The Imbalances in China's Economy Book Chat Talking with authors about their work. Nicholas R. Lardy, a senior fellow at the Peterson Institute for International Economics in Washington, is an authority on China and its economy. In his latest book, "Sustaining China's Economic Growth After the Global Financial Crisis," he warns about dangerous imbalances in China's economy, starting with its emphasis on exports rather than household consumption. But Mr. Lardy's book goes further, showing how Chinese policies hamper the development of private companies and the service sector. Because interest rates and the exchange rate are tightly managed and not market-oriented, Mr. Lardy says economic growth over the past decade has been badly distorted and inefficient. And that, he says, could set the stage for a lengthy period of sluggish growth. In an exchange by phone and e-mail, I asked Mr. Lardy about the roots of the imbalances, and whether China's long-running economic boom could be coming to an end. Why did China's imbalances begin showing up in about 2003? Was it because of policies aimed at propping up weak state-run banks and corporations by managing interest rates in a way that favors banks, or was there some other reason? The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure. China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China's currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined. The key point is that China's external and internal imbalances are intimately linked. If the imbalances are so troubling, why has China continued to record impressive growth, year after year, even in periods of weak global growth? Is China immune to slowdowns or does it simply take a while for imbalances within a country to undermine its growth? China's impressive growth of the past few years has depended largely on rising investment demand. Some of this has been for infrastructure, which will support long-term economic growth. But a growing share is due to higher and higher investment in residential property. Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth. In your book, you argue that China should liberalize interest rates and adopt a more market-oriented exchange-rate policy, suggesting that these would be the most effective policy tools to rebalancing the nation's economy. If Beijing follows your prescription, what would we expect to see within a year of such a move? Within a year or so we should expect to see that private consumption expenditure would pick up relative to the overall growth of the economy and that investment outlays would moderate. We should also expect that China's external surplus would continue to decline. With a somewhat longer lag I would also expect that households would reduce their now highly elevated rate of savings, reinforcing the expansion of private consumption expenditure. You say vested interests in China, such as banks, exporters and manufacturers, are blocking reforms. Those sectors account for a large portion of China's growth. Wouldn't a major policy shift damage some key growth engines? Yes, rebalancing inherently requires slower growth of the manufacturing sector, which is quite outsized, and more rapid growth of services output, which in the last decade stagnated in relative terms. A large share of manufactured goods are exported, whereas services are almost entirely consumed. Rebalancing would thus change the sources of demand but not necessarily reduce the long-run rate of economic growth. Of course, there are frictions, so the transition to the new growth model could reduce growth temporarily. Do you see any signs Beijing is looking at these imbalances not as an effort by Americans and Europeans to get them to import more goods and consume more, but as a serious threat to China's own well-being? The Chinese premier has been arguing for rebalancing the sources of China's growth for five years. But the necessary reforms have been blocked by vested interests, so a pessimist would say reform now is unlikely. The optimistic view is that the Communist Party will undertake reforms. It won't be costless. But if they don't engage, there's a chance China's economy will grow substantially slower for a very long period of time. The big risk is a larger, more gradual and deep decline. Housing prices are now down 25 percent from their peak. Land sales are in the toilet. You could have a period of slower growth. But nothing focuses the collective mind of the party like the prospect of slower growth. You say near the end of your book that if China does not rebalance, the United States would struggle with its own recovery. If China does not rebalance the sources of its growth, a large external surplus could re-emerge over the next couple of years. That would mean China would be adding more to the supply of goods to the rest of the world than it would be adding to the demand for goods from the rest of the world. Thus China would be a drag on global economic growth. That would be adverse for both the United States and Europe, where recovery from the global financial and economic crisis has been subpar. Better that China further reduce its external imbalance so that its rapid growth is more fully transmitted to the rest of the world.