THE GASPING DRAGON:

CHINA LOCOMOTIVE RUNNING OUT OF STEAM (Gordon G. Chang, 7/08/04, NPQ)

Even official statistics show the extent of government spending; fixed asset investment was up 43 percent for the first quarter of this year. Some say that the numbers released to the public have been lowered to hide the extent of Beijing's pump priming, but in any event it is clear that the central government is essentially destroying money, with fiscal stimulus increasing four times faster than GDP.

As a result of all this spending, the central government accounts for about two-thirds of investment in the country, and this is alarming by any standard. China started its "proactive" fiscal program in 1998 and has promised to end it many times. But China has become addicted to that stimulus, even as it is losing its steam.

As the traditional spending program loses effectiveness, Beijing tries to create positive, as opposed to negative, multipliers. The latest tactic is to stimulate housing, which is thought to have a favorable ratio of growth to expenditure of 16 to 1. Unfortunately, central planners are just creating an asset bubble along the coast and burdening China's insolvent banks with even more loans that will turn bad. If anything can halt the Chinese economy dead in its tracks, it's a complete breakdown of the banking system caused by some $720 billion U.S. dollars in non-performing obligations. The last thing Beijing should be doing is making its banks even sicker, but that is precisely what is happening.

Many people think that the non-performing loan problem is a residue of the Maoist years, but that is not correct. Mao Zedong, for all his faults, did leave China with solvent banks and no non-performing loans. During the reform era -- and especially in the last decade -- the banks have become the weakest anywhere, or at least the weakest in a major economy. How in the world did this happen?

The state's first priority was to modernize state-owned enterprises. So grants from the central treasury were replaced with loans from the state banks. The theory was sound economics: force sick enterprises to become self-sufficient.

In practice, however, the plan was a disaster: State enterprises knew they did not have to pay back the banks. So they didn't. In an economic system divorced from economic reality, banks effectively became gift-givers. They vacuumed cash from hundreds of millions of small savers and disgorged it onto hundreds of thousands of state enterprises.

Because this appalling state of affairs could not continue forever, Beijing has tried to fix the banks. Four newly formed asset management companies, or AMCs, have assumed some of the non-performing loans. There have been two partial recapitalizations in the past four years, but even after spending about $250 billion, the banks are still insolvent and the AMC plan is faltering. Now, even the AMCs look like they need bailouts because they cannot pay interest on their bonds. Beijing is merely passing the problem from one group of state entities to another: from the state-owned enterprises to the state-owned banks and from the state-owned banks to the state-owned AMCs.

In other words, China's leaders had better create a self-sufficient economy because Beijing will have to find about a half trillion dollars to fix the banks. And he will have to do that while repairing the financial condition of the central government. Official figures say that the annual deficit to GDP ratio is now 2.7 percent, just below the 3.0 percent international alarm level. Others put the number at 3.5 percent, and it is probably higher than that, perhaps 10 percent or more. According to official numbers, the ratio was just 0.75 percent in 1997. China has been running large budget deficits even though the economy is growing at a fast pace according to official statistics. That's unusual, to say the least. And disturbing.

What's more disturbing is that deficits eventually turn into debt. Beijing claims that its debt-to-GDP ratio is in the teens, well below the 60 percent alarm level. Yet once you add debt that is not officially counted and the "hidden obligations" like bad bank debt and unfunded social welfare liabilities, the ratio goes up to perhaps 170 percent.

Experts, ignoring China's debt problems, keep on saying that the country will have another banner year for gross domestic product. True, the People's Republic can continue to create growth for a few more years, but increasing levels of deficits, debt and non-performing loans indicate that the productive capacity of the economy is, in reality, weak. On its own, the Chinese economy is running out of gas.

Central government leaders are now in the sixth year of what has been called the "growth-at-all-costs strategy" because they have run out of ideas as to what else to do. But they had better come up with some ideas fast. In order to continually increase GDP, Beijing has permitted the destruction of China's environment, abandoned education and health care as well as other essential social services, permitted provinces and localities to go into debt, failed to provide much in the way of pensions and severance benefits for the unemployed and ignored intractable problems in the countryside. Technocrats must solve these problems because they will ultimately make it impossible for them to maintain growth.

Yet leaders in the Chinese capital cannot bring themselves to undertake the remaining structural reforms that are needed for long-term success. The system in which they operate is losing the capacity to change itself from within. The change that we now see is more the product of creative destruction than conscious reform.

Backsliding is not an option. China's problem is that it has become stuck in the middle of the reform process even though it is now a member of the World Trade Organization. During the next few years the worst effects of membership will be felt. The country may gain from joining the global trading organization, but the benefits come later -- after structural reform has had an opportunity to take effect. In the immediate future there will be pain: more business failures, more layoffs and more social unrest. That's inevitable -- China is trying to cure more than five decades of economic mismanagement with the shock therapy of WTO.

There's likely a whole department of the CIA warning that the next century belongs to China...

Posted by Orrin Judd at July 13, 2004 8:23 AM