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China's prospects not so rosy

By Christopher Lingle

Sunday, Oct 21, 2001, Page 9

ILLUSTRATION: YU SHA

conomic conditions are looking bad in much of Asia. Singapore and Taiwan are staring recession in the face after double-digit declines in electronics exports during the first half of the year. Malaysia and Hong Kong seem poised to follow them into recession as demand for exports spreads into other sectors.

With all this turmoil sweeping through East Asia and much of the rest of the world, some observers regard China as a calm port in a brewing storm. With growth rates slumping and recession looming for many of neighboring countries, Beijing continues to rule out devaluation of the yuan and unswervingly maintains a target rate of economic growth of 7.2 percent.

As in human illnesses, even severe economic symptoms may go unnoticed. Diagnosticians may get a clearer understanding of conditions by ignoring the protestations of the patient. Therefore, China's true condition might be better understood by ignoring utterances from Beijing. In due course, it is likely that many will be scrambling to explain why their optimism about China was so wrong.

`Instead of considering China a safe haven in a brewing Asian storm, it is more accurate to depict it as a titanic economy awaiting its inevitable iceberg.'

Perhaps they can be forgiven for focusing upon what are promising signs. State-owned enterprises that once accounted for over 80 percent of industrial output in the early 1980s now produce less than 25 percent.

And it is also argued that China is less dependent upon high-technology industries than many of its neighbors like Singapore, Taiwan and Malaysia. Further, China's exporters have extensive advantages in low costs. However, the impact of the expected slowdown of consumption demand in the US will be significant.

This has led to recalculated forecasts by investment banks that suggest sharp declines in China's exports. For example, Salomon Smith Barney expects export growth to fall to 5.5 percent this year, down from 28 percent last year. Along with the decline in export demand, investment demand is also likely to decline. Beijing has relied upon high levels of public spending to boost investments in fixed capital. However, further attempts to offset the slide in export growth with more public funds are likely to be wasted on unproductive projects and low-quality economic growth.

In all events, the logic of China's domestic economy will present a mounting raft of problems. The real problems are deeply-rooted in the contradictions associated with the ersatz capitalism of its so-called "socialist market economy."

As with other communist economies attempting transition, the bills for decades of irrational policy must eventually be paid. Those bills will include rising unemployment and falling production. Delays in these unavoidable adjustments have been bought through diverting scarce capital resources toward bankrupt state-owned enterprises (SOEs). Despite moving many of nonperforming loans off their books, China's banks are in a state of arrested collapse as funding continues to be provided to essentially bankrupt ventures.

This brings up concern over whether China's fixed exchange rate system and large foreign reserve balances can protect the yuan from external pressures to devalue. Anyone who understands how markets operate would realize that neither of these conditions can stave off changes dictated by economic realities. Values of foreign exchange have as much to do with internal conditions, such as inflation or productivity measures, as they do with external pressures. Although speculative attacks cannot be mounted in the conventional manner, the value of China's currency must eventually become more realistic relative to its trading partners and competitors.

China needs high economic growth to satisfy rising expectations of a growing population and to absorb workers who will ultimately lose their jobs with failing SOEs. But high growth cannot continue indefinitely. And it almost unquestionable that official figures on growth issued by Beijing are exaggerated. For one thing, financial capital continues to be squandered on some loss-making SOEs. This means it is diverted from being used for more productive activities that might create new jobs. In particular, there are still severe restraints on access to capital for truly private-sector enterprises that could offer a lifeline of extended growth.

Among the international credit agencies, only S&P seems to be willing to make an honest assessment. It kept its ratings of BBB and A3 respectively on Beijing's sovereign long-term and short-term foreign currency issues. These ratings were the result of a single notch downgrade in July 1999 and indicate that S&P takes a more negative view of China than its rivals, Moody's and Fitch. S&P points to low valuation of assets and a high rate of growth in public debt caused by direct and from implied costs required to prop up the banking system.

Resolving the weakness of the banks is critical since they hold savings that are worth nearly 40 percent of China's GDP. While officials at the Bank of China insist that 29 percent of its loans are nonperforming, up to half of the 11.3 trillion yuan of loans in the banking system would be considered nonperforming according to international standards.

Under normal conditions only 20 percent of nonperforming loans are recoverable. This best-case scenario suggests that recapitalization will cost at least 50 percent of GDP, nearly 4.5 trillion yuan. Clearly, the recovery ratio could be much lower due to the poor performance of the SOEs and the fact that most loans are unsecured.

And Beijing's expansionary fiscal policy has put additional stress on its banking system by causing credit growth to exceed economic growth. This is an indication that financial resources are being diverted towards non-economic projects and that banks will be facing larger loan losses.

There have been some reforms and the Ministry of Finance has overseen partial capitalization by transferring 1.4 trillion yuan of NPLs into its own asset management companies. However, there are many unresolved weaknesses in the banking system that will involve substantial contingent liabilities. These obligations combined with funding of the pension system will put considerable strain on Beijing's finances in years to come.

In all events, political considerations that promote the preservation of the power of the Communist Party are the determining factor for all decisions made in Beijing. Consequently, economic rationality will be shoved aside. Like other authoritarian regimes, Beijing is likely to react to economic crises by forcing down living standards rather than doing the right thing.

History has shown that communist economies cannot be reformed. Eventually, they simply collapse. The weight of over 50 years of irrational policies makes it inevitable that China's turn is coming. Instead of considering China a safe haven in a brewing Asian storm, it is more accurate to depict it as a titanic economy awaiting its inevitable iceberg.

Christopher Lingle is global strategist for eConoLytics.com
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