Wall Street Journal Reports on the Grim Situation of China's Economy

By GORDON G. CHANG

June 19, 2002
Major Business News

Chinese Premier Zhu Rongji believes his nation's economy was on the verge of "collapse" in the late 1990s, and leaders in Beijing use "grim" and "grave" when they speak about the economic outlook today. Yet some foreign experts assure us that almost everything's fine in the People's Republic. So who's right?

As an initial matter, China's economy is decelerating. Optimists like to remind us how well the private sector is doing, but statistics show its contribution is not enough. Gross domestic product increased by 8% in 2000. Last year, it grew by only 7.3%. Worse, growth was only 6.6% in the last quarter of last year, well under the 7% official target for the current five-year plan.

Growth in this year's first quarter looked robust at 7.6%. But the corresponding figure for the first quarter of last year was 8.1%, so growth has declined by a half point when measured on a year-on-year basis. Even according to the official figures -- which exaggerate China's output -- growth declined in each quarter of last year. China, therefore, is starting this year from a much lower base.

There is also the more fundamental matter of how a country can record high growth when it is experiencing worsening deflation and massive unemployment, a highly improbable feat. Although reported tax collections have increased, this is not a sign of an improving economy: Beijing has merely regularized the collection of revenue once kept off official books.

The real story, however, is not that the numbers are doctored, but the amount of fiscal stimulus the government uses to keep the economy going. This year's most important economic statistic received virtually no attention: Fixed asset investment, the result of pump priming, increased by 26.1% in the first quarter when measured on a year-on-year basis.

Beijing is merely buying low-quality growth. Today the central government accounts for more than two-thirds of investment in the country, alarming by any standard. Government spending is inefficient, and such spending is now growing more than three times faster than GDP. The story gets worse -- pump priming is not having the desired effect of igniting consumer demand.

Deflation has returned to China.

The country can ill afford the fiscal stimulus campaign, now in its fifth year. China is running ever-larger budget deficits, just like the record one of 310 billion yuan ($37.5 billion) announced for the coming year. Even if the official GDP figures are correct, China's annual deficit has already zoomed past 3% of GDP, the internationally recognized safety limit. The current pace is unsustainable and out of control.

The erosion in the central government's finances was evident in the first quarter of this year. Expenditures rose 23.9% while tax revenues increased just 3.4% from the same quarter last year. Finance Minister Xiang Huaicheng had just one word for China's recent spending, calling it "reckless." "The fiscal situation is grim," he said in mid-April, commenting on the first quarter figures. "Revenue is growing too slowly and expenditure is growing too fast. Not enough money is being collected and too much is being spent."

Unless it can patch up the situation, China risks becoming Asia's Argentina. Like that South American country, the People's Republic can go from boom to bust in just a few short years. Both countries stuffed their banks with bonds, created growth through fiscal means and attracted foreign direct investment. Argentina, last decade's model reformer, was hit when there was a fall in the demand for its debt obligations.

Argentina deferred reforms by living on foreign capital, and China is playing this game too. Capital flows to a country are largely dependent on global liquidity. As economic strategist Chi Lo pointed out in a March 12 article on this page, because China now lives on inward flows, "its ability to sustain investor confidence is crucial. As and when the flow of international capital tightens again, China's deteriorating fiscal and debt conditions will come under international scrutiny."

China as the next Argentina? Today that sounds preposterous. Yet it is worth remembering that Argentina did not have to undergo the shock therapy of joining the World Trade Organization. China is doing so now, and the sweeping promises made to get into that group mean Chinese technocrats no longer have the same power continually to defer solutions to fundamental problems.

For example, China has lost control of the timetable to reform its banking system because of its commitment to open up this sector. The largest state banks are insolvent, as a group perhaps the weakest in the world. Beijing must rehabilitate them in the next half decade to the tune of a $500 billion -- or face their failure and the collapse of the economy itself.

Beijing talks a lot about structural reform but has implemented very little of it these past few years. In this upcoming period of political transition, during which almost all the top posts in the Communist Party and central government will change hands, the paralysis will become even more evident.

There is ample evidence that Beijing understands these problems and grasps many of the solutions needed to fix them. But whether Beijing is on the right road is not the issue. The critical issue is time. Peasants and workers are impatient. They're not about to wait five more decades to see if Communist Party economics work. Despite progress, many Chinese today are hungry, angry and, worst of all, desperate. Beijing's leaders know how to use the coercive power of the state to keep a lid on unrest. Yet force is only a short-term solution. Time is running out.

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