Chinese giant is up and dressed but still shabby

By BRIAN FALLOW

Because it is so big and growing so fast, China tends to be regarded with some combination of awe, dread and avarice.

It is China the juggernaut, the unbeatable competitor, the insatiable market. No longer the sleeping giant, it is up and dressed and off to work.

But there is also China the developing country, which is grappling with profound structural reform and whose impressive growth rates are off a low base.

Its gross domestic product grew 9.6 per cent in the year to June, but its per capita GDP is only US$1100 ($1670).

That is an increase of about $150 per Chinese, or roughly one-ninth of the increase in New Zealand's per capita GDP over the past year.

And as the International Monetary Fund's chief China-watcher, Eswar Prasad, told a Harvard audience back in April, "Despite the image of China as having taken over most of the world's export markets, it still accounts for only about 6 per cent of world trade."

However, given China's population of 1.3 billion, it is a $2 trillion economy, the sixth largest in the world, and the IMF estimates that China accounted for almost a quarter of world growth over the past two years.

"China's voracious appetite for imports, both for its processing trade and domestic consumption, has kept the regional [Asian] economies growing despite the slowdown in global demand," said Prasad.

"Thus there is a great deal at stake in China's ability to successfully manage its vulnerabilities."

One area of vulnerability is that China's growth has become heavily skewed to investment rather than consumption.

The Chinese are estimated to save about a third of household income.

The problem is that the intermediation between those savers and borrowers is mainly conducted through the banking system. Equity and corporate bond markets are comparatively underdeveloped.

The banks are not necessarily very good at judging the commercial risks of the ventures they lend to.

Add rapid growth in the supply of credit (in part a consequence of China's fixed exchange rate policy), and you have the makings of misdirected investment and overcapacity. In short, a bubble.

This is being addressed.

The Government has used administrative methods like withholding land or planning permission to retard investment in sectors it considers over-invested.

And the central bank, the People's Bank of China, has raised the banks' required reserves ratio and widened the range of permitted interest rates.

Under commitments given when it joined the World Trade Organisation, China has to open up its banking sector to foreign institutions by 2007.

Its state-owned banks are bedevilled by a legacy of lending to state-owned enterprises that has resulted in a large stock of bad debt.

IMF's Prasad said significant progress had been made in recent years in reducing the overhang of non-performing loans and strengthening balance sheets of the major banks, but much remained to be done.

Even though there was no explicit deposit guarantee system, the problem of bad debts in state-owned banks was likely to have fiscal repercussions, he said.

"With a deficit below 3 per cent of GDP and public debt of only about 25 per cent of GDP, fiscal sustainability is hardly an immediate concern," he said.

"The problem is that there are substantial medium-term fiscal obligations relating not just to the remaining contingent liabilities in the banking system, but also the unfunded obligations of the state pension system and the rising expenditure pressures for education, health and other social needs."

Since 1997 more than 27 million workers have been laid off as a result of the closure of loss-making SOEs or redundancies in those which remain. More will follow.

To mitigate the social impact authorities have strengthened the safety net by such measures as increasing pensions and widening coverage of unemployment insurance.

In addition the IMF reckons hidden unemployment in the countryside is of the order of at least 150 million people. This is the number of people who would be freed up if the comparative productivity of farm workers rose to levels prevailing elsewhere in East Asia.

Prasad said that even if the economy grew at around 8 per cent a year (its average over the past 20 years) unemployment would increase over the next few years.

Investment bank JP Morgan in a report earlier this month concludes that China is on track towards a soft landing.

The 9.6 per cent annual growth recorded in the June quarter was flattered by the fact that a year ago the economy was overshadowed by Sars concerns. On an annualised basis, growth was down sharply from the average 12.3 per cent rate of the previous three quarters.

Crucially, given the concerns about over-investment, growth in fixed asset investment slowed to an annual rate of 22 per cent in the June quarter from 43 per cent in March, though it remains above the long-run-trend.

"Although inflation touched the central bank's 'red line' of 5 per cent year on year, we believe inflation will remain benign, preventing interest rates from rising substantially," JP Morgan said.

Inflation had been pushed up mainly by food prices, which represent about a third of the index. "The good summer harvest should ease inflation pressure going forward."

The bank expects growth for 2004 to come in at 8.6 per cent and ease back to 7.5 per cent next year.

It sees China's growth as becoming more balanced between domestic consumption, investment and exports.

Exports and imports have grown at an average rate of 15 per cent a year since 1979, more than twice the rate at which world trade generally has expanded over the same period.



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