Lecture at Liaoning University

Lecture at Liaoning University

November 7, 2005

I will give a lecture this Friday at Liaoning University, which is in Shenyang, about an hour’s flight north of Beijing. Shenyang is working hard to make the transition from being known as China’s Rust Bowl to the heart of its new industrial base. As such, there are vast opportunities to invest in privatizing companies there.

In addition to lectures and a lunch at Liaoning university, I will visit the Neusoft Group, a successful software company, make a half hour television program for Liaoning TV on China/US economic relations, and spend time with local busines and government leaders.

Thought you would like to see the following brief outline of the points I will cover in the lecture.

JR

The Impact of Integrated Global Capital Markets on China and the U.S.

•China has committed to fully opening capital markets as part of the WTO process. This will have important impacts on both the Chinese and American economies.
•We can best understand the impact of opening capital markets on the economies of China and the U.S. by using the laws of thermodynamic systems from physics.
•China and the U.S. were effectively closed economic systems for most of the past six decades.
•A closed system is one in which temperature, pressure, and other state variables are everywhere driven to uniformity.
•In economics, we refer to closed systems as “markets.” A market is defined as the area in which price tends toward uniformity. This is known as “the law of one price.”
•In closed economic systems, prices, wages, incomes, the price of capital, and the return on capital are determined by local supply and demand conditions, by population, and existing stocks of both human and non-human capital.
•Dramatic changes in China during the past 27 years have bought these formerly closed economic systems into close communication. This has been caused by:
–Changes in laws and regulations,
–China’s WTO membership, and
–The opening of Chinese capital markets.
•When formally-closed economic systems are brought into contact, to form one large closed system, the speed at which prices and wages are driven together depends on the ‘bandwidth’ of the channel connecting the systems.
•Traditionally, these adjustments occur through trade in goods, where bandwidth is limited by shipping capacity. This makes the resulting adjustments slow.
•More recently, changes in communications technology, in the form of information technology (IT) and fiber-optic communications, have broadened and deepened these channels, dramatically increasing channel bandwidth.
•This has speeded convergence of prices, wages, and returns on capital. For the first time, the adjustments are primarily driven by changes in the service sectors, i.e., by changes in wage rates.
•Open capital markets are very important for China. In order to continue to grow at high rates and to develop its energy resources, China must import growing amounts of foreign direct investment and technology.
•Fully open capital markets will reduce risks to foreign investors and make the investor decision about where to locate capital more responsive to return differentials.
•This will accelerate the flow of foreign direct investment (FDI) to China from the U.S., Europe, and Japan, and will allow China’s economy to sustain high growth.
•Result: Two formerly closed systems will become one closed system. Flows of capital and labor services will drive relative prices, wages, incomes, and returns together.
•Issues brought about by economic convergence:
–What will the new set of relative prices and wages look like?
–Will the transition be smooth? Or marred by disruptive stops and starts.
–How will the changes impact domestic politics and policies in both countries?
•Preliminary conclusions:
–The new relative prices will tend toward the mass-weighted average of current prices in both countries.
–Although prices and wages will change substantially in both countries, changes will be larger, and more disruptive, in China.
–The adjustment is unlikely to be smooth.
–Chaotic change frightens people and leads to political pressures on governments for ‘protection’ against change.
–Political pressures in both countries will give rise to unproductive short-term policy reactions—such as tariffs, quotas, or pressure to change exchange rates–that can have permanent effects.
–Policy should attempt to make the adjustment stable and orderly.
•Issues to discuss:
–The link between exchange rate policy and domestic monetary policy.
–Developments in rule of law.
–Corporate governance
–Transparency in financial markets
–Availability of both public and private risk capital.
–The increasing importance of small businesses in China.
–Developing management education programs for Chinese entrepreneurs.
–Need for increased mutual understanding of history, culture, and language.

John Rutledge

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