Wed, Aug 18, 2004 page8

• China cools, but reform must go on

  • By Tung Chen-yuan童振源
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  China's overheating economy is due to excess investment expansion over the past year. During the first quarter of the year, fixed asset investment in China increased by 43 percent. Since March, the Chinese government has adopted decisive economic cool-down measures, including suppressing rapid monetary and credit growth, restricting the use of agricultural land for non-agricultural purposes, reclaiming the authority for approving investment projects, etc. As far as we are concerned, these measures seem to be effective.

  At the end of June, the M2 balance had increased by 16.2 percent year-on-year, marking a 2.9 percent slowdown in growth compared with the end of the first quarter of this year. Loans from financial institutions, including domestic and foreign currencies, increased by 16.7 percent year-on-year, or 3.8 percent slower than the end of the first quarter of this year.

  In addition, during the first half of this year, fixed-asset investment in China only increased by 28.6 percent, a 14.4 percent decrease in growth, compared with the first quarter. In particular, the number of new projects increased by only 5.9 percent year-on-year in April and fell by 15.7 percent year-on-year in May. These numbers represent a significant drop from the 31 percent year-on-year growth of new projects during the first quarter of this year. All the data listed above suggest that the Chinese government's economic cool-down policy is effective.

  The cool-down policy focuses heavily on industries that are overheated, such as iron and steel, electrolytic aluminum, cement and real estate, among others. In fact, the rapid growth of real estate investment led to the expansion of investment in other industries. At the beginning of the year, real estate investment accounted for 30 percent of fixed asset investment in China.

  Because of the cool-down measures, such as credit and land use restrictions and more stringent procedures for the approval of new projects, the growth of real estate investment dropped from 43.6 percent in the first two months to 30.2 percent in the first five months of this year. Following this dramatic decrease, the expansion of fixed-asset investment in general fell from 53.0 percent to 34.8 percent.

  Although the administrative measures to control and suppress the expansion of certain industries seem to be working well, China's government must undertake long-term fundamental reforms in its investment and finance system to avoid a re-emergence of economic overheating once the measures are removed. While local governments have the ability to interfere in investment activities in the short term, China's real estate market remains a monopolized market, producing very high rates of profit.

  Local governments enjoy economic growth driven by real estate development. Real estate offers low-risk, high-return business opportunities for financial institutions and government agencies alike. In this respect, China's rapid economic expansion of this year and last looks very similar to the overheating that occurred a decade earlier. A mutually beneficial relationship has developed between local governments, developers and banks in China. Thus, local governments are generally hesitant to support the current economic cool-down policy. Some local governments went so far as to strongly request the central government adjust the policy.

  Although the total volume of loans from commercial banks in China decreased significantly, the objective of the macroeconomic adjustment and control measures conflicts with commercial banks' loan policies. The urgent task of China's economic cool-down policy is to suppress the expansion of mid to long-term fixed-asset investment, but the policy seems to work much more effectively in regards to working capital than fixed-asset investment.

  Mid and long-term loans have continued to expand rapidly. During the first five months of this year, they increased 32.7 percent, accounting for 75 percent of the new loans in China, up 31 percent compared with March. On the other hand, commercial banks in China have generally reduced loans to small and medium enterprises, regardless of the fact that they are primary channels of employment. In the long term, China's unemployment is likely to increase gradually.

  Finally, China's incremental capital-output ratio (ICOR) indicates an extremely low return on investment, which would jeopardize the sustainability of rapid economic growth in China. During their rapid development periods, the ICORs of Japan (1961 to 1970), South Korea (1981 to 1990) and Taiwan (1981 to 1990) stood between 2.7 and 3.2. In comparison, China's ICOR increased from 3.4 during 1991 to 1995, to 4.5 during 1996 to 2000, and 5.1 during 2001 to last year. On average, China's ICOR stood at 4.1 during 1991 to last year. In comparison with Japan, South Korea and Taiwan, China's investment efficiency is very low. Furthermore, it is deteriorating, not improving.

  Overall, although the Chinese government's decisive administrative measures have been effective in cooling down the economy, fundamental reforms in the investment and financing system are needed. Otherwise, in the short term, rapid economic expansion may re-emerge once the cool-down measures are removed. In the mid-to-long term, inefficient resource allocation will make it increasingly difficult to maintain high growth and avoid a serious financial crisis.

  Tung Chen-yuan is an assistant research fellow at the Institute of International Relations of National Chengchi University and director of the China Economic Analysis project of the Prospect Foundation.
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