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Daunting Challenges Ahead for China's  Economy

Since China is the low cost producer in many areas, it can often continue to grow even when others get squeezed. More importantly, the process of institutional globalisation makes it resilient, writes WILLIAM OVERHOLT

China's economy has demonstrated extraordinary resilience in the face of a global economic slowdown combined with the SARS tragedy and the stresses of WTO entry. This resilience results from the successful shift to domestic-led growth prior to the global slowdown and from rising productivity caused by economic reform, rising competition, a highly entrepreneurial economic structure, and high levels of foreign direct investment. Overall, the success results from a disciplined and politically courageous process of reform and opening.

Each phase of Chinese growth and reform presents new challenges. The challenge of the initial phase was to open the economy to trade, to revive farm productivity through an orderly transition to family farms, and to move toward market prices. In the early 1990s the principal challenge was to overcome inflation. In the later 1990s the principal challenge was to get state-owned enterprise (SOE) inefficiency and losses under control. Failure to cope with any of these challenges would have been fatal to China's economic miracle. So far, each challenge has been successfully surmounted. Along the way, major successes have been registered. Growth has been high. Poverty has fallen sharply. Trade has grown rapidly. Foreign direct investment has exceeded all expectations. A dynamic private sector has emerged as a major contributor to growth.

Daunting Challenges Ahead

As in the past, China's successes are being achieved by reforms that overcome severe challenges. The challenges for China's new leaders are as daunting as those faced by their predecessors.

One immediate challenge is a combination of foreign pressures and domestic problems created by the currency. The G-7 is bringing pressure on China to revalue its currency. In America's Mid-West and South, Japan's Kansai, and Europe's Po Valley, the politics of this issue has become feverish. These foreign pressures are largely based on bad economics. While Japan's deflation is caused overwhelmingly by domestic banking problems and industrial over-capacity, it is more convenient for Japanese political leaders to blame China for their deflation than to undertake the politically painful banking reforms and corporate closures that would allow banks to lend freely and companies to price their goods profitably. At most 0.1 to 0.2 percentage points out of Japan's estimated 3.5% deflation could conceivably be caused by China. While an RMB revaluation would do little to increase U.S. jobs, it is easier with an election looming in 2004 to blame China than to request union and corporate patience in the face of the inevitably slow recovery from bubble over-capacity and from the inexorable consequences of productivity that grows much faster than GDP. While the Euro has not yet rebounded to the level that European leaders declared desirable several years ago ($1.17), it is much easier to blame China than to increase resource mobility and to admit errors in the charter of a central bank that, through excessively high interest rates, is depressing growth and creating inappropriately strong incentives for investment in euros.

Having said that, China has a problem. As a result of massive purchases of dollars to stabilise the currency, the money supply is expanding excessively and the economy is blinking warning lights. First quarter 2003 GDP growth of 9.9% constituted overheating, and that overheating would have become serious had not SARS intervened. By June, foreign exchange reserves had reached $346.5 billion dollars and M2 money supply was growing at a 20.8% annual rate (monthly figure, year on year), which is only consistent with economic stability if the real economy is growing around 15%. New loans in the first half of 2003  (1.78 trillion RMB) were nearly as large as new loans for all of 2002 (1.85 trillion RMB). Normally, such growth of money supply would create a threat of inflation, but in an economy where over-capacity is prevalent, the prices of goods are unlikely to inflate.

Instead the surplus money is feeding into such things as bank loans for fixed asset investment, which could lead to an explosion of non-performing loans, and into property, which could lead to a classic Asian property bubble. In fact, signs of such a bubble are already apparent in Shanghai, where property prices rose 15% in 2002 and 18% in the first seven months of 2003. Such bubbles eventually pop, and when they do economic miracles can suddenly end; that is what happened in Bangkok, Tokyo, Taipei, and Hong Kong. It would be catastrophic if China followed a similar path. In the past, Beijing has suffered sale price declines of 75% and Shanghai has suffered rental price declines of 84%, but as the percentage of the population who own houses becomes high the social and economic costs of such busts become severe.

To avoid such bubbles, China must either revalue its currency, allow large capital outflows, encourage a large flow of imports in order to run a large current account deficit, or use some combination of reserve requirements and higher interest rates to tighten monetary policy. China must choose some combination of these that fits its own national interests, but it must choose. Otherwise the Tokyo-Taipei crisis of 1990 and the Bangkok-Seoul-Jakarta crisis of 1997 -- 1998 will be followed several years from now by the Beijing-Shanghai crisis of 2005, 2006 or 2007. For the other Asian miracle economies, such a bust has caused the end of the miracle and engendered a period of political weakness.

The bubble risk is tightly connected to another of China's increasingly urgent challenges, namely the banking system. While official statistics calculate non-performing loans (excluding those transferred to asset management companies or AMCs) at about one-quarter of GDP, the IMF estimates them (including those transferred to AMCs but not yet resolved) at between one quarter and three quarters of GDP; the lower end of the IMF estimate is included only to be diplomatic. If bubbles are forming, and if a whole range of new steel mills, car factories, and property developments go sour several years. Hence, the banking squeeze could become unmanageable.

Just as serious, China's economic growth now depends on successful financing of small, medium and private enterprises that the big state banks don't know how to fund. Moreover, banks' inability to enforce legal judgements on debtors who do not pay means that even highly skilled new banks cannot prudently lend to companies that do not have government backing. So the system is unable to perform the basic function of any market-oriented financial system, namely to allocate resources to their most productive uses. In this respect it is discouraging that the corporate bond market is shrinking; it cannot compete with banks that have vast resources to lend despite their problems.

State enterprise reform has hitherto taken priority over financial reform, on the reasonable argument that the banks cannot be fully reformed until their principal customers, the state enterprises (SOEs), have been reformed. While that decision on priorities has been defensible, a great deal of progress has now been made on SOE reform and the banking problem is becoming both a formidable threat to government finances and a formidable barrier to the financing of the companies that provide China's growth. Future historians writing about the accomplishments of China's new leaders are likely to focus heavily one of two stories. (A) The new leaders of 2003 implemented revolutionary reforms of the banking system and far-reaching supportive improvements of the legal process, while taking decisive measures to avoid the emergence of financial bubbles. Their decisiveness avoided a banking meltdown and enabled the nation's resources to be allocated much more efficiently. That carried the Chinese economy to a whole new level of growth and development, and it created the vast number of jobs needed for social stability. Or (B) The new leaders of 2003 continued very gradual banking reforms and mistook the emergence of bubbles as evidence of rapid economic progress; in this way they followed the errors of Japanese, Thai and Korean leaders and endangered China's future economic progress and political stability.

The South Korean banking transformation since 1998 may be a useful model for China. The South Korean and Chinese banking and corporate systems shared many characteristics. China chose to give priority to enterprise reform over banking reform, South Korea to banking reform over enterprise reform. The two countries have many lessons to share.

China: a Man Chased by a Tiger

China is like a man being chased by a tiger. It is very impressive that he runs faster than virtually anyone else in world history; it is also impressive how big the tiger is. The West's literature on China is divided into two parts: one about how fast the man runs, emphasising all the growth rates, the other about the tiger, emphasising the banking, unemployment, inequality, and political problems. Any real understanding, however, must include both the man and the tiger.

Most other countries facing such a big tiger would get eaten. Indonesia, the Philippines, Argentina, and many others have been eaten by far smaller tigers. What distinguishes China is both economic and political. It has chosen a process of gradual reform and opening that has proved economically successful in several Asian countries. And for 24 years it has demonstrated an ability to form a workable leadership consensus regarding the most important problems, to implement solutions in the face of enormous political and social stress, and to overcome the stress by delivering large benefits to most of the Chinese people. Effective politics has been the key to good economics. This year China has new leaders. How fast they can pull China ahead is about to be tested by new bubble, banking, and budget tigers.

Dr Overholt is the Asia Policy Chair, Center for Asia Pacific Policy, RAND Corp. The opinions expressed are those of the author and should not be interpreted as representing those of RAND. Abridged from Harvard China Review.