china's worries

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China’s Policy dilemmas (appeared in Mumbai Business Standard on January 2,2003)

Basic structural changes are the only way out, writes Christopher Lingle

With each passing day, there are more reasons to worry about China’s future. It

would be unsetting enough if the problems were merely Beijing’s bellicose

rumblings across the Taiwan Strait. At least there is hope that disputes with

Taipei can eventually be resolved peacefully.

Not so with the mainland’s economy that is suffering from deeply imbedded

problems. At the top of the long list of economic difficulties are entrenched

corruption, high and rising unemployment and a looming banking crisis.

In assessing these disorders, two pitfalls must be avoided. First, it is

pointless to try to identify any one of these as the cause or effect to the

others. While it is true that each aggravates the other, they all arise from

the adjustment costs of eliminating the distortions created by decades of

irrational economic policies and distorted incentives.

It is crucial not to think that the problems can be resolved by tinkering around

the edges of its economic system. Fixing China’s economy requires fundamental

and structural changes in the role of the state and the nature of commercial

activities. Unfortunately, Beijing is employing macro policy to tools designed

to address cyclical problems.

A variety of policy tools have been applied to try to keep economic growth rates

high. These include a variety of measures to boost overall domestic demand.

Government expenditures have been increased through deficit financing funded by

the sale of government bonds. Authorities have also tried to encourage consumer

spending by triggering a wealth effect by attempting to "talk up" values on the

stock exchanges.

The proportion and volume of non-performing loans within China’s banking system

is probably greater that in Indonesia or Thailand. Official estimates suggest

that one-quarter of total savings of the Chines people in state banks have

disappeared due to bad debt and mismanagement.

Moody’s investors services has estimated that Beijing must spend Rmb 1 trillion

( $ 120 billion ) to clean up the bad debts held by China’s top four banks.

Behind China’s financial problems are structural impediments, including "policy

lending" whereby state-owned banks lend to struggling state-owned enterprises, (

SOEs ) regardless of their poor performance.

Manufacturing over capacity has driven down average return on investments by

SOEs to less than 5 percent while many SOEs are effectively bankrupt. The

average asset-liability ratio is 80 percent, well above the international norm

of below 50 percent. Deepening losses for SOEs lead to distortions that affect

many other sectors of the economy.

And there is the economic effect of corruption and graft. National auditors

uncovered cases of graft that included about 20 percent of annual national tax

revenues. China’s auditor-general announced that in the first six months of

1999, party cadres and government bureaucrats pilfered about Rmb 117 billion (

$ 14 billion ) in state funds.

Most of the stolen funds were intended for special projects including

improvements in infrastructure to bolster the weakened economy. A particularly

cynical twist is seen that some of the diverted money was to be used to combat

devastating floods that have affected China over the past few years.

In response to the impending banking crisis, asset management companies ( AMCs )

have been debts of the major banks. The worst of these debts will eventually be

written off while those under-performing loans that are recoverable will be

sold at discounts from their original value.

But now the government is on the multiple horns of a complex dilemma. If

state-run banks continue making "policy loans" to failing SOEs, they risk

collapse. However, closing inefficient SOEs would make tens of millions of

workers unemployed.

In order to halt the deflationary cycle, the authorities are trying to encourage

higher levels of consumption and investment. Yet rising consumption would mean

that funds will be withdrawn from the banking system or less would be going in.

this might accelerate the banking crisis.

One method for encouraging spending for the central government to run a budget

deficit funded through bond sales. These bonds as well as those offered by the

AMCs will offer interest rates higher than those paid by banks, draining off

funds that might have kept the banks afloat.

The authorities are damned if they do; damned if they don’t Whichever path they

take may lead to social unrest and economic instability.

Is there a way out ? Yes dramatic increases in foreign investment or

double-digit growth exports or a boom in domestic spending would boost economic

growth. But domestic consumption and investment remain stagnant due to a

deflationary cycle.

Furthermore, the contribution of net exports to growth is declining due to

rising imports and declining exports. To make matters worse, actual foreign

investment in China fell by over 11 percent year-on-year and contracted foreign

investment fell by more than 12 percent on-year. Furthermore, the number of

foreign-in-vested enterprises approved by Beijing in 1999 fell by nearly 14

percent year-on-year.

New foreign investments seem less likely as long as there are tensions over

Taiwan. At the same time, the average rate of return on investment by

foreigners in China is less than 2 percent over the past 20 years.

Beijing should rely more on private initiatives to restart economic growth by

allowing private companies by allowing them the same access to stock markets as

state-run enterprises. It could start by removing tax and land-use policies that

discriminate against private companies

This would mean privatising SOEs while allowing private entrepreneurs to create

more new businesses as well as letting foreigners hold majority or full

ownership. Yet such steps would undermine the survival of the Communist Party.

One can only despair knowing that preservation of the political status quo will

overwhelm good economic sense.

( Christopher Lingle is professor of economics at Universidad Francisco

Marroquin in Guatemala and global strategist for eConoLytics. You could mail

him feedback at - Clingle (AT) ufm (DOT) edu.gt

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