Nitin Desai: A measure of power

The projected power of China is latent and requires institutional reform and capacity enhancement to become effective

Hindsight always works better than foresight. So one can sound wise about the prognostications made 20 years before 2031 about the rise of China. But it is worth asking why analysts think this way now. Is it an exaggerated reaction to the long recession the Organisation for Economic Co-operation and Development economy is going through? Is it an over-simplification of the dynamics of power?

A well-known book, Eclipse by Arvind Subramanian, published this year, has made dramatic projections of how China is going to dominate the world economy in 20 years. This thesis is based on some fairly simple bit of routine analysis that seeks to explain global economic dominance in terms of GDP at purchasing power parity (a concept used in the old days when many services were immobile and non-tradeable), international trade and net capital exports, all measured as ratios to the world totals. He has abstracted from factors like technology and human capital on the argument that they would be correlated with GDP.

The key to his prognosis is the differential in the growth rate between China and the West, more particularly the United States. He projected this on the assumption that China’s growth and capital-exporting potential were understated. His trade projections were derived from GDP projections from a gravity model for predicting trade flows. The net result of this playing around with exponentials was that what seemed like a plausible difference in growth rates led to projections of a large GDP difference between China and the United States over a 20-year time span. 

Mr Subramanian is not alone in his emphasis on observed growth differentials. Arvind Virmani had earlier used GDP growth-based calculations of power to forecast a tripolar world by mid-century. Expectations about the rise of China to economic dominance were shared by many other data bashers. The Composite Index of National Capability, a frequently quoted index produced in the US, had placed China as numero uno even on the basis of the 2007 data. But this index also placed India at number three, which was hardly plausible at that point in time. 

Chinese researchers were more circumspect. A government-sponsored think tank in China had produced a measure of Comprehensive National Power that placed China sixth, after the US, UK, Russia, France and Germany and placed India tenth with Japan, Canada and South Korea between it and China.

China has grown more or less at the rate projected by most data bashers and its weight in world trade has increased but not quite at the rate predicted by the gravity model. But the biggest difference is in the role of the renminbi, which, though important, has not displaced the dollar as the dominant international currency.   Why doesn’t a method that was fairly successful at explaining the history of economic dominance in the 20th century do as well in explaining how global economic power relations have evolved over the first quarter of this century?

One reason is the possibility that the share in world trade is as much a measure of vulnerability to trade disruption as of power to use trade as a weapon. This was seen when China had to accept a variety of conditions that required 900 pages of legal text when it acceded to the World Trade Organisation in 2001. 

Twenty years ago, much of China’s industrial capacity was in the hands of multinationals and designed to produce products to meet foreign demand. Its own per capita income, even after a half century of relatively rapid growth, is less than half the per capita income of its Western trade partners and a switch to domestic markets has not happened at a rate necessary to make up for the markets lost to new low-cost producers from South Asia and Africa. The renminbi appreciation forced on China when the West faced a double-dip recession in 2010 worsened the situation.

The US came out fine because its ecosystem for taking game-changing innovations to market remained intact. A new company in the booming south-west US came out with an energy storage technology that revolutionised energy systems by making renewables wildly profitable and electric cars a practical option. America’s GDP growth and exports got a boost, narrowing the growth rate differential quite substantially.

The world economy has a high degree of capital mobility. Currency preferences in enterprises and central banks are shaped as much by capital account as by trade considerations. The dollar remains the currency of choice for capital transactions even though the  renminbi is convertible. The reasons why the renminbi has not displaced the dollar seem obvious now.  The high investment economy that China ran in the first decade of this century led to a huge portfolio of bad debts in the books of Chinese banks. This also contaminated the open capital market enclaves of Hong Kong and Shanghai. This bad debt overhang, which required continuous nursing by the government, prevented the emergence of a globally competitive financial services industry. 

There are other factors that explain why the distribution of power would be so different 20 years later. The disruption in the world oil economy when the West Asian democracy revolutions have reached a peak would put a severe pressure on countries like China and India, with urbanisation and rising car ownership driving manufacturing growth. There is also the butterfly effect: how a seemingly minor event can trigger a massive change, as one saw in the agitations that followed the first direct election of the Hong Kong Chief Executive and led to the jasmine revolution.

Therefore, with hindsight one can say that the mistake is to take the latent power measured by numbers like GDP or trade as effective power. For that, countries need institutions that can transform latent power into a continuing social and political dynamism and a diplomatic and military capacity to project that power to influence others.  The analysts should have been more cautious since they had before them the examples of Japan and Germany where high GDP, trade share, and capital exports never got translated into effective global  power.

nitin-desai@hotmail.com