Mon, 14 Feb 2000

Politics meddle in China's economic dilemma

By Christopher Lingle

SYDNEY (JP): With each passing day, there are more reasons to despair over China's future. It would be unsettling enough if the problems were merely the bellicose rumblings across the Taiwan Strait. At least, there is hope that Beijing's current dispute with Taipei will eventually be resolved.

Unfortunately, there can only be despondency when considering the many problems of the Mainland's economy that are so deeply imbedded. At the top of the long list of economic distress are a pernicious deflationary spiral, entrenched corruption, and the slowdown in economic growth accompanied by 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 of 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.

Similarly, 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.

China's bout with deflation, now well into its second year, shows little sign of relenting. Data from the State Statistical Bureau indicate the retail price index fell by more than 3 percent and consumer price index fell by about 2 percent during 1999.

A variety of policy tools have been applied to offset flagging economic growth. 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, Japan or Thailand. Estimates suggest that nearly one-quarter of total earned savings that the Chinese people have entrusted to state banks have been disappeared in an ocean of bad debt and mismanagement.

Moody's Investors Services estimates that Beijing must spend RMB 1 trillion (US$120 billion) to clean up bad debts held by China's top four banks. Behind China's financial problems are entrenched structural impediments, including "policy lending" whereby state-owned banks lend to struggling state-owned enterprises (SOEs) regardless of their poor performance.

Manufacturing overcapacity has driven down average return on investments by SOEs to less than 5 percent while many are effectively bankrupt. The average asset-liability ration is 80 percent, well above the international norm of below 50 percent.

As losses for SOEs continue to deepen, it sets into motion distortions affecting other sectors of the economy.

And there is the economic effect of corruption and graft. National auditors have uncovered corruption that included about 20 percent of the annual national tax take. China's Auditor- General announced that in the first six months of 1999 party cadres and government bureaucrats pilfered about RMB 117.4 billion ($14.20 billion) in state funds.

Most of the stolen funds were earmarked for special projects including improvements in infrastructure intended to bolster the flagging economy. A particularly cynical twist is seen that some of the diverted money was supposed to be used to combat floods that hit China with such devastating effect over the past few years.

Needless to say, the authorities in Beijing are trying to implement policies to correct these problems. Charges have been brought against 280,000 individuals for bribery in the first half of this year. In response to the impending banking crisis, asset management companies have been established to take over the bad debts of the major banks. The worst of these debts will eventually be written-off while under-performing loans that are recoverable will be sold at a discount of their face 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 nearly 50 million 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 is 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.

In sum, 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 in exports or a boom in domestic spending would boost economic growth. But new foreign investments are unlikely to be forthcoming due to tensions over Taiwan and disappointing returns for most foreign ventures.

Over the past 20 years, the average rate of return on investment by foreigners in China is less than 2 percent. Increasing global competition will make it hard to rely upon export growth. And domestic consumption and investment remain stagnant due to a deflationary cycle.

Perhaps the best approach would be to privatize SOEs while allowing private entrepreneurs to create more new businesses while allowing foreigners to exercise majority or full ownership. Of course 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.

The writer is an independent corporate consultant and adjunct scholar of the Centre for Independent Studies in Sydney.