Prognosis for China, Page 12, Rev. 4


3. The Economic Dimension of the Actual Problem

In order to understand economic statistics related to China, one must first come to appreciate that they are grossly unreliable. This is the fundamental reason that it is possible for China to be in deep recession at this time even though official statistics indicate it had a growth rate of no less than 7.1% per annum for the first half of 1999. An examination of the reasons these statistics are so misleading is also useful for developing an appreciation of both the depth and breadth of the present crisis in China.

The first problem is that the Communist Party has always required rosy figures and always overstates the rate of growth industrial output in particular. Gerald Segal, Director of the International Institute for Strategic Studies in London, informs us

China claimed that its average annual industrial growth between 1951 and

1980 was 12.5 percent. Japan=s comparable figure was 11.5 percent. One

can reach one=s own judgement about whose figures turned out to be more accurate...Few economists trust modern Chinese economic data; even Chinese

Prime Minister Zhu Rongji distrusts it. The Asian Development Bank routine

deducts some two percent from China=s official GDP figures, including notional

GDP growth rates of eight percent. (1)

He Quinglian explains

The fact that economic growth is regarded as the chief indicator of an official=s performance has encouraged local official to play with statistics and hand higher authorities false information. The central government then bases judgements on

such seriously inflated statistics, and works out policies accordingly. The

inefficiency of such policies can well be imagined.@ (2)

The second problem is that many of China=s state controlled enterprises produce junk. As in Russia, these enterprises actually destroy valuable raw materials. It would be less destructive for the economy if their workers were simply paid, but did nothing, since the goods they produce require raw materials which otherwise could produce something of economic value. Again, Mr. Segal: ASome two or three percent of what might be a more accurate GDP growth rate of six percent is useless goods produced to rust in warehouses.@ (1 again) Another dimension of this is make-work projects:

Over the past few years the Chinese government has increased spending on

infrastructure projects across the country to boost domestic demand. The

result: a large number of >bean curd,= or badly built, projects, which deplete

the treasury by 100 billion yaun ($12.08 billion) a year, an amount equal to

the sum of treasury bonds issued in 1998. (3)

Prognosis for China, Page 13, The Economic Dimension (Continued), Rev. 4


Yet other aspects of the official GDP figures do not represent actual increases in meaningful economic output. According to Segal AAbout one percent of China=s growth in 1998 was due to massive government spending on infrastructure. Some three percent of GDP is accounted by for by the one-time gain that occurs when one takes peasants off the land and brings them to cities, where productivity is higher. Taking all these qualifications into account, China=s economy is effectively in recession. Even Zhu calls the situation grim.@ (4)

Now recall the effects of the environmental disaster described in Section 2 above: The World Bank concluded that >total air and water pollution costs are conservatively estimated at U.S. $54 billion a year, or roughly 8 percent of GDP. (5 & 6 again; See also 7) If this almost unbelievable rate of destruction of assets is factored in, it is clear China is experiencing the deepest of recessions, possibly a depression. Even assuming the World Bank estimate is twice the correct figure means China is in serious trouble. This is supported by a finding of the International Institute of Strategic Studies: AAfter two decades of exceptionally fast growth, the Chinese economy is faltering under the effects of East Asia=s crisis, the inherent limitations of the state-dominated system and environmental problems...it is no longer certain whether Beijing is strong enough to implement radical and painful changes.@ (8)

A detailed examination of China=s banking sector reveals one foundation for the problems described above. The Economist reports AIf the health of China=s banks is measured by the proportion of bad loans to good ones, then China=s may be the worst banks in Asia...the very process of reform raises the odds of a full-blown banking crisis. China may be hard-pressed to move the financial system out of its socialist past towards its capitalist future without some very difficult times along the way.@ (9) A chart in this article indicates that the return on assets of China=s big four banks from 1994 to 1995 was only 0.3%. The analysis concludes A...reform of the state banking system is likely to fail unless a good measure of competition is also introduced.@ It goes on to explain that only A...a handful of small commercial banks have been allowed to operate nationwide.@ Also, AThe 46 foreign bank branches in China are even more curtailed...loans may be extended only to foreign joint-ventures...if foreign banks were allowed unfettered access to local deposits, then savings would pour out of the state banks, threatening their very survival. It is this fear that will help place a limit on reforms to China=s banking system...But postponing it will leave an even more severe financial crisis looming just over the horizon. (10) This crisis is confirmed by Mr. Segal: ABy conservative estimates, at least a quarter of Chinese loans are nonperformingC a rate that Southeast Asians would have found frightening before the crash. Some 45 percent of state industries are losing money, but bank lending was up 25 percent in 1998 C in part, to bail out the living dead.@ (11) Nicholas R. Lardy informs us AIn 1996, the People=s Bank of China acknowledged that some banks had lent funds >without recording them in their account books= and that other financial institutions created >false assets= to conceal large losses on their balance sheets.@ He also reports Acredit has expanded excessively@ to 100% of GDP in 1997 and Amore and more firms will not be able to service their debts if the economy slows down.@ (12) The economic slowdown of 1999 has placed exactly that pressure on many companies. A rating agency reports Athe underlying asset quality of mainland banks deteriorated sharply last year.@ (13)

Prognosis for China, Page 14, The Economic Dimension (Continued), Rev. 4

An examination of Foreign Direct Investment (FDI) is instructive of how the corruption of the PRC system itself yields deceptive statistics.

Even in 1997, China=s peak year for FDI, some 80 percent of the $45 billion

inflow came from ethnic Chinese, mostly in East Asia. This was also a year

of record capital flight from China...an outflow of #35 billion. Much so-called

investment from East Asia makes a round-trip from China via some place like

Hong Kong and then comes back in as FDI to attract tax concessions. (14)

In any case, the scale of Foreign Direct Investment is declining. The United Nations reported in 1998 that FDI into China may be cut in half. (15) It has fallen a further 20% in 1999. (16) At the same time China=s domestic economy is not generating needed employment the rate of jobs created by FDI is also in decline.

The most ominous aspect of the economic crisis is unemployment. Anita Chan and Robert A. Senser, writing in Foreign Affairs, advise us (in 1997): Today [1997] the number of registered urban unemployed is 5 million...But 20 million...have either lost their posts or been temporarily laid off...In addition there are 30 million retirees from enterprises whose pensions are not keeping up with inflation or are not paid at all. (17) If these numbers are not bad enough, consider that Aroughly 130 million former peasants already work in factories, and that number again is considered surplus on the farm.@ (18 again) Official unemployment reached 5.7 million in 1998 (19) and 7.4 million in 1999. (20) Even this does not describe the full extent of the problem. Neil C. Hughes, writing in Foreign Affairs, describing the situation in the A4,031 state-owned textile firms, employing four million workers...@ informs us A...that one government official stated that 40% of these enterprises are on the brink of collapse...In 1997, $1.2 billion in debt was converted to equity in 555 state textile enterprises, and twice this amount has been allocated in 1998. About 1.2 million workers will be >diverted= to other jobs in ways not spelled out yet.@ (21)

Events in 1999 have made the unemployment situation even worse than the general situation in 1997 and 1998 described above. In August, the government announced a dramatic reduction in the number of employees in the government sector itself, amounting to 1.2 million jobs. (22) Also, Prime Minister Zhu Ais still intent on reforming state companies.@ (23) The South China Morning Post reported on September 15 AEnhanced reform of state-owned enterprises will be the theme of the plenary session of the party Central Committee which opens in Beijing on Sunday.@ (24) While it is not clear exactly how far these reforms will proceed, Edward S. Steinfeld estimates Arestructuring now threatened as many as 20, 30, or even 40 million livelihoods.@ (25) Van Kemenade concludes AThe downfall of all the dynasties was caused by the forces of the liu-min (the >floating population=). Which of the two now poses the biggest threat to China=s stability C the floating peasant population or the threat of massive unemployment in the old centers of state industry C is difficult to guess and varies from region to region.@ (26)

Prognosis for China, Page 15, The Economic Dimension (Continued), Rev. 4


This writer estimates the number of unemployed to be substantially in excess of 100 millions.* It is clear is that this problem is a significant part of China=s crisis of governability. It is also clear that the contracting economy is not going to solve this problem in the near term. (27) In this context, observe that mobilization of large numbers of reservists and militiamen has the de facto impact of generating jobs. So do any capital equipment orders requiring defense related industries hire more workers. Both of these measures mitigate the unemployment crisis.

China=s workers have other problems besides obtaining adequate employment. Anita Chan and Robert A. Senser, writing in Foreign Affairs, tell us

After a decided improvement in living standards during the first half of the

1980s, income inequality has widened, with worker= social status declining

apace...Some 17 million Chinese people work in coastal factories funded by

foreign investors...often under sweatshop conditions. Low wages are not the

worst of the workers= problems. The most repugnant abuse is physical punishment, including beatings...As a result, even verbal threats are intimidating...the coercive regulations...are unbelievably detailed, prohibitions on talking, even while eating; marked routes for walking within the factory-dormitory compound; bans on

leaving the compound at any time...; prohibitions against getting pregnant,

married or even engaged. In one factory, anyone using the toilet more than twice

a day forfeits nearly a fifth of her monthly wage. Workplace health and safety in

such enterprises is often scandalous...When hired workers typically must surrender official papers...and pay a substantial Adeposit@ or bond. Either or both will be

forfeited if the workers quit...Why does the Chinese government allow foreign

companies to abuse its citizens so outrageously? Many of the partners in joint

ventures are actually government agencies or their affiliates...China=s apartheid-

like household registration system...divides the population into two distinct groups,

urban and rural. To stay in urban areas, peasants must get and retain temporary residence permits linked to employment, a dependency that exposes them to easy victimization. Though less publicized, sweatshop conditions have also permeated China=s state-owned enterprises...In eliminating the Maoist system...the

government transferred wage setting power to individual enterprise managers...Now payday is often a day of mystery...=You never know how much money you will be given for the month.= Today the tacit consensus...is that workers must be sacrificial lambs for the nation=s economic advancement...almost all policy proposals have chosen to

leave labor issues out of their blueprints for China=s development...Friction is

bound to increase due to contradictions between liberalizing the marketplace

and denying its most numerous participants, workers, the freedom to articulate

their own interest. (28) **

* Karl Jackson, director of Southeast Asian policy studies at John=s Hopkins University, places the number of unemployed and underemployed at 300 millions. (19 again)

** In some professions, e.g. coal mining, China=s workers face a considerable risk of death. See Note 29.

Prognosis for China, Page 16, The Economic Dimension (Continued), Rev. 4

The policies described above mean that a large fraction of Chinese who do have jobs are not respectful of the policies of their government. When this is combined with the frustration of those who have no jobs or who only technically have jobs but are Alaid off@ without pay, the implications for China=s governability crisis are compounded. (30) These implications are described by Lardy when he says A...the reform program is fraught with risk. China already has an unprecedented unemployment rate, and the political system may not withstand the even higher rates that will accompany the restructuring of state enterprises. Moreover, the transition is beginning under unfavorable external conditions...@ (31) Similarly, Barry Naughton thinks AThe rapid growth of urban unemployment is one of the greatest challenges facing the program of state enterprise restructuring. Laid-off workers are joined in their discontent by workers who find that their wages are not fully paid and by retirees whose pensions or medical benefits have disappeared. The unemployment numbers indicate that state economic enterprises are under enormous economic pressure from which they are simply unable to shield their workers.@ (32; See also 27 again)

Space does not permit a sector by sector analysis of the Chinese economy, but the above discussions are typical. Inflation is a serious problem. (33) The gap in living standards between urban and rural China is growing. (27 again) The local tax burden in poor rural areas is excessive and often visibly abused. (34) The classic Chinese problem of APopulation pressure on arable land has led to scarcity@ has returned on a grander scale than ever. (35; See also 33, 36 & 37) The economic aspect of this is inadequate food production. Nevertheless, the economic dimension of China=s governability crisis is complex. If China goes to war with Taiwan, there will be serious negative economic impacts. These were hinted at by the performance of China=s stock market. Thomas L. Friedman informs us AThis time, when China rattled its saber at Lee, it knocked down Taiwan=s stock market, the Teiex, by 20 percent. What people didn=t notice, though, was that the Shanghai Stock Exchange B-share index plunged 40 percent!@ (38) Mr. Friedman also notes that A...the Taiwanese C who avoided the Asian economic flu and don=t mind the cowboy capitalism required for doing business in China C Ahave become Amore important to China than ever@ because of the decline in investment capital from other places. ARoughly 46,000 Taiwanese-funded enterprises are operating in China today...Taiwan=s total contracted investment in China is now $46 billion.@ Finally, he quotes Douglas Hsu, head of one of Taiwan=s biggest firms, to the effect that ATaiwan is China=s biggest capital supplier today...but this may not last forever.@ (38 again) Not only will trade between the mainland and Taiwan suffer in a war, such a conflict would also impact foreign trade with other nations. It is not clear, however, that such negative impacts are sufficient to deter China from such a war. Gregor notes ABefore the Tienanmen massacre in 1989 most analysts were convinced that the Beijing authorities would not use violence against the unarmed civilian population...it would threaten China=s economic program. The leaders of the Chinese Communist Party were well aware...that the predictable international response would threaten continued modernization, reduce access to foreign markets, and outrage investors. None of that dissuaded the leadership from its purposeC and it is not certain that such considerations could now stop Beijing... @ (39, see also 40).