Tinsel begins to show on the Chinese dragon
The Asian crisis has enhanced China's reputation, but its ability to
sustain a stabilising role must be questioned, writes MARTIN WOLF
President Bill Clinton's visit is an indicator of US willingness to treat China with respect. This is particularly appropriate against the background of the country's stabilising role in Asia. Yet Chinese willingness to sustain such a role cannot be taken for granted. Remember that its leaders' aim is, above all, to make their country a powerful, prosperous and modern nation. For them, this is an end in itself. It is also a condition for retaining power.
The Chinese empire was humanity's most successful adaptation to the technology of settled agriculture, and the world's most advanced civilisation for 1 000 years before AD1500. Yet the resulting sense of superiority made it hugely difficult for China to adapt to competition from the Western barbarians.
Only under Deng Xiaopeng - after one-and-a-half centuries of collapse, invasion, civil war and Communism - did China make a serious start on the task. Even today, it has only just begun.
At market prices, China's gross national product was $906-billion in 1996. This already put it seventh in the world after the US, Japan, Germany, France, the UK and Italy. It was the world's ninth-largest merchandise exporter in 1997, with $18-billion, and the 11th-largest importer, with $142-billion. China has also become the world's second-largest holder of foreign exchange reserves, after Japan.
Yet this is a country with gigantic economic problems. China has had two good decades. It is an open question whether it will have the two to three more needed to become the superpower it wants to be.
That question is illuminated by a fascinating forthcoming book from Nicholas Lardy, a distinguished analyst of China's reforms. Lardy focuses his attention on the triangle formed by China's inefficient state-owned enterprises, the dire condition of its banks and the weakness of its public finances. His conclusion is that the past pattern of gradual reform has papered over huge problems that must be tackled soon.
The number of people employed in state-owned enterprises actually grew from 72-million in 1977 - 79% of the urban labour force - to 112-million in 1996, still around 65% of the urban labour force.
Even in 1996, the share of investment in fixed assets within state-owned and other collective enterprises was 69%.
Does this matter when the economy has been able to grow at 10% a year for two decades? A partial answer is that past growth has been exaggerated. The performance of state-owned enterprises has deteriorated over the reform period, both economically and financially: the return on investment fell from 15% in 1987 to 5% in 1994.
By allowing state-owned enterprises to retain their profits, the Chinese state lost a huge part of its fiscal revenue. But by also opening the enterprises to competition, it reduced their ability to finance themselves.
The solution was to encourage increased lending by banks. The resultant "quasi-fiscal" deficit was far larger than the published one. Lardy estimates the public sector borrowing requirement at more than 10% of gross domestic product for almost a decade.
Fortunately, the savings of the Chinese people soared as prosperity increased. Household assets rose from 42-billion Renmimbi (Rmb) in 1978 to Rmb5 032-billion in 1996, 77% of which was put in banks and another 12% in cash. The banks then lent the money to the state-owned enterprises.
Much of the investment financed by the banks has turned out to be bad. Already in 1995, 22% of bank loans were counted as non-performing. The likelihood is that this will turn out to be a very serious underestimate. The state-owned sector as a whole was in the red in the first quarter of 1996.
The implication is that liberalisation of the financial system is impossible. It would lead to a financial collapse as people pull their money out of the evidently bankrupt banks and shift to more remunerative alternatives. The government has to recapitalise the banks. An estimate is that state-owned enterprises need a debt write-off equal to 25% of GDP.
Fortunately, the government's internal debt is less than 10% of GDP. Unfortunately, floating the extra public debt to finance recapitalisation of the banks would be pointless without fundamental changes to the operation of both state-owned enterprises and banks.
But these reforms must also mean a big rise in urban unemployment, which is already high by Chinese standards.
China's financial crisis is just as bad as that of any other Asian country, except for the fact that foreigners are not involved. While that gives the country breathing space, it is still threatened by a slowdown in economic growth, as low returns on past investments become evident and, at worst, by outright pressure to monetise the overhang of internal bad debt.
Yet an unelected Communist government whose raison d'Ítre is widening prosperity can hope to deliver reform only if economic growth continues. So, if China is to avoid a disruptive devaluation, it needs to be able to sustain rapid growth, while undertaking reform. Can it do so? The answer has to be: with considerable difficulty.
True, devaluation by a country with huge foreign exchange reserves and a strong balance of payments will be seen as highly predatory, particularly in the context of a regional financial crisis. But since Japan has busily done exactly that, this is not going to seem an overwhelming objection by the Chinese leadership, if pressed hard enough.
An effort is being made to sustain domestic demand by promoting investment in infrastructure and housing. But any serious attempt at enterprise and banking reform will reduce China's wastefully high investment, which was an astonishing 42% of GDP in 1996.
This will lower growth quite sharply. And that will make the leadership look with renewed attention at the need to sustain dynamism in exports.
China has been able to play a stabilising role in the regional crisis not because it is healthy but because of a combination of exchange controls with huge foreign exchange reserves. Yet if it proceeds with the planned reforms now, growth will probably slow, as wasteful investment is cut. If it does not reform, growth will still slow, probably more slowly and durably, as resources continue to be wasted.
Either way, devaluation will prove tempting. The question is more when it will happen than whether it will do so.