China: What's Going Wrong
We will prevail. That was the message Chinese Premier Zhu Rongji sent to the world a year ago, when the National People's Congress unveiled a $1.2 trillion, three-year plan to keep the Asian crisis at bay. The public-works spending would keep China's millions employed and the economy expanding by 8% annually. Meanwhile, Zhu would tackle the thorny tasks of shutting down profitless state factories, curbing corruption, streamlining a bloated bureaucracy, cleaning up the banking system, and privatizing housing. With China still growing, Zhu thought the country could absorb the shock of reform.
He was wrong. Instead of embarking on a year of triumph, China is entering a year of peril--its worst in a decade. When Zhu set his plan in motion, he underestimated how out of control the economy already was; he miscalculated its frailty and the impact of the crisis. Now, millions of unemployed are clogging the cities. Protests occur almost daily. Consumers have stopped consuming. Housing privatization has stalled. State factories still churn out billions of dollars in unwanted goods.
INVESTOR FATIGUE. Meanwhile, many foreign investors, burned by Beijing's policies, are rethinking their commitment to China. "We are wondering if this is a government we can trust," says a Western banker in the southern city of Guangzhou. China has always been a tough place to do business. The threat this time is that investors will shift to more lucrative, more easily managed markets just when China needs outside capital most. As investor fatigue deepens, foreign investment could drop from $45 billion in 1998 to $30 billion this year, according to some government estimates. China cannot afford to lose investors' favor.
Beijing policymakers are deeply worried. China could fall into the same trap that snared Japan: The government tries to reignite spending, but the banks, riddled with bad loans, stop lending. Deflation becomes unstoppable, and the consumer economy grinds to a halt. To get at least some growth, authorities are forced to devalue the yuan. Meanwhile, social unrest could pose a serious threat. This year marks the 10th anniversary of the bloody night at Tiananmen Square, as well as the 50th anniversary of the founding of the People's Republic. Celebrants can easily turn into demonstrators if they are angry enough and poor enough.
With these threats looming, Zhu has quietly set aside much of his politically destabilizing reform plan. He is also engineering a crackdown on the provinces, shutting down heavily indebted, corrupt investment trusts, and sealing the exits for any Chinese company that wants to ship money out of the country. There's some merit to the crackdown: China needs a better regulated and less corrupt economy. But the moves show Zhu is as much a party cadre intent on control as he is a reformer. And while Zhu in the past used the levers of state power to curb inflation and promote growth, this time his policies seem likely to lead to even more stagnation.
Zhu and his advisers were supposed to avoid this mess. They knew the economy was starting to slow a year ago. But they figured Keynesian stimulus was a tried-and-true formula for growth. The spending did boost growth for much of 1998, but then the economy started to cool in the fall. Too much of the money was siphoned off by corrupt officials, and too many of the projects' were unable to trigger new economic activity. Workers got spooked as state enterprises continued to shut down, and consumer spending evaporated. The central government, suddenly frightened, pulled back from closing state factories.
Other reforms ground to a halt, especially housing reform. The plan was that the middle class would buy the homes they rented from the government and so create a spending boom, with banks issuing mortgages and new homeowners refurbishing their flats. But the middle class hesitated to spend their savings on apartments they had been renting cheap, and the banks shied at the risk of lending to buyers. The expected housing market never materialized.
Chinese authorities hoped that cheap, skilled labor could keep exports humming. Instead, the coastal export zones began faltering in the second half of 1998, after the AsiAn crisis wiped out China's markets in neighboring countries. Suddenly, instead of buying Chinese goods, South Koreans were undercutting Chinese steel and petrochemical prices on Chinese soil.
WASTED CASH. Then, late last year, authorities discovered companies and government agencies on the coast were anticipating even tougher economic times ahead--and trying to smuggle money out of the country as a result. More than $45 billion is believed to have gone missing. As officials tried to stem the outflow, they started examining the books. To their horror, they discovered that many companies had tAken on far more hard currency debt than regulators realized. Many international trust and investment corporations (ITICs)--set up initially to trade with the West and raise foreign capital--were awash in debt. Much of the cash was wasted. According to a local official, the Guangzhou city ITIC sunk most of a $10 million Japanese loan into lavishly redecorating one of its buildings.
So in September, Zhu imposed draconian controls on foreign exchange dealings. At the same time, he started putting the squeeze on one investment trust after another. But the unintended damage has been huge. Legitimate businesses find themselves encumbered by the heavy documentation needed to obtain hard currency. In Shanghai, an American maker of steel beams is so frustrated with forex controls that he wants out of his joint venture. And Procter & Gamble Co. is considering delaying new investments in southern China because of them, according to a Guangzhou city official. P&G denies this but says regulations are slowing payments to suppliers.
The consequences of Beijing's actions keep multiplying in coastal provinces. In Guangzhou, the crackdown on smuggling and corruption has struck fear into the hearts of entrepreneurs, scaring many of them from new investments. One city official now predicts only 3% growth in exports and foreign investment in 1999, half the levels of last year. "We have suffered a serious negative impact," says city official Weng Wenxiang. Guangzhou city's ITIC may also be shut down, if an ongoing investigation finds serious financial mischief. That could spell trouble for the city government, which parked pension funds for the police force in the trust, according to a well-connected Chinese lawyer.
PRICE PINCH. It's not just the high-flying South feeling the pain. In the northeastern port of Dalian, once a hot growth area, Korean and Japanese companies are freezing new investments worth $2 billion per year. The city is now littered with half-constructed buildings started by companies such as Hyundai Group. The local government has ordered that all building exteriors be finished to mask the extent of the real estate bust.
While the economy slows, Zhu is resorting to other expedients. Deflation is ravaging Chinese enterprises. These companies, most of them state-owned, have accumulated hundreds of billions of dollars in unused inventories. The solution: price minimums in 21 industries, including steel, glass, autos, and electronics. Tottering state factories may get a reprieve, but price floors create weird distortions. The manager of a Western chemical factory near Shanghai complains that local suppliers of polyester chips, a key component for his products, have hiked prices to nearly 75% above world market rates, even though they all faced a glut. "It's definitely a cartel," he says. "No matter what the order is, the price is always the same." Not surprisingly, his plans for a second production line are on hold.
Even more egregious are new protectionist moves. Late last year, Beijing announced it would curb operations of foreign telecom companies such as Sprint Corp. and Siemens, allowing China's main provider, China Telecom, and small rival Unicom more time to reap profits and cement control over the telecom sector. And Beijing has pushed a "buy local" policy requiring provincial authorities to steer clear of foreign telecom and power equipment.
In Dalian, drugmaker Pfizer Inc. is posting only 5% revenue growth rather than the expected 27% because Beijing is limiting hospitals' purchases of drugs made by joint-ventures, which benefits Chinese producers. "Of course they're going protectionist," says the head of another Western company. "Beijing knows 1999 is not going to be an easy year."
To his credit, Zhu has backed a new securities law to improve the quality of China's bourses. He has helped convert the central bank into a Federal Reserve-type system that reports to Beijing--not to reckless local officials. He is also supporting constitutional changes to give more recognition to private enterprise. And he is trying new taxes and enforcement to increase the provinces' contributions to central coffers.
But anti-Beijing feeling on the coast is rising rapidly, and could make it tough to reignite growth. A source close to the Guangdong ITIC insists the central authorities were gunning for the company when they shut it down, though he admits to weak management. According to this insider, GITIC had sufficient money to cover its debts, but Beijing authorities prevented the company from converting this to foreign exchange. "Beijing wants to pull in the reins and show who's in charge," says Laurence Lipsher of the American Chamber of Commerce in Guangdong.
China's lost momentum for reform creates a twofold risk. The first is that China drifts along. While it relies on ad hoc measures and the old tools of central planning to stave off unrest, it loses time transforming itself into a market economy. The second is that multinationals' enthusiasm for China seriously weakens, leaving China without new technology and management and ultimately further behind the West.
Chinese authorities know foreign investors are hurting. They are doing little about it, hoping a recovery in 2000 will compensate. But it's a gamble. The U.S.-China Business Council recently found that 80% of its members are affected by the new forex regulations. More than 50% of them are delaying new investments in China in response. "The side effects of these immense assaults by the regime on business as usual are proving very painful," says Robert A. Kapp, president of the Council. "At the end of the day, American companies have business decisions to take. Some will say, `Let's go home or cut back."'
It would be tragic if China put reform on hold for too long. The country has traveled a long and hard road to its present level of prosperity. And a stagnating China would pose a serious threat to Asia's recovery as well as the global economy. Zhu's biggest challenge is just beginning.