July 06, 2002
The Chinese Miracle
China has changed dramatically! It started with foreign policy initiatives introduced under Premier Deng Xiaoping in the late 1970s. China gradually began moving from a passive, isolationist state to a more active player in the international arena. As it ventured out of its shell, it began to participate more in various international organizations, especially financial ones. This enabled it to gradually modernize its economy. In 1984, America’s 3M company became the first U.S. corporation to establish a wholly-owned subsidiary in China. But the sleeping giant was just beginning to arouse.
Between 1988 and 1994, China normalized or established diplomatic relations with 18 countries. In further bids to promote its trade and security interests and in attempts to limit America’s influence in the region, China started meeting with senior officials of the Association of Southeast Asian Nations in 1995. It also extended its hand to Europe in 1996 and was a founding member of the Asia-Europe Meeting, which holds biannual summits and yearly meetings. China has also resolved a number of territorial disputes with at least six of its neighbors. In 2001, it signed a Treaty of Good-Neighborliness and Friendly Cooperation with Russia. All this diplomacy and much more, along with opening up its economy in various ways, helped China to attract more foreign direct investment and expand its economy. The quick transformation that ensued is nothing less than stunning.
China is amazing. It is capitalism, but at an unprecedented speed. China’s transformed economy has been called a miracle by some, and China has been labeled the world’s factory floor. In 1982, Chinese exports were only about $22 billion. By 1992, they were almost $85 billion. Then exports took off and shot up to over $325 billion in 2002, and skyrocketed to over $438 billion in 2003!
China produces over 50 percent of the world’s cameras, 30 percent of its television sets and air conditioners, 25 percent of its washing machines and almost 20 percent of its refrigerators. This year, together with Hong Kong, it is expected to produce more than half of the world’s DVD players, more than a third of its personal desktop and laptop computers and about a fourth of its mobile phones, personal digital assistants and car stereos. The Chinese economy now the sixth largest in the world has raced ahead to become the world’s fourth-largest industrial producer after the United States, Japan and Germany.
The prosperity is beginning to spread. In 1979, there were no millionaires in China. Now the top 100 richest people in China have an average wealth of $230 million. Another 10,000 or so are worth at least $10 million each.
China has over 200 cities with populations of over a million. Astonishingly, almost 90 percent of urban Chinese own their homes. And there are color TVs in almost every urban home, washing machines and refrigerators in over 80 percent, air conditioners in half, microwaves in almost a third and computers in 20 percent.
Moreover, in 1989 there were fewer than 5 million fixed phone lines. Now there are 397 million. As recently as 2000, fewer than 9 million accessed the Internet through personal computers. Now more than 69 million use the Internet. More than 200 million Chinese households have cable television the world’s largest cable market. China is also the biggest market for cell phones, with 200 million in use and growing by an average of 2 million per month.
China has come a long way in a very short time! Such growth attracts even more foreign capital for those looking to profit from the so-called China miracle, especially since the Chinese yuan is pegged to the U.S. dollar and undervalued by as much as 30 to 40 percent by some estimates. Some investors are speculating that the yuan will be allowed to float, thereby increasing the value of their investments overnight.
Another reason for increasing foreign investment is persistently low interest rates in the U.S. Chinese individuals and companies are transferring dollar savings back into China to take advantage of higher Chinese interest rates. To date, only four countries in the world have received more foreign direct investment than China, but at its current growth rate China could leapfrog into second place this year behind only the U.S.
These capital inflows have helped fuel investment growth in the first quarter of this year to an amazing 43 percent over last year. In January and February, 16 of 30 industrial sectors exceeded 100 percent growth and industries such as iron, steel, cement and other construction materials grew as much as 170 percent. In Beijing, for example, authorities are forging ahead on unprecedented construction in preparation for the 2008 Olympic Games. The capital city is spending more than $30 billion on new subways, roads and stadiums.
The unleashing of capital spending in the world’s most populous country is driving up demand and raising prices worldwide for the raw materials it devours. Last year, China gobbled up 25 percent of the world’s supply of aluminum, 27 percent of its steel, 30 percent of its iron ore, 31 percent of its coal and between 40 and 50 percent of its cement. In fact, it can’t even get enough steel. The Organizing Committee for the Olympic Games has had to cut the amount of steel planned for the National Stadium by 40 percent. Other construction materials will be used instead.
Yes, the Chinese economy is on fire, but one of the lessons of life is that too much of a good thing can be bad. In China, the economy is overheating and in danger of meltdown, and the government knows it.
Beneath the Glitter
In May, Premier Wen Jiabao warned that the economy risks coming off the rails. He described China’s growth as excessive and compared the economy to a speeding car that needs to slow down.
One problem is the threat of inflation. In April, food prices jumped 10 percent and the cost of grain soared by more than a third. Overall, the annual rate of inflation hit a seven-year high of 3.8 percent. This is not surprising, since the money supply grew 19 percent over the previous April and that was the 16th month in a row that it exceeded the central bank’s target. Coupled with increasing demand for scarcer commodities, the growth in money supply is a recipe for inflation.
Money supply is plentiful because Chinese banks are awash with huge cash inflows from exports, surging foreign investment that must be converted into yuan to keep its currency pegged to the U.S. dollar and a national savings rate of 33 percent (Chinese households piled up $350 billion in new savings last year). Of course, banks are eager to lend this money to make a profit. Last year lending increased 21 percent and surged to a record $1.9 trillion. And therein lies one of China’s biggest problems the banking system and its lending practices.
The core problem is that banks do not allocate capital according to market forces and sound risk assessment. Loans are made based on political and social considerations. Questionable projects are financed because of shady relationships that the banks maintain with members of the Communist Party and state-owned enterprises. Those relationships are what drive the flow of billions of dollars from banks to money-losing state-run companies. These companies often invest in ill-advised projects that Communist Party officials have vested interests in. This results in a staggering amount of debt that is not repaid. Standard & Poor’s estimates that about 45 percent of all Chinese loans are nonperforming!
Massive investment has indeed created a tremendous expansion of productive capacity, but much of it is redundant. For example, an area in Guangdong has eight airports in a region the size of Massachusetts and Connecticut. Investors have also been shoveling money into real estate. At the end of 2003, estimated real-estate vacancies stood at 26 percent. That’s quadruple the U.S. figure and eight times higher than Hong Kong’s. Such massive over investment leads to decreasing profit margins and ultimately will cause firms to go bankrupt, which will augment the bank’s loan problems even more.
Other loans have been used for projects of marginal economic utility. Almost all of China’s 660 cities and 20,000 towns have built or are in the process of building town squares, industrial parks aimed at phantom investors and other prestige projects. In China, mayors and local leaders are more likely to be promoted if they make big and obvious changes to their towns. But some of these towns have essential needs that are not being addressed, such as treatment of waste water.
The government is well aware of these problems. The fragile nature of China’s financial institutions was highlighted in January when Beijing announced a $45 billion bailout of two state banks. Beijing is trying to curb bank lending by increasing the reserve requirement, cracking down on insider loans to related parties, restricting investment in the overheated sectors of the economy, placing restrictions on land use, putting a halt to wasteful projects, and other means. It has also stepped up its anti-corruption campaign with widespread arrests of managers of state-owned enterprises who were in cahoots with bank officials.
Beijing knows it has a major crisis on its hands and is trying to take steps to control the situation. It worries that the over investment is generating unhealthy bubbles in the economy reminiscent of the mid-1990s. China’s financial system is already riddled with uncollectible debt and is in no position to withstand the bursting of a real-estate bubble or a sudden market realization that key manufacturing sectors are overbuilt. Beijing is desperately trying to engineer what is called a soft landing a gradual applying of the brakes and avoid the crash landing that occurs if the brakes are applied too hard or if nothing at all is done. But will it be successful?
It’s not easy to stop a runaway train. That’s why Beijing’s ability to engineer a soft landing is possibly the most important issue in global finance this year.
One of the obstacles is enforcement of the reforms. Recently, 10 steel-company executives were arrested when they went ahead with a $1.3 billion steel project that was not authorized. But for every over-investor caught, the concern is that there could be 10 who are not stopped. Just because Beijing says stop it doesn’t mean local officials and companies will listen. Local officials, who are paid by the local province, have their own agenda to preserve jobs and social stability and to advance themselves. When the central government tries to cool down the economy, it conflicts with their agenda. These often-corrupt locals are the ones who put pressure on the banks to loan them money.
Local Communist Party cadres can bend the rules and get local branches of the big banks to lend when they shouldn’t. And it’s not just the four big national banks that come under pressure from local notables. Seven regional commercial banks, 100-plus city commercial banks, and 1,200-odd rural cooperative lenders are all active often shelling out credit with nary a glance at a borrower’s books.
Soft landing or hard, only a gargantuan effort by central authorities will resolve the structural issues plaguing China’s money system. The latest over investment scare is just a symptom of a deeper malady that afflicts China’s hybrid economy, which blends elements of free markets with the heavy hand of a one-party state that still has a huge say in how credit gets allocated. China is still burdened with a backward financial system that can’t tell a good risk from a bad one and often doesn’t seem to care.
For various reasons, the stock and bond markets in China are not well developed, so banks account for 85 percent of the credit created. If banks had to compete with developed stock and bond markets for capital, they would have to lend more sensibly. Unlike the Western markets, where the major source of financing comes from selling shares in businesses, the Chinese market relies almost solely on bank loans. So maximizing the rate of return on capital normally a core measure of economic performance for private investors is not a major consideration for the banks since they are lending out other people’s money. Consequently, the banks are not as concerned about the quality of investments and return on investment as private investors would be.
Because of these underlying structural problems, some observers are pessimistic about China’s turnaround. There are simply too many underlying problems with the economy and the banking system, too many hot money investors with itchy trigger fingers, and too many recent examples of Asian economies in similar circumstances that have landed hard. The situation in China is suggestive of what happened in Japan in the mid-1990s and much of the rest of Asia in 1997.
Japan went from being an economic superpower that was predicted to dominate the global economy in the 21st century to an economic cripple during the early 1990s. East and Southeast Asia, excluding China, similarly passed from economic miracles to economic catastrophes in 1997. In both cases, the striking characteristic was the speed at which overblown Western expectations turned into disappointment. It is our view that China, which got started later than other Asian economies, is on course to be the third Asian meltdown in this generation. The euphoria about China until very recently and China’s assiduous attempts to stoke expectations tracks with what happened in the rest of Asia.
China has gone through boom-and-bust cycles before, but this time the stakes are much higher. The global impacts of the coming slowdown in China cannot be taken lightly, Morgan Stanley chief economist Stephen Roach said. When today’s Chinese economy sneezes, Asia and possibly even the rest of the world could well catch a cold. China’s ability to disrupt the world economy is growing to alarming proportions. The Chinese economy is interconnected with the rest of the world much more today than it was even a decade ago.
Trouble in the Chinese economy will affect Asia most of all. The United Nations annual economic report identified China as the locomotive for growth in Asia. Last year, China took in about half of the region’s exports and accounted for virtually all of Taiwan’s and the Philippines export growth and more than half of the growth in exports from Japan, Malaysia and South Korea. These countries rely heavily on China’s demand for their goods.
In Japan, the increase in exports is helping the country finally climb out of an economy in malaise for over a decade. Unfortunately, a large portion of those exports are to the overheated sectors of China’s economy such as steel and construction, and this has Japanese policymakers rightfully worried. For South Korea, China is now its largest trading partner, and trade with China is what kept the South Korean economy from slipping into recession last year. And despite political tensions, Taiwan’s economy is intimately connected to China’s. Taiwan has invested as much as $100 billion in Chinese ventures, and hundreds of thousands of Taiwanese have moved to the mainland to manage those ventures. Moreover, China is Taiwan’s number-one export market.
There’s no doubt that if China’s economy cools, the Asian region especially Japan, as well as South Korea and Taiwan will feel the repercussions the most. But the shock waves would not be limited to the Asian continent.
China’s investment boom has fueled a rapid rise in raw material imports that along with the wider global expansion has pushed up key commodities prices across the globe and is driving new investments in ports and other transportation infrastructure from Australia to Africa to South America. What happens if the demand for those raw materials dwindles? Take steel as an example. China purchased 20 percent of the world’s steel last year 31 million tons. If it’s internal demand falls to that of just four years ago, steel analysts estimate there will be enough excess capacity on the market to cause a glut so rich that prices would plummet below costs and destroy overseas manufacturers.
Even America may not be immune from the perils of a troubled Chinese economy. Japan and China, especially in the last two years, have been the primary funding source for the U.S.s growing budget and trade deficits. They have purchased hundreds of billions of dollars of U.S. securities primarily Treasury bonds. Since China’s yuan is pegged to the U.S. dollar (and therefore undervalued), part of China’s motivation is to keep the dollar propped up as much as possible. Without China’s financing, the U.S. dollar would have tanked even more.
One of the solutions to China’s problems would be to float the yuan instead of pegging it to the U.S. dollar. Much of the foreign direct investment coming into China is hot money looking for a quick profit in anticipation that the Yuan’s value will soon rise. By floating its currency, even partially, China would curtail foreign direct investment, decrease the money supply (because it would not be forced to sell yuan in exchange for dollars to maintain the peg) and rein in overinvestment, thus cooling the economy. With the peg removed, that could lead to China’s withdrawal of support for the dollar and trigger a fall-off in Chinese purchases of U.S. Treasuries. Were China or Japan to withdraw support for the dollar, U.S. bond yields would likely rise sharply, driving up mortgage rates and threatening the housing boom that has sustained American domestic consumption since 2001.
On the other hand, many analysts do not believe that China will revalue the yuan because exports would decrease, likely leading to higher unemployment. A revaluation would also hurt some of the banks biggest borrowers by wiping out exporters profits. The last thing an already beleaguered banking system needs is more companies that can’t service their loans.
China is facing some tough choices. Administratively, the government is doing all it can do and although the economy has recently shown signs of slowing down, it is still overheating. A revaluation of the yuan may not be out of the question. As Asia Times commented, playing with the currency does come with many risks. But the risks of maintaining a status quo are far greater.
It remains to be seen to what extent China will be able to skillfully and effectively maneuver out of its current crisis. Even if it avoids meltdown, avoiding deterioration will be much harder. What is happening to the Chinese economy will have global ramifications. How China deals with this financial runaway train will impact the world’s major economies.
All Beijing has to do is to mention the possibility of a sell order going down the wires. It would devastate the U.S. economy more than any nuclear strike the Chinese could manage at the moment. Considering how dependent the U.S. economy is on China, we cannot afford to ignore the possible ramifications on the U.S. of a Chinese economic meltdown. Even if it doesn’t happen, you can be sure that at some point China will float the yuan and distance itself from the U.S. which could have a crippling effect on America.
It is also fascinating to witness the historic transformation taking place within Asia. China is a key player in a coming Asian power bloc that will be the largest in history! Its stunning economic rise has made much of Asia more interdependent than ever before. In the past it has appeared that Japan would be the primary technology and military engine for the coming Asian power. But China’s growth even if overdue for a cooling off appears increasingly likely to make significant contributions of its own. The growth in its industry will not disappear, even if the economy browns out. China is sure to recover, as its neighbors have before it.