Can China Reform Its Economy?

It is furiously trying to create an economic superpower by transforming state industries. That may not be enough

By any measure, it has been one of the most breathtaking economic transformations in history. In only 19 years since China opened its doors to the outside world, what once was a destitute, hermetically sealed museum of Marxist utopianism has evolved into an explosively entrepreneurial powerhouse. The ensuing years of hypergrowth have left China with one of the world's biggest stashes of foreign reserves and a trade surplus that has many Americans fretting about a second Japan. And perhaps most remarkably, while comrades in Eastern Europe have been swept away, China's Communist Party has managed to stay solidly in power.

But as President Jiang Zemin and other senior leaders are acutely aware, the new China that seems so formidable to the outside world is actually living dangerously close to the edge. True, there are hundreds of manufacturers that are becoming as globally competitive as rivals in any of Asia's Tiger economies. But there also are thousands of hopelessly unprofitable industrial dinosaurs. These factories, on whom 100 million workers depend for survival, are being kept alive at a staggering cost to China's banking system, which is now nearly insolvent. And while the economy is surging at a 10% annual clip with just 4% inflation, the forces driving that growth--foreign investment and exports--may start to plateau. A sudden shock--a bank scare, say, or a leap in global interest rates--could spell financial crisis and social upheaval.

Behind Jiang's groundbreaking Sept. 12 speech opening the 15th Party Congress in Beijing's Great Hall of the People is the implicit recognition that the unorthodox brand of market-driven socialism that has propelled China this far needs a radical overhaul. In one of the most sweeping sets of policy changes since the late Deng Xiaoping unleashed the forces of modernization in 1978, Jiang announced that the state sector is in for a wrenching downsizing.

Considering the risks of worker unrest, it's a bold agenda. How big a role the state will retain in China's $800 billion economy will be a critical issue for years to come. Containing free markets will be difficult, given the capitalist fervor that has swept the country every time Beijing has liberalized in the past. Indeed, Jiang's plan is so sweeping that it could unleash perhaps the largest wave of corporate restructurings, mergers, and acquisitions the world has ever seen.

Jiang wants to convert most of China's 305,000 state companies into shareholder-owned corporations and begin opening them to foreign competition. Under the guidance of ministries and top planners, state companies in key sectors will be merged to form 1,000 huge corporations modeled on Japanese and Korean conglomerates. They will dominate industries such as telecommunications, petrochemicals, and high-tech electronics. And though the state will continue to control and subsidize these behemoths, most will be thrown open to foreign and domestic share ownership as well.

Hundreds of thousands of other companies will have to fend for themselves. Some will go bankrupt, while others will be sold to workers or peddled to Hong Kong tycoons or foreign investors. China's stock and bond markets will be greatly expanded, so companies can raise capital through public listings. That will allow banks to lend on commercial terms for the first time.

Jiang has been deliberately vague about the exact ownership structure of these companies. He has scrupulously avoided calling this process privatization and assures his comrades that "advancing socialism" is the ultimate aim. But in reality, he is vastly narrowing the scope of the state's economic power. Previously, the party defined state control as majority ownership of industry. Now, it means controlling a few strategic sectors. Nor does "state enterprise" any longer mean the government must own a majority of stock. That goes beyond anything even Deng would have dared.

Jiang's goal is to build a "complete market system" that will allow China to grow at an average 6.5% annually for 25 years and emerge as a $5 trillion modern industrial superpower. If Jiang can pull off his balancing act, the impact on the global economy of the 21st century will be immense. Hong Kong, the nerve center of Chinese capitalism, could rank alongside London, Tokyo, and New York as a financial hub. As Chinese entities rush to tap global bond and stock markets to finance everything from superhighways to steel mills, the country could absorb an even greater portion of the world's capital. As in Russia, this will help give rise to a large shareholder class that will likely be more demanding in the future.

BACKLASH? While many believe Jiang has no choice but to forge ahead, skeptics remain. Some critics see his moves as more show than substance. They point out that this isn't Western-style privatization. They also don't think he has gone far enough in meeting U.S. demands to open the economy to foreign goods and services. Others fear that Communist Party hard-liners will attempt to undermine the new reforms in the name of political stability. That is not an idle concern. The risk of political backlash will rise as Jiang's campaign adds more unemployed to China's vast army of jobless workers.

The degree to which China carries out its reforms will have a profound impact on the shape of the global economy in the 21st century. China already is an export juggernaut of garments, appliances, and other low-end goods. By curing its state-sector ills and turning its inefficient financial system into one that can smoothly channel the country's nearly $400 billion in annual savings to its best performers, China will emerge as a rival of Japan, the West, and neighboring Asian Tigers in industries from steel to heavy machinery. With its immense pool of engineers and huge domestic market as a lure to multinationals, China will put even more heat on struggling Southeast Asian economies in the competition for new industrial and high-tech investments.

But this emerging giant could also be a driver of global growth. The agenda coming out of the Party Congress may hold out hope that China, while not an outright ally of the U.S., will be a power Washington can live with. Jiang's reform package should improve his reception when he arrives in Washington in October for a summit with President Bill Clinton. As a prelude, Beijing announced it will slash tariffs on 4,800 goods by an average of 26% on Oct. 1. If China opens its markets and joins the World Trade Organization, as Jiang vows, it could become an enormous market and a valuable partner in the global supply chains of U.S. companies such as Motorola, General Motors, and Hewlett-Packard.

Washington and its allies may also take heart from an expected political realignment in Beijing. If economic czar Zhu Rongji replaces Li Peng as Prime Minister in March at the annual National People's Congress, as many observers expect, China will have a No.2 leader the West can feel comfortable embracing. The former central bank chief and Shanghai mayor is urbane, straightforward, reform-minded, and free of the taint of the 1989 Tiananmen Square massacre. Zhu also will be a zealous enforcer of Jiang's economic wishes. Indeed, some analysts fear that China's reforms could falter if Zhu--a man known for ramming through tough decisions--doesn't get the job.

THE SOVIET LESSON. But what's driving China's reforms is not a desire for approval from abroad. Rather, behind Jiang's great leap is a sense of urgency. With communist ideology dead, the collapse of Mikhail Gorbachev's Soviet Union has taught Beijing that the party's legitimacy rests on delivering ever rising living standards. Even though economic growth has lifted 200 million Chinese out of poverty since 1978, nearly 300 million people still live on less than $1 a day. The country's pension system is in tatters, and the number of elderly is expected to double, to 150 million, by 2020.

Real fear of mass unemployment is one reason Beijing can't adopt an even more drastic sell-off of state industries. Already, cities such as Shenyang, Harbin, and Wuhan have slashed payrolls and left millions of workers jobless. Because the government lacks the money to pick up medical, pension, and housing expenses now provided by employers, pushing too many companies into bankruptcy too quickly would mean social disaster. "How to balance the speed of reform with unemployment--this is a major problem," concedes Cao Yuanzheng, director of Beijing's Economic Research Institute of Economic Systems & Management.

You get a glimpse of what Beijing is up against at state-owned Wuxi Qingfeng Group Ltd. in Jiangsu Province. Inside its gritty buildings, women toil in choking dust and an ear-shattering racket as looms spin cotton and silk into yarn for everything from pillowcase covers to uniforms for the People's Liberation Army, its main customer. Despite laying off 1,700 workers in recent years, Wuxi Qingfeng is still unprofitable. And like most state industries, it must pay for cradle-to-grave welfare benefits for a staff of 10,000, half of whom are retired. There are believed to be tens of thousands of factories around China such as Qingfeng that are beyond reform.

Fortunately for China, there are thousands of companies that already have learned to thrive in a market economy. Just across town from Qingfeng, for example, the scene at Wuxi Little Swan Co. is entirely different. Its three-story, whitewashed headquarters hums with blue-smocked workers assembling the latest in washing machines. With its efficient workforce, a research lab in Los Angeles, and coffers bulging from the proceeds of a successful stock offering last year, Little Swan boasts sales of $163 million and 18% of China's market for clothes washers. It's also starting to export to Southeast Asia, South America, and the Middle East.

For competitive companies such as Little Swan, the Party's plan to accelerate development of China's capital markets will be a boon. After four years of debate, Beijing seems ready to enact a securities law establishing a modern regulatory system for its nascent stock exchanges in Shenzhen and Shanghai. The government also is pushing many of its best companies to list overseas. No matter that many investors got burned in the initial wave of China stock offerings a few years ago. This year alone, China has raised more than $25 billion in international bond and equity offerings, ranging from a $23 million deal for a telecom equipment maker owned by the Aerospace Ministry to a $278 million IPO by Beijing Enterprises Holdings Ltd., a conglomerate that includes McDonald's Corp. franchises and a tourist concession at the Great Wall of China.

LISTINGS FEVER. Most of these listings are in Hong Kong, whose stock market capitalization has exploded from $84 billion in 1990 to $500 billion today. Gary Coull, chairman and chief executive of Credit Lyonnais Securities (Asia) Ltd., estimates that China will further Hong Kong's boom by pumping out as many as 350 initial public offerings a year for at least a decade.

In anticipation, city and provincial governments across the country are furiously reorganizing holdings from tractor makers to toll roads and restaurants in the hope of listing them in Hong Kong. And Wall Street investment-banking firms, foreign-fund managers, and accounting firms such as Arthur Andersen & Co.--which employs a staff of 550 across China, mostly to handle IPOs--are beefing up their China operations.

Foreign investors stand to play a much bigger role in financing infrastructure. The World Bank estimates that China could spend as much as $75 billion annually for power plants, highways, telecommunications networks, and other public works. Beijing is counting on a quarter of that sum coming from overseas. GE Capital Corp. has grabbed an equity stake in the $250 billion Zhabei power plant near Shanghai, the first Chinese power plant to be financed entirely by the private sector without a government guarantee or Export-Import Bank backing. And giant investment funds backed by American International Group, Peregrine Investment Holdings, and New World Development are pouring billions more into road, port, and bridge projects around the country.

While all of this dealmaking is rapidly helping China ascend the capitalist learning curve, the government wants to stage-manage the process as much as possible. For a sense of what Chinese planners consider a model enterprise, look at Beijing's Yanshan Petrochemical Group, controlled by state-owned China National Petrochemicals Corp. With the blessings of the powerful State Council, Yanshan has been on a nationwide acquisition binge. It now boasts assets of $5.4 billion spread among 32 subsidiaries making everything from synthetic rubber to plastics. Thanks to a stock listing in Hong Kong, Yanshan has gained the financial clout for more acquisitions. Its goal is to grow big enough to go head-to-head with multinationals. "To be able to compete internationally, we have to be large," says General Manager Liu Haiyan.

Yanshan is one of hundreds of big state-owned companies Beijing hopes to turn into world-class conglomerates. Others include Shanghai Textile Shareholding Group Co., the result of mergers involving 241 companies, and Shenzhen Konka Electronics Group, a television maker that recently took over rivals in three provinces. In part, the idea is to bring about a badly needed consolidation in industries where hundreds of small factories compete for a limited market. But in the process, the state intends to keep control over industries it regards as strategic for China's future, such as telecom services, chemicals, electronics, steel, and aviation.

To many analysts, the strategy of building conglomerates modeled after Korea's chaebol is fraught with problems. Chaebol have been too inflexible to keep pace with the global economy of the '90s. And if Beijing continues to protect its strategic conglomerates from foreign competition, it's bound to run into new trade frictions with the U.S. and other partners.

VITALITY. Yet even as Beijing seeks to shield many key industries, it is opening the door to forces that may eventually spell the undoing of state domination. Jiang has made it clear that he is counting on the booming private sector, which now accounts for 13% of industrial output, to help soak up displaced workers let go by state companies. Their new bosses may be local entrepreneurs, opportunistic Hong Kong takeover artists, and even Party officials who have acquired assets for a song.

The offices of Shanghai City United Bank, one of China's fast-growing urban credit cooperatives, illustrates the private sector's vitality. Since the 1980s, when they were established to serve small businesses, credit cooperatives have spread like wildfire in Wuhan, Shanghai, Beijing, Tianjin, and other cities. Now, they are merging to form larger institutions with extensive branch networks that lend to credit-starved small and midsize businesses.

Two-year-old Shanghai City is made of 99 former co-ops. Its shareholders are small companies and employees, from the president down to the women who serve tea. The bank has led the way in consumer finance by offering mortgages, something unheard-of until recently in a nation where virtually all savings have been channeled into industry. Already Shanghai's third-largest bank, with 231 branches, it hopes to triple assets, to $18 billion, by 2000, says President Fu Jianhua.

New financial opportunities are luring foreign companies, too. In May, GE Capital won permission to open China's first wholly owned foreign finance company. The Shanghai-based entity will lend money for everything from General Electric Co. medical gear to Eastman Kodak Co. copying machines. Even though the company isn't yet in operation, "the phone started ringing off the hook as soon as we got government approval," says Daniel H. Mudd, president of GE Capital Asia Pacific. A sister company is lending to consumers in southern China for everything from refrigerators to pianos and foreign vacations.

These experiments in finance will form a foundation for Jiang's reforms. By steering more money to consumers and small companies, a growing financial system will help broaden the scope of an economy that is overdependent on heavy industry and exports and threatened by a state banking system that is all but broke.

In facing the Party Congress, Jiang has broken free of the ideological straitjacket that has kept Beijing from embracing free enterprise and attacking its deeply rooted structural woes. Making his program work could prove to be one of the most daunting challenges any leader has ever faced. "The blueprint is there," says economist Cao. Now, Chinese leaders hope they have enough time to finish their ambitious agenda.

If Beijing's new reforms give rise to a booming consumer economy, perhaps fears of China becoming another Japan will lessen. In a country of 1.2 billion with a growing middle class, there's plenty of room for strong Chinese companies and Western multinationals alike. But if China opts to export its way of out of domestic problems--still a possibility--tensions with the U.S. and the rest of Asia will intensify.

Much, too, depends on how far the reforms can go without triggering a political backlash. Jiang may be willing to bury communist ideology. But he has no intention of being another Gorbachev, who reformed himself and his comrades out of power. Rather, Beijing's leaders are betting that by controlling the reform process and delivering continued growth, the Communists can retain absolute power for decades to come.

It's a big gamble. No communist country ever has found a blueprint for turning ailing state enterprises into world-class corporations. And despite its stifling control of the political system, the Party's ability to impose its will on commercial matters is astonishingly weak. When it comes to business, Beijing ministries and even the PLA will rush to build empires under their own rules. And in far-flung provinces and cities, officials will turn any new economic latitude into a license to do as they please. By endorsing privatization in all but name, Jiang is unleashing a whirlwind that may transform China far more drastically than the Party ever envisioned.

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