Beijing Review: What role is China playing in the global economy?

Steven Dunaway: Obviously China has become a very important country in the world economy. It's the third largest economy, as well as the No.2 trading nation in the world. Because it has become so important with respect to trade, what China does has a significant impact on the other countries.

You said time is running out for China to change its economic model at a recent seminar at The Heritage Foundation. What does that mean?

The government recognizes that the need to try to re-balance the economy has become more dependent on domestic demand. The government believes it has a lot of time to make this transition. I don't think it does.

I think, in particular, with the global recession—and the prospect global growth and trade growth will continue to be relatively slow for the next few years—time is running out on the current growth model. The government needs to speed up this transition of the economy to move toward more dependence on domestic demand.

How can China make the transition according to your interpretation?

Part of the problem may be that the best time to do so was three years ago when the world economy was growing relatively rapidly. Now is certainly not as good a time to do that because you have slow growth in world trade and the domestic economy. But I don't think there is much choice, because I think growth will slow down significantly over the next few years if China tries to stick to its current course.

I think there are three things that need to be done to re-balance the economy. The first is to deal with certain key price distortions present in China's economy. The cost of capital is probably one of the most distorted. The cost for investment is extremely low. So the result is you get very heavily dependent upon investment to drive growth.

The best way to probably raise the cost of capital and, at the same time, feed consumption would be to get rid of the cap on deposit rate. If you take off the cap on the deposit rate, you'll increase the return Chinese households get on their savings, and that would provide more funds for consumption. By raising the cost of capital, it would make investment more efficient. The investment will tend to be directed to those activities that will yield higher returns because of the higher cost of funds.

The second key reform is in the financial system. At present, the banks play a major role. Banks do a very bad job by taking the savings of Chinese households and lending them on to businesses. They have a tendency to lend predominantly to large projects that are capital-intensive in production. They are not lending necessarily to projects that would yield the highest returns. Small and medium-sized enterprises in China are cut out of a lot of funding. That has impact on consumption behavior as well—and it also has a big impact on employment.

The third big area has to do with the government itself. Efforts have been made to increase spending in three key areas: health care, education and pensions. But the government needs to do much more to bring fundamental reform to ensure education is provided to all Chinese and that there is adequate health care and [available] pensions. That will effectively boost consumption because it will remove one of the reasons why the household savings in China are so high.

What can the United States do to help China change its economic growth model?

That has been [a significant] part of the economic dialogue that has been going on between the United States and China. The key role of the dialogue is to try to convince the Chinese authorities that they need to move much faster in re-balancing the economy.

Do you think the S&ED is offering a practical framework in this regard?

I think it provides a useful forum for discussion. One of the key parts on the strategic side is climate and environmental issues. I think actually both countries can do a lot to cooperate with each other to help set the agenda for discussions for the whole world. On the economic side as well, I think they can also accomplish a lot. n

(With reporting by Chen Wen in Washington, D.C.)