The pleasure of having been invited to present a paper at our two-yearly conference, this year focusing on the interesting theme ‘Europe facing Outward', is overshadowed by the fear that I probably will disappoint you with my paper, being not a specialist of problems related to Europe and the rise of China and India. Moreover, having more information at my disposal on China than on India, I decided to concentrate my reflections mainly on the rise of China and on its impact upon Europe's economic development in the past, at present and in the near future.

The paper will be divided into three parts. Firstly, I will give a brief overview of China's economic performance since 1980. Secondly, I will try to give an answer to the question: what challenges China is facing at this very moment and what challenges China will be facing in the near future? Thirdly, I will try to give also an answer to the question: what challenges Europe is facing at this moment in relation to China's rise and what challenges Europe will be facing in the future as a consequence of a probable further rise? In the conclusion I will briefly touch on the rise of India.

2. China's impressive economic growth since the 1980's
When Deng Xioping started, at the very end of the 1970's, a policy of de-socialization of the Chinese economy, he first privatized agriculture, industrializing on a private basis the countryside at the same time. At a later stage he started restructuring and modernizing the urban industrial sector, opening also this sector gradually to the working of the market , internally and externally. Since the introduction of Deng's new policy, China's economic growth has been impressive. Between 1980 and 2006 growth has been nearly 10 % per annum in real terms, with the result that China's economy at this moment is the fifth largest of the world (after the United States, Japan, Germany and the United Kingdom). The prospect is that soon China's economy will become larger than the British and German one, becoming at that moment the third largest economy of the world. Moreover, the opening of the economy to the world market had a very stimulating effect on China's international trade At the end of the 1970's the value of China's export was a poor 20 billion US$, in 2005 it had risen to 760 billion US$.

Each of the three production factors capital, employment and productivity contributed to China's impressive growth, but they did not contribute to it to the same extent. The net contribution of physical labor was, surprisingly, rather modest, due in the first place to the restructuring drive within the state-owned enterprises, which generated a massive dismissal of workers and other employees, and in the second place to the restructuring of the agricultural sector, generating in some way just a transfer of labor from the agricultural sector to the private rural and urban industrial sector.

The contribution of capital, on the contrary, was substantial: investment in fixed assets, financed by foreign capital, and, not less, by a very high level of personal savings, was crucial. This investment boom was combined with the creation of special economic zones by the government in the eastern part of the country, combined also with highly entrepreneurial talent and with an increasing level of education of the Chinese, in China itself and also overseas (between 1978 and 2005 nearly one million Chinese youngsters went studying abroad, mainly in the disciplines of engineering and science). The result was a significant growth of total factor productivity.

The bulk of foreign investment in China, surprisingly, did not originate in the world economy's centers of technological growth. Indeed the European Union, Japan and the United States each accounted for only about 10% of total foreign investment, the rest coming mainly from Hong Kong, Taiwan and South-East Asia. Furthermore,, the investments from the United States, Europe and Japan were not the only source of transfer of technological know-how, the investments from Hong Kong, Taiwan and South-East Asia had a similar effect. They all helped the Chinese manufacturing sector in moving from originally labor-intensive enterprises, specialized in textiles, clothing and leather products, to successful technology-intensive industries. High-tech sectors are now contributing substantially to maintaining the strong growth performance of China, which means that foreign-owned firms and their R & D input in China are pushing the Chinese economy closer to the technological world frontier.

China's trade follows the same pattern of development as China's global economic growth performance. The country has therefore become an important player in the global economy. Looking at China's trade geographically, the intra-South-Asia regional dimension is evident, based substantially on intra-company trade of multinational firms. Outside this intra-regional trade the United States and Europe are China's major trading partners, the European Union now outpacing the United States. China's trade surplus is foremost with the United States, but the European Union and Hong-Kong are also in deficit, although to a lesser extent than the United States.

China's comparative advantage in foreign trade is not static. Chinese trade is indeed moving away from a model based on imports of raw materials and exports of final goods, the latter mainly resource-intensive, low-tech and labor-intensive products, to a model based on specialization in specific product groupings, which are capital-intensive, medium- and high-tech products, and already high in the value added chain. Examples are: office machines and tools, automatic data processing machines, telecommunication and sound recording apparatus.

A new stage in China's integration into the world economy is the rising intensity of Chinese investment abroad. Large purchases of oil and gas sources have been made, inter alia in Kazakhstan, Australia and Indonesia. Large investments have also been made in the copper and iron mining sector of Brazil and Central-Africa. Chinese energy consumption will overtake Western Europe's by 2010 and North America's by 2020. China's search for energy and raw materials is therefore a contributing factor to the emerging inflationary tendency in the sphere of world prices.

Chinese leaders realize that the success of its growth strategy depends to a large extent on a benign international environment. Hence a foreign policy of avoiding any confrontational approach, even a clear strategy of enhancing China's ties with the United States and with Europe. In 1992 China became a member of the World Trade Organization and in 1996 a founding member of ASEM (the Asia-Europe Meeting).. China's foreign policy, moreover, has been based, and still is based, on its Five Principles of Peaceful Coexistence: respect for sovereignty, mutual non-aggression, non-interference in each other's internal affairs, equality and mutual benefit. Within the framework of a large scale economic integration into the world economy and a benign foreign policy China has been able to become, in a very short period of time, an important player in world affairs.

3. The challenges China is facing at present and will be facing in the near future.
China's spectacular economic performance of the last three decades does not imply that it is not facing challenges at present and in the near future. Indeed, many challenges remain at the socio-economic, legal and political level.

A first challenge will be securing balanced macro-economic development. The gradual liberalization of trade and investment and the restructuring of the domestic economy will place heavy demands on China's macro-economic policy instruments, such as instruments to manage aggregate demand, instruments to control credit, to accommodate the increase in public debt, to manage capital movements and a floating exchange rate, finally, instruments to diminish regional income disparities. Closely connected with the problem of balancing macro-economic development is the upgrading of the financial system. At the moment this system is still dominated by four State Owned Commercial Banks, which have focused their lending on the large State Owned Enterprises. Most of these enterprises are virtually bankrupt with the result that the four large commercial banks have masses of non-performing loans in their portfolio and are therefore technically insolvent. In order to keep the four banks afloat the government subsidizes them, but the fragile situation of these banks handicaps them in financing investments in the quickly expanding private sector.

The limited size of the existing capital markets is also a serious handicap to securing a balanced economic growth. In order to eliminate this handicap, the expansion of equity markets, bond markets and investment funds should be extra encouraged. The production sector should also be modernized further On the one hand, more in depth reforms in the public industrial sector are necessary. In the private industrial sector, on the other hand, reforms should be focused on removing the still many barriers to entry and to exit, as well as barriers to expansion, to trade and to competition.

As far as public finance is concerned, indirect taxation should be diminished and direct taxation should be enhanced in order to weaken the actual dangerous tendency of a growing income and wealth inequality, which could generate very serious social unrest and political conflict. An important reform in the domain of public finance should be the refocusing of public expenditure to address social challenges in the sectors of pensions, health and education. Connected with the need to a much greater emphasis on education is the need to develop China's innovative potential. China has a huge potential pool of human capital, but in order to actualize this potential China should develop with greater vigor its public research infrastructure, it should modernize its research institutes, reform its higher education and stimulate private research. Much more action should be undertaken in this respect.

Another great challenge consists in the absorption of surplus labor. Not only is the age group between 15 and 64 year still growing from 900 million at the moment to one billion in 2015, but the layoffs at the state-owned enterprises (23 million between 1993 and 2003) and the dramatic reductions in the demand for agricultural workers, taking place at this very moment and to rise further in the near future, are pushing masses of extra labor on the job-market. An additional problem in this respect is the need of absorbing all this surplus labor into higher quality jobs. Skills mismatch remains a big headache for the leaders of the expanding private sector.

A very serious problem for the Chinese government is also the environmental challenge. Several of the most polluted cities in the world are Chinese. Air pollution is mainly caused by the use of coal. Almost all of the nation's rivers are considered polluted to some degree. New legislation on the matter has been introduced in 2003, but effective monitoring and enforcement of the laws by local agencies are hopelessly insufficient, inter alia because of large scale corruption at the local level.

Finally, the government has to cope with a quickly changing Chinese society. A middle-class of predominantly young, urban, well-educated Chinese is emerging, in which young urban entrepreneurs, the many returning foreign-educated students and a new political class are getting the upper hand. This change could become a challenge to the political monopoly of the Communist Party, which tries to maintain its legitimacy by linking economic development with the ideology of nationalism. But nationalism is a double-edged sword. Together with the rise of a middle class it could generate a quest for more democracy and freedom, which in its turn could provoke a more repressive approach by the Party towards society. It also could generate a shift towards a more aggressive attitude vis-à-vis the outside world. Europe, in its relations with China, should take all these challenges into account.

4. The challenges Europe is facing in its relations with China.
Let us now analyze more in detail the impact of China's rise upon the European economy. In theory China's rise should provide significant opportunities for the European Union: In theory China, indeed, offers an important market for exports and low cost imports for consumers and firms alike. But in concreto, things are more complex than what theory pretends.

In 2004 the European Union became China's largest trading partner and China the European Union's second largest trading partner, behind the United States. But European imports from China have grown faster than exports to China. It resulted in a growing deficit, which, to a large extent and quite happily, has been offset by a growing European surplus with the United States, because of the buoyancy of the American market in recent years. The future, however, seems to become much more fragile in this respect, because of the threat of an American economic recession.

The recent growth of Chinese exports to the European Union has been most remarkable in high-technology sectors, thus challenging the traditionally strong position of the European economies in these sectors, but it does not mean that complementarity between Europe and Asia has vanished entirely. The European Union, for example, seems to have strengthened its comparative advantage position in sectors, such as chemicals, rubber, plastics and electrical engineering, the last sector concentrated mainly on capital goods, especially machinery. In mechanical and electronic engineering, on the contrary, the Union's comparative advantage has been declining. The same decline can be expected in the car industry, given the fact that recently the Chinese government has targeted cars as a strategic sector.

Somewhat surprisingly, the European Union, without its ten new Member States, has been gaining competitiveness in food and beverages, in textiles and clothing, but only as far as high-end products and luxury brands are concerned. On the other hand, for the ten new Member States the challenges posed by China are particularly relevant in sectors such as standard textiles, clothing, leather products, food and beverages, branches in which the new Member States had performed strongly in the 1990's. Recent European foreign direct investment towards China has mostly been 'resource seeking' in manufacturing activities, attracted by the low costs of production in China and less by the actual size and potential of the Chinese domestic market. Recently the same pattern of production and exports can also be observed in some high-tech sectors, such as personal computers, peripherals and mobile handsets. Consequently a considerable share of production by foreign enterprises, located in China, has been exported, which means that many European and American firms have relocated their manufacturing plants from a third country (in South-East Asia or in Eastern or South-Eastern Europe) to China.

In the light of this recent developments in the Euro-Sino trade relations, what should the policy strategies be of the European Union towards China? Before going into more detail about this question, one should emphasize the fact that the European Union and China have two different visions about foreign policy. The European Union's commitment to its founding principles of human rights, democracy and the rule of law (instead of the rule of man) and its attachment to promoting good governance and effective multilateralism are the main pillars of its policy vis-à-vis China. On China's side, the Five Principles of Peaceful Coexistence, which include non-interference in other countries' internal affairs, are the basis of its foreign policy vis-à-vis Europe. These two visions may collide, clearly demonstrated by making the lifting of the European arms embargo contingent on human rights reform in China. Another good example is the Chinese principle of non-interference, such as applied in China's relations with Sudan, Zimbabwe, Congo, etc.: it poses the risk of undermining the European Union's capacity to influence some developing countries in the direction of good governance, human rights and political freedom.

An additional problem in this respect is the institutional complexity of the European Union. China's bilateral relationship with the European Member States still serves as the basis of its multilateral relationship with the Union. The challenge of the European Commission in Brussels therefore is to promote democracy, human rights and the rule of law with a degree that does not spoil either the Member States bilateral relations with China, or the Union's trade relations with China. Moreover, if the European Union wants to become a pole in a multipolar world it aims at creating, it needs the emergence of other poles, inter alia China.

The last political problem is the triangular relation between the European Union, the United States and China. The Union, unlike the United States, has no significant security strategic interests in the region. It has the luxury to develop its relationship with China unencumbered by the strategic and security responsibilities that the United States shoulders in Asia. The American concerns are fourfold: Taiwan, the future of the Asia Pacific region, energy and trade. All four have the potential for conflict with China. The asymmetry between the American and European interests in the region is for this very reason a fertile ground for misunderstanding and many observers believe that there are strategic limits that Europe cannot cross. However, the limits to the triangular game can be drawn clearly once it is acknowledged that Europe and the United States have much more in common in terms of common values and global interests than differences in terms of commercial interests.

Given this political environment, one should focus on the important question of what economic policy the European Union should conceive vis-à-vis China? In the first place European economic policymaking should be based on a sound understanding of China. The presence of a delegation of nearly one hundred people, the European Union is maintaining at the moment in Beijging, should be helpful in this respect. Moreover, the effectiveness and coherence of European policy should be improved substantially. Europe should also help China in succeeding its transition and reform process, but at same time it should maximize economic opportunities and minimize risks for European firms by backing the development of information and by coordinating export promotion.

A crucial task has to be to improve the capacity of the European economy to adapt. Here there are reasons for concern. First, the pace of China's transformation and rapid build-up of comparative advantages in a number of areas, including higher technology, is unprecedented. Second, comparative advantages of several Member States are increasingly overlapping with China's. Third, the European economy is inadequately equipped to adapt smoothly and reallocate resources quickly in response to structural shocks. The Union's policy should therefore strive to support an environment conducive to firms moving into high-tech value added production and also conducive to improve the European economy structural ability to adjust. Crucial in this respect are labor market reforms and extra initiatives to improve education.

Finally, the Union should insist that China allows more meaningful and more effective access to its market. Non-tariff barriers, especially in ‘strategic' goods and in the service sectors, and domestic standards should be eliminated. Intellectual property rights should be enforced with more vigor, preferential treatment for domestic companies in some areas should be abolished, etc. The Union thus needs to develop an overall China strategy.

5. Conclusion
From what has been said in this brief overview, it has become clear, I hope, that still much has to be done to make the economic and political strategy vis-à-vis China more adequate and effective. As a matter of fact, similar conclusions can be drawn as far as India is concerned. India's economic growth has been impressive too in recent years, but it should be emphasized at the same time that India's economic achievements are more fragile than they look. Many things restrain India's economy: from a government that depends on communist support to the caste system, to a government that maintains rigid labor laws. Moreover, India's unreformed and corrupt public sector is a great barrier to further economic expansion. The government's debts, resulting in disastrous infrastructural failings, are also setting a lower-than-necessary speed-limit to the economy and the government's budget deficit makes it reluctant to free banks, pension funds and insurers, because it needs them to buy its bonds. Finally, the disastrous public finances of India are setting off an inflationary spiral, which in the end also could hamper economic growth in the longer run. Economic policy of the European Union vis-à-vis India should therefore be still more cautious than its policy vis-à-vis China. To be more precise about this policy, we need a more in depth analysis, which I did not have at hand and which was be beyond the scope of this paper.

Selected bibliography

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European Commission, China, the EU and the World. Growing in Harmony?, Brussels, 2007

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IMF, China's Growth and Integration into the World Economy: Prospects and Challenges (paper n° 232), Washington, D.C., 2004.

Izraelewicz, Quand la Chine change le monde, Paris, 2005.

Lardy (N.), Integrating China into the Global Economy, Washington, D.C. (The Brookings Institution), 2005.

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