Beijing's annus horribilus

The 21 million or so Australians know January 26 as Australia Day. But, for 1.3 billion Chinese, as well as the 40 million of China’s diaspora around the world including 650,000 in Australia, it ushered in the new Chinese New Year.

The Year of the Bull - signifying success through courage, hard work and fortitude - should be an auspicious one. But celebrations will be more muted this year. China is indeed entering troubling times. Growth forecasts have been revised down from 12 per cent to about 5 per cent within the last six months and Beijing will still not commit to a figure. As its once seemingly impregnable economy falters, China’s 1.3 billion people will look to their leaders for courage, hard work, and fortitude in order to reform the Chinese “authoritarian model” toward a more sustainable path.

The increasing problem of fleeing bosses in Guangdong sums up the country’s turn for the worse. Guangdong is China’s richest province and is the epitome of the Chinese “economic miracle”. For the last five years, the economy in this province had been growing at an average of 30 per cent per annum. Yet, in the last two months of 2008, almost 120 chief executives simply packed up and left as signs grew more ominous that their businesses were failing. These bosses left an average of 20,000 workers in the lurch and with unpaid wages. At Guangdong - the chosen destination for almost 30 million migrant workers - tens of thousands of itinerant workers have no choice but to go home empty handed every day. Currently, there is no law against fleeing bosses. Until now, Guangdong province never needed one.

President Hu Jintao tried to put a positive spin on the previous year by concluding that: “For the Chinese people, 2008 was a very extraordinary and uncommon year.” In reality, 2008 ended badly and ominously for the government.

December 2008 saw the publication of Charter 08 signed by more than 300 prominent Chinese, including high profile intellectuals and government officials. The charter called for those both inside and outside government to work for “the rapid establishment of a free, democratic and constitutional country”. The charter ambiguously described itself as a “civic” petition rather than one advocating “opposition” to the government. The objective behind it is unclear but it is the most significant call for political reform in China since the failed Democracy Party that died in the late 1990s.

The timing of the charter’s release also comes at a time of immense Chinese economic insecurity. This is not a coincidence. The Chinese Communist Party’s (CCP) implicit bargain with its people is that it will remain in power in order to secure prosperity for the country. This is now under threat. More importantly, many of China’s intellectuals, bureaucrats, and even politicians are beginning to see that it is the Party itself that is the cause of many of China’s problems.

If not a “catastrophic year”, 2008 will definitely be seen as the year when cracks appeared in the façade of the Chinese “economic miracle”. By the end of 2008, the Shanghai Exchange had declined by two thirds. Growth in the Chinese export sector, responsible for 40 per cent of GDP growth over the past decade, is flat-lining. Some estimate that 20 per cent of factories in the Pearl River Delta area - the jewel of Guangdong province - have already closed down and half will be gone by the end of the year. Although there are no reliable figures on the numbers of people laid off in the export sector, it is most likely to be in the tens of millions.

Importantly, economic growth is almost certain to dip below the 8 per cent mark - the point at which unemployment (and therefore unrest) begins to rise dramatically. If we look at informal but probably more accurate indicators such as power consumption, the Chinese economy is close to stagnating and even contracting. Power use in China fell 9.4 per cent in November 2008. December figures have not been released.

Two steps forward, one step back

Mass urbanisation and the creation of industrial centres such as those in Guangdong province has been one of the drivers of China’s boom. But modern China remains a largely rural society. If China is to become what its leaders term “a moderately prosperous country” by 2020, raising living standards in rural China is the key. In the early 1990s, there were still about one billion people in rural China eking out a living. Even now, there are still around 740 million rural Chinese.

Critically, in the 1980s, across-the-board incomes in rural regions were rising at the same rate as overall economic growth. Chinese peasants and those in rural communities - not just urban dwellers - were getting richer. The private sector - much of it based in rural China - was humming along and received almost three quarters of all the domestic capital in the country. Eighty percent of the poverty alleviation that occurred in China took place in the first 10 years of reform from 1979-89.

Deng Xiaoping came to power in 1978 and was China’s de facto supreme leader until the early 1990s before his death in 1997. In 2006, Time magazine named him one of “Asia’s Heroes” - a Maoist who reinvented himself and his country. He is understandably credited with leading reforms within China that have led to its economy averaging 9.8 per cent growth per annum for 30 years. But Deng’s genius was not that he planned the miracle. Many of Beijing’s major policies in the 1980s were actually “command and control” failures. But where the people showed independent initiative such as in the spontaneous creation of the highly successful township and village enterprises, Deng had the wisdom to allow it to occur. China’s economic return was built on the back of Chinese entrepreneurialism. This, Western leaders expected, would lead to political reform. It almost did. The Tiananmen protests in 1989 brought the leadership to its knees. But the CCP survived and China’s political-economic model changed.

The CCP decided to enlarge its role in China’s economy and society in order to remain in power. The rise of an independent and dominant private sector proved to be threatening. Critically, the private sector was excluded from competing in the most lucrative industries, which were reserved for state-owned-enterprises (SOEs). Moreover, promising private companies were subsequently denied loans from banks. Instead, three-quarters of these went to SOEs - an exact reversal of what occurred in the 1980s.

The impact of the policy change on Chinese society has been huge. The government owns more than two-thirds of all fixed assets in the country. In reality, China is ruled by a highly decentralised system. More than 35 million local officials now control access to land, capital, licenses, and even labour. Getting ahead means the need to network with these largely unaccountable officials. Systematic corruption is now rife throughout China. Since the 1990s, China has been scaling all the major “corruption” indices and the level of corruption is now rated worse than in India. Critically, China’s state-based model of development has widened the gap between well-placed and well-connected “insiders” who benefit at the expense of the majority of the population.

The consequences of the shift in strategy since Tiananmen have been profound. Within one generation, China has gone from being the most to the least equal country in all of Asia in terms of distribution of wealth. Even before the current global crisis, absolute poverty (those earning less than US$1 a day) doubled in China over the past decade. More than 400 million had seen their net incomes decline over the same period despite record GDP growth. The social gains in terms of across-the-board rising prosperity we saw in the 1980s have been reversed. Chinese in rural regions on average earn one-third the incomes of their urban counterparts. In the latest available figures, there were 87,000 instances of “mass unrest” in 2006. The overwhelming majority of these took place in rural China.

It is no wonder that domestic consumption levels continue to lag behind expectations. Too many people have been missing out despite three decades of growth. Domestic consumption is currently at around 35 per cent of GDP, the lowest of any major economy in the world. The idea that 1.3 billion people would consume enough to save Asia from recession if America and Europe faltered was never a realistic possibility. Despite 30 years of GDP growth, China increasingly relies on exports and state-led fixed investment to keep growing. Now that consumers in America and Europe are tightening up, weaknesses in the Chinese economy have been exposed. The model of over-reliance on exports and inefficiently pumping capital into SOEs to ensure high growth is nearing its end.

Cracks in the wall

The pervasive role of the state in the Chinese economy goes to the heart of the country’s economic weakness. High rates of GDP growth since the Tiananmen protests have created a false impression of resilience.

Since the early 1990s, three quarters of GDP growth has been driven by fixed asset investment, although it has since dropped to driving around half of China’s growth. The state has retained control over the financial sector. Subsequently, state-owned banks lent out more than three quarters of all capital to SOEs (and state controlled businesses). Unfortunately, these SOEs use the capital extremely inefficiently. For example, in the 1980s, it took $2 of capital investment to produce $1 of additional output. By 2000, the ratio was 4:1. It is now 6:1 and approaching 7:1. In terms of use of capital, this is twice as bad as India. Quite simply, China is getting less bang for its buck. In fact, the World Bank estimates that one third of investment projects initiated by SOEs are wasted and offer zero or negative returns.

There are still about 100,000-150,000 SOEs in the country. Many of the 100-150 centrally managed ones are extremely profitable. Yet, just a handful of them are responsible for 80 per cent of total SOE profits. Most are breaking even or unprofitable. Nevertheless, loans to SOEs have increased by an average of 25 per cent per year since 2000 and inefficient businesses continue to receive the lion’s share of the country’s capital. Not surprisingly, many of these loans are never paid back. Many experts have given up on estimating the level of non-performing loans in the Chinese financial system - said to be more than US$1.5 trillion and counting. At these levels, China’s major banks would all be technically insolvent.

As exports decline, Beijing is forced to pump even more capital into these SOEs in order to stimulate growth at any cost. Almost the entire US$586 billion stimulus package, announced in late 2008, is destined for SOEs. Yet, by Beijing’s own admission, this is an unsustainable strategy. Even after 30 years of reform and averaging almost double digit growth each year, China oversees an economy that threatens to implode at the first sign of decline in export volumes.

There is also another problem. Many private businesses, denied capital from the banks, have been relying on “hot money” from outside China. Multinationals and other local businesses had found ways of bypassing the controls restricting the flow of capital in and out of the country. A year ago, the amount of “hot money” was estimated at about US$200 billion-$300 billion, and this provided much needed “informal” finance for both private and state businesses. As the weaknesses in China’s economy and society become more apparent, massive amounts of capital are now leaving the country. Last month, one estimate put the capital flight at US$45 billion. As the “hot money” leaves China, both SOE and private businesses will have problems paying back their legal loans - prompting a further hike in non-performing-loans. Worryingly, private businesses will have extreme problems getting access to finance.

The Ox or the Bull

Many China watchers now believe that unemployment in urban and rural China is around 10–15 per cent and 15–20 per cent respectively. As Tiananmen showed, these are dangerous times for the regime. China’s rise is far from over. But optimism about China’s future assumes that Beijing will continue to initiate further reforms. The 800 million people mainly in rural China still earning US$2 a day or less will certainly hope so.

There is an old Chinese joke that good times mean that it is the Year of the Bull while bad times mean it is the Year of the Ox - a castrated bull. If China’s leaders lack the foresight and courage to reform for the future - and return the power to its determined private sector - the hard work and fortitude of the people will be wasted.