September 5, 2008
HP-1127

Remarks by Special Envoy for China and the Strategic Economic Dialogue
Alan F. Holmer
at the Symposium on Building the Financial System of the 21st Century
Shanghai, China

I would like to begin by thanking and acknowledging the leadership contribution of these outstanding organizations – the China Development Research Forum and Harvard University Law School – in this your fifth annual symposium. It is an honor for me to present this keynote address.

Your joint efforts these past five years have contributed to a deepening understanding of key issues in China's social and economic development. While there is a lot of information in the U.S. about China, and a lot of information in China about the U.S., there is not enough authentic understanding about our different perspectives, motivations, and histories. Moreover, there is also not enough true wisdom about how we should engage with each other on this hugely consequential relationship. This year's Symposium – the insights that will be shared and the relationships that will form – will help expand that understanding and wisdom as China presses ahead with its economic reform agenda.

Today I will discuss the importance of the U.S.-China relationship and the work of the Strategic Economic Dialogue (SED); the financial market turmoil in the U.S. and global markets; and some of the lessons we have learned from recent experiences. I will also describe why recent events should encourage China to proceed with further financial sector reform.

Possibly the most important economic question of the 21st century for the United States is whether we get the economic relationship with China "right." Our interests increasingly overlap on virtually every issue – from trade, to national security, to climate change – and in virtually every region – from North Korea to Iran to the Sudan.

Our economies are intricately linked, with China being our third largest export market. In the past decade, U.S. exports to China have increased 350 percent, six times faster than the growth of our exports to the rest of the world. And yet the United States' largest trade deficit is with China. For those in the U.S. who oppose free trade and open markets, China has become a symbol of the threat of globalization, and some argue the U.S. should limit China's access to the U.S. market.

And yet such an approach would ignore the benefits of openness. I have been deeply involved in international economic issues for over 25 years, beginning in the administration of President Reagan – nearly as long as China's "reform and opening" period. One of the clearest lessons I have learned is that those countries, including the United States, that open themselves to competition, reform their economies, and welcome foreign investment benefit their citizens greatly. Direct investment in another country, such as in manufacturing plants or service companies, is the ultimate vote of confidence in that country's economy.

There is no better example of this principle than the experience of China.

Because of the importance of our bilateral relationship, President Bush and President Hu launched the Strategic Economic Dialogue (SED) in September of 2006. The Special Representatives of the two Presidents are Vice Premier Wang Qishan for China and Treasury Secretary Hank Paulson for the U.S. Our joint approach has proven effective and has achieved important, tangible results, despite the challenges. For a review of the U.S. perspective on our strategic economic engagement, I refer you to an article by Secretary Paulson in the current issue of Foreign Affairs.

In the SED we have grappled with the most significant, challenging, and strategic issues in our bilateral economic relationship. This includes managing financial and macroeconomic cycles; sustaining strong and stable economic growth; achieving energy security and environmental cooperation; maintaining open markets for trade and investment; encouraging innovation; and other critical issues. Among the results of our Cabinet-level meetings in June was the signing of a Ten Year Framework Agreement on Energy and Environmental Cooperation and the launch of negotiations of a Bilateral Investment Treaty.

We have also been able to use the SED to address pressing issues that threatened our economic relationship. For example, when product safety issues placed consumers and the "China brand" at risk, our two countries engaged in a rigorous effort to achieve two Memoranda of Agreement: one on food and feed, another on medicines and medical devices. We have also kept the relationship on an even keel and avoided enactment of legislation in the U.S. Congress that would have been harmful and counterproductive.

Close communication between the United States and China is especially critical at a time when both our countries face the daunting global challenges of rising commodity prices and financial market turmoil, which have impacted both Americans and Chinese. At the June meeting of the SED, our policy responses to these negative economic developments were the subject of lively and candid discussion. Because the global economy gains much from strong U.S. and Chinese economies, collaboration and consultation between our two countries' economic leaders is a national and a global responsibility.

It is important that our countries harness market forces to address our macroeconomic challenges. In particular, at a time of strong global demand for commodities and other resources that are in short supply, both our countries must allow prices to adjust so that consumption levels reflect the current realities of the global economic market. China's recent decision to raise fuel prices is an important step towards reducing domestic energy consumption. We urge China to continue its reforms in the energy sector.

The SED has expanded our areas of shared understanding on macroeconomic policy matters. And even in areas where we and the Chinese disagree on the causes of our recent economic ailments and how best to cure them, it has been invaluable for each side to understand the motivations, priorities and concerns of the other.

Perhaps most importantly, we have established new habits of cooperation and a culture of collaboration with our colleagues in China, across all economic ministries, and at both political and career levels. Our relations are more productive today than ever before. The SED has established an impressive body of work since it was established two years ago. We will continue to build on those achievements as we plan for the Fifth Round of the SED to be held before the end of the year. There is simply no substitute for active engagement and communication.

The current turmoil in U.S. and global financial markets stemmed from a long period of benign macroeconomic and financial conditions that encouraged widespread complacency about risk. Investors in search of higher yields created significant demand for structured credit products but, in many cases, did not conduct adequate due diligence.

Meanwhile, demand for housing in the U.S. began to slow in 2004, and credit standards loosened significantly, particularly for subprime mortgages. At the same time, the pace of financial innovation gathered momentum and the trend toward securitization of assets accelerated. Financial innovation clearly brought enormous benefits to investors and consumers, and contributed to domestic and global economic growth. We also see, however, that the resulting dramatic increase in leverage and complexity of financial instruments brought new risks to financial markets – not only to the United States but to other interconnected markets around the world.

The looser credit standards, combined with the complacency described earlier, inevitably contributed to an unexpected rise in mortgage delinquencies. This, in turn, triggered a global reassessment of risk beginning in August 2007, followed by significant de-leveraging. The dramatic swing in sentiment, subsequent market volatility and heightened uncertainty ratcheted up demand for cash and liquidity. Many structured finance markets seized up, causing markets for asset-backed commercial paper to contract substantially.

The Bush Administration has responded vigorously, both on the domestic and the international fronts. Here at home, the Administration's response includes near-term as well as longer-term measures. The goals are straightforward: minimize the impact on the real economy; maintain efficient and liquid markets; ensure continued availability of credit; and enhance risk management. Our domestic approach includes three sets of actions to help accomplish these goals.

First, the Administration has acted aggressively to support the economy as it weathers the housing correction and financial market challenges. The housing correction will undoubtedly take time to run its course. The fiscal stimulus package, signed into law by President Bush in February of 2008, provides economic stimulus payments to over 130 million American households and temporary tax incentives for businesses. This year's $150 billion infusion will help American families and businesses weather the considerable headwinds facing the U.S. economy.

Our housing market initiatives also seek to increase the availability of affordable mortgage financing, prevent avoidable foreclosures, and minimize the economic disruption of the housing correction. They include temporary authorities for Treasury to support Fannie Mae and Freddie Mac and the creation of a strong, independent regulator to address the risks that these entities pose. Two other key initiatives include FHA Secure and the HOPE NOW Alliance, launched in the fall of 2007 at the encouragement of the Treasury. To date, the HOPE NOW Alliance has helped over two million homeowners avoid foreclosures since July 2007.

Second, U.S. policymakers have also initiated a number of medium-term efforts to strengthen market discipline and address weaknesses in markets, institutions, and regulatory policies. Secretary Paulson chairs the President's Working Group on Financial Markets – the PWG – an interagency policy coordination group that includes the Fed, the SEC, and the CFTC. In March of this year, the PWG released a policy statement on financial market turmoil, addressing issues including credit ratings, securitization, mortgage origination, investor due diligence, and OTC derivatives, and designed to mitigate systemic risk, restore investor confidence, and facilitate stable economic growth.

Treasury also presented a Blueprint for a reformed regulatory structure, to be considered after the present market difficulties are past. The Blueprint lays out a vision for a more flexible, efficient, and effective regulatory framework. This new structure is designed for the world we live in, one that is more flexible, that can better adapt to change, that will allow us to more effectively deal with inevitable market disruptions, and that will better protect investors and consumers.

China has weathered the recent global financial turmoil relatively well, but will need to achieve stronger growth in domestic consumption to offset weaknesses in external demand and achieve its goal of more stable and balanced economic growth over the long term. The sharp fall in Chinese equity prices since last October appears just as much due to domestic factors as to linkages with global stock markets.

There is growing concern that the recent bout of turbulence in global financial markets is viewed by some in China as a reason to slow or pause financial sector reform. I hope Chinese policymakers will ask the more pertinent question: What lessons should China's leaders draw from recent events as they consider the pace and potential benefits of financial sector reform?

Here I will outline only four of the many lessons to be learned from the turmoil, all of which are relevant to the challenges China faces as well.

Recognize Problems and Address Them Quickly. Though the impacts of the global market turmoil have been far reaching, these effects have been mitigated somewhat by a swift and transparent response. Treasury Secretary Paulson has led the U.S. government effort to ensure a comprehensive, timely and appropriate response to the turmoil. He and other authorities have urged banks to recognize promptly and report losses, and raise additional capital as needed. Many global financial institutions have done just that – reporting subprime-related losses of over $569 billion and raising additional capital of more than $381 billion. China's regulators are also taking steps to ensure that financial institutions are recognizing impaired assets quickly and provisioning for them appropriately. Taking such steps will be key to ensuring that markets and supervisors are fully aware of the risks facing China's financial institutions, and that the banks themselves are able to take prompt steps to mitigate those risks.

Ensure Disclosure/Transparency in Financial Institutions. Another lesson from recent events is the related failure to provide and obtain information. Prompt and consistent communication between financial institutions and market participants is critical to avoid suspicion and build market confidence.

In China, banking regulators took steps to have Chinese banks disclose quickly exposures to subprime securities. Consistent efforts to ensure that financial institutions communicate news – both good and bad – to the markets will win market confidence over time and promote greater market stability.

Ensure Supervisory Coordination. The issues that have arisen during this bout of turbulence have spanned several supervisory authorities within the United States. Frequent and sustained regulatory coordination has been necessary to address effectively the problems that have been exposed. Strengthening coordination of regulatory authorities within China can help implement China's reform agenda and prepare the authorities to have a coordinated response to any problems that arise in the financial sector. In addition, as Chinese banks move ahead with implementation of Basel II, which places a premium on strong supervisory authorities, it will be essential that China's supervisors further enhance their capabilities and coordination.

Allow monetary policy to focus on price and financial stability. Moving toward a more flexible currency regime in which monetary policy does not have to target the exchange rate would allow monetary policy in China to become a much more effective and valuable tool for countering inflation and ensuring continued financial stability.

China has made enormous progress in financial sector reform in the past decade, from the banking sector to the stock, foreign exchange, and bond markets. These reforms have been important for laying the foundation to address the key challenges ahead in China's financial sector development. Financial regulation and supervision must be developed in tandem. But policymakers in China must also recognize that there will be significant costs if China slows the development and reform of its financial sector. Important gains for China and its people would be left unrealized. An ambitious reform agenda will advance China's economic goals in four important ways by:

• Rebalancing the sources of China's growth to ensure that it is more harmonious, more energy and environmentally efficient, and provides greater welfare for Chinese households;
• Creating effective macroeconomic policy tools to ensure stable, non-inflationary growth;
• Supporting China's transition to a market-driven and innovation-based economy; and,
• Assisting in dealing with demographic challenges.

First, as China's economy becomes more sophisticated, an efficient, well-developed financial sector is essential to channeling capital to the new ideas, businesses, and entrepreneurs that will power future growth. As China's economy becomes more complex, so too will its need for financial services. A more developed financial sector is necessary to fund the industries -- and fuel the growth -- of tomorrow.

A more developed financial sector is also essential to shift to a growth model that can be sustained in the future, one less dependent on industrial activity and exports, and one more oriented towards services and household demand. Key to this is reducing the need for very high saving rates. A greater diversity of financial instruments for saving, risk diversification, and consumer borrowing would relieve some of the need for precautionary saving.

A higher risk adjusted return from a broader array of financial assets would allow Chinese households to achieve their financial goals – such as buying a house, educating children, or achieving a secure retirement – without having to set aside large portions of their current income. A more developed financial sector will also provide Chinese enterprises with options beyond reinvesting earnings primarily in expanding their own capacity. This will enhance the efficiency of capital allocation and dampen the volatility of investment cycles.

More developed financial markets will help bring greater stability to China's economy by giving the authorities the macroeconomic tools – flexible and more powerful monetary policy in particular – to assure stable growth and prices. Deeper, interconnected bond markets would give the central bank greater ability to guide market interest rates and credit throughout the economy to ensure continued strong, stable, and non-inflationary growth.

Finally, a robust financial sector will help to enable China to deal with the demographic challenges that lie ahead, including population aging and the provision of healthcare. A deep and sophisticated financial sector will be critical to strengthening the social safety net and providing tools such as health care insurance and retirement investment vehicles necessary to cope with growing demographic pressures.

Greater foreign participation will contribute substantially to financial sector reform, and, for that reason, it has been a top priority for the Strategic Economic Dialogue (SED). We recognize the concerns of some in China who believe that opening the doors to foreign financial firms could jeopardize the position of domestic firms. Nonetheless, we believe that increased foreign participation would expand the breadth and depth of opportunities for all firms in the market, including domestic Chinese firms. This is not a zero-sum game. It's true that foreign firms stand to benefit from expanded opportunities in China. But such firms will also enhance the diversity of financial products in China, improve allocation of capital, spur innovation, and expedite the development of world class financial sector talent within China, all of which will benefit China's economy, its people, and financial centers like Shanghai.

The economic and geopolitical landscape of the 21st century will be greatly influenced by the way in which the United States and China work together. Nowhere is our work more important than in the financial sector, the central nervous system of any economy.

In the SED, we will continue to focus on the long-term, strategic, transformational issues; work diligently on immediate and concrete shared objectives; strengthen our new habits of cooperation and a culture of collaboration; and keep our relationship on an even keel. In this way China and the United States will write the next chapter of our strategic economic engagement.