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Behind the Overheated Chinese Economy

Experts and politicians debate the outcome of the ever-expanding Chinese economy, the only apparent consensus being that it’s anybody’s guess.

Many scholars have noticed the current overheating of China’s economy, and a fiery debate is ongoing among the people who claim to be "China savvy" about the manner in which the high-flying economy will come back to earth: a soft-landing, a hard-landing, or even a crash landing? Mr. Wen Jiabao, China’s Premier, seems to be the person sitting in the cockpit of that proverbial Chinese airplane struggling to be grounded without too much impact. On April 28, 2004, Mr. Wen told Reuters that the country would take "very forceful action to cool its red-hot economy, since inflationary pressure was building due to a surge in money supply, credit and fixed investment." Whether Mr. Wen really meant business when he said that-and more importantly, if he did, whether he will ever have any chance to see his words translated into reality remains to be seen.

Overheated Chinese Economy

The National Development and Reform Commission released China’s total investment in the year 2003 as 1.6 trillion yuan (~$200 billion). This was about the same as the total investment of 2000, 2001 and 2002 added together. If you need a reference point to have any idea about the magnitude of those investments and the rate of their increase: China’s GDP of 2003 was only 1.16 trillion yuan (~$140 billion, according to official numbers released by the National Bureau of Statistics of China). As it turns out, those numbers are only a small part of the sizzling economy; when you go behind them, some more disturbing patterns emerge, indicating the breakneck boom is as much about the dollars spent on wasteful show-piece projects as about China’s sclerotic system.

After Hu Jintao became China’s President, most seats in the Politburo were still occupied by protégés of former President Jiang Zemin. What is more, Jiang had already placed many of his close allies into different key positions in the government in advance of that transition personally ordained by Deng Xiaoping. However, the two factions, of Hu-Wen and Jiang respectively, differ in their philosophies about economic growth—such as the priorities and strategies—and their interests vary too. In Jiang’s plans, Shanghai and the neighboring Jiangsu Province would have the priority, while Hu has picked the rust belt of Northeastern China (also known as Manchuria) as the new economic focus. But their similarities are just as evident: Both factions have aggressively resorted to exorbitant but doomed loans from state-owned banks to finance and sustain the boom. As a result, what we saw was a top-down chain reaction, as unbridled investments at the national-level bred provincial-level investments, which in turn trickled down to the city-level and the township-level.

The central government has made a practice of not releasing the number of investment projects. Some might guess that the government probably doesn’t track it to start with, given the insurmountable task of doing that. According to related administrative rules, projects under 500 million yuan (~$63 million) do not need to have mandates from the provincial level government. For example, the city of Changzhou, a medium-size boomtown on the Yangtze River can proceed with any projects of choice under 500 million yuan (~ $63 million). By the same reckoning, Nanjing, the capital city of Jiangsu Province with a population ten times larger, should be given the discretion to go ahead with any projects under $630 million; and Shanghai, one of the four directly governed cities in China, can freely work on any projects under $6,300 million. It is easy to see that China’s directly governed cities, its 27 provincial-level cities, its over 200 regional-level cities, its 400 town-level cities, and its over 2,000 town-level executive units have joined forces to form a vast pool of "sovereign" investments that are unknown to the mandarins at the central government.
Some China experts have estimated that China’s inflation is well within manageable areas as long as its currency in circulation is kept under 1,200 billion yuan (~$145 billion). Since the fourth quarter of 2003, China has experienced three waves of price surges, and the total amount of currency in circulation once peaked at around 6,000 billion (~ $727 billion). A quick, backward calculation would tell us how much those "sovereign" investments could be, for they are supposed to fill in the gap between those two divergent numbers—a hole of several trillion yuan.

Problem Solved?

It is no secret that both Hu and Wen are well aware of the complexity and the seriousness of an overheated economy. The conundrum facing the new leadership, however, is not the symptoms—and problems—of the economic fever but any prescription drug to cure it. A larger, Catch-22 question is: if there is such a drug, one that not only relieves the pain but kills the old patient to create a new, more robust one, are Hu and Wen ready to swallow it? And if they do, will Jiang and his Shanghai faction be willing to go along with it? Right now, the chest-thumping and empty rhetoric from above to cool down the economy is nothing but background noise to the special projects championed by the Shanghai (Jiang) faction. In reality, those projects are still going forward full blast, just as those special projects in Manchuria, darlings of Hu and Wen and their much-hyped New Deal, cannot be recalled or cancelled, either. As such, a question with Chinese characteristics would naturally come to mind: is this discussion about "economic landing" a healthy debate about economics, or another thinly-disguised game for power?

For all the talk, and uncertainties, about deflating any bubbles in the Chinese economy, one thing is certain, that is, it will be those millions of middle—and small—size private enterprises that bear the brunt of the sacrifice required by the "cool-down" measures fervently pitched by the Chinese leadership. Without any political clout, these private enterprises are at the bottom of the pecking order, and subject to unconditional "closure, suspension, or merger" as long as they need support from state banks. In contrast, those enormous special projects in Shanghai and Manchuria will continue to hurtle forward defiantly, although the consensus has it that China’s hope lies in its fast-growing private sector. Apparently, this paradox is not so much about Chinese economics as about the country’s engrained political culture.

Another likely, and ironic, victim of the policies to douse the heat in the economy will be Taiwanese business people throwing big money into all kinds of projects in China. During most parts of the 1990s, Beijing bent itself backward to jump-start its stalling reform program in the wake of the Tiananmen Massacre, when most western investors, still hounded by gory pictures on the TV, balked at doing business there. As it turned out, those Taiwan businessmen filled the void and received a lot of benefits, including preferential treatment in taxes. Now there are over 300,000 Taiwanese-funded enterprises in China. However, all indications suggest that Beijing no longer needs to be so sweet to Taiwan businessmen. The main reasons are as follows:

  • Most Taiwan businessmen do not have very strong political allies in China. Those who are in favor of the popular President Chen Shuibian are more vulnerable to economic penalties due to their political orientation.
  • For cultural and other reasons, much of the Taiwanese merchandise produced on the Mainland competes with similar Chinese products.
  • China is vigilant about its reliance on money pumping across the Taiwan Strait, as it could erode its firm stance against Taiwanese independence—right now a bargaining chip with the U.S.

Some shrewd businessmen from Taiwan have realized this, and have started to leave the Mainland. For the majority still refusing to come to terms with the reality, and to fold their business in China, it is only a matter of time before a trickle becomes a torrent that becomes a tidal wave, rolling for withdrawals from the Mainland. If they wait for too long—until next year or even later—they may not be able to recover the losses due to a hostile investment environment.

Why So Much Spending?

i. Waste

In China, because of poor management, most projects cost more than can be justified. Consequently, Return on Investment (ROI) of many special projects was zero or even negative. This problem was compounded by blind passions and thus poorly planned actions of many Communist functionaries aggressively promoting economic development as a way to promote their own political careers. They do not respect economic laws governing the market; all they want is statistics that give them the bragging right and the stepping stone for ascendance in the regime.

When former Party leader Zhao Ziyang resigned following the Tiananmen Massacre and Jiang Zemin took over, the reserves in the four major state-owned banks were over 1,300 billion (~$157 billion). After 15 years of breakneck development, or low-efficiency exploitation of resources reminiscent of the famed Schumpeterian growth theory, Chinese banks are now full of non-performing loans. In November 2001, the former chief of the People’s Bank of China (China’s central bank) Dai Xianglong openly admitted to the public that total loans of the four major banks were 680 billion (~$82 billion), among which non-performing loans accounted for about 20% and losses about 7%. This has resulted in none of the four largest state-owned commercial banks reaching the 8% Capital Adequacy Ratio stipulated by the Barsel Accord. On May 8, 2002, former Premier Zhu Rongji said at the National Financial Leadership Caucus, an internal meeting, that national loan losses were as much as 680 billion (~$82 billion). Since he didn’t have to lie at a meeting closed to the outside, this means the entire savings of Chinese citizens had been almost all gone by then.
At the beginning of the 1990s, there were about 110,000 state-owned enterprises (SOEs). In 1999, only 1,000 of them survived after being repeatedly resuscitated by state-owned banks. These survivors, mostly national champions carefully cultivated by the central government over the years, all weathered the storm that swept across the country between 1995 and 2001, when most SOEs, and the central government, finally accepted their fate to go bust. In fact, the losses of 680 billion yuan (~$82 billion) only refer to those stemming from bank loans; there are many other types of losses associated with those tens of thousands of failed SOEs that will never be known.

In addition to deficits of the four major banks, there are different types of debts of the government, for example:

4,000 billion yuan (~$500 billion) foreign debt;
6,000 billion yuan (~$727 billion) treasury bonds;
8,000 billion yuan (~$969 billion), deferred salaries of state-owned enterprises and social securities;
6,000 billion yuan (~$727 billion) local government debts.

Debts of the government are at least 24 trillion yuan (~$2.9 trillion). The total internal and external debts of the Chinese government are over 50 trillion yuan (~ $6 trillion). If the 1.3 billion of Chinese population have to share this debt now, each person needs to be responsible for 38,461 yuan, equivalent to $4,668. In comparison, China’s GDP in 2003 was 1.16 trillion yuan (~$140 billion).

ii. Corruption

A primary reason for overheated investment in China is rampant corruption. For a government official in charge of investments, an additional project means an additional source of kickbacks and extra power. There are about 60 million Communist Party members in China. Among them, about 6 million are cadres, or the functionaries supervising the rank-and-file members. The Stalinist system that was kept intact during the economic boom has enabled these cadres to be at the forefront in the drive to "get rich hilariously," as exhorted by Deng Xiaoping. Since it is always hard to draw a line between political and economic matters in China, these cadres, no longer called "party secretaries" but perhaps known as "CEOs" or "the Chairman of the board" to outsiders, take on all the trappings of a capitalist but still retain the unquestioned power accorded to them by the Party over every matter within their jurisdiction, whether it be a county or the whole country. Chinese law dictates that any officials who have more than 10,000 yuan (~$1,212) in inappropriate income are to be brought to trial. In the eyes of the masses, those officials with petty violations are only "small greed’s." There are millions of "big greed’s" that take bribes in millions of yuan. According to the Financial Times and other credible sources, in the past five years, over 10,000 corrupted officials in China took $450 billion out of the country, earning China the dubious distinction of number four (after Venezuela, Mexico, and Argentina) in capital loss from large numbers of high-ranking officials and their families fleeing with the country’s financial resources.

While it is common knowledge that the overheated Chinese economy is caused by excessive investments, the root cause for the country’s economic fever is systemic and intrinsic to its basic infrastructure. Before any substantial changes take place in China that allow it to take real “medicine”, such talks of a soft versus hard landing might be misleading. Remember, the Chinese economy is not yet a free-flying airplane seeking a better landing spot, but only a blip on the screen of a kid’s game machine that is monitored and completely controlled by much older tacticians whose motive and belief are at odds with each other and different from outside analysts. For them, effecting a soft-landing is as easy as producing a consistent 8% GDP growth rate as prescribed in the country’s five-year plan. So, when the Chinese economy finally achieves a landing, the real question is not whether it is "soft" or "hard," but whether it is real.

Li Ding is a Washington DC based economist.