Opening address in the Seminar "Integration of Russia and China into the world economy", Helsinki December 11-12, 2007

Ladies and Gentlemen

It is a great pleasure for me to open this research seminar "Integration of Russia and China in to the World Economy", organised by the Bank of Finland. It focuses on the macroeconomic and financial aspects of the integration process.

The end of the cold war implied among other things significant economic consequences. Much attention was initially devoted to the so-called 'peace dividend'. At the end of 1980s and the early 1990s this term referred to the reduction in military expenditure due to the end of the arms race between the United States and the Soviet Union. This was significant even at the macro-economic level. Between 1988 and 1996 the world military expenditure declined in real terms by almost a third, most notably in the Western European countries and in the Russian Federation. However, the peace dividend turned out to be temporary. After 1996 military expenditure has increased, and in real terms it now approaches the level of 1988.

It retrospect, a much more important and more permanent consequence of the end of cold war than the end of the arms race was the gradual integration of the former command economies, in particular those of Russia and China, into the world economy. Of course, even this can be thought as a sort of peace dividend, even though the term usually is used more narrowly.

It is interesting to note that both Russia and China have integrated into the world economy largely on the basis of their resource endowments. This is in line with the classical trade theory and in particular the Heckscher-Ohlin theorem. It can be contrasted with the experience of developed countries. Relative resource endowments have little power in explaining trends in international trade and division of labour between developed countries.

Russia's comparative advantage lies in its natural resources. These have enabled it to become a major player in the international raw material markets and a superpower in international oil and natural gas markets.

Recent increases in oil and other energy prices have accelerated Russia's GDP growth. This year it is projected to reach some 7 %. In view of the country's earlier track record, this can be regarded as a good achievement, even though conventional GDP figures may somewhat exaggerate the country's actual growth performance as they fail take into account the depletion of natural resource stocks.

In exploiting its natural resources, Russia has relied heavily on state-owned or state-controlled companies. There are inefficiencies in the production, and in view of the challenge of developing the relatively inaccessible oil and natural gas fields in the Barents sea and in East Siberia there are also concerns about timeliness and sufficiency of investment in the energy sector. Transparent and more liberal third party access to oil and gas transmission systems would improve competition and efficiency.

Capacity constraints have slowed Russia's energy exports in recent years. Thus economic growth has been based increasingly on strong productivity growth, rising real incomes and rising consumption, instead of energy and raw materials. A major challenge for Russia is to continue and intensify this trend also in the future, diversifying its economy further away from natural resources. In my opinion, improvement in the country's investment climate is essential for that purpose. Russia has consistently performed rather poorly in international comparisons of the investment climate, the predominant complaints being corruption, bureaucratic meddling and lack of property rights. Reforms of civil service, public administration and legal system could do much to rectify the situation. In this context, I would like also to mention Russia's accession to WTO. A number of issues still remain to be resolved bilaterally before the start of multilateral negotiations, including issues like recently introduced export duties, level of agricultural support and enforcement of intellectual property rights.

China's comparative advantage today lies in its abundant, industrious and inexpensive labour force.

Economic reform began in China already in the late 1970s, also well before the end of the cold war. The country's leaders then concluded that the Soviet-style system that had been in place since the 1950s was making little progress in improving the standard of living of the Chinese people and closing the economic gap between China and the industrialized nations. The earlier attempt at a Great Leap Forward from socialism to communism had turned out to be an economic failure. After the end of the cold war, China's integration into the world economy has gained momentum.

Even though China's reform policy has been managed and controlled by the leading Communist Party, it has been characterised by pragmatism and reformism. China's growth strategy appears to be a close imitation of those of other Asian economies such as Japan, Korea, and the newly industrialized emerging economies of Asia. Growth has been largely export-led, with China serving as the final processing and assembly platform for imports from other Asian countries exported as consumer goods to Western countries. Trade reforms and the general opening of the economy have led to a surge in foreign direct investment and increased integration with the global trading system.

China’s growth performance after the start of the reform policy has been remarkable. Annual GDP growth has been on average about 8 percent, and is projected to reach 11.5 percent this year. The country has also made progress in reducing poverty. Measured at $1 per day of expenditure, poverty came down from about half of the population in 1980 to less than 10 percent now. Poverty at $2 a day has declined from over 70 percent of the population in 1990 to some 28 percent now.

China’s economy has good potential for sustained robust growth over the medium term, based on its attractiveness as a destination for FDI, a high domestic saving rate, underlying improvements in productivity stemming from reduced barriers to both internal and external trade, and significant surplus labour. But fulfilling its potential will depend largely on successful response to the diverse set of financial and social challenges China faces.

To mention just one of them, there is clearly a need to change the country's heavy dependency on exports as the main source of economic growth. This need for change in economic strategy arises not just from the threat of protectionism in developed countries. More importantly, a country as big as China cannot sustain growth in exports that is consistently higher than growth in its markets.

Success in China's response to its economic challenges will depend crucially on the pace and effectiveness of core macroeconomic and structural reforms. China’s traditional approach to reform is incremental. However, in future a more concerted approach may be needed.

In both Russia and China economic growth in last two decennia or so has been based largely on mobilization of nation's economic resources. As these become more fully employed, the focus needs to be changed from mobilization to productivity.

While further privatization or domestic and international market integration are important in enhancing factor productivity, I would like here to stress the pivotal role of the financial system in identifying and funding productivity-enhancing products and processes, and equally important, leaving less efficient products and processes at the mercy of creative destruction by market forces. If properly developed, Russia's and China's financial sectors could have an important role in fostering productivity gains and in shifting demand from exports to domestic consumption, implying a shift to services, which are less capital intensive and create more jobs per investment done. I welcome this seminar's focus on the Russia's and China's financial sectors.

During the past two decades China and Russia have become more and more integrated with the global economy. Through this process they have assumed increasingly important roles in the global economy. This year China will account for approximately one third of the global GDP growth, and Russia's contribution will be larger than that of Japan. We can expect that the integration process proceeds rapidly also in the future through foreign trade, international lending and foreign direct investment.

In view of Russia's and China's important and continuously increasing role in the world economy, we have a pressing need for more thorough and deeper analysis on their economies. This conference covers a wide spectrum of issues in this field. I look forward for presentations and discussions, and I am sure that they make an important contribution to our understanding of the integration of Russia and China into the world economy.