaceted approach to addressing global imbalances.
So What's the Bottom Line?
To recap, the emerging economies in Asia, particularly China and India, are fast becoming important players and formidable competitors in global markets. From a historical perspective, their rise to economic prominence is not unusual. There have been many examples, and there will be more, as part of the economic convergence that sees poor countries catching up to richer ones.
The economic ascent of China and India brings with it many benefits, not just for them, but for the rest of the world.
To be sure, given the size of these two economies, their rise to prominence also raises a number of policy issues for the international community. I hope that policy-makers in the industrialized countries will not respond with protectionism, but that they will instead continue to focus their efforts on doing what is right for their domestic economies. This means, providing a stable macroeconomic environment, making their economies more flexible in order to meet the growing competitive challenge, and facilitating the transfer of resources from shrinking to expanding economic sectors.
For the Asian economies, a key issue is the choice of a monetary policy framework, including an exchange rate system that will best serve their needs over the longer term as they become more and more integrated into the world economy. Adjustments in those countries will also require a focus on social policies aimed at sharing the gains from global integration across income groups.
The Canadian Economy
Let me now turn to the Bank's outlook for the economy and inflation in Canada.
I don't need to tell you that 2003 was a particularly eventful and challenging year for the Canadian economy. In addition to the fallout from the war in Iraq, we had to contend with a number of other shocks—SARS, mad-cow disease, a large-scale electricity blackout in Ontario, and forest fires, floods, and drought in Western Canada. But perhaps the most significant and persistent shock to our economy, as a whole, over the past year, has been the rapid appreciation of our currency against the U.S. dollar. The stronger Canadian dollar has held back export growth and increased competition from imports.
Under the effect of all these shocks in 2003, output growth slowed and, at the end of the year, our economy was operating further below its production capacity than we had predicted earlier. With this, the inflationary pressures that had started to be felt a year ago eased significantly, and inflation fell below the 2 per cent target.
To support aggregate demand and return inflation to 2 per cent over the medium term, we have cut our policy interest rate four times since last July, by a total of one percentage point, to 2 1/4 per cent.
In our January Monetary Policy Report Update, we lowered our projection for output over the next year and a half. Information received since then has been broadly consistent with the base-case scenario that we laid out in the Update. Although final domestic demand might be marginally weaker than projected, net external demand could be somewhat stronger because of the pickup in global economic activity, especially in the United States and Asia, and higher commodity prices.
On balance, then, our economic projection is essentially unchanged from January. We still expect output growth to average about 2 3/4 per cent this year and to accelerate to 3 3/4 per cent next year. This should help absorb most of the slack in the economy by the third quarter of 2005.
Core inflation—which excludes the most volatile components of the consumer price index, thus providing a better reading of the underlying trend of inflation—fell close to the bottom of the 1 to 3 per cent target range in February. But we expect it to move back up within the next few months and to stay around 1 1/2 per cent through the rest of this year, before rising towards 2 per cent by the end of 2005.
To conclude, our economy is going through a period of adjustment to new global forces. These include stronger world economic growth, higher commodity prices, and heightened competition, particularly from countries like China and India, as I have discussed at some length today. In addition, there is the realignment of world currencies, including the Canadian dollar, in response to large global imbalances. And this is another shock that we will have to adjust to.
The main uncertainty for the Canadian outlook continues to relate to the adjustment of our economy to these global forces.
The Bank of Canada has a role to play in facilitating these adjustments. That role is to support aggregate demand and to keep inflation low, stable, and predictable. To this end, we will continue to closely monitor the evolution of domestic and foreign demand, and the pressures on inflation, as the economy adjusts to global changes.