China's explosive economic growth hinges on the rest of the world, radically changing the global production chain and challenging the global trading system.
If China maintains its growth momentum over the next two decades, the global system will face huge challenges. Indeed, the question is not so much whether the global system will endure the imbalances spawned by China, but how severe those imbalances will prove to be.
Much of the concern over the past few years has centered on the US' gaping current account and fiscal deficits, and its efforts to get China to let the yuan float more freely against the dollar. China, by contrast, sees its growth as tied to a stable currency, and may not want to introduce a more flexible exchange-rate regime, even after the 2.1 percent revaluation in July, pending the alleviation of structural problems, for which it is extremely difficult to set a timetable.
In fact, even as China's economy has boomed over the past decade, structural adjustment in its domestic sectors has slowed, mainly owing to political constraints. The banking system remains unhealthy and fragile capital markets are dying.
The private sector's growth is hemmed in by its inability to invest in economic sectors that the government still monopolizes. Mounting regional disparities, as well as the widening urban-rural income divide, impede household consumption growth, increasing the economy's dependence on exports and foreign investment.
For years, as optimists see it, China has been the world's cheap assembly shop for shoes, clothing and microwave ovens. Now, it is laying the groundwork to become a global power in more sophisticated, technology-intensive industries. Billions of dollars are flowing into auto, steel, chemical and high-tech electronics plants, setting the stage for China to be a major exporter of high-end products.
While this argument suggests that the global trading system must make more room for a rising China [and India], it overlooks the need to address the enormous structural problems in China's domestic sectors if export-led growth is to become sustainable. For these sectors, rapid investment-driven growth in the past decade has produced a mountain of excess capacity, reflected in stagnant prices and the banking sector's soaring volume of bad loans, as price wars squeeze profitability and stimulate real-estate speculation.
Postponing structural reforms eventually constrains economic performance, as we saw in Japan in the 1980s and 1990s. China has similar problems, with the investment-growth nexus threatening macroeconomic stability -- notably the overheating that occurred in 2003 and last year.
Indeed, China faces tremendous challenges in maintaining macroeconomic stability under conditions of export-led growth, with huge repercussions for the rest of the world. Given China's size and its rising share in the global market, macroeconomic instability there fuels volatility in global prices for basic commodities and raw materials.
But the political reality is that China's government favors rapid growth in the short-term over the structural reforms needed to sustain long-term economic performance. Fiscal consolidation and the abrupt closure and restructuring of inefficient banks and state enterprises would, after all, constitute a powerful brake on short-term growth, threatening social peace and political stability.