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Beijing's annus horribilus

By John Lee - posted Monday, 2 February 2009


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.

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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.

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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.

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A shorter edited version of this article was first published in The Australian on January 27, 2009.



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About the Author

Dr John Lee is a non-resident senior fellow at the US Studies Centre and the Hudson Institute in Washington DC.

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