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.
ILLUSTRATION: YU SHA
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.
While there are some other encouraging signs, there is likely to be a considerable lag before the positive impacts are seen. Of particular note is that China's parliament, the National People's Congress, passed comprehensive legislation protecting the rights and interests of the Mainland's entrepreneurs. This formally ratifies a constitutional amendment proposed last March that gave official status to the private sector by identifying it as an important part of the national economy.
Referred to as The Law on Solely Funded Enterprises, the legislation lays out qualifications as well as the procedures for establishment, management and dissolution of a private business. The aim is to offer support and impose some regulations upon the country's 1.26 million private businesses. The government undertakes to the protection of property and other legal rights and interests of the solely funded enterprises.
This law is to come into effect on the first day of the new millennium. Despite the auspicious timing of the validity of the law, traditional attitudes are unlikely to change rapidly, especially among state bankers and other elements of the governmental bureaucracy.
Another important action was taken this past June when the State Economic and Trade Commission completed guidelines for the establishment of loan guarantees private firms in order to facilitate bank borrowing. Central bank policy has also tried to direct more lending to smaller and medium sized firms. An earlier announcement accorded the private sector with the same rights as state-owned enterprises (SOEs) to raise funds through share listings on domestic and international exchanges.
Going private
Most private firms are unlikely to acquire bank loans since they will lack collateral to meet lending requirements that are often ignored when it comes to borrowing by state enterprises. When granted, many of the debts for most SOEs are routinely written off. Most troubled among the SOEs due to overstaffing and excess capacity are armaments, non-ferrous metals, machinery, metallurgy, coal and textiles. China faces a tough choice when it comes to the restructuring of its SOEs. Eliminating unnecessary production and spending would require massive layoffs at the risk of large-scale social and political upheaval. This is evident by the fact that it required subsidies of 150 billion yuan to generate earnings of 49 billion yuan profit in 1998. This is a poor return on investment by most standards. The need for restructuring the SOEs is clear, however the social and political costs are imponderable. Unemployment has reached a record level for the communist era with at least 10 percent of the 200 million urban workers. It is certain that rural areas face much higher rates.
If China is to escape from its many stubborn problems, it must move toward developing a world-class financial sector that rationally allocates capital. The most important first steps are to privatize banks, non-bank financial firms, and state-owned enterprises (SOEs) while removing barriers that inhibit foreign ownership and restrain competition.
China also needs to create an institutional infrastructure that moves it towards a market economy with private property rights. Only then can a rule of law be implemented whereby a competent, independent judiciary can protect contracts and private property rights. Regardless of a recent rebound in export growth, declining inbound foreign investment and its deflationary cycle has pushed China's economy into a corner. Promoting an explosion in the growth of its private sector may be the only way to preserve cohesion of the economy and, by implication, the country.
These structural changes are a long-term project that will tax the formidable talents of Prime Minister Zhu Rongji(
Christopher Lingle is Global Strategist for eConoLytics.com.
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