Quotes of the Day

Until a few years ago, the big question was, is China's growth for real? Now the question is, How long can it last? Even with the U.S. economy slowing, the concern is not so much that China will run out of resources or markets to sustain high growth, but that economic imbalances are becoming too severe.

Put simply, China has been investing too much, too fast, particularly in its export-oriented manufacturing sector. The most striking evidence of this is the relatively small role Chinese consumers play in the economy. Household consumption as a percentage of GDP fell to 36% in 2006, perhaps the lowest such ratio in the world. At the other end of the scale is the U.S., with a household consumption–GDP ratio of 72%. For years the U.S. has been consuming too much and saving too little. China has the opposite problem.

China's imbalances are likely to get worse. This is largely because the country's spectacular economic boom is driven by a self-sustaining flywheel of rapid productivity gains and increasing profits, which generates excess capital that is in turn invested in more manufacturing capacity. This is why the country's trade surplus with the rest of the world has been rising at an alarming pace, growing nearly 50% to a record $262 billion last year (although the trade gap narrowed in the final three months of 2007). Because many Chinese companies are awash with cash, traditional policies aimed at slowing investment growth, such as raising interest rates, seem to have lost much of their effectiveness.

Recognizing the danger of growing imbalances, China's government is now trying to improve the quality of growth, while de-emphasizing the rate of growth. Beijing hopes this will help reduce social tensions by promoting more equity in income distribution and access to consumer goods, including housing, through increasing rural subsidies and other measures. The government also has recently intensified its rebalancing efforts by allowing somewhat faster exchange-rate appreciation and imposing some export taxes.

The exchange rate remains a contentious issue. Since China's currency, the yuan, was delinked from the U.S. dollar in July, 2005, it has appreciated about 14% against the greenback. However, because of the declining international value of the dollar, the yuan has depreciated by some 6.4% against the euro. This has made the Europeans very unhappy. Their trade deficit with China is now also very large.

China has resisted foreign pressure for faster appreciation of the yuan out of concern that such action will slow the economy and reduce employment. But policymakers also know their stance is fueling trade frictions and that exchange-rate appreciation is not always bad for job creation. A stronger currency could ease the trade surplus and fight domestic inflation. It could also help the country reduce its reliance on low-end manufacturing; a mightier yuan would encourage the development of higher value-added businesses and service industries, which have lagged manufacturing but hold greater promise for long-term job creation.

To restore balance and maintain harmony, more reforms will be needed, among them a significant increase in government spending on social infrastructure, such as education and health care, and on environmental cleanup. With its vastly improved fiscal situation, the government has the money to do these things. It has other tools at its disposal as well, perhaps more than policymakers realize. For example, productivity in Chinese companies is soaring, enabling manufacturers to absorb cost increases without cutting employment. Indeed, high productivity growth is a more important factor than the exchange rate or government subsidies in explaining China's international competitiveness. Researchers for the Conference Board in New York City recently calculated average annual productivity growth in China's manufacturing sector at an astonishing 20.4% from 1995 through 2003. That's almost six times faster than productivity growth in Europe or the U.S.

China has shown an almost unprecedented willingness to allow dynamic competition to force greater efficiency on the economy, including state-owned enterprises. Still, having been the world's fastest-growing economy during the past three decades, China's challenge is to tackle economic imbalances decisively to make its growth sustainable for the future.

• Pieter Bottelier and Gail Fosler