It appeared that Beijing was able to escape relatively unscathed during the worst of the financial crisis that swept East Asia. Unfortunately, whatever benefits Beijing might have enjoyed while hiding behind capital controls have been squandered. While there has been some rebound from a decline in GDP growth, unemployment is rising while a deflationary cycle is in full bloom. Whatever the expectations or intent, China's eventual admission to the WTO will do nothing to reverse the problems that Beijing faces with the economy.
In particular, the Marxist fixation with expansions in industrial capacity left China with a large number of state-owned enterprises that were driven by political rather than economic incentives. Most were kept open with subsidies to avoid massive increases in unemployment, leading to considerable overcapacity in manufacturing and mountains of unsold or unsellable output.
These rising inventories are both a cause and an effect of the deflationary cycle. With consumers buying less and with declining export growth, there is little incentive to maintain workers or hire new ones.
China faces a formidable challenge. An additional 10 million new jobs must be created each year in order to hold the line against rising unemployment. That means that China's economy must grow at about 8 percent annually to absorb new entrants as well as those who lose their jobs due to industrial restructuring.
Several of China's largest state-owned commercial banks are technically insolvent with their ratio of non-performing loans as high as 40 percent of their total lending. According to Moody's Investors Services, state banks currently hold more than a trillion renminbi (US$120 billion) in non-performing loans that could result in a mass default. To avert insolvency, State banks must attract more savings, but the government is trying to induce households to spend more to stimulate flagging GDP growth.
Bad debt
Now resolute steps must be taken to establish a modern financial architecture. Until China moves to a proper capital market guided by profits instead of party politics, it cannot pretend to have a world-class financial center. In response to its various problems, China has chosen to re-capitalize its state banks and financial firms rather than to privatize them or to allow in foreign owners. Asset management companies (AMCs) have been set and debt-for-equity swaps have been encouraged. Bad debts to be taken over by AMCs will require issuing bonds worth almost US$50 billion to compensate for unrecoverable loans. However, the amount is seriously understated since bad loans amount to around 25 percent of GDP. There are so many sick assets that it may be almost impossible to generate sufficient cash flow to redeem the bonds.
China's financial system is plagued by entrenched structural impediments. Most problematic is the policy lending whereby state-owned banks lend to struggling SOEs regardless of their performance. China's four biggest state-owned banks control 60 percent of overall lending. They allocate most of the investment funds to state-owned enterprises. Despite the fact that the non-state sector now accounts for over 70 percent of the value of industrial output, little funding is made available to new startups.
As the Chinese people save nearly 40 percent of their incomes, there should be adequate capital for private development. However, state-owned banks face no competitors. The truth is that a staggering amount of funds are simply being wasted on spending that destroys wealth rather than creating it. If individual savers were given private investment alternatives offering market rates of interest, the non-state sector would put funds to higher-valued uses than under the existing state-run financial system.
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