China’s Unfinished Economic Revolution by Nicholas R. Lardy, Brookings Institution Press, Washington, $44.95 cloth, $18.95 paper.
It looks as if China has successfully evaded the impact of the Asian economic crisis--at least on paper. During the first nine months of this year, as the economies of its Asian neighbours sputtered, China posted respectable growth: Gross domestic product rose 7.2%, consumer spending climbed 6.3%, and industrial production was up about 8% from the same period last year.
But while China’s leaders have been patting themselves on the back, it may be premature to declare victory. As economist Nicholas Lardy points out in his new book, China’s Unfinished Economic Revolution, China’s policy of gradualism has failed and the fragile economy is actually hanging by a thread.
This timely book, which comes out as the region ponders whether China will emerge as the main engine for economic growth in Asia, provides useful insights into the significant challenges confronting China, as well as suggestions for dealing with them.
Lardy argues that the financial performance of state enterprises has actually deteriorated during the two decades of economic reform. He says that half of all state-run firms exist on the brink of insolvency--remaining in operation only because of generous access to bank loans at unreasonably low interest rates. Many firms operate continuously at a loss, their output worth less than the cost of labour and other inputs required to manufacture products.
Lardy urges that immediate banking and enterprise reforms are needed--particularly if China wants to sustain high economic growth. He warns that if the government does not meet this challenge--and there’s not much recent evidence to suggest that it will-China could be pulled into the Asian financial crisis, deepening it.
The problem, according to Lardy, is simple. Government, state banks and state enterprises all are caught in a vicious downward spiral. State enterprises are saddled with heavy obligations for social services, including health care, housing, education and pensions. Furthermore, they are required to keep an excessive number of workers on the payroll to meet the states’ political objective of maintaining a low level of unemployment.
To cover these expenses--financed in most countries through the state budget--state firms, unable to cover their costs with sales income, are falling deeper into bank debt.
Meanwhile, the government is forcing state banks and other financial institutions to extend loans at economically unsustainable rates to keep state firms afloat. More troublesome is that the bulk of these loans are non-performing, which means the amount the four largest banks will have to eventually write off will almost certainly exceed the combined value of their own reserves and capital. Several of China’s state banks are already insolvent, and survive only because of the high household savings rate. The situation has become a classic case of Catch-22. “The banks cannot operate on fully commercial terms until the behaviour of their principal borrowers fundamentally changes,” Lardy says. But he cautions that until the state relieves them of the obligation of providing social services and excessive employment, even potentially profitable enterprises will find it difficult to improve their financial performance, thus making it almost impossible to deal with banks on a normal commercial basis. The state, in turn, will not be able to finance social expenditures from the budget until a fundamental reform of the tax policy and administration increases government revenues relevant to output.
He proposes a recapitalization of banks, introduction of greater competition in the formation of new local private and foreign banks, strengthened banking supervision and a gradual liberalization of interest rates. Lardy says the central bank must be given the independence to insulate banks from political leaders’ demands to make loans for projects that do not meet commercial lending standards. Finally, it must ensure that subsidies for policy lending are financed through the budget, not the banking system.
If the reforms are unsuccessful, Lardy predicts, China will move along a slower growth path, which in turn will dramatically expose the underlying weaknesses of its banking system. an ensuing loss of public confidence in the banks could trigger a demand for a large-scale withdrawal of funds, a demand that could only be met if the central bank were to serve as a lender of last resort. The resulting increase in the money supply, he says, would likely set off an inflationary spiral that could lead to a collapse of credit and thus a major recession.
Despite these problems, Lardy believes China will not face a crisis like several Southeast Asian countries experienced in 1997 for several reasons. Because Chinese currency is not convertible for capital-account transactions, it limits the ability of both local and foreign investors to quickly move their funds out of the country. Second, China’s capital inflows also have predominantly taken the form of foreign direct investment, which tends to be more stable. Third, China has enjoyed record trade surpluses since the mid-1990s, and at the end of 1997, had built up $139.9 billion in foreign-exchange reserves--enough to finance a full year’s worth of imports.
In an attempt to achieve its goal of 8% growth for the year, China’s leadership announced it had set aside $1.2 trillion for infrastructure spending for 1988-2000. Unfortunately, says Lardy, this programmed is not being financed through government revenues, but mostly by a significant increase in state banks’ lending Furthermore, the central bank in June ordered state banks to continue to expand lending to money-losing state enterprises. The main rationale appears to be increasing levels of urban unemployment and related social unrest, which Lardy calls “misguided.”
China has made short-term growth its highest priority, he says. However, as he argues in the conclusion of his book, a delay in carrying out reforms in the long run is an almost certain path to a lower pace of economic growth, a declining rate of job creation and an even greater threat to political stability.