Can China Avert Crisis?

China's economy is wobbling, and a major shift in policy toward public spending is about to change history

The swank bars and restaurants of Shanghai are filled with nervous talk these days about how the bottom is falling out of the local real estate market. Shanghai's five-year construction binge soaked up $18 billion and astounded the world with its audacity. But now the city touted as the financial capital of the world's next superpower is filled with half-empty office towers and the concrete shells of apartment buildings. It may be Asia's biggest property glut yet.

Hundreds of miles away, in an export zone of the Pearl River Delta, the general manager of an import-export firm in Guangdong is worried, too. His company has been a star exporter of shoes and textiles. But now his suppliers are laying off half their workers, unable to compete with rivals in Southeast Asia who lowered prices after their currencies tumbled. With earnings dropping, this manager thinks he may have to cut workers, too.

China's economy is starting to sputter as the big sources of its economic strength all show signs of fatigue. Foreign investment is slowing because cash-starved Asian companies can no longer afford to build in China. Exporters are seeing business shift to cheaper factories in Thailand and Malaysia. The real estate boom in the rich coastal provinces is turning into a bust. Unemployment is rising, and bad loans keep piling up in the state-owned banks, threatening the health of the entire economy. True, China does not have the convertible currency and massive short-term foreign debt that triggered the meltdowns across Asia. But there are enough similarities that the outside world is now asking if China can avert a crisis.

Acutely aware that the country must change course, Beijing's mandarins are scrambling for solutions. As thousands of delegates meet in Beijing for the National People's Congress, the Chinese are waiting eagerly for signs of decisive action from new Premier and economics czar Zhu Rongji. "We need a New Deal with Chinese characteristics," says Chinese Academy of Sciences researcher Hu Angang, recalling the bold economic activism of the U.S. six decades ago.

The pieces of China's new deal are still taking shape as the country's best and brightest pen white papers by the score. Much hinges on the outcome of leadership changes and a major shakeup of government ministries now under consideration. But some key elements are emerging: Instead of devaluing its currency to boost exports, the government will try a major policy shift. To stimulate domestic growth it will abandon its current austerity program and promote hundreds of billions of dollars in new investment over the several years, much of it in public works and housing. The government will likely raise most of these funds by significantly expanding its fledgling bond market and loosening up on credit. And Beijing will inject $32 billion in fresh capital into the country's four top banks so they can start shedding bad loans.

TWIN OBSESSIONS. For Zhu Rongji, who is expected to take over as China's Premier at the Congress, the moves to prime the pump signal a big change in thinking. Through administrative fiat, Zhu--nicknamed Lao Ban, or The Boss--started to choke off credit in mid-1993 to squeeze out speculation in the property and stock markets. His other obsession has been stopping inflation, which has cooled from 22% in 1994 to under 1% now. Associates say Zhu ignored appeals to ease up on his fight against inflation until the Asian crisis was well under way and its implications for China were clear. But by December, he realized that China's own economy could stall disastrously if he didn't step on the gas, risking the ire of die-hard conservatives who oppose any increase of inflation and deficit spending. Perhaps in anticipation of his new role as Premier, Zhu has been having sympathetic meetings with unemployed workers.

Party members are steeling themselves for a more fundamental reform of China's state-run capitalism. The country needs a modern banking system, not the profligate method of state-directed credit it has now. The Chinese must treat foreign investors as genuine partners and not as gullible sources of cash and technology. And the government must realize that the easy days of export-led growth are ending and that the task of building a domestic economy lies ahead.

What's amazing is how swiftly the Asia crisis has undermined China's growth formula. Under Deng Xiaoping, Beijing let the coastal provinces invest willy-nilly in hundreds of thousands of real estate and manufacturing ventures. The boondoggles and corruption were astounding. Zhu finally started cutting off the flow of cheap bank loans to pet projects. The austerity drive left even many sound companies starved for funds and forced to lay off workers. But Zhu and other leaders figured that as long as export industries remained strong, the economy would keep growing briskly. Officials figured they would have years to fix the state sector and perfect their brand of red capitalism.

But export growth may slow to 5% this year, from 22% in 1997, and cities from Beijing to Shanghai are feeling the pinch. The coastal factories, many of them started by the go-go party cadres, are having trouble finding buyers for all their low-grade air conditioners, vacuum cleaners, and consumer electronics.

Consumer demand is dropping fast, and many retailers are desperate for shoppers. At Beijing's new Cofco Plaza shopping center, for example, the top two floors are empty of shops. And the designer clothes and bedding sold in the largest third-floor shop come from boutiques elsewhere in the building in order to fill up otherwise unoccupied space.

Such signs are alarming. If growth slips below 7%, the economy will not generate nearly enough jobs to soak up the 6 million Chinese entering the workforce each year, as well as the 12 million laid off by restructured state enterprises. Unemployment is expected to jump by an additional 10 million through 2001. The steel industry will dismiss a half-million workers--38% of its workforce--by 2000. The country's textile machine will probably lose 600,000 jobs in the next few years. City officials are frantically trying to retrain these former factory hands, many of them over 40.

Chinese policymakers know that a significant slowdown could force them to devalue their currency. That would send a new jolt through the world economy. Devaluations, warns Zhu Min, an economic adviser to the Bank of China's president, would lead to "export wars in the second half of this year and a vicious cycle of depreciations." A slowdown could also trigger the kind of social unrest that horrifies China's leaders. And if China slides into stagnation, the world loses one more important source of growth.

FEUDING PLANNERS. That's why reigniting growth is a central part of the new plan. But don't expect to see a lucidly packaged, well-organized stimulus program emerge from the Congress. Instead, the cadres will unveil remedies piecemeal as disagreements rage over the details. Even the official China Daily newspaper is reporting the debate among technocrats over the wisdom of abandoning fiscal rigor and risking the creation of another bubble. Sinologists say current Premier Li Peng favors only a 10% increase in government spending, below Zhu's target. Yet, at the end of the day, analysts expect the government to boost its spending on public works and other projects as much as 20% a year.

Much of this is to come from vast personal savings--some $560 billion piled up in state-run commercial banks throughout the country after a decade of economic growth. The goal is to ladle this money into everything from Beijing's fourth ring road to Shenzhen's subway to such megaprojects as the Three Gorges and the Yellow River's Xiaolangdi dams. The usual way to capture these savings would be to issue bonds. But ordinary Chinese investors have traditionally steered clear of long-term debt instruments, either because interest rates are low or because it is too difficult to sell them on a secondary market. Banks also are not eager to see a major bond market, which could divert funds from their deposits and make it more difficult to carry their estimated $240 billion in dud loans.

Yet policymakers are actively debating several bold ideas that could vastly expand China's debt markets. One would be a major expansion of corporate bonds, which authorities until now have kept at under $2 billion a year. Liu He, an official at the State Information Center, recently proposed a big increase in the number of highway and railroad bonds. A more controversial idea is to let cities and provinces sell bonds both at home and abroad, a scheme Zhu opposes because local officials could go overboard again. The central bank is also considering an expansion of the money supply later this year through new loans to commercial banks. Plans are afoot to bankroll construction of $350 billion in apartments over three years. The central bank also would earmark loans for infrastructure projects and small businesses.

The most urgent task Zhu faces, however, is to clean up the banking system. A key first step is Beijing's recent decision to pump $32.5 billion in capital into its four main commercial banks by issuing new state treasury bonds. This will boost banks' capital levels to meet international standards, making it easier to carry nonperforming loans, lower lending rates, and increase profitability.

The government is also making attempts to curb the rampant growth in finance companies, which were notorious for providing loans to speculative investments. Computerization of bank data is making it easier for regulators to monitor loans. Zhu also wants to dramatically reduce the number of branches of the People's Bank of China to lessen the chances of local meddling. Top bank executives at the regional level now are appointed directly by Beijing and no longer report to provincial governments or party officials. Wang Qishan, former president of China Construction, has been named Vice-Governor of Guangdong Province, where he will try to ensure that local cadres don't dictate bank lending.

GREEN LIGHTS. Beijing will also sweeten terms for investors from the U.S. and Europe. "When the economy is bad, the authorities are polite to people like me," says William A. Hanbury Tenison, chief representative of Jardine Fleming Securities Ltd. in Shanghai. "At the moment, people are very polite."

They're about to get even nicer. Chinese authorities will soon sign off on major infrastructure projects involving Western multinationals that have been bogged down for years. In February, for example, Royal Dutch/Shell Group finally got the green light for a $4.5 billion chemical complex, China's biggest foreign investment ever. Jack Perkowski, chairman of Asimco, a direct-investment fund with 17 joint ventures across China, is currently negotiating two more ventures, which are suddenly going more smoothly. "For everything in the contract, we're finding more flexibility now. We're seeing tangible signs," he says.

Reforms aimed at streamlining China's stifling bureaucracy would improve the investment climate immensely. Reducing the power of the Ministry of Post & Telecommunications, which both regulates and operates most of the telephone system, would help open China's phone market. Limiting the ministries' role in industry also could weaken China's ability to impose onerous rules on technology transfer and local content.

Beijing may even make it easier for foreigners to turn a profit, something it has not cared much about. Watch for new low-interest loans and reduced tax rates for particular infrastructure projects built by foreign joint ventures.

Ambitious stuff. But will it be enough? A good clue will be in how China tackles its banking problem. Although Western analysts praise the $32 billion capital injection as an important first step, "in terms of solving the problem, it's only a fraction of what they need to do," says Standard & Poor's China analyst Wayne Gee.

China's banks probably need a much more massive injection of new capital so that they can write off bad debts to state enterprises. Western economists also fear that China's short-term foreign debts--the Achilles' heel that brought down Thailand and South Korea--may be understated. Officially listed at $15 billion, the real figure could be several times that if the offshore borrowings of Chinese corporate branches in Hong Kong and the U.S. are included. Beijing's $140 billion in foreign reserves is still a comfortable cushion, but China may be more vulnerable to an external financial shock than it thinks.

KOREAN MODEL? Throwing money at the banks won't work unless they also start lending on the basis of credit analysis, rather than politics. Also lacking so far is a comprehensive plan for the banks to wipe bad debts off their books, which is necessary if they are to stand on their own as profit-making institutions. China does not have a legal framework for banks to seize corporate assets and sell them off to outside investors. And because there is no insurance program to protect depositors, shutting down bad banks is difficult. There isn't even a system to monitor the assets of state banks. All of these issues are now being debated actively in the Chinese press, but decisions aren't expected in the coming months.

The government also has not figured out what to do with the largest state-owned enterprises, the biggest money-losers in the system. Beijing has been urging strong state companies to buy up the weaker ones to create conglomerates modeled after South Korea's chaebol. The well-run Baoshan Iron & Steel Corp. in Shanghai, for example, is being strong-armed into buying a poorly run metallurgy company, while Beijing's Snow Lotus Cashmere Co., one of the profitable textile makers, may have to acquire other, money-losing cashmere producers. "We are being encouraged to take over a hurting enterprise, but I'm not sure that that is a sound strategy," says General Manager Li Yuanzheng.

The crisis of Korea's chaebol may well force Beijing to abandon this model and even to rethink the party's emphasis on large corporations. Now, policymakers are exploring special loan funds for smaller businesses, and they may make it easier for private enterprises to issue stocks and bonds. Ready cash raised in 1997 from Hong Kong's securities markets was supposed to ease the pain of restructuring state-owned behemoths. But that money has now dried up. So the government plans to approve $3.7 billion worth of initial offerings in China's domestic markets this year, a sum that may grow. Trouble is, regulators fear that if failing companies manage to list, the already shaky credibility of China's bourses will be undermined further.

Opening up the interior of China to serious economic development could offset the slowdown in exports and boost demand for locally made goods. Beijing is hoping its ambitious public-works program will spread the wealth to such interior cities as Wuhan and Zhengzhou. They also want to help the three-quarters of China's population that lives in rural areas but who account for only 45% of retail sales. The average annual income of a Chinese farmer is a mere $250, whereas city residents pull in about $620. But this will take years: The roads and power generators must be built before industry moves en masse to the hinterland.

Give credit to Zhu Rongji and China's ablest bureaucrats for recognizing a developing crisis and mobilizing to solve it. Outsiders applaud his ambition. "Zhu is shooting for the moon, but even if he ends up only half way there, it will be a tremendous acceleration of what we have seen so far," says Nicholas R. Lardy of Washington's Brookings Institution.

Yet Zhu and his colleagues have only a few years to reignite China's economy with public works and public debt. If they succeed, China's economy will be vastly more market-oriented but with the party still at the helm. If they fail, China will have the same problems it has today, except it will have a lot more debt and far fewer options. Six months ago, the Chinese thought they could avoid the fallout of the crisis. Today, the crisis is already forcing major change in Asia's most dynamic economy.

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