The Chinese Economy on a Rotten Foundation (Part II)

(8/15/2003)

Qingxi Zhang
Professor of Economics
National Taiwan University
Taiwan, ROC

Chinese Economy on a Rotten Foundation (Part I)

1) The Chinese Economic Surface
2) The secrets of the "progressive growth"

http://www.clearwisdom.net/emh/articles/2003/8/22/39388.html

3) Growth could lead to disaster

Beneath the veil of the rapid growth of the Chinese economy lies the question of whether or not it entails underlying dooming factors. While high economic growth is an aspect that many countries seek, it cannot be the sole aim of a nation's economy. This is because it could come at the cost of other economic necessities, i.e. social justice, environmental safety, payment fairness, etc. These sacrifices are extremely detrimental to China. The reform as executed in China could only lead to the economic demise of the country.

At the beginning of the reform, the government adopted the traditional economic system as a method to handle the state-owned enterprises, i.e. the treasury subsidiary for "red-ink" losses. However, the choice resulted in huge financial deficits. Within the first year of the reform the deficit ran as high as 17 billion yuan (RMB) in 1979. In order to solve this problem as well as the problems caused by the influence of local governments, the People's Bank or Central Bank changed its system and also completed the policy of "Subsidy to Loan" in 1983.

The purpose of the "Subsidy to Loan" program was to convert financial support for enterprise losses and investment needs into loans that were applied to banks by the state enterprise. This policy was enacted to alleviate financial tribulation and also to establish the looming liability of the state enterprise. On the other hand credibility for the debt has not been instituted. The nation's capability of integrating resources and supporting enterprise has been abolished, but the local governments are abusing the extra funds by means of chaotic investments. The effect has not only wasted national resources, but also resulted in an abrupt increase of bad bank accounts.

The "Subsidy to Loan" policy has failed in instilling the concept of borrowing capital and repaying debts among the state enterprises for the following reasons: the state bank only audits reports that have been submitted, the government has a significant influence on the bank loan process, and government officials and businesses have tried to secure loans without a guarantee. Many state enterprises, especially the larger ones, are poorly managed. According to regulation they are not permitted to obtain loans. However, by providing workers with housing, schools, jobs, pension, and medical benefits the state enterprises play a critical role in the government. If the state enterprises were forced into bankruptcy, social problems would begin to arise. As a result, governments demand banks to approve loans for the state enterprises. These inappropriate and unsecured loans resulted from the association between government officials and businesses and have not only failed in fostering liability, but has also caused faulty bank accounts.

In the era of Mao Zedong, more than 50% of the budget was funneled into basic construction and enterprise upgrading. This was called the "construction finance." Now governmental finance, rather than being allocated to state enterprises, most expenses have been directed to the salaries of government workers, i.e. "food finance". During the sixth five-year-plan of 1978 to 1982, there was not a single investment made exclusively for energy or raw material. In the seventh Five Year Plan that lasted from 1983 to 1987, natural resources were stressed in disarray. Consequently the state finance does not have significant influence on resource integration, and all levels of government and institutions that have enacted their own policies and investments are in financial chaos.

To clarify the problem one should take the issue of energy and its use into consideration. Many local enterprises have been only able to maintain a "three on and four off" or a "four on and three off" policy since 1983. In order to stimulate power supply development, the government set forth a favorable policy and guaranteed to purchase electricity at the negotiated price. The communist party, the government, the military forces, public security, prosecutors, the court, in addition to the department of electricity management were all mobilized to build power generators by acquiring loans from the bank. After more than ten years, combustion generators in China, on average, can only log 4,200 hours or less. This is below the half of 8,760 hours needed for one year. The investment for this surplus capacity is nearly 800 billion Yuan (RMB).

In Mao's era, watches, bicycles, sewing machines among many other products were all short of supply and resulted in high prices and good profits. At the beginning of reform in 1980s, all these products were the focuses of investment. Factories were set up in almost every mid-size city. This deregulated the expansion of manufacturing development and along with the rapid turnover of oversea products, led to the problem that product life on the market had ended before the factory was even ready to operate. Nowadays, the manufacturing capacities of three products have been idle for more than 90% of the time that had been opened. In addition, it is astonishing to see that hundreds of production lines have been imported for televisions and automobiles. The global production capacity for televisions is 70 million sets. Among them, China takes up to 40 million sets and the television market in China only needs 20 million sets or less. The loans from the bank made these investments possible.

Despite this process "eating up the finances and consuming the banks", the Chinese academy says it is the most splendid era of China's reform. This is the fundamental reason that several industries have declared bankruptcy, huge amounts of production capacity go unused, investment cannot be claimed, and bad accounts at banks make up as much as 40 to 50% of the capital. Because of incapability of state finance, the near-sighted behavior of local government and enterprise, the waste of social resources in China has reached an alarming stage.

4) The Collapsing Financial System of China

There are many devils in China's economy. Some are hiding, some are disguised---none can compare with the problems of its financial system. Even though the Chinese government puts a good face on everything, the problems are very apparent anyway. As many economists as well as economic magazines and business-consulting firms point out, the financial system of China is facing a very difficult problem indeed.

Standard and Poors (S&P) Index estimated in June 2002 that China's non-performing loans exceeds 50% of its total bank loans. Moody's also released a credit rating report entitled, "China's Banking System: Tight Rope Walk", stating that China's banking system has become technically bankrupt. Some Western scholars (such Nicholas Lardy at Brookings Institute) say that China's financial crisis is only short by one "trigger" to be set off. Far East Economic Review published "On the Road to Ruin" (Lague 2002), which talks about China's banking problems. Not long ago, Ma Guonan, the economist from HK International Clearance Bank, said that if the Chinese government still does not solve the fundamental problems of the non-performing loans of its state banks, it is impossible for China's economy to continue with its current growth. Studwell (2002) and Gordon Chang (2001) have both sent this kind of warning message before. The only question remains: When the disaster occurs, how serious will it be, and who will pay what is due?

It is estimated that China's banking system has $500 billion in non-performing loans. Considering the deficit in its social insurance and pension fund, the internal and external debt of the Chinese government would exceed its GDP of about $1,100 billion. The problem in China's banking system is far more serious than that in Japan. The non-performing loans in Japan's banks only account for 10% of its GDP, while for China it is 43%. Now China is copying what the U.S. did a decade ago when its saving and loans went bankrupt by setting up an asset managing company. However, when U.S. savings and loans went bankrupt 10 years ago, it only cost $160 billion, which was only 3% of U.S. GDP at that time.

Hazardous Equilibrium. In public, the head of People's Bank of China, Dai Xianglong, only admitted that the non-performing loan rate is 25%. Even if it were true, China's banking system is immersed in debts. The question is: why hasn't it collapsed already? As a matter of fact, quite a few scholars think there is no need to worry, since there is so much capital inflow into China's banking systems. There are actually two main reasons behind the non-collapse of the banking system.

Plenty of capital inflow, including the high saving rate of Renminbi and large amount of investment or loans poured into China from foreign countries. The savings rate of Chinese people must be the highest in the world; in the 1990s, the total domestic savings accounted for 40% of the GDP each year. The savings (year end balance) was 6% of the GDP in 1978 and this figure increased to 70% in 1999. In addition, China is outstanding in attracting foreign investment---ever since the beginning of its economic reform and opening up to the outside world, the foreign investment in China has reached $450 billion, second only to the United States.

The Chinese government exercises tight control over media, foreign exchange and foreign banks. Since there is no freedom of the press, Chinese people blindly believe in the words of the government that their savings in the banks are safe. Due to the foreign exchange control, everyday people cannot exchange RMB easily. Now that China has joined the WTO, it still has not let go of its strict constraint of RMB operation by foreign banks. Consequently, Chinese people have no other choice but to deposit their money in state banks.

It is a delicate balance in a hazardous situation. China's state banks are like vulnerable puppies, sustained by sufficient domestic savings or foreign investment; however, they will collapse once the replenishing is disrupted. In fact, as required by WTO agreement, China must open up its domestic market to foreign investment and foreign banks to run domestic currency business. So, on one hand, as the competition gets intense and the deficits of SOE get larger, the non-performing loans problem becomes even more severe. On the other hand, as the mass media, especially the Internet, finally breaks through the information blockade of the Chinese government, and as the information then becomes available to the Chinese people, the latter will awaken to their savings disappearing like the wind. This would lead to a run on banks; foreign investors would find the consumer market in China does not exist anymore and then foreign investors would have to withdraw. When that time arrives, any incident would become the straw that breaks the camel's back. The crisis, then, would be unmatched by South American standards or elsewhere. Stuwell has told us clearly that everything in China is tied to public confidence. (Stuwell, 2002)

The Chinese government actually knows the severity of its banking problem. The collapse of the financial system will definitely lead to political and social turmoil in this most populous country in the world. After the 16th Congress met in November 2002, some high-ranking officials inside the Chinese government said the big four state banks would again receive a huge amount of funding from the government. In the past, the Chinese government had injected large lump sums of money into the banks. In 1998, the Chinese government provided $33 billion in funds for its loans. A year later, in the so-called "last dinner" by the big four state banks, the Chinese government wrote off the non-performing loans of $169 billion on the books of state banks and transferred that sum to the so-called "State owned asset management company." According to the International Clearance Bank, this state owned asset management company, subsequently issued $141 billion worth of bonds to the banks, and paid out $28 billion in cash to help the banks.

The Chinese government hoped to get back part of the non-performing loans, but this is not likely to happen. To transfer the non-performing loans to a state asset company is no real cure of the problem since it is merely a transfer. This strategy also gravely weakened China's People Bank (China's central bank), which provided all the funding to buy the non-performing loans of the big four.

Anything that would cause the loss in public confidence in the Chinese government would lead to diminished public saving. Runs on the banks would follow. So, as long as the economic growth is slowing down, an economic crisis is ready to emerge. This is also why an "aggressive fiscal policy" was employed in recent years. A great amount of money was used to stimulate the economy, including a large amount of expenses on infrastructure and an increase in government employees' salary. However, many Chinese high-ranking officials have already warned that this approach could not last long.

In addition, if the global economic recession drags on, and if the demand for Chinese products slows down or the foreign investment to China decreases, either of those could act as the trigger to instigate a financial crisis. If the Chinese government allows the free exchange of Renminbi, or foreign banks are allowed to enter China and compete with China's banks, this too would lead to the free exchange Renminbi into US dollar or gold, and hence setting off a crisis too.

How to solve the problem then? There are several ways: (1) print more money; (2) collect more taxes; (3) borrow the money. It could issue domestic bonds or borrow from foreign countries. China could, for instance, ask for help from the World Bank. (4) sell land or buildings; (5) issue stock for banks; (6) allow the state owned banks to go bankrupt. However, in order to protect China's economy and the Communist regime, none of the above will work for both. Any approach must cause damage of some kind, and it could easily develop into a situation where public confidence is lost and the result would then be disastrous for all.

In order to solve the problem of non-performing loans, at the very least we need to guarantee that no more new non-performing loans are generated. This requires the banks to stop making loans out of those inefficient state-owned enterprises. This is also something that is not possible. As a matter of fact, right now, the number of non-performing loans continues to increase.

S&P estimated in June 2002 that the non-performing loans in China's banks account for 50% of its total bank loans. It would take China 20 years before the non-performing loan rate would be brought down to a "manageable" 5%. And that alone would cost $518 billion. Far East Economic Review (Lague 2002) said it is obvious that China's authority knows that it does not have 20 years, especially since China signed the WTO agreement. Given when that agreement was signed, China would have to allow foreign banks to enter and run businesses by 2007.

(To be continued)

Source: http://www.washingtonchinareview.org/newsdetail.php?id=753

Please see Part 1 on
http://www.clearwisdom.net/emh/articles/2003/8/22/39388.html