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Growth, Reform, and the Effects of the Asian Crisis on China

In the context of the apparent collapse of many of the "Asian miracle" economies in 1997, China's continued strong growth is striking. After all, many of the lessons drawn from the Asian crisis might seem to apply to China. For example, one clear lesson of the crisis is that it is dangerous for a country to have weak, poorly regulated banks making policy loans to inefficient, over-leveraged state enterprises--a reasonable description of China. Some commentators, such as Nicholas Lardy at the Brookings Institution, argue that China's financial system looks at least as bad as, and perhaps far worse than, those of other regional economies.

Keeping the house warm

Even after two decades as the world's fastest-growing economy, China remains a relatively poor country. The World Bank estimates that China's income per capita is roughly one-tenth that of the United States--comparable to Egypt, Macedonia, or El Salvador. Small reforms had a rapid and radical effect on China's very poor, inefficient, centrally planned economy. China's reforms have allowed an active, dynamic non-state sector to grow outside of the centrally planned core. Several years ago, a Western diplomat in Beijing suggested to me that the house analogy helped explain the process: just as shutting the windows rapidly improves conditions inside the house, reforms that allowed for individual initiative--such as the cont ract responsibility system and the dual-track pricing system--unleashed rapid growth despite substantial structural problems.

China's approach to reform is often described as a gradual one, in which changes are made around the edges of the centrally planned economy. But as Stanford economist Laurence Lau and his collaborators have argued, China's seemingly small steps were in many ways quite radical. They meant that at the margin, market forces widely determined what goods were produced. Of equal importance, the gains were fairly evenly spread across the country, minimizing political opposition. World Bank Chief Economist Joseph Stiglitz pointed out in a recent speech that if one considers each of China's provinces as a separate economy, then the 20 fastest-growing economies in the world from 1978 to 1995 have all been in China. Also, though income inequality appears to have risen, there have been few outright losers from reform.

Postponing the inevitable

In a recent and wide-ranging survey o f financial liberalization, John Williamson of the Institute for International Economics argues, along with co-author Molly Mahar, that there is considerable evidence that financial liberalization fosters a more efficient allocation of investment. Hence, making the transition to a commercially oriented banking system is clearly important to China's ability to sustain high growth. At the same time, however, they point out that the process of liberalization can itself lead to financial crisis. The transitional stage--where controls have been lifted but incentives remain inappropriate--holds clear dangers, as was evident in the Asian crisis economies. In this perilous transition, banks and other financial institutions have an incentive to take too many risks: if the government will bail them out when they run into trouble, then bankers are not fully responsible for any losses they incur. But they keep the profits if these risky loans are repaid. In other words, bankers have little to lose and much to gain from taking too much risk.

In China's case, the real dangers of partial liberalization have been largely, though perhaps not entirely, limited to the fringe of non-bank financial institutions, such as the Guangdong International Trust and Investment Corp. (GITIC) and other ITICs. GITIC's activities were widely reported following its closure in fall 1998 and subsequent bankruptcy in winter 1999 (see The CBR, May-June 1999, p.36). These activities exemplify the moral hazard problem. GITIC's investments were far too risky, because the institution could capture gains without bearing responsibility for any losses. Over time, the scope of GITIC's activities widened considerably. Poorly regulated, its relatively legitimate activities included excessively risky real-estate ventures. Its less legitimate ones have led to allegations of fraud and corruption.

Chinese ITICs are important to their creditors, but nevertheless remain small relative to the rest of the financial sector. Lardy and others have emphasized the parlous state of the four major banks, with their substantial overhang of bad loans, low transparency in and accountability for their actions, and little experience or skill in assessing loans on commercial grounds. Though bad for the long-run health of China's economy, the fact that China's financial liberalization is only beginning suggests that these severe problems need not spark a crisis.

That is, Chinese banks remain subject to substantial restrictions on their activities, and not fully subject to market discipline. As a result, they--and China--remain less vulnerable to financial collapse. For example, regardless of their other, often adverse effects, capital controls prevented most Chinese financial institutions from borrowing excessively abroad, and helped keep the country's external fundamentals strong. Domestically, Chines e banks can continue to operate with negative net worth, because the government implicitly guarantees deposits. Berkeley economist Barry Eichengreen notes a more extreme example: "North Korea's financial system is immune from crises because it is subject to such draconian controls." China is no North Korea. But it does remain subject to substantial controls.

Of course, just as a tourniquet on a bleeding arm is no substitute for proper medical care, controls--to the extent they did contribute to China's stability--have serious costs. First, controls are often leaky. A tourniquet may slow the flow of blood from a wound, but if it's not tight enough or if the wound is serious enough, you will bleed to death slowly rather than quickly. Similarly, controls may for a time work well enough to prevent financial crisis, but people always have incentives to find ways around the rules. Moreover, this evasion potentially contributes to further problems in the form of corruption and fraud, such as capital flight through under-reporting exports or over-reporting imports. Second, the controls may in some sense work too well. If you twist the tourniquet too tight, to stanch all flow of blood, the arm will eventually die. North Korea, for example, may have survived the Asian crisis--but its harsh controls help explain its extreme poverty.

Fortunately, capital and other controls are not the whole story behind China's resilience. The PRC financial system may be weak, but many of the economy's fundamentals look far stronger than in the front-line crisis economies. In particular, China has relatively low external debt relative to GDP, large foreign-exchange reserves, a current-account surplus, and continuing sizeable inflows of foreign direct investment, though these have been less robust of late. And much of the non-state sector remains vibrant.

What risks remain

On the demand side, the most serious concerns are probably consumption and investment. Precautionary saving appears to be very high, reflecting the need to pay much more--though how much more remains uncertain--for medical care, retirement, and housing, for example. If uncertainty rises further, precautionary saving could continue to rise. In addition, to the extent that consu mption is interest-sensitive, then the current high levels of real interest rates also work to depress consumption. Though nominal interest rates are now relatively low, having been cut steadily since 1996, China's deflation implies that in real terms, interest rates are much higher now than they were then.

Private investment is constrained by restrictions on the availability of financing. Despite the fact that the non-state sector has grown much more rapidly than the state sector, a striking aspect of China's financial landscape is how little bank financing goes to this sector. Instead, most intermediated financing goes to the state sector; for example, HSBC economist Chi Lo reports that 86 percent of state-bank lending went to the state sector, as of September 1998 (see The CBR, March-April 1999, p.50). The non-state sector relies heavily on retained earnings, foreign direct investment, and leakage--or relending--of funds from the state sector. All three of these sources could continue to slow. A weaker economy, for example, tends to reduce retained earnings. New FDI inflows appear to be falling as well, reflecting both concerns about the desirability of investing in China and the residual effects of the Asian crisis, given that about 80 percent of FDI appears to come from Asia. Improvements in accounting standards and tighter scrutiny of enterprise activity may make the on-lending of funds from the state sector more d ifficult. Hence, private investment could continue to weaken.

Public investment probably has a limited ability to take up the slack. After all, in order to provide a continuing stimulus to output growth, public investment must not only remain at a high level, but must continue to grow strongly. Given China's relatively low level of tax revenue and undeveloped bond market, financing a further surge in investment is difficult (see p.16). Finally, such a surge may be undesirable--even in countries with a high degree of transparency, public investment projects often reflect pork barrel politics rather than sound economics. Press reports suggest some concern about the low quality of some projects, and the potential for corruption.

In assessing China's potential vulnerability, commentators often stress the narrowing trade surplus or continuing deflation. But these are probably not the major sources of concern for the future. Consider the trade balance, which has deteriorated sharply in 1999. Although the deterioration shows some weakness in export growth, it primarily reflects a surge in the recorded level of imports in 1999--after remaining roughly constant since 1995. If the deterioration indicated mainly an overvaluation of China's real exchange rate, concern could be warranted. But because of China's low inflation, its real exchange rate has largely reversed its strong appreciation following the Asian financial crisis.

Instead, this import surge has largely resulted from China's anti-smuggling campaign: previously unrecorded imports are now recorded and taxed. The resulting narrowing in the trade and current account surpluses in 1999 does not, then, appear to indicate a fundamental change in the state of the economy, and thus its economic effects are probably small. As of July 1999, year-over-year export growth remains weak, but that actually is the result of weak exports in the first half of 1998--not this year. Adjusted for seasonal factors, the dollar value of exports actually grew in the first half of 1999 relative to the second half of 1998.

The deflation bogey

These effects are much less important in China than in other countries, since it is unclear that the real value of borrowers' debts has a major effect on bank's activities. State-owned enterprises and other politically connected enterprises, regardless of who technically owns them, do not necessarily repay their deb ts in any case. For this reason, demand for bank loans is unlikely to be sensitive to the interest rate.

Deflation does, presumably, affect the incentives of households to consume or perhaps invest in ways not intermediated by the banking sector. That is, high real bank interest rates affect households' incentives to save through the banking system versus "direct investment" in non-state enterprises, such as start-up businesses, loans to relatives, or loans through the illegal curb market. This suggests that deposit rates may have some effect on investment decisions, although the quantitative effect is uncertain. To the extent that capital is more productive outside the state sector, deflation is likely to worsen the long-run allocation of capital.

Another risk is that China's reforms may slow. The increase in state investment since the second half of last year appears to have been financed to a large extent by substantially faster lending by the four major banks. Hence, the increase in growth appears to be at the expense of previously announced enterprise and bank reform.

A slow freeze?

China's approach is to try applying steady reform pressure throughout the system--for example, pushing ahead with sales of small and medium-sized state enterprises where possible, telling banks that they are responsible for any new bad loans, and cleaning up balance sheets. Indeed, China has made steady progress; in 1998, state enterprises reportedly shed about 6 million workers. But each step causes dislocations or problems that need to be addressed, as suggested by the apparent backtracking in some areas in 1998. Moreover, in a system with numerous distortions, economic theory tells us that eliminating any single distortion may not improve the functioning of the system, since one distortion might help offset the effects of some other distortion. Thus, one should not expect any quick panaceas.

Indeed, enterprise restructuring can, in the short term, contribute to a slowdown in China. For industrialized countries, recent macroeconomic literature explores the importance of "sectoral shifts," the idea that reallocating resources across sectors is costly in the short term. The controversy in this literature is not whether reallocations and restructuring are costly, but whether they are important in practice. They might not turn out to be a significant source of shocks to the United States, for instance. So this macroeconomic literature suggests that some further temporary slowdown could occur in China, if the necessary reforms proceed.

China is attempting to balance conflicting concerns--a desire for short-run stability and growth, which tends to slow reforms--versus a need for long-run improvements in the allocation of resources, which requires that reforms move forward. This tension was apparent in 1998. Growth slowed in the first half of the year, and as a result, investment by state firms rose sharply in the second half of the year, financed by lending from state banks.

Elsewhere in Asia, decades of strong growth ended--one hopes only briefly--in metaphorical fire. In China, there remains the serious risk that it could end in ice. Without major structural reforms, China's economy is something like the house with a lousy furnace and uninsulated walls. The economy could then stagnate, and China would rem ain relatively poor, just as the house would remain cold in winter. Fortunately, Chinese leaders appear to be aware of the risks. Unfortunately, their choices are hard, requiring a trade-off between the political risks of a further short-term contraction and the economic risks of a long-term slowdown in growth.

John Fernald is an economist at the Federal Reserve Board. The views in this paper are the sole responsibility of the author and should not be interpreted as reflecting the views of the Federal Reserve System or of any other person associated with the Federal Reserve System.