OPERATOR:  This is a recording of the James O’Connor teleconference with Atlantic Council of the United States on Thursday, June 18, 2009 at 10:00AM Eastern Time. Excuse me, everyone, we now have Alexei Monsarrat, director of Atlantic Council Global Business and Economics Program and Atlantic Council board member and member of the Council’s Business and Economic Advisory Group, Timothy Adams, on the line. Please be aware that each of your lines is in a “listen only” mode.

At the conclusion of Mr. Adams’ presentation, we will open the floor for questions. At that time, instructions will be given as to how to proceed if you would like to ask a question. I would now like to turn the conference over to Mr. Alexei Monsarrat, who will be followed by the opening remarks of Mr. Timothy Adams. Mr. Monsarrat, you may begin.

ALEXEI MONSARRAT:  Thank you very much. Thanks, everyone, for joining us today. As the moderator noted, I am Alexei Monsarrat here at the Atlantic Council and we’re very pleased that you’re joining us today for this second conference call in our series which is called, “Mapping the Economic and Financial Future.” This is a conference series that is generously supported by Deutsche Bank and is an effort by the Council to create a unique forum that brings together top leaders from both the business and policymaking worlds to discuss the critical issues facing the U.S., European, and global economy during this time of crisis. We’re very pleased today to have with us Mr. Timothy Adams, a longtime friend of the Council, and a director here as well as a member of our Business and Economic Advisories Group. In addition, Tim is the managing director of the Lindsey Group and is former U.S. undersecretary of the Treasury for international affairs. During his time at Treasury, Tim was the administration’s point person on international financial issues, including exchange rate policy, G7 meetings, and INS and World Bank issues. As we all know, he has circled the world any number of times in his duties and is well informed with what’s going on with the governments around the world.

Right now, I think we can agree that we’re at a time in the crisis where we’re starting to see some indications and a few places of recovery but those are generally evenly if not overmatched by some difficulties that continue. In this context, a lot of people are looking to China to see what’s going to happen there and some hope they might help spark a global recovery. Tim has just gotten back from his most recent trip of four or five over the course of the last six or seven months and we’re very much looking forward to his thoughts on how China’s doing, what the attitude is over there, and what he’s seeing from his view. So, Tim, I’ll turn it over to you and thanks so much for joining us.

TIMOTHY ADAMS:  Great. Thank you, Alexei. It’s an honor to be back here on your second call. I had the honor of moderating your first event with my good friend, Tsubasa Scali from Egypt and now it appears that I’m in the hot seat on the topic matter. And just looking over the list of participants on the call, we certainly have a gold-plated list of participants, many on the call have probably been spending more of their career looking at China than I have but I’ve certainly been intensely involved in the last several years and then have picked up that intensity once I left government and was shed the constraints that sometimes being an official representative of the U.S. government puts on you.

As Alexei noted, I just returned from a week just in Beijing this time. I think it is my fourth or fifth trip in about six or seven months and it’s interesting going during this time to see the body language, the mood music, as well as the real statistics as we’ve gone through this cycle. Last fall there was a sense of fear and astonishment at the speed with which this financial and economic crisis have evolved through the Chinese economy. Obviously coming on the heels of their own set of policy directions as they caught their real estate bubble, I suspect they wouldn’t have been as aggressive popping that bubble had they known what would succeed that, which is the collapse in global trade and collapse in exports to the U.S. and Europe and other places. So, there was a sense of fear, a sense of astonishment. Officials were going back on their heels. The discussion about the decoupling which was so prevalent in the discussions in 2007 and early 2008 had given way to a notion that indeed we’re all one world, we’re all inter-connected and what happens in other places has enormous effect on China and this inter-connectedness is something that needs to be understood and respected. I suspect it made China more vulnerable than they’d like to believe they were and I think that vulnerability will probably draw out policy longer term.

This recent visit just last week, there was a real sense of buoyancy, cautious buoyancy, swagger, a cautious swagger, but a swagger nonetheless, as there is obviously a recovery in place and I would describe it as a modest recovery. I may even be generous and call it modestly robust and I guess I’d be generous in my description because of where we were four or five months ago and the fact that exports have collapsed dramatically and the export sector is such a large portion of their economy. Net exports, I know, matter most for GDP but if you just look at the contribution of the export sector by itself to growth of size of the economy and to productivity growth over this expansion but over the years and the decades, the collapse in exports certainly weighed on the economy.

So, any sense of buoyancy anywhere in the world is welcome given that the previous week I’d spent a couple days in Detroit and was so depressed when I left after meeting with various suppliers who feed into the auto industry that any kind of good news was well accepted. It’s not only exports obviously that have suffered collapse in China but foreign and direct investment which obviously is a part of the export story, has dropped dramatically and a variety of other pieces, consummation is soft, but they’ve been able to force-feed the economy with a tremendous amount of stimulus. As a percent of the GDP, their estimates range in Beijing, I heard private estimates as much as seven to 14 percent of GDP and some of that is based on how you net out the leakage but there isn’t much leakage but it is the fiscal policy which was rolled out last November, the $585 billion, and then there’s been a succession of various industry specific proposals metered out since then as well as policies addressing the social safety net, pension reform, and health care proposal, all which sound very good but there’s a question about whether there’s sufficient amount of resources behind it but certainly direction correct and addressing some of the key issues.

Then, of course, there’s the liquidity tsunami and is washing through the economy as the banks have turned on this spigot of lending. The credit expansion in just the first five months of this year is already surpassed what was expected for the entire year, which is $5 trillion, and I think just for the first five months, we’re at $5 trillion, RMB, so it an economy which is awash with liquidity which is again helping to force-feed growth into investment. This is also probably showing up in the stock market and we’re starting to see probably a little bit of speculation in the housing market. Housing, which has been key to growth in the past, the real estate sector, both commercial and residential, as I noted earlier, was a bubble that officials popped and we saw a dramatic drop-off throughout last year. There does appear to be that in general the real estate sector has hit bottom and, in fact, some places you’re seeing some increase in prices, certainly a lot of transactional activity. It varies from city to city. Affordability has become more attractive in the sense that real estate has become a more affordability; it’s still well below countries in the region but has improved.

So, there’s a whole host of elements which are driving real estate which leads one to conclude, I think objectively so, that in general it has hit bottom and we’re starting to see a recycling and, again, in some markets, some speculative behavior. I think the Chinese would like to focus more on low-income housing, affordable housing, which I think is appropriate and that will help drive some of the increase in residential investment going forward but even, and in the high end market, there’s still tremendous amount of inventory in many markets but nonetheless I think real estate, which is an important part of the economy, has probably bottomed. So, what are the challenges going forward? Well, there are many challenges and I will focus on four or five quickly and then we’ll turn to your comments and your questions. One is that it’s tough for China to achieve anything near the growth rates they’ve had in the past until global growth returns. There’s only so much growth you can squeeze out of a return of the pouring concrete, laying rebar, building infrastructure, and fueling growth through liquidity. They certainly are getting growth out of it and I assume they’ll meet their eight percent target for the year. So, the World Bank today has issued their report and has penciled a higher number than before. Goldman-Sachs and other private sector firms have been re-estimating upwards their growth forecast for the year.

So, I suspect they’ll probably hit the eight percent official target but getting beyond that is hard to see given the morbid state of the global economy and principle export markets of the U.S. and Europe. If anyone believes that the U.S. consumer is going to come roaring back anytime soon and be a driver of growth anywhere in the U.S. or in China, I think we’re going to be waiting a very long time. The U.S. consumer is certainly the bottom half of the country is tapped out probably technically bankrupt, credit constrained and we, at the top of the pyramid, have been hit with such enormous wealth loss. I can’t see how the U.S. is going to be a driving force going forward. We can certainly debate that but there are constraints on the top line growth for China until we see a resumption, global growth. In maybe 2010, maybe 2011, we can discuss that. In the corollary, China is not adding much to growth. I think the topic today is will China lead us out of this? And I don’t think so. We don’t see much leakage. Imports have dropped pretty dramatically as well, obviously commodities have picked up, some of that is stockpiling in a gestation of resumption of demands, some of it is for demand, some of it is taking advantage of cheap commodity prices but we’re not seeing the leakage into the global economy and one would argue that China is not doing what it needs to do to be an indigent growth.\

I suspect there’s some imports substitution policies being promoted. We certainly know it’s occurring in specific industries and probably more broadly but, if we are going to deal with the global imbalance and certainly the imbalances that existed regionally and those imbalances that existed before this crisis, if we’re going to address those imbalances, China is going to have to be a key part of that by consuming more and exporting less, which takes us to the second challenge and that is just sustainability in this model. This resumption of growth is really using the old pipelines. The banks really need to stay on enterprises to do big investment projects and, what we’re not seeing is a quick jump to the new growth model which we’ve been talking about here and officials have been talking out of Beijing for at least five years if not much longer and that is a more domestic consumption based growth trajectory, one more reliant on services than on heavy industry and obviously bringing in small/medium enterprises as a key to that growth and some of you are on the phone know this better than I.

If you look at all the white papers that have been written, the official pronouncements, the speeches, the five year plans, it all sounds perfect with respect to rebalancing growth going forward. That is incredibly tough to do. They’re putting various policies in place. I mentioned before health care, pension reform, others which we’ll address some of the precautionary savings put in social safety net. But moving the dial on consumption which is a percent GUV has been dropping for 20 years, moving the dial on consumption in a meaningful way and a short term, is I think probably incredibly difficult to do and unlikely. So, I think as this stimulus burns off in the next 18 months, one must wonder where growth will come from. If this is a bridge to something else, will that something else be consumption based trajectory and will it happen fast enough and significantly enough to make a difference or might this be a W-shaped recovery in the median term. The third issue is risk to new bubbles. We talked about the mass amount of liquidity convulsing through the system, showing up in the stock market and real estate and you want to ask the question about the quality of the lending the banks are making. MPL’s are remarkably low; they are lagging indicators and you would think they would be remarkably low. I think they’re officially, the CBRC is two percent, but I wonder if we’re not sowing the seeds of a banking and this is sort of a crisis, five years down the road as banks pushing capital out the door at a breathtaking pace.

The fourth issue is where will productivity come from in the future? The export sector, which is 30, 40 percent of GDP, has been a big driver of productivity and, therefore, a facilitator of rising living standards. If the export sector is less important going forward either because of policy decision and/or because of weakness in external demand, where will productivity come from and hopefully it can come from the service sector and from greater consumption and small/ medium size businesses. But it remains to be seen if that will happen again quickly enough and substantial enough to make a difference. And then the last issue, and there are many more, but just for purposes of brevity, we’ll stop there is the issue of excess capacity and the efficiency of capital. The great thing about China is they can throw tremendous amount of capital at the problem they have. Their style of government is obviously attractive when you’ve got a dramatic downturn and you can turn all the dials, pull all the levers, and overwhelm the system with stimulus but there is a question about how efficient the use of capital is. I would argue quite low. You would look at the numbers for investment and wonder why you’re not getting greater growth out of China and that’s been an issue for some time and I just wonder if at some point in the future, 10 or 15 years from now, some future generation of leaders don’t look back on this period and weep with the sorrow of how little growth they got out of the mass amount of investment they put in place.

And then, of course, excess capacity. Every time I ask the question I’m told that they’re taking the least efficient producers out. We’re looking at where various firms are on the cost curve, trying to consolidate industries but I’ve got to think the amount of six investments that has been put in place the last five or six months are simply going into industries in which there already was excess capacity, begs the question, what do you do with that excess capacity and I expect there some of it will show up, if not a lot of it, on global markets, which could sow the seeds for trade friction in the future. So, let me just conclude by saying, look, they’re going to hit high single digit rates. There are some median term challenges. There are some longer term challenges, demographic challenges, and such, that I think come into question whether they can replicate the double digit growth that we’ve seen over the past 30 years and the question is whether the political leadership understands those challenges sufficient that they’re willing to be bold and move more quickly and more boldly with respect to putting in a new policy paradigm and, if not, might they have to be jolted into additional policies by some reduction in growth, retraction in growth. It could occur 18 months or two years out in a W-shaped progression. Lots of other questions we get into, exchange rate, reserves, but I’d rather open it up and get your thoughts and your comments.

ALEXEI MONSARRAT:  Excellent. Thanks very much, Tim. That’s exactly the kind of ground truths and deep insight that we look for and encourage in this Deutsche Bank series and it was an incredibly informative overview and I’m sure there are going to quite a few questions. I’m going to take the liberty, as moderator, to ask the first question and then the Operator will come on and explain to others how they can chime in. I actually want to pick up a little bit on your last point about the attitude of the government right now and whether you’re seeing a sense that this right now is a unique opportunity to try to make some of these transformations, particularly in the banking sectors and state-owned enterprise and do a little bit more, sort of, open market, liberalization, at a time when they have a little bit of an advantage in not having been hit so hard by the recession as others.

TIMOTHY ADAMS:  I guess the way I think about is it is not the previous generation and I think the current leadership is more cautious. That said, over the past seven or eight months, they have put in a remarkable array of policy changes that if sufficiently funded could have remarkable impact on the economy’s trajectory over time and truly transform it. As we look at the health care proposal, for example, which I believe is providing somewhere between 90 to 95 percent of the population with a basic plan, whatever basic means, by 2011 and it’s in a sense universal health care, which is incredibly important in rural areas. The problem is the funding was about $100 billion, give or take, and on a per capita basis that is trivial, but if you can put in place the infrastructure and the right policy prescription and some of this they actually experimented with on a provincial level, then it could be scalable over time. It’s just making the commitment, putting in a resource and building in an incentive structure for it to work.

You mentioned banking. I attended a conference while there and a few people came away more optimistic about banking in the sense that Shanghai wanted to be the financial capital of China and one of the financial capitals of financial economy and that one way of doing that is liberalizing and allowing more outside competition which would force them to be better and you could certainly walk away with that interpretation and I also walked away with the interpretation that there institutions and probably with some government support are looking to expand globally, taking advantage of the weaknesses in other places, and building global champions. What I didn’t hear is that bank’s looking to do more business with medium or small enterprises or looking for other ways to integrate themselves vertically in China but looking externally and I think we’ll see that in a number of industries. I think we’ll see that in the auto industry which is under, obviously globally under a remarkable change, but I think in China we’ll see consolidation and an effort to build national champions, which while seizing opportunities in the domestic market and in some ways protecting the domestic market looking for ways in which to break into foreign markets is not the U.S. and Europe and other places.

ALEXEI MONSARRAT:  Thanks very much. I think we’ll have our Operator come on and explain how to dial in.

OPERATOR:  At this time, we will open the floor for questions. If you would like to ask a question, please press the “star” key followed by the “one” key on your Touchtone phone now. Questions will be taken in the order in which they are received. If at any time you would like to remove yourself from the questioning queue, press “star two”.

ALEXEI MONSARRAT:  While we’re waiting for some questions to chime in, actually we’ve now got Burt Keidel on the line who would like to ask a question. Burt, go ahead.

BURT KEIDEL:  Tim, good to hear your voice on the line. Welcome back. Very interesting time and great to have your high-level discussion report. I wanted to go back to two things. One, your comparison of the whole decoupling discussion and then to ask you about the efficiency. There’s a sense that I get that they made the “wink winking” at us and using the crisis to accomplish some things that they were having difficulty doing. Did you hear anything about this pilot program in South China to restructure the national economy by closing a lot of firms that were small, polluting, bad labor relations? They started it in about 2007 and the state council announced in December this winter that it was in its final form and had already laid off a lot of people but the idea that they can blame this on the outside and say, gee, we really are all coupled and yes, now it’s all integrated, as a way of allowing them domestically to do some things that they were really having a lot of trouble doing in terms of closing inefficient plants and upgrading their whole structure.

TIMOTHY ADAMS:  Burt, again, it’s good to your voice. You’ve obviously been around the China issue a tremendous amount of time and your knowledge is respected and always welcomed. Yes, I’ve heard that. Whenever I bring up either the excess capacity issue or the issue of the smaller inefficient producers and I’m told repeatedly that, in fact, this transformation has occurred and is occurring I, for one, have never seen evidence of it but, unfortunately, I spend most of my time in Shanghai, Beijing, and I don’t get out enough in places where this is actually going, said to be occurring and I’ve not actually seen it visually myself but I was assured that that was indeed the case.

But you did raise another point which I thought was interesting because I kept asking a question about the export sector and why can’t the export sector simply re-engineer itself and I know this is a gross generalization, but re-engineer itself to produce domestically and it was interesting because I got three responses why the export sector can’t do that. One is that the transportation costs of moving goods from the coast internally are obviously higher what it takes to put them on a ship and ship them here or to Europe but were excessively so that it had a substantial reduction in the margins. Two is that the interior producers protected their markets and they didn’t want the coastal, the exporters moving in, so there was some really truly anti-competitive behavior going on. And three that there was a payment risk, that if you’re an exporter and you sell something to the U.S. or to Europe and you get a standard letter of credit from your normal bank, that that is solid payment structure but trying to sell things domestically and internally is more precarious from a payment risk perspective.

So, it sounded to me like many of the export firms, again a gross generalization, were wedded to the export sector. Their outlook rose and fell with the outlook for the global economy. Obviously some have fatter margins than others that can eat into those margins in order to maintain market share but those with very thin margins, as you noted, were going to be out of business and some of that business is already migrating to other places. But I found it fascinating in the sense they couldn’t simply engineer and supply whatever those goods are for domestic consumption.

BURT KEIDEL:  That’s a very helpful response. Thanks. Those are some factors that really deserve to take a closer look at. I’m also interested in just how they see themselves as a part of the problem with global imbalances and you mentioned that this, in your view, is something they really need to get on if we’re going to avoid these kinds of problems down the line or even they’re going to avoid a W-shaped recovery because there seems to be two models of thinking about how this crisis began. One is that there was a savings imbalance between China and the U.S. in particular that caused this huge deficit on the U.S. side and surplus on the Chinese side. The other is that the Chinese surplus really came too late to explain the U.S. crisis and that the U.S. deficit was huge, way before China’s global surplus even appeared at all. How do they discuss with you that whole issue about their responsibility for and the need for global imbalances to start with them and I know when we think about their household savings rate, that real estate interest rates are still quite high given the fact that prices are falling, but how did you get a serious pushback or did you get an agreement, yeah, we need to restructure ourselves and it’s partly our fault and we helped create the crisis? How did that discussion go?

ALEXEI MONSARRAT:  Thanks for your question, Burt. What I’d like to just because we have a few questions stacking up and I want to make sure everyone has a chance to ask. I’d like to actually turn now and we can answer a few questions at a time. I’d like to go ahead and turn to Jacob Frenkel, chairman of the Group 30 and a member of the Atlantic Council’s Business and Advisory Group.

JACOB FRENKEL:  Well, thank you very much. This was a very, very thorough presentation and I really enjoyed it. I would like to come back to the export sector with some focus maybe on the exchange rate. I think you described properly that growth while it would not be what it used to be it’s not going to be insignificant; it’s going to be very significant growth. Initially, it will be stimulated by the stimulus budget and thereafter their hope is that there will be enough growth of productivity and other things that will support the robust growth.

My question is the following: We know this consumption growth is going to go very slowly. Based on that, my assumption is that they will need to continue to rely on foreign demand, domestic demand will not be picking up sufficiently quickly. If foreign demand is the major source for supporting their growth and given the fact that foreign growth is not going to accelerate sufficiently quickly, I assume they will need to rely on their exchange rate, which means that the prospects for a significant appreciation of their currency is going to be relatively grim because that’s the only mechanism they can do in order to stimulate foreign demand for their growth. So, this is one question, and the second related one is we’re talking a lot about the dependence of China’s export on the growth of the rest of the world. What about the rest of Asia and how is their growth affecting on China? We know how China impacts on them but you might want to talk on this but the first was on the exchange rate really.

TIMOTHY ADAMS:  Sure, Jacob, thank you. It was great seeing you there and I want to say that I sat through three days of speeches and I was saying this because you’re on the phone but yours was the best; you were the only one who didn’t read their speech. And I actually came away from the session thinking if someday I could stand up in front of a crowd that size and give an extemporaneous set of comments the way you did it, I would feel myself as a very successful public speaker. So, bravo on the work that you did there. I’ll take your question and I’ll go back to Burt’s as well. On the foreign exchange, we don’t see much change at all actually. Jim Gidner was there the week before. I think they have decided that they’re going to keep the exchange rate issue off the front of the newspapers, out of the headlines and they have emphasized it privately but they certainly aren’t going to make noise about it now. Obviously there are reasons for that because we need China to do a variety of things to continue to buy Treasury, which we’re going to issue in such large volumes in whatever time they might want to use, next week, next month, next year, next 10 years, that we need to ensure that we have an amicable relationship with them and I think there’s a view that this is antagonized.

So, I get the impression that on the exchange rate certainly on a nominal level that it is basically locked in place. That they won’t appreciate because they can’t afford not to; they want to balance their needs of their exporters with the needs of the U.S. and others who are concerned about their exchange rate policy. Now, the issue is what happens to inflation and whether there’s a real appreciation over time which is what the fund’s been advising them on and it remains to be seen. As you know, the consumer price index is heavily related toward food, food prices have been volatile over the last couple of years and I noticed the World Food Organization came out today with a report about food prices going forward but I agree with you that I think that the export sector will remain an important part of their growth equation but I think the exchange rate policy is pretty much in neutral and put on hold. On the dependence on Asia, you’re right. It’s not just the U.S. and Europe. I think Europe accounts for about 40, 45 percent of their export sector and there has been growing inter-regional trade. It’s tough to disaggregate that trade to know how much of that is just the supply line being defragmented to their various nodes and how much of that is for final demand.

But even, as I mentioned China not importing much, there’s not much leakage in this recovery. There’s not much leakage in the sense they’re buying more from the U.S. but it doesn’t appear they are buying more from South Korea and other places that sell into China the non-commodity input to their exports or potentially for domestic consumption. What I did hear while I was there was a growing interest in becoming less dependent on Europe and the U.S. and there were comments by many officials who said they were selling more to the emerging markets. I haven’t had a chance to study what the data looks like. I don’t know what those products are, whether they’re intermediate goods, final goods, and the composition of those products but I do think there is an effort to move away from dependency on the U.S. and Europe but ultimately the U.S. and Europe drive global growth, whether it’s direct exports from China or exports that go to the Gulf because the Gulf is selling oil to the U.S. On global imbalance, Burt, it depends on who you talk to and how official they want to be. The official pronouncements are pretty much consistent with what we’ve seen in the G20 process, which has been a concerted effort to extract even the language of global imbalances from the discussion because their view is global imbalance is an emotive term that is pejorative in the sense that it’s seen as China’s the problem.

So, they were successful in Washington in November and in London in April and I suspect probably in Pittsburgh in September of keeping that discussion and that language out of the communiqué and trying to shift the debate. Certainly they tried shifting the debate ahead of April by talking about SDR’s, as playing a greater role in the dollar, but informally those who want to be honest about it, they understand that they’re a part of the problem. Yes, the U.S. current account deficit actually is in percentage terms grew more in the ’90’s than it did in the last cycle and the U.S. has been living beyond its means for 25 years without question. But they do understand that they have a role to play, going forward if we are to grasp these imbalances, even if to address these imbalances, if not for economic reasons certainly for political reasons especially as unemployment continues to rise in the U.S. I think from a political perspective Washington is less concerned with China than it has been in the last year or certainly when I was in Treasury. There’s less animosity on Capitol Hill. There’s less complaining about the exchange rate but Washington’s a volatile place and we’re at double digit unemployment next year and growth in the U.S. is really not much better than where we are now, that political equation can change. We always need villains and China is a convenient villain when we want to vilify someone. So, the honest answer is I think officially they don’t see imbalance as a problem, they don’t want to talk about it. Unofficially, they understand that they have a role to play but I think the greater role…

ALEXEI MONSARRAT:  I’d like to go ahead and take a couple questions again just so we can get a few in. Right now, I have Rhian Chilcott from the Federation of British Industries.

RHIAN CHILCOTT:  Thank you. Tim, I just want to ask you a little more about this question of how or whether this is a deliberate policy to limit leakage into the world economy. My starting point is what I obviously I’m doing in DC at the moment where all my companies are worried about buy America when they read the piece yesterday’s FT about buy China. How is the leakage being contained or is this just a factor of what local procurement offices are doing? Is it government policy? Is it just they’re spending money with the people they know? How is leakage actually being contained and I guess my worry is that leakage is something which is politically acceptable but economically damaging in the long run. So, deliberate policy or just factor of what’s happening on the ground?

TIMOTHY ADAMS:  Probably a function of both and let’s take, for example, the auto sales, which are growing at an extraordinary pace. China has fallen in love with the automobile but most of the sales, or a big portion of sales growth has occurred in smaller displacement, Chinese manufactured autos. That’s not to say that the Germans, which really had dominated the market, aren’t doing well and even GM is doing well but and some of that is the function of the subsidies which are given the tax breaks. The stimulus, the industry-specific or product-specific stimulus, is often designed in a way which favors the domestic producer and you can couch it in terms of the environmental concerns and other, you can couch it in a variety of ways which truly mask your ultimate objective but has the same objective nonetheless. There’s also issues about firms having to get authority to buy certain intermediate goods from abroad rather than using domestic producers.

So, I think it’s a product of policy, all of which can probably, which they will defend as saying it’s the same thing, they’re replicating what other countries are doing but buy America so we’ll have buy China, which is why buy America is such a bad idea. It’s a bad American policy because it just gives other countries a reason to replicate. So, I think there’s some micro-specific. I think there’s some macro and I think there’s just unwritten rules of engagement that says we want to try to limit the leakage. Now, on those items such as the inputs to production that they don’t have or don’t have in substantial amounts or it’s much cheaper to buy from abroad whether it’s various commodities and they’re obviously doing that and they are stockpiling to take advantage of tax advantages. But I do think there is an effort underway, an official effort underway, to manage imports and to try to engage in import substitution where possible but I don’t think that China is the only country in the world doing that.

ALEXEI MONSARRAT:  Thanks very much. I believe that we now have Amy Herrick.

AMY HERRICK:  My name’s Amy Herrick and I’m from Freedom Capital Partners. Tim, thank you so much for your information today. It’s been really excellent and very in depth. I have some questions that are specific to Chinese production. I was wondering if maybe you could inform me a little more about where the production’s actually coming from, where the demand for that is coming from. The statistics that have been coming out the past couple of months have shown that the purchasing demand index has been increasing. It’s now up to, I think, 53, which is in positive territory and the economy is growing. Production has been increasing in most industries. There’s been a vast consumption of commodities, whether that’s due to pricing or not, I’m not sure. But yet domestic demand has not increased and we know the export market is disseminated. So, I’d like to know who’s buying these products? Why are the purchasing mangers producing more? Why is production increasing? Is this mandated from the government? Do you have any insight on this? Did you hear about any of this?

ALEXEI MONSARRAT:  Thanks very much, Amy, and just to help people get their questions in, I’d like to go ahead and turn to Dana Marshall.

DANA MARSHALL:  Thank you. I just wondered if you could elaborate a little on a very important, sort of, political economic point that you made before in passing but it’s really important, I think if you could elaborate. On this question about the relative balance in interest between the United States that I think would want to see an appreciation of their currency and the concern that we not do things that are going to make it more difficult to fund all our government indebtedness. Who do you think has the stronger case over here? One could make, you could sort of sketch out other scenarios as well, but if you could speak to that I would appreciate it. And also, just quickly, as to the point on the politics of China right now around town. I think you’re right that the heat is a little bit off but there still legislation pending once again on China currency and allowing that to be a factor in taking trade measures so there is that to hang out there, too. Thanks.

TIMOTHY ADAMS:  Yeah, Dana, I’ll take yours and then I’ll go back to the young lady before you. I always do a round of Hill briefings whenever I’ve returned from trips just to do a download and it’s bi-partisan and the staff at the last couple of sessions I’ve had on the Hill have been pretty honest and they say our members have learned to live with the currency issue. But these are extraordinary times obviously if you come to the floor again and there could be a vent to trigger renewed political interest going forward. So, I didn’t want to give the impression it’s not on the stove and it’s gone cold, I would just say it’s on a simmer on the back and it’s not on a boil but it always could be and each side should remember that as we engage in discussions, especially as we head into the strategic and economic dialogue which is the end of next month, which is a nice segue into the G20 in September.

But if you look at our fiscal trajectory and I’m biased on this and my bias will come through, I think it is incredibly unsustainable. We just saw a journal today that the American public is starting to pay attention to and I’m just setting aside, not taking criticism of particular policies on the agenda, but just strictly the deficit as a political issue, which Dick Cheney once said it doesn’t matter. I think he was wrong or it doesn’t matter except when it matters and I think it’s beginning to matter. So, we’re seeing it showing up in the polling and the American people are paying attention and they should. If you look at the deficit will run this year and you ask how’s it going to be funded, we’ve got to jump in household savings to 5.7 percent but, even with that remarkable increase, we will probably need substantial portfolio shifts which have implications for equities into fixed income to help fund. If you take corporate cash flows and just set aside just enough to cover the appreciation, it’s still a small piece that’s funding and, if we just borrow from abroad at levels we have in the past two years, even with that, we have an enormous gap. Now, Ben Bernanke at the Fed has said that they’ll buy $3 billion of the treasuries and that obviously helps.

But even with the Fed’s contribution, there’s an enormous gap. So, as a ball or this year, next year and what CVO said $9.3 trillion over the next 10 years without a health care policy on top of it, we are not in a position to antagonize our creditors and I think the Chinese understand this. They also understand that they’re sitting on $1.5 trillion worth of dollar denominated assets, 787 in treasuries, so they have a vested interest as well and those interests were certainly apparent when Secretary Gidner was there and will continue to be apparent. But I think we have the lesser hand and I think as a borrower and until and unless we move those trim lines in a more meaningful way, we’re vulnerable and we’re reliant on import capital. Going back to the young woman, where’s all the production going to? We had an enormous de-stocking process that occurred late last year, not only China, but in the U.S. as well and what we’re seeing is some restocking and some because of resumption of growth and some in anticipation of a resumption of growth. So, it is a reversal of a fairly acute and severe de-stocking process so some of this is rebuilding inventories.

The other is that if you look at fixed asset investment, I’m just thinking of the numbers here, in May we had in real terms in year over year and, unfortunately, the genre tend to be year over year, you’ve got a 40 percent increase so there’s a tremendous amount of investment that is occurring, especially in the public sector which is building bridges, highways, railways, and then back into the real estate sector as well. So, a lot of it is actually going to final demand. Consumption has held up. I think Jacob said he was a little bit worried about consumption, could soften a little bit going forward but retail sales has been pretty strong and consumption has probably held up better than one might expect given the convulsive hit that this crisis has hit China with.

ALEXEI MONSARRAT:  Okay. That’s great. Now, we have Ellen Frost from The Peterson Institute.

ELLEN FROST:  Hi, Tim. I really appreciate the clarity and candor of your remarks. I want to ask you to revisit this savings issue again from the perspective of someone who is lower-middle or low income in the interior. There’s an obvious correspondence between the need for China to raise the personal living standards of all of these people on the one hand and the leadership mantra, “harmonious society, blah, blah.” I’ve heard specifically that among other measures the Chinese government is lowering the down payment requirement for mortgages and trying somehow to deal with pensions; in other words, to address the reasons why people save so much. Now, you’ve mentioned that the difficulties of health insurance and you’ve also explained why the export sector can’t meet this demand, potential demand, but I’m still wondering where there’s a demand, there may well be a supply. After all, in the Mao Era, the three wants were a bicycle, a radio, and a sewing machine and even poor people have moved well beyond that. So, could you look at that issue in say the next three to five years and see a substantial increase in the standard of living of people in the interior and I know the infrastructure is not always there but there has been quite a lot of building roads and so forth so could you kindly evaluate the potential for personal consumption growth in these poor areas?

TIMOTHY ADAMS:  Sure, Ellen. It’s good hearing from you and I enjoyed our session that we had together a couple of months ago. Great to hear from you again. There’s a whole host of challenges to dealing with the high level of savings. Some of it is generational. Those who have lived through big experiments in China and have seen those experiments not only they’re not positive but sometimes disastrous outcomes. Too is that many of those who grew up in the state-owned enterprises with the so-called iron rice bowl that the set of expectations that their needs would be taken care for the rest of their lives and to see that dismantle in the ’90’s and so there are demographic issues, there are generational issues that are at play. There is the, as you noted, the interior versus the rural areas versus the coastal areas and I think Chinese officials are very concerned and very focused on rural areas. The number of firms that I work with that are doing and want to do business in China, they’ve all been directed to stay away from the coastal areas if you really want to do business with China and you really want our support, “our” being official China support, we would love for you to go West and go into the interior.

There is, as I mentioned earlier, pension reform, health care reform. There is land reform. There is an issue of how do you actually monetize landholding so you give farmers an asset. The average size of farms in China is about 40 acres, about a tenth the size of U.S. farming and, if we want to see real productivity growth in China, one way to get is transformation in agriculture. Only 15 percent of China is arable but for that which they can grow more crops going to corporate mechanized farming, larger farms, is a real opportunity for them. Unfortunately, you have the issue what do you do with those who own a farm and do you just feed this mass urbanization migration to urban areas? The financial sector. Having financial instruments that allow individuals to consume, but one of the reasons savings dropped and the drop for a variety of the reason in the U.S. is that Americans didn’t need to save because we had access to credit and we had, the average American has eight or nine credit cards, you keep three or four of them in your kitchen drawer to use in times of emergency. That kind of access to credit doesn’t exist certainly in rural areas and there’s not a culture of it. So, the financial innovation and putting credit in the hands of individuals in small businesses will go a long way to doing it. Affordable housing will help as well.

So, I think, again, if you look at the white papers, you look at the official pronouncements, you look at the speeches, the Chinese have done a remarkable job of understanding the challenges they face and I think they fully appreciate those challenges and are determined to address them. It really is the ability in which they can move in a substantial material fashion move quickly enough and then more importantly really build in the political incentives so that local and provincial authorities actually implement and that’s there’s the phrase that the mounds are high and the emperor is far away. Beijing can be a long way from a lot of these places and as long as local officials are rewarded and move up through the ranks based on just top line nominal growth, then that’s what you’re going to get and so what you have to do is build in the incentive structure that it’s not just quantity of growth which is what we’re getting out of China but it’s about quality of growth which they need to focus more on.

ALEXEI MONSARRAT:  Thanks very much, Tim. I’ll go ahead and take the last two. First, we have Uri Dadush from the Carnegie Endowment. Very good to hear from you.

URI DADUSH:  Thanks, Alexei and thanks, Tim. You’ve put on an excellent exposition of the issues. My question really is a fairly straight-forward one. As I understand it, consumption is up significantly year over year. I saw a number from the World Bank, 11 percent. GDP year over year cannot be up and when year is high ago the savings leg in China is now declining. I’d like your comment on that. The second is it’s difficult for me to understand they’re having this growth now protected somewhere between seven and eight percent for this year. How it is that imports are actually falling so rapidly? I mean, I understand imports falling around the world with GDP shrinking at record rates and also some places. It’s kind of difficult to understand how you reconcile the very slow or actually declining imports as I understand significantly declining imports and rapid growth of output.

ALEXEI MONSARRAT:  Okay and then we’ll turn quickly to Mark Brzenski from McGuire Woods.

MARK BRZENSKI:  Thanks very much for the presentation. Could you comment on Chinese growth and its global role on the one hand and Chinese demographic on the other? I’m holding my newborn. But with regards to this by 2025, they expect there will be over 300 million Chinese over the age of 65. That’s the entire size of the current U.S. population over the age of 65. How will that impact Chinese growth and its global role?

TIMOTHY ADAMS:  Congratulations on your newborn, by the way. It’s a great question and the catchphrase you often hear is that China is growing old before it grows wealthy and unlike other emerging markets, and I think about India or even among the Arab population where two-thirds of the population is below 25, you have a very different demographic profile in China and, of course, you have the one child policy which is also creating interesting demographic trends as well as interesting psychological and sociological implications which we just now are beginning to grapple with. But the age of the population, aging population, will affect views about consumption, about making a sacrifice, about being more cautious and having lived through some very tumultuous times in Chinese history that will affect the way in which they think about saving and spending patterns. So, demographics are an important, I think demographics are an important driver in a lot of places and I tend to think about the demographic challenges and opportunities in a lot of countries, in India and in the Arab world especially.

So, I think you’re right to focus on that and it’s impact on growth. On the other questions on the savings rate, I know the World Bank had their quarterly report out today. I haven’t had a chance to look at those numbers and I did see David Dollar, the World Bank rep., when I was there last week, who is now taking over the Treasury position as attaché and counselor in Beijing. I did not know that the consumption year over year had jumped. That’s a good thing and maybe that goes toward some needed necessary rebalancing but I will look at the data and look at today’s World Bank report on those numbers and I owe you a lunch anyway so I will get back to you with those numbers.

And on imports, it is something of a paradox why we’ve seen it fall so dramatically and, of course, the year over year data and there’s nominal numbers and how do you deflate them given the various price swings we’ve seen, massive price swings and commodity prices over the past 18 months? And is there a distortion occurring on the export side as well as the import side that accounts for some of this, again the paradox of why we’ve seen imports fall so dramatically given the pace of growth? I think a number of people are starting to ask the question shouldn’t you see a greater leakage and I don’t have an explanation for it other than one I offered earlier, which is I think there is some import substitution going on and some efforts to manage net exports. That certainly doesn’t account for all of it and I agree with you, I think it’s something we ought to consider. It could be quite possible that the growth numbers, the official growth numbers, are overstated and I don’t want to accuse anyone of doing that but there’s always data quality issues in China as there is in many places around the world and so I think you have to look at more than just one statistic and ask yourself is there something else going on here? Is there a more complex story that we just don’t fully appreciate?

ALEXEI MONSARRAT:  Thanks very much, Tim. This was just an outstanding presentation. It was coming in at exactly an hour which we like to make sure we’re using our own time efficiently and was deeply insightful and filled with excellent information. Everyone reads all these things in the paper every day and we can do our research but there’s really no substitute for having an actual call-in and having a chance to hear things, how they’re really going on on the ground. So, I want to thank everybody for joining in. You can look forward to more of these as we go through the rest of the year covering different areas of the financial crisis and thanks very much for chiming in.

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