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China today – restructuring the iron rice bowl

By Susanna Mitchell
Jubilee Research
9^th July 2003

‘European conceptions of China have rarely reflected Chinese reality, but have first and foremost been the response to European needs.’ 

Bodo Wiethoff, An Introduction to Chinese History

Synopsis

While the policies advocated by Western international financial institutions continue to lead to economic crises in many developing countries, China’s gradualist approach to liberalisation has proved exceptionally successful. Gross Domestic Product (GDP) has grown by an average of 7-8 per cent per year since 1997, while over the past two decades the country’s per capita income has increased by an average annual rate of almost 9 per cent. 250 million people have been lifted out of poverty[1] and, unlike so much of the developing world, the country is on track to achieve its Millennium Development Goals (MDGs).[2]

This paper points out that the country’s track record of cautious and limited deregulation has much to teach us, and offers a useful corrective to the ‘shock-therapy’ model that continues to fail so much of the developing world today. It also suggests that the recent acceleration in the pace of economic reform, which is now giving rise to increasing inequality and unemployment, may well undermine China’s remarkable achievements and depress the domestic demand that is so crucial to its continued prosperity.

Overview

At their annual conference in Beijing in March, the National People’s Congress ratified a number of decisions already agreed by the 16^th Communist party congress last November. The incoming Premier, Wen Jiabao, pledged his newly-elected government to continue building a ‘xiao kang’ (relatively affluent) society in an ‘all round way’, while maintaining the social stability and socialist principles of the country. To achieve this end, he said, it was crucial for China to keep pace with the times. Over the next five years, the new government would accelerate the pace of socialist modernisation, deepen reform, and continue to open up to the outside world. Such development would involve slimming down and reforming the country’s government and bureaucracy, and the inauguration or widening of various programmes designed to further the country’s integration into the global market economy.

Coming on the heels of China’s accession to the World Trade Organisation (WTO), these policies have typically been represented by the West as a conclusive affirmation of the primacy of neoliberal economic theory, a final proof that, however belatedly, China has seen the light. Much gratuitous advice is on offer as to how the country should complete its transformation as quickly as possible, in order fully to become part of the ‘developed’ world.

The patronising air with which this guidance is offered seems extraordinarily inappropriate.  In the last six years alone, the prescriptions urged by the International Financial Institutions (IFIs) – premature liberalisation of capital account and trade regulations, widespread privatisation, and deflationary ‘structural adjustment’ policies – have resulted in the South East Asian crisis, the collapse of the Russian economy, and widespread recession in Latin America. In Africa, where 23 countries are now poorer than in 1975,[3] these same recommendations have totally failed to alleviate poverty. Here life expectancy has fallen to 47, the lowest since records began. Indebtedness has become unsustainable, food security non-existent, and famine and disease ravage the land.

In stark contrast to this dismal picture, China has continued to prosper. In this vast country of 1.27 billion people, per capita income has increased by an average annual rate of almost 9 per cent over the past two decades, reaching $890 last year.[4] Moreover, despite the South East Asian crisis and the recent global downturn, annual GDP growth since 1997 has been among the highest in the world, averaging 7–8 per cent a year. Figures recently released for the first quarter of 2003 show growth standing at more than 9 per cent, the fastest quarterly expansion for six years, and GDP is now forecast to quadruple to more than $4000 billion by 2020.[5]

This record has proved extremely attractive to foreign investors, and last year China overtook the United States to become the world’s leading destination for foreign direct investment (FDI). Actual inflows of FDI reached $52.7 billion for 2002, up 12.5 per cent on 2001, while the country’s foreign exchange reserves now stand at $286.4 billion. [6]

This is clearly not the profile of a mismanaged economy, and its achievements are all the more remarkable when they are placed in context. In 1978, for instance, China accounted for only one quarter of the GDP of the low-income countries, and only 40 per cent of their population; yet by 1995, its economic growth represented nearly two-thirds of the increase in total income of all these countries put together. At the same time, this growth was widely shared, with 20 of the country’s 30 provinces showing faster per-capita growth rates than any other country in the world over the same period.[7] In 2000, China entered the ranks of lower middle-income developing countries, and as we have seen, its GDP has continued to show vigorous growth.

Direct comparison has frequently been made between this successful and consistent progress towards a socialist market economy, and the disastrous fate of Russia.[8]  Here, the ‘shock-therapy’ cocktail of liberalisation, stabilisation, and privatisation urged by the Western institutions ended in economic meltdown. The abrupt freeing up of prices created rampant inflation, followed by a frenzied effort to contain the explosion through the imposition of excessively high interest rates. This in turn both stifled investment in the newly privatised companies and encouraged asset stripping, while an over-valued rouble (again urged by the IMF) caused a flood of imports and strangled domestic productivity. Between 1990 and 1999, GDP fell by 54 per cent and industrial production by nearly 60 per cent.

As the economy declined, the capital account liberalisation recommended by the IMF allowed billions to flow out of the country. As always, this benefited a corrupt elite, but the middle class was decimated, overall incomes fell, and poverty soared. Meanwhile, foreign investment banks continued to push debt-creating loans and, even as crisis loomed, the IMF persisted in bailing out the currency, further exacerbating the problem. As everyone knows, Russia’s 1998 default and devaluation precipitated a global financial crisis that carried particularly severe consequences for other developing economies.

This is not the place to delve further into the details of Russia’s ruin at the hands of the IFIs. Nonetheless, its fate should be born in mind when examining the very different sequence of development adopted by China as it moves towards integration in a globalised market economy. Instead of embracing neoliberal restructuring, the maintenance of social stability has been the key to China’s progress. Rather than prioritising privatisation, precedence has been given to maintaining employment through the creation of new enterprises. Above all, the country has resisted pressure fully to liberalise its capital account, although it has opened itself to long-term foreign investment. It has thus avoided the catastrophic problems associated with the volatility of speculative capital flows. In the words of the IBRD report, it has ‘relied on stimulatory macroeconomic policies and a stable exchange rate to sustain domestic demand and support continued structural reforms’.[9] 

Some of the features that have marked this transition from a centralised economy, and distinguished China’s rapid progress from that of many other developing countries, are briefly discussed below.

Land Ownership

Despite continuing migration from the countryside to the cities, China’s agricultural households still officially number 210 million, a figure that represents two-thirds of its population, and a third of farming families worldwide.[10] In 2000, the majority of the labour force (499 million out of 711.5 million) was still classified as ‘rural’, although it was estimated that many of these were employed in rural industry or services, rather than on the land. Given this huge agricultural population, it is hardly surprising that land tenure policy has played such a crucial role both in China’s revolution and in its subsequent development.

Unlike the former Soviet Union and Central and Eastern European countries, where programmes of farmland privatisation have usually been adopted, China has concentrated on land use rights reform. Following the horrific human costs of the failure of the land collectivisation system based on the Soviet model, a new policy enabling individual farming known as the Household Responsibility System (HRS) was introduced in 1978. It was immediately and dramatically effective, and the output of grain increased by more than 100 million tonnes within only six years. This surge in production did not last, falling off after 1985 and stagnating during the 1990s, but the problem of feeding the huge population was nonetheless effectively solved.

In its original form, HRS was wholly egalitarian, with land constantly being reallocated as the populations of farming communities waxed and waned, but the resulting insecurity eventually began to reduce productivity, and the system has gradually been amended. It now consists in a legal framework of 30-year land-use rights, including the right of voluntary lease or full transfer. A ‘two-tier’ system designed to maintain equality has also been widely adopted, with local land divided into ‘food land’ for family consumption, and optional ‘contract land’ for commercial production sold on the free market.[11]

Meanwhile, town and village enterprises (TVEs) were set up by the government to provide non-agricultural employment to the rural population by bringing industrialisation to the countryside. Initially, these were strikingly successful, and from the mid-1980s through the early 1990s, they constituted the largest contributor to growth in employment and GDP. By 1996 they employed 131 million workers, or 28 per cent of the rural workforce, and more than 40 per cent of rural incomes now come from non-agricultural activities. To a large extent these measures provided a safety net for the huge rural population as the country moved towards a market-based economic system.

Current Problems:

Rural poverty and unemployment are notorious side effects of neoliberal ‘globalisation’ policies, and now that China’s drive towards liberalisation is accelerating, it is becoming clear that neither land reform nor the TVEs are sufficient to solve the problem. Despite the country’s high growth rate, poverty reduction has slowed since the mid-1990s, and income inequality between rural and urban areas has gradually increased over the last two decades. It is now estimated that over 100 million people have migrated to the cities in search of higher pay, forming a body of poorly paid ‘floating’ migrant workers, whose presence in turn puts an enormous strain on the urban infrastructure.

A number of factors have contributed to this rural exodus. In the first place, over-production in the heady days following the institution of the HRS eventually led to collapsing prices in the sector, while prices for farm supplies such as fertilisers and pesticides rose steadily, and ‘readjustment’ policies increasingly fragmented farming land. In addition, the agricultural community has been further impoverished by heavy rural taxation, and by a system of often illegal fees, fund collecting programmes, and fines imposed by local authorities attempting to make up their increasing budget deficits.

Allegations of corruption and nepotism against these authorities have been rife, and a sweeping tax-for-fees reform, originally piloted in Anhui Province, has just been instituted on a nation-wide basis in an attempt to remedy the situation. According to State Council estimates, this reform will cut the financial burden of 620 million people by almost a third in 2003, standardising the tax system and abolishing arbitrary levies. Now that China has entered the WTO, this relief is critically important to the rural community, because farmers’ incomes will inevitably fall again as cheap imports come into the country.

Privatisation

After 1949, China’s economy was rebuilt around the principle of production to meet social needs. Accordingly, its State Owned Enterprises (SOEs) were not designed merely as profit-making organisations, but to play a social role within the wider economy: part of their function, for instance, was to bear the responsibility for social services and housing for their employees. In Socialist terms this arrangement constitutes a proper use of productive forces, but to profit-oriented capitalism, welfare obligations are simply liabilities, resulting in the inefficient operation, and sometimes the outright insolvency of the enterprises concerned. (As we will see below, the nature and purpose of the SOEs also has great bearing on past and present problems within the country’s banking system.)

As we have noted, however, China’s decision to move towards a market economy did not take the form of an abrupt dissolution of the state sector. Instead it concentrated on building a new infrastructure to replace the old centralised economy, gradually establishing the institutions, regulations and safety nets that would be needed under the changed conditions. The rampant inflation experienced in Russia and Eastern Europe was initially averted by the imposition of a short-term two-tier price system that provided a bridge between the fixed prices of the old command system and those dictated by the new market economy. Under this arrangement, the old prices remained fixed with regard to established core production quotas, while production in excess of these requirements became subject to market demand. This enabled distorted pricing to be eased out with minimal disturbance to the economy. At the same time, land reform and the creation of the TVEs formed the base of a new system of production, creating millions of collectively owned new enterprises, and the government invited foreign firms into the country to invest in ‘joint ventures’, paving the way for today’s enormous flows of FDI. 

The reform of the SOEs was a key factor in this restructuring process. The state owned nearly 80 per cent of industrial production at the start of the 1980s, and transformation again began relatively slowly. However, in the second half of the 1990s it gathered momentum, and by 1997, many of China’s smaller SOEs, which were mostly administered by local bodies, had either been closed or sold to their employees or managers. During this process, bankruptcies increased rapidly (according to Cao Siyuan, Director of the Beijing Siyuan Research Centre, their number rose from 98 in 1989 to 8939 in 2001, with about 60 per cent being SOEs), and it is estimated that nearly 26 million workers in SOEs lost their jobs between 1998 and mid-2002, of which only 17 million have since found employment.[12] As the SOEs still employ over 50 million people, it is recognised that the social consequences of further closures are bound to be grave, and although the proportion of companies that go bankrupt in China relative to GDP is less than a tenth that of the United States,[13] a proposed reform of the bankruptcy law designed to speed up liquidation has now been indefinitely postponed.

Nonetheless, under Premier Zhu Rongji, the sale of certain categories of SOEs became overt political policy,[14] and proceeded rapidly. In 1999 the constitution was amended to give private enterprises rights and legal protection on a par with the state sector, and by the end of 2001, there were already more than two million private companies in China, giving employment to some 22 million people. There was also a radical downsizing of central government administration, which left only 190 of the biggest SOEs operating under central authority, while a new law gave rights to localities to dispose of their own firms as they saw fit. Stimulus packages of domestic low-interest credit were provided by the government, and domestic shares denominated in renminbi (RMB) were opened to limited offshore portfolio investment for the first time. More attention began to be directed towards finding external domestic buyers and foreign investors for some of these smaller state companies (now estimated to number between 150,000 and 175,000), rather than simply offering them for sale to their own employee groups.[15] As a result, merger and acquisition (M&A) deals have doubled in China over the past 15 months, contrasting with a global reduction of 40 per cent over the same period. In 2002, transactions involving Chinese corporates were worth $27.8 billion (of which $13.5 billion involved foreign acquisitions), and accounted for 25 per cent of Asian M&A activity.[16]

However, although many new laws are ostensibly aimed at promoting foreign investment, they also place considerable constraints on transactions, stipulating that they must not ‘cause excessive concentration, eliminate or restrict competition, disrupt the social and economic order or damage the interests of society.’ Foreign companies are required to apply to the central authorities if they own assets worth more than $360 million, control more than 20 per cent of any Chinese market, or hold stakes in more than 15 companies.[17] Opinion remains divided as to how far, in practice, the government intends to implement these anti-monopoly regulations. Nor is it clear to what extent administrative interference and central control will limit the autonomy of firms in which foreigners have substantial holdings.

What is plain is that the government is presently faced with a choice between retaining a degree of state regulated production one the one hand, and experiencing rising unemployment and social unrest on the other. Responding to this dilemma, the new administration under Premier Wen Jiabao has effectively reversed the emphasis placed by Mr Zhu on the importance of continuing to sell off the smaller SOEs. Instead it has instituted a centralised strategy for their reform, based on a new type of relationship between government and management, and designed to improve efficiency and reduce profiteering by corrupt local cadres. Under this new five-year plan, ownership of state companies will be transferred from the many local ministries and commissions to a State Assets Supervision and Administration Commission (SASAC). The commission’s goal is to reconstruct the SOEs, transforming them into solvent firms that can compete successfully in the international market place.

At a press conference in Beijing on 22 May 2003, the commission’s director Mr. Li Rongrong, outlined nine categories of action in which SASAC will operate. The first of these will be the legal field, where it will establish a new Statute authorising the regulatory framework for the rest of its work. Attention will be focused on proper supervision at all levels, in order to improve performance, institute accountability and ultimately eliminate failing enterprises.[18]

Mr. Li also announced that SASAC already supervises and manages 196 enterprises owning a total of 6.9 trillion yuan ($834 billion) in assets, but he did not reveal how many of the remaining SOEs were destined to come under the commission’s jurisdiction. However, he declared that SOEs must continue to form the dominant part of the economy, and that it was essential to build large successful state-owned enterprise groups capable of controlling their own sectors. “State enterprise reforms cannot proceed quickly if we don’t have the necessary conditions to support it,” he said. “If the number of laid-off people becomes large and there are not sufficient financial resources to support them, there will be social unrest.”[19]

The Chinese Banking Sector [20]

At the moment the Chinese banking sector is ranked second in Asia. By 2010 it is expected to account for roughly 30 per cent of Asian banking assets, and by 2016 will have reached the same size as the banking sector in Japan. At the moment, there is still a very limited ability for foreign investment (except indirectly through Hong Kong), but under the terms of its WTO accession China has made a radical commitment to allow the entry of foreign banks from 2007. Accordingly, Western banks see China as a locus of vast opportunity, and are desperately competing to acquire stakes in the sector as liberalisation gets under way.

At the same time, however, the Chinese banking system is currently the main target of Western criticism. Scorn is typically focused on the large proportion of bad loans, which are seen to represent a ‘silent’ banking crisis that must immediately be addressed. At the moment non-performing loans (NPLs) officially stand at 28 per cent of total assets, but since Chinese banks use a variety of measures to define NPLs, this estimate tends to be unconvincing to independent economists, many of whom put the figure as high as 40 per cent. Nonetheless, whatever the measurement, it is clear that the ratio is high.

This is not a problem that can be understood, or successfully remedied, unless the history and nature of the Chinese banking system is taken into account, for despite ‘reconstruction’, its purpose and performance remains very different from that of Western banking. For a start, its NPLs are not predominantly the result of unregulated involvement in credit markets, as they are in the West. Indeed, Chinese bank law still forbids commercial banks from engaging in securities trading and underwriting, or investing in non-bank enterprises or trusts. Nor are the NPLs simply the corollary to a centralised economy, for ‘loans’ in the Western sense of the word are not a constitutive feature of such systems: rather they are the outcome of China’s as yet incomplete transition to a market economy.

Before 1983, China had relied on a central planning system based on the recycling of revenue produced by the SOEs by way of budgetary grants. At this time, the banking system was simply required to hold and disburse centrally-owned wealth for use in the economy, providing the credit needed by enterprises and government to implement national production plans, and supplying the funds for certain requirements that exceeded state quotas. Prices were centrally regulated, and investments in fixed assets for SOEs were directly transferred from the government budget. Western-style commercial banking principles did not operate under this arrangement, and production and investment decisions were not made by the banks.

However, as part of the economic reform programme, direct grants to the SOEs were replaced by interest bearing loans in 1983, and the banking system gradually became an increasingly important instrument for exercising macro-economic control. Between 1985 and 1993, the sector expanded rapidly, with total deposits increasing from 427.3 billion to 2.3 trillion yuan, and total loans from 590.5 billion to 2.6 trillion yuan. Total loans from the banking system rose to 5.2 times the government budgetary expenditure, and the comparative absence of administrative control both increased the incidence of risky loans, and encouraged neglect of the public goods sector. The reimposition of anti-inflationary monetary regulations in 1993 caused the new speculative investments to suffer financial losses, and created instability the banking system,[21] while the subsequent devaluation of the yuan in 1994 (from 5 to 8.3 to the US$) made servicing dollar loans virtually impossible. Much of the current NPL problem stems from this period.

In 1994, a new banking law officially established the Big Four [22] as commercial banks to be operated for profit. Between them, they account for between 80 per cent and 90 per cent of domestic deposits, or considerably in excess of $1 trillion. In theory they are now freestanding institutions, but they remain wholly state-owned, and in practice act largely as agents for government policy as laid out in five-year plans that include continued lending to the SOEs. Up to 80 per cent of their loans are to SOEs, and estimates of the NPLs in their portfolios vary widely, from 25 per cent to almost 50 per cent. Irrecoverable loans are thought to be between one third and one half of outstanding NPLs.

This situation would obviously be unacceptable were it to arise in a Western banking system, but as we have noted, the circumstances are quite different in China, where the risks inherent in universal banking do not apply. To the contrary, NPLs in the Chinese banking system are not the result of failed speculative investment, but are simply indirect loans by the state banks to the state itself in the form of the SOEs. It is therefore perfectly logical that they should be regarded as part of the public debt, rather than evidence of commercial banking failures. According to government sources the existing stock of NPLs is equivalent to something between 20 and 25 per cent of GDP,[23] and although government debt has been increasing (rising from 11.4 per cent to 23.8 per cent of GDP over the five years to 2001, and predicted to reach 26.3 per cent of GDP by 2005[24]) the combined figure of around 50 per cent of GDP still compares favourably with the ratio in many developed economies. In the United States, for instance, the ratio of federal debt to GDP was 60 per cent for 2002, and is still rising.

As things stand, however, China is caught between the legacy of a command economy and pressure from Western IFIs urging a market-orientated approach, and its debt restructuring policies reflect both influences. The government has made two significant attempts at partial recapitalisation, although neither of these measures seriously attempted to put the banks on a sound footing. The first was in 1998 when it propped up the Big Four by issuing $34.5 billion in bonds. The second was in April 1999, when it removed a further $157 billion of NPLs from the banks’ books, and created four asset management companies (AMCs) to manage and dispose of them. These measures by no means cleared the Banks’ burden, but the government claimed that they reduced the percentage of NPLs to 25 per cent of their portfolios.

The AMCs operate under the regulatory supervision of the central bank, the Peoples Bank of China (PBoC), and one of their main activities consists in engineering debt-to-equity swaps to convert NPLs into shares in state firms, which are selected by the State Economic and Trade Commission (SETC). From the start, however, they were faced with the almost impossible task of negotiating loan workouts that would reduce loss without adversely affecting the social stability and employment afforded by the operations of the SOEs, and the Bank of International Settlements has recently pointed out that they too face liquidity risks, and may themselves come to pose a threat to the PBoC. Nonetheless, their operation has had a limited success so far, and to date they have disposed of about a third of the bad loans stripped from the banking sector. A successful performance by the new SASAC, and a good level of co-operation between the two bodies, would greatly improve the AMC’s prospects, as it would clearly be much easier to sell equity in the more efficient and less corrupt SOEs envisaged by the Commission.

According to Liu Mingkang, Chairman of the new China Banking Regulatory Commission, the Big Four have a target of cutting their NPL ratio by three to four percentage points this year, and every effort will be made to reduce their NPLs to 15 per cent of total lending by 2005. This will almost certainly involve a new recapitalisation, probably by transferring more loans to the hard-pressed AMCs. However the government appears to take a realistic view of AMC operations, and has to date approved a low recovery rate averaging 20 per cent for their NPLs.

A number of other crucial factors also make it unlikely that the West’s gloomy prognosis of crisis and collapse in the banking system will materialise. In the first place, the Chinese savings rate is exceptionally high, standing at around 40 per cent of GDP, and since the currency is not freely convertible these savings cannot be changed into foreign currency (see Financial Liberalisation below). Instead they provide an enormous source of revenue, which both services the public debt and finances investment. In fact, although ‘foreign funded companies’ – in Western terms, foreign affiliates – now account for 30 per cent of manufacturing in China, the role of FDI in capital formation is low (10 per cent in 2002) and has been falling for eight consecutive years, while almost no companies in the country have foreign debts.[25]

Secondly, consumer lending is increasing, and balancing a reduction of loans to the SOEs. In the last two years roughly a fifth of all new lending has been to this sector, and consumer loans outstanding have increased from almost nil to 8 per cent of the total loan portfolio of the whole banking system. At the moment, the vast majority of these loans are asset-backed mortgage loans for the purchase of housing, and these should prove much more profitable for banks than lending to SOEs.[26]#

Thirdly, ruinous attacks on the currency are rendered very unlikely due to the fact that the exchange is pegged to the dollar, and the capital account remains closed to speculative flows (see below).

Financial Liberalisation and Capital Account Liberalisation

When discussing financial liberalisation, it is very important to be aware of the distinction between the general process and the institution of capital account liberalisation (CAL) as such. Financial liberalisation can include some or all of the following: freeing up restrictions of entry of private sector and/or foreign banks and financial institutions into domestic financial markets; privatisation of government owned banks and financial institutions; removal of credit controls; deregulation of interest rates; introduction of market based instruments of monetary control; and, but not necessarily, CAL.

CAL itself involves the dismantling of all barriers on international financial transactions and the purchase and sale of financial or real assets between countries.[27] This is the process that has wiped out the ability of governments to control the destabilising speculative financial flows that can reduce economies to ruin, and has provoked crises all over the globe, from the Southeast Asian economies to Argentina.  This fact notwithstanding, powerful IFIs, including the OECD and the WTO, incorporate CAL in their Codes and regulations, and of recent years the IMF has been its most vigorous exponent, aggressively pushing CAL on developing countries through its loan conditionalities. (Recently, the Fund appears to be rethinking this position. In particular they are beginning to make the distinction between financial liberalisation and CAL referred to here, and to question the invariable desirability of the latter.[28])

Fortunately for China, its government has so far resisted pressure to adopt CAL, and as a result of this ongoing discretion, did not experience the huge outflows of capital that characterised other economies stricken by the Asian crisis in 1997.  It is beyond dispute that the country’s success in weathering this disaster relatively unscathed was largely attributable to this factor. Moreover, despite Western example, a gradualist approach to CAL continues, and although full convertibility of the RMB for current account transactions was reached in 1996,[29] capital account transactions are still only partly liberalised. Of the 43 IMF categories of capital account transactions, only four items (or 9.3 per cent) are fully convertible, and the rest are either restricted or prohibited. In the words of the Governor of the PBoC, these regulations exist ‘to protect China’s economy and its financial industry from attacks by short-term cross-border capital flows, especially speculative capital flows.’[30] 

Nor does the government intend to drop the currency peg, a position Zhu Min, economic advisor to the President of the Bank of China, recently reaffirmed at the World Economic Forum at Davos. “We don’t have any plans to float the renminbi,” he said, “and I think the fixed exchange rate works very well for us.” More recently, as the dollar continues to fall, speculation about a revaluation of the RMB has begun to run at a high level, with the United States hopefully predicting an appreciation, and the PBoC declaring that a policy of ‘stability’ will be maintained.

This phrase is very ambiguous, and much clearly depends the country’s balance of payments position. China’s capital account has recovered from its decline during the Asian  crisis and is now in surplus to the tune of 3 per cent of GDP in 2001, and probably rather more in 2002. Until recently, China has also run a current account surplus, meaning that the country has been accumulating substantial volumes of foreign exchange reserves. However, the  current account surplus has been trending downwards both absolutely and as a percentage of GDP, and was only 1.5 per cent of GDP in 2001; while in the first quarter of this year, when China incurred a $1 billion trade deficit, the first for seven years, it fell into deficit too.[31] Although the trade figures are volatile (in May China again posted a $2.23 billion. trade surplus) imports are also rising fast, and while the government may make some small adjustments, it is arguable that they will be reluctant to allow a significant appreciation of the RMB while the current account surplus is in decline. Such caution may be extremely irritating to the United States as it watches China’s share of global trade expanding, but it seems to be suiting the Chinese economy very well.

Trade, Openness, and WTO Entry

After years of negotiation, China became a member of the WTO in December 2001. However, although there is a perception that its accession will result in a sudden spectacular transformation of the country’s trade regulations, it should be noted that a steady reduction in tariff and non-tariff barriers had already taken place over the previous decade. Between 1993 and 2001, for example, the average import tariff rate fell from 40 per cent to around 15 per cent. Moreover, the ratio of imports to GDP was already 20 per cent in 2001 (compare 8 per cent for Japan and 12 per cent for the United States), while the sum of imports and the domestic sale of goods produced by foreign affiliates represented over 35 per cent of GDP. In fact, As Dr. Lardy[32] points out, China has for some time been a very open economy.

Nonetheless, China did make substantial commitments on entering the WTO, such as opening its services sector to foreign providers, and reducing specific tariffs – on agriculture to 17.4 per cent, for instance, and on industrial products to 9.4 per cent.  By 2005 when it has fully implemented its obligations to the WTO, its average tariff will be just under 10 per cent, which is very much lower than that expected from other emerging markets at the same date (compare say Brazil 27 per cent, India 32 per cent, Indonesia 37 per cent). In addition, and while it has been granted permanent most-favoured-nation (MFN) status by the United States, it has also been declared subject to various discriminatory provisions favouring those who consider that their markets have been disrupted by its access, such as special restrictions on imports from China, and anti-dumping regulations.[33]

Despite these precautions, and although it still accounts for only about 5 per cent of global trade, other developing countries continue to feel threatened by China’s staggering expansion. Despite the global trade downturn, its trade grew by roughly 8 per cent in 2001; and last year, while global trade expanded by 3 per cent, China’s increased by more than 20 per cent. Moreover, FDI into China has long been increasing in relation to its competitors, and its irrevocable commitments under WTO rules have further encouraged the private sector and fostered confidence in foreign investors, directing more wealth away from other locations. As noted above, inflows are now the highest in the world, standing at $52.7billion for 2002. 

In short, the country’s WTO accession has been the culmination of a long sequenced programme of global integration, and although entry has boosted the process, there has been no dislocating change of policy. As a result, the trends set by China’s gradualist advance towards a market economy have simply accelerated: trade continues to expand, FDI to increase, and despite a global downturn, growth remains extraordinarily high.

Even so, each stage in the liberalisation agenda has carried profound implications for the social structure in China, and cumulatively these have produced many undesirable side effects. Entry into the WTO, and the deadlines this entails, will exacerbate many of these. It will put renewed pressure on the agricultural sector and the SOEs to speed up their ‘restructuring policies’, increasing the rising unemployment and poverty already emerging from current reforms. It will further facilitate privatisation of vital public services, where reduction in government expenditures is already causing great suffering (see ‘Health’ below). It will force China’s state-owned commercial banks to meet competition from a universal banking system and the large complex banking organisations with which it is associated, while they are still unready to do so. Above all it will encourage the country to focus on the export sector instead of pursuing policies to stimulate the domestic demand that is so critical for the country’s continued prosperity.

Deflation

The spectre of deflation is now looming large in the global economy, and its vicious spiral of ills is well known: as the price of commodities and wages falls, unemployment rises, demand drops away, production slows and the growth rate decreases.  Moreover, when prices are falling the value of debts increases in real terms, bringing growing distress, and not infrequently ruin, to the indebted persons or enterprises. Efforts to recharge the economy by reducing interest rates hit the buffers when rates reach zero and can fall no further, and deep recession becomes a possibility.

Lately, there has been much speculation both about the extent of China’s deflation, and about the extent to which it is likely to ‘export’ this condition to other economies. Opinions vary on both these questions, which are related but distinct.

As far as China’s Consumer Price Index (CPI) goes, the government’s successful battle against inflation in the mid-1990s culminated in 1999 with a drop in the CPI of 1.8 per cent over the previous year, but the situation has since stabilised, with prices fluctuating between a positive and a negative 1 per cent. For 2002 they fell only 0.2 per cent. Now the PBoC’s quarterly report for the first three months of 2003 shows that the downward trend has been reversed, and predicts an increase of up to 2 per cent for the forthcoming year. This may or may not occur (the IMF, for instance, predicts a rise of only 0.2 per cent) but it does seem likely that the deflationary trend has halted. As importantly, it should be noted that certain features of China’s economy – a high growth rate, a low external debt ratio (standing at 12.2 per cent of GDP in 2002[34]), increasing consumer demand, stable money supply, and so on – mean that a stagnant or falling CPI does not necessarily carry the same implications as it would do in economies where these factors are not present.

Nonetheless, it is clear that China currently faces several problems that make it imperative that deflation is kept at bay. The most critical of these is the SOE/NPL/banking crisis situation outlined above. Selling off NPLs at a loss, as the AMCs are now doing, is clearly not an optimum solution: what is needed is a reduction in the scale of the NPLs themselves. This could be attained if the SOEs became profitable, that is, if rising wages and employment boosted domestic demand enough to solve the over production problems that have bedevilled them for years. This is vitally important, for inventory accumulation has been huge in China, and though it has fallen considerably since the mid-1990s, it is still a significant feature. (It stood at 6 per cent of output in the run up to the Asian financial crisis, when growth was averaging 11 per cent, and has averaged between 1 per cent and 2 per cent over the last four years.) Export growth alone cannot solve this problem: indeed China’s net exports account for a relatively small percentage of GDP, standing at just under 3 per cent in 2002.

As far as the ‘export’ of deflation is concerned, two facts should be born in mind: firstly that deflation is currently a global phenomenon, born of financial liberalisation mainly in developed countries, and of deflationary policies imposed on developing countries by the West; secondly, that China still accounts for only 5 per cent of global trade.[35] Under these circumstances, it can hardly be cited as a root cause of the initial problem, and even now its influence is clearly limited by its comparatively small share of world exports.

Nonetheless, in its two most important markets – North America and Europe – China is already displacing other suppliers, and it is clear that its ability to produce enormous quantities of goods exceptionally cheaply is bound to add to the woes of its trading competitors. This is particularly so where the countries concerned are already mired in deflation, as is the case with Hong Kong and Japan, or where they are approaching that position and an influx of cheap imports can push them over the brink. In such cases, the volume of trade is also critical, and the countries with whom China has the closest economic links have been most affected by its falling prices.

This holds true of the United States, where the notion that China is ‘exporting deflation’ to the detriment of the global economy originated. As is well known, the United States now has a huge global trade deficit ($423 billion in 2002), and it is now China’s largest export market: in 2002 its trade balance with China showed a deficit of $100.2 billion (up from $68.7 billion in 1999). At the end of April 2003 this figure already stood at over $34 billion for 2003, with the figure for April itself at almost $9.5 billion.[36] It is not surprising, therefore, that the United States is concerned about the low price of China’s exports and would like to see an appreciation of the RMB. But it must not be forgotten that the deflationary trend to which the United States is now falling victim is rooted in a broad failure of global neoliberal policies and changes to the international financial architecture that have allowed them to maintain an overvalued currency and acquire assets cheaply from the rest of the world over a period of many years. If the asset bubble that has sustained North America now shows signs of bursting, the blame can hardly be laid at the door of China, one of the few economies that have developed in virtual isolation from the prevalent model of financial globalisation that is causing the distress.[37]

Poverty, Inequality, and Health Care
Overall China is now on track to attain its Millennium Development Goals and, as we have seen, per capita GDP is rising. However, despite its impressive record of poverty alleviation and growth, more than 200 million of its people still live on less than $1-per-day, accounting for about 18 per cent of the global poor. Now, as ‘liberalisation’ policies take their toll, the poverty reduction rate of the early 1990s is no longer being maintained, and although overall incomes continue to rise, equality of distribution is worsening.

This inequality is growing both within and between regions, with the coastal regions to the East becoming ever more prosperous and attracting wealth away from centre and the West. Although lately urban poverty has been increasing, to a large extent this inequality cross cuts with rural/urban inequality, with average rural income for 2002 standing at 2476 RMB, per capita, 34 per cent of the average urban income of 7703 RMB. At the national level the Gini coefficient index rose from 28.8 in 1981 to 41.6 in 1999, and by now can be assumed to have risen further. Unsurprisingly, this growing disparity is causing increasing social unrest.

Unemployment is also on the increase, feeding into this situation. The Asian Development Bank’s (ADB’s) Key Indicators show unemployment steadily rising from 1.9 per cent in 1984 to 3.1 per cent in 1999, while the World Bank Key Indicators project an employment rate of 4.5 per cent for 2003. However, they point out that this is the figure for official unemployment only, and does not include laid-off workers. It appears that the latter are no longer in work, but have not yet officially severed their links with the SOEs. With these persons included, the ADB put the urban unemployment rate at 7.3 for 2001, but best estimates by independent Chinese economists now suggest a figure of between 10 per cent and 12 per cent.

The country’s social indicators confirm these unhappy statistics, and nowhere is this more evident than in the public health sector. Mao Zedong’s healthcare system, with its ubiquitous township health centres and its army of ‘barefoot doctors’ successfully provided basic needs for almost the whole of China’s huge population, and was once one of the country’s proudest boasts.[38] The system began to be decentralised in 1978, but while the government remained the sole employer, a Labour Insurance Programme (LIP) provided health care to virtually all workers through the SOEs. A Government Insurance Programme (GIP) additionally insured civil servants, students, retired officials and the like. Health indicators continued to improve, and right through from 1960 to 1990, maternal, infant, and under-five mortality rates fell with unprecedented speed in comparison with overall growth rate.

However, as market reform gathered speed, user fees began to play an increasingly important role in financing the healthcare system, and the improvement slowed or stopped. With the restructuring of the SOEs and the reduction of subsidies, the number of uninsured rose, and the service providers who were asked to shoulder the costs responded by substantially increasing them. As a result, it is estimated that healthcare costs have jumped 500 per cent to 600 per cent over the last decade. For example, medical costs per visit rose by 625 per cent, and costs per admission by 511 per cent between 1990 and 1999. At the same time, insurance cover fell by 22 per cent in urban and 25 per cent in rural areas, leaving only 9.58 of the rural population with any insurance.[39]

Meanwhile, with increasing decentralisation, available healthcare spending has become concentrated in the cities and rich provinces, adding to the enormous regional variations that developed during the 1990s; for example, by 1999 infant mortality in inland provinces was three times higher than the rate for coastal provinces. By 2000, the World Health Report ranked China 81 out of 191 countries in overall quality of health, but 188 in terms of fairness in financial contribution. Moreover, in many regions, the genuine problems arising from unequal sub-national finance have been exacerbated by local government corruption.[40]

The rise in overall expenditure on health (from 3.17 per cent of GDP in 1980 to 5.3 per cent of GDP for 2000 according to the WHO), masks the fact that government expenditure only accounts for 36.6 per cent of this sum, leaving 63.4 per cent of the total represented by private out-of-pocket expenditure, a ratio that clearly represents a terrible situation for the poor. Indeed, the majority of the population, mainly those in the rural areas as well as the unemployed in the urban area, can no longer afford healthcare at all, while the remaining LIP and GIP programmes have become exceedingly expensive to run. Entry into the WTO, by increasing unemployment still further, can only exacerbate this destructive spiral of ill health and inequality.

To some extent, the Chinese government does appear to have recognised the problem and has attempted to implement a number of policies to alleviate it, such as instituting an urban medical insurance programme in 1998. Rural insurance schemes are currently being piloted, and reforms designed to improve the system of financing rural health care at different levels of government, and designed to help redistribution, are also in hand. The SARS epidemic recently illustrated how inadequate the system is to deal with emergencies, and in June this year Premier Wen Jiabao urged health authorities to adopt more vigorous measures further to improve operations.

It is vital, however, that such rhetoric be rapidly translated into action, for debt-burdened local governments have allowed the whole structure to deteriorate gravely and the situation is now acute. Malaria and tuberculosis are rife, incidence of neonatal tetanus and hepatitis B are among the worst in Asia, and AIDS is increasing. It is very plain that more public resources must be directed towards the sector, especially towards the preventative services such as inoculations, health advice, and the provision of anti-parasitic drugs. Increased privatisation is clearly not the answer, for the market inevitably directs its attention both towards those who can pay, and towards the most lucrative areas of medicine, such as treating the already ill with highly priced drugs. Accordingly the trend tracked by the WHO, showing that spending on health fell from 15.5 per cent of government revenue in 1995 to 11 per cent in 2000, should be reversed.

Since revenue is rising (see below), the real increase generated by such a reversal would be considerable. In the short term, it would also be practicable, for the government deficit remains within reasonable bounds, and in the long term it would also be economically beneficial. At a recent joint seminar of the State Development Planning Commission and the WTO in Beijing, Cai Renhua, Director of the China National Health Economics Institute
made this point very plainly. ‘China should invest more money in promoting public health for the country's macroeconomic development,’ he said. ‘Any investment needed to improve the health of the 1.3 billion people in China would be much less than the losses caused by poor health.’
 

Government Revenue

Government revenue in China has been rising at a rate that is remarkable by any normal standards. From a very low base of 10.7 per cent of GDP in 1994, it rose to 12.1 per cent in 1997, and by 2002 had reached over 18.5 per cent. It is predicted to rise to 19.5 per cent of GDP by 2005. Bearing in mind the rate of GDP growth both achieved and expected, this represents a large increase in resources available to the government, and in fact, over the four-year period 1997 to 2001 government expenditure as a share of GDP, increased by 6.5 per cent. Over the same period, the budget deficit seesawed, increasing from 1.8 per cent to 4 per cent in 1999, and then starting to fall, reaching 3.2 per cent of GDP in 2001. It is predicted to be down to 2.1 per cent by 2005, and this would leave government debt standing at 26.3 per cent of GDP (up from 23.8 per cent in 2001), a figure is not alarmingly high. It is also very clear that more revenue could be levied if structural changes to the tax thresholds were made, and the collection system tightened.

At the moment the system is unduly regressive, and personal income tax, although it has increased a great deal, still represents a very small proportion of fiscal revenue (approximately 4.4 per cent in 2001). Moreover, it is not playing its necessary regulatory role. The highest rate on salaries is 45 per cent and on property income 20 per cent, leaving the middle/lower income workforce carrying the bulk of the load. The threshold for taxation is also set much too low, starting at only $96. Inefficient collection and corruption are also hallmarks of the system, and tax evasion is acknowledged to be rife.

Both these problems have been acknowledged by the administration. Government advisers have urged that the failure of high income earners to pay sufficient tax should be speedily rectified in order to reduce inequality; in March this year, for instance, Qu Shijing, of the National Committee of the Chinese People’s Political Consultative Conference, called all for a more progressive tax system to replace the ‘irrational’ system currently in place. The government’s efforts to reduce the burden of taxes and fees paid by farmers have also been marginally successful. Last year Chinese farmers’ per capita net income reached $298.3, an increase of  $13.1 or 4.8 per cent, compared with a year ago, with per capita fees and taxes standing at $9.5 compared to $11.[41]

The State Taxation Bureau has also enjoyed some success in reducing tax evasion, with anti-corruption measures recovering $4.2 billion in evaded taxes in 2002. However, although good intentions have been expressed, there is a long way to go before either corruption or disparity is satisfactorily remedied. The GDP proportion of personal tax still lags far behind that of most other low-income countries, and high levels of tax fraud continue to exist.

Meanwhile there has been a rise in the proportion of indirect taxation, which has now become the major contributor to revenue. In the first eight months of 2002, tax revenue amounted to $135 billion, a rise of 11 per cent over the same period last year, and indirect taxation accounted for 65 per cent of this increase. At the moment the system is rather unusual in that it practices a production-based value added tax, with fixed assets classified as eligible; but pressure is on to shift this burden from business by incorporating the levy into an expanded consumption-based VAT.

This is the tax that notoriously penalises the impoverished, who consume a greater proportion of their income than the rich, and although the proposed reform has been welcomed by neoliberal commentators, it seems to sit ill with the aims of the government’s 2003 budget, which is overtly designed to allocate more resources to the urban and rural poor.

Analysis and Conclusion

This paper is narrowly focused on China’s economic achievements over the last two decades, and is not meant to be an overall hagiography of the country. I do not defend China’s human rights record, and am well aware that the legacy of Chinese history and the current state of Chinese politics have enormous bearing on the functioning of the economy. In particular it is plain that the absence labour regulations, workers rights, and democratic participation has contributed to the low production costs that make the country’s exports so competitive. But exploitation of labour is unfortunately not confined to China, and ‘democracy’ remains a meaningless charade in all too many countries. China’s politics are of course fundamental to its economy, but it is beyond the scope of this paper to examine this relationship, which in any case does not negate the lesson that its economic success can offer to the rest of the world.

 To sum up, the basic facts of this lesson are plain for all to see. In the first place, China’s economic policies gave no quarter to the ‘globalisation’ paradigm of shock-therapy liberalisation pushed so enthusiastically by the Western IFIs. Secondly, the gradualist strategy it has followed instead (in its own words ‘a pro-active fiscal policy and a prudent monetary policy’), has been a great deal more successful in promoting growth than have the programmes of other developing economies, especially those emerging from centrally planned systems.

What is interesting about China, however, is not so much its remarkable growth rate – other countries have frequently exhibited extraordinary, and often extraordinarily volatile bursts of growth – but rather the consistency of its progress, and the stability of its economy even in the face of the chaos caused by the badly-advised and inappropriately sequenced ‘structural reform strategies’ of others. Its solid record of poverty reduction, its sustained success in weathering the South East Asia crisis, and its continued advance in the face of the current global economic downturn are what make its record impressive.

It is also these factors that make its example particularly salient when we are seeking ways to lift today’s many failing economies out of the spiral of debt, poverty and permanent or intermittent recession in which they are currently mired. Brief hectic bursts of growth, so frequently hailed as ‘economic miracles’ by the prevailing orthodoxy and so frequently followed by economic meltdowns, are not the answer for these, or any other countries. Instead, what is needed is a pattern of even, sustainable progress, based where possible on self-reliance, and coupled with an equable redistribution of wealth (including land ownership) within the economy concerned.

As we have seen, China has gone far towards achieving these objectives. It has consolidated its domestic assets, and refused premature privatisation of its public industries and banking system; it has established an equitable system of land distribution; it has kept its external debt exceptionally low, and has financed its investment largely from its domestic savings. (Indeed, contrary to common perception, the level of foreign financing has been declining over eight consecutive years, and despite the rise in FDI, which of course has contributed in other fields, such as new technology, export generation and so on, it accounted for only 10 per cent of capital formation in 2002.[42]) Above all, its government has so far resisted all pressure to liberalise the capital account, and has thus protected the economy from the destabilising speculative capital flows that have characterised financial globalisation, and brought disaster to so much of the developing world.

Up to 1995, much of China’s rapid growth was attributable to capital investment (some 55 per cent of GDP between 1978 and 1995, according to the National Bureau of Statistics), but this proportion has now diminished, and (remembering that inventory accumulation remains a problem, and that exports still only constitute some 3 per cent of GDP), it is plain that the country’s future growth is increasingly dependent on domestic demand. This demand is certainly growing, but if it is to be maximised it is vital to continue to reduce the country’s incidence of poverty, and equip as many people as possible to share in the consumption boom. In my opinion, all pressure to prioritise ‘liberalisation’ policies over this objective should be stalwartly resisted by government,

Unfortunately this is no longer the case, and instead, restructuring measures are gaining momentum. As a result, poverty reduction has slowed, and unemployment and inequality have substantially increased. These effects are currently offsetting the gains achieved by the array of distributive government policies designed to promote general prosperity. Many of these have been admirable in themselves; there is certainly appalling corruption in China (total loss from corruption between 1999 and 2001 has recently been estimated at almost 15 per cent of GDP[43]) and a clean-up of the system is urgently needed; the rural tax reforms were overdue, and the redistribution of resources towards impoverished regions outlined in the 2003 budget is badly needed. But these measures are not enough to combat the socially destructive power of the market, and a far more comprehensive safety net will be required for the poor if ‘reform’ continues to quicken its pace.

‘Economic growth’ is the mantra of the age, but in fact it is a complex phenomenon, and its relation to overall wellbeing is by no means straightforward. There are frequently many unwanted consequences – pollution, overcrowding, stress, and loss of community, to name but a few, while its benefits almost invariably become concentrated in the hands of an old or a new elite. Where this happens, and when the distribution of wealth becomes sufficiently skewed, the imbalance starts to reduce the potential for fresh wealth generation, since poor, sick, ill-nourished and ill-educated members of the population are plainly unable to produce or consume to their optimum capacity. Moreover, laying basic needs aside, numerous other factors – security, affection, recognition, a degree of leisure and a sense purpose, for instance, are fundamental for human flourishing, and feed back into the human capital necessary for sustained economic prosperity.

None of these qualities are facilitated by a market economy that gives rise to vast social disruption, millions of ‘floating’ workers, urban squalor, environmental degradation, and abrasive inequality. Such liabilities can be controlled by regulation, through the imposition of adequate redistribution legislation, a progressive tax system, a minimum wage, substantial welfare and healthcare systems and the like, but the demands of a globalised market place are inherently opposed to the pro-active fiscal policies that are needed to fund these measures in developing countries.

In the case of China, it is becoming increasingly clear that social policy that is no longer adequate to meet the problems incurred in the accelerating progress towards liberalisation. Lip service continues to be paid to the thought of Three Represents,[44] but ‘the interests of the overwhelming majority of the people of China’ appear to be increasingly ill served. Under these circumstances, domestic demand cannot possibly be maximised, and despite its remarkable progress to date, it seems probable that much of China’s real wealth – the productive and consumption power of its vast population – will fall victim to the vagaries of market forces and ultimately remain unrealised.

Appendix 1

Following the founding of the People’s Republic in 1949, the radical farmland revolution of the early 1950s first distributed land expropriated from landlords to landless peasants, creating a stratum of private smallholders. Then came the disastrous land reform collectivisation of the mid 1950s, known as the Great Leap Forward. This experiment, modelled on the Soviet system, totally destroyed the farmers’ autonomy, and led to famine in 1958-61 when an estimated 30 million people died.

Smaller units were then instituted, based on residential production teams, and in 1978, China definitively broke with Soviet doctrine, abandoning its collectivisation policies, and returning to a system of individual farming. This ‘third land revolution’, known as the Household Responsibility System (HRS) gave farmers freedom of land use rights and decision-making, and closely linked performance and reward. It was immediately and dramatically effective, and the output of grain increased by more than 100 million tonnes within only six years.

Although this surge in production did not last, falling off after 1985 and stagnating during the 1990s, the problem of feeding the huge population was nonetheless effectively solved.

It was eventually concluded that the main cause of the levelling off of production was the principle of extreme egalitarianism on which HRS was based. This involved a policy of continuous ‘readjustment’ of land use entitlements by local cardres, with households shifted around between different parcels of land in order to keep per capita allocations equal as populations fluctuated. In practice the result was to create high levels of insecurity among the farming population, discouraging farmers from making long-term investment to improve productivity.

To correct this problem, several significant policy and legal reforms were instituted, starting in 1993 with a policy of 30-year use rights (finally legalised in 1998), and extended to cover the right of voluntary lease or full transfer in 2001/02. In order to prevent growing inequality as land concentrates in fewer hands, a ‘two-tier system’ has also been widely adopted, under which local land is divided into ‘food land’ for family consumption, and ‘contract land’ for commercial farming. All households have their own food land, but contract land is optional, and those who take it have an obligation to fulfil government production quotas and can sell their produce in the free market. These measures have begun to show dividends in increased security and investment, but it is critically important that the reforms are now pushed forward. As the Rural Development Institute points out, the focus must now be on the implementation of the new legislation; at the moment only 98 million out of the 210 have received their contracts, and land market activity has barely begun.[45]