Survey China: Keep Growing

Keep growing

Mar 23rd 2006
From The Economist print edition

Easier said than done

SHOULD China's growth falter, the country's ability to maintain social and political stability would be in great doubt. A prolonged slump in property prices would confront homeowners with their first taste of negative equity and banks with a millstone of bad loans. Urban unemployment would rise perilously. Bottled-up grievances over corruption and poor governance could set off open unrest with support from an urban middle class no longer so enamoured of the status quo.

But how likely is that? For a quarter-century, China has officially enjoyed average annual GDP growth rates of more than 9%. Even allowing for occasional over- and underestimates, average rates may have been higher than those achieved by any other Asian country during a similar period of rapid development. China suffered sharp slowdowns in the early 1990s and again later that decade, but quickly recovered. Those who predicted a hard landing for the country's economy two years ago as it applied the brakes have been proved wrong, at least so far. Growth in 2006, barring some calamity, looks likely to be only slightly lower than last year's 9.9%. Few expect a protracted slowdown in the remaining years of this decade.

However, big problems need to be tackled if China is to maintain rapid growth through the next decade. “We've pretty well done the easy reforms. What's ahead are the difficult ones,” says Gao Shangquan, a senior government adviser. These include a state-owned banking system burdened with non-performing loans, a state sector which despite considerable trimming remains massive and inefficient, and a social-security system that does not live up to the name. If China fails to deal with these, it could find itself going through the same experience as Japan in the 1990s, when bad loans led to a credit crunch and a long economic slowdown.

China's economy has a number of strengths beyond its rapid growth. Government finances appear reasonably healthy, with national revenue growth averaging 18% a year since 1994, a deficit of 1.6% of GDP and public debt of less than a quarter of GDP (see chart 4). This gives the government some room to pump up the economy if need be. China has one of the world's highest saving rates, at some 40% of GDP, and foreign-exchange reserves of $845 billion, second only to Japan's.

The country is making some headway against its problems, partly by design and partly thanks to rapid growth. It has laid off 20m-30m workers from state-owned enterprises (SOEs) in a huge wave of closures, mergers and privatisations that has halved their number since the mid-1990s. Although this has pushed up unemployment, many workers have been absorbed into the rapidly expanding non-state sector. SOEs now account for less than one-third of GDP, against almost all of it in the early 1980s. But that still leaves nearly 140,000 of them, employing 40m people. The state sector still accounts for more than half of all industrial assets, only ten percentage points down on 1998. More than one-third of these SOEs are making no return on their investment and need to be closed down or sold off.

On the brighter side, profits in the 169 large centrally controlled enterprises grew by nearly 28% to $78 billion last year. In bigger SOEs, efforts to remove the state from day-to-day control, introduce western commercial practices and strengthen the role of shareholders are making progress. The creation in 2003 of a new body to manage non-financial state assets, the State-Owned Assets Supervision and Administration Committee, has put a buffer between government and enterprise management and clarified rules for restructuring. A new bankruptcy law could be adopted this year, though it remains to be seen whether this is good for banks, whose claims come low in the pecking order under current legislation. The government's priority has been to pay off workers.

With half of all bank loans going to SOEs, the problems of the two sectors are closely interlinked. But even in banking, which many regard as the weakest link in China's economy, there has been some progress. There is less talk now about a possible banking crisis than there was at the beginning of the decade. Non-performing-loan ratios remain high, perhaps twice as high as official figures put them in the “big four” state-owned commercial banks. But following the transfer of 1.4 trillion yuan of non-performing loans to asset-management companies in 1999, a series of capital injections into the banks since the late 1990s and a tightening of credit management, three of the big four—Bank of China, China Construction Bank and the Industrial and Commercial Bank of China (ICBC)—are looking somewhat healthier. They have introduced stricter monitoring of non-performing loans and trimmed their staffs by a total of nearly 250,000 people. UBS, an investment bank, reckons that the non-performing-loan stock of the big four and other Chinese banks is now only around 30%, half of its peak level in the late 1990s (though that would still make China's one of the worst banking systems in Asia).

These moves have helped prepare the banks for listings overseas, which are intended to sharpen their operation as commercial institutions. China Construction Bank launched its initial public offering in Hong Kong in October 2005. Bank of China and ICBC, which has the biggest assets of the commercial banks, say they are getting ready to follow suit this year and expect to raise $5 billion-10 billion apiece.

In advance of their listings, the banks have also been selling strategic stakes to foreign financial institutions. But foreign ownership of banks is capped at 25%, and it is not clear how much say in management these investors will be given. Wu Xiaoling, a deputy governor of the central bank, the People's Bank of China, says the government has no plans to surrender control of any of the big four within the next five years. The party still regards state ownership of the banks as a vital bulwark against financial instability. It knows that this often leads to unproductive investments. But it also shores up public confidence in the banking system, which is essential for maintaining the flow of savings and foreign investment.

Chinese banking officials admit there is a need for foreign expertise, but fear that encouraging the development of privately controlled Chinese banks would exacerbate financial risk. As Ms Wu explains, private investors in China tend to regard such banks as vehicles for raising money for their own business interests, and private business interests can be very murky. In 2004, the government took over D'Long, a private investment firm in Shanghai that was billions of dollars in debt. It was a signal that the state will still intervene if it thinks that a company's collapse might threaten social or economic stability.

Too much saving is bad for you
With its huge foreign-exchange reserves, strong revenues and low deficit, China still has the wherewithal to prop up its banks. The saving rate is likely to remain high, given concerns about pensions and other social-security provisions. And there are few other places for savers to put their money: China's SOE-heavy stockmarkets have been among the world's worst performers in the past five years, and controls on capital outflows remain largely effective. The opening up of China's banking system to foreign competition at the end of this year—a commitment made by China when it joined the WTO—will have little effect in the short run because Chinese regulations make the cost of setting up large branch networks prohibitively high.

But if China's growth is to be led by consumption rather than by investment and exports, as most analysts agree it needs to be in order to avoid boom-bust cycles and growing friction with trading partners, the country will need to get used to a lower saving rate. And the banks are still in poor shape. A large share of lending from the boom of 2001-04 could turn into bad debt. Although official figures for non-performing loans look encouraging, they mostly rely on the accounting trick of moving such loans into asset-management companies. China's property market, though sustained by strong demand for new urban housing, could turn into a bubble.

Boosting private consumption could be difficult in a country with a GDP per person of only $1,700, especially given the absence of a comprehensive social-security system. The government needs to boost its own consumption first. This means spending more on health care and education, and expanding the social-security network in rural as well as urban areas. Changing demographics make this all the more important. Over the next 10-15 years, the rapid ageing of the population will increasingly make itself felt. As the labour force begins to shrink, the current pay-as-you-go pension system will become unsustainable. Life expectancy in China is high by the standards of developing countries and is likely to go on rising.

Goldman Sachs, an investment bank, reckons that China's “demographic bonus” of a large working-age population with a small number of dependants (helped by the one-child-per-couple policy introduced in the late 1970s) will shortly run out as the number of young workers starts declining (see chart 6). The country's dependency ratio will begin to rise by 2010, whereas India, on current trends, will not reach that point until 2040.

The government has been trying to develop a new pension system, including elements of both pay-as-you-go and funding, whereby it invests on behalf of workers and then pays them pensions from their individual accounts. But it will be many years before China has a sufficiently mature bond and equity market to make this workable. Yields on domestic bonds are low, and the 15-year-old stock exchanges are still hardly worthy of the name. The cost of establishing the new funds at the same time as meeting current pension obligations will be very heavy. It could be reduced by bringing more workers into the scheme (at present only one-third of urban employees are covered, and rural residents not at all), but it would be difficult to persuade them to take part in such a seemingly risky venture. With no expansion of pension coverage, liabilities for future pension payments could amount to 70% of current GDP.

But Goldman Sachs argues that the effect of China's growing dependency ratio will be mitigated by the rising productivity of an increasingly well-educated workforce. It could also be counteracted by productivity gains as more people migrate from rural to urban areas if China can sort out its rural land mess. Officials are considering an easing of the one-child policy, which could help as well.

President Hu and Mr Wen have signalled a greater willingness to spend on public services. They have repeatedly stressed that they want to steer China away from an environment-destroying blind pursuit of economic growth, devote more resources to health care and education and reduce inequalities. Their curious choice of slogan is, “Put people at the centre”—a phrase that in China is known mainly as the Chinese rendition of Nokia's trademark slogan “connecting people”.

However, the new five-year economic plan adopted in March gives little hint of any fundamental shift in spending priorities. It modestly calls for a mere doubling of GDP per person between 2000 and 2010, which implies that the current GDP growth rate might slow down considerably. The plan modestly forecasts an average annual growth rate of 7.5% for the next few years. But in their own five-year plans many local governments are predicting double-digit growth. High growth, the party believes, is still vital to its grip on power. And for the foreseeable future this will mainly come from the same sources as it does now: investment and exports.

In this, China is following the development pattern of several other Asian economies before it. But along with economic growth will come rising expectations—on the part of Chinese citizens for a greater say in decision-making, and on the part of the rest of the world for a China wedded not just to capitalism but to the principles of open government, private initiative, sound corporate governance and legal impartiality. Elsewhere in Asia, rapid growth has often gone hand in hand with political change. China's leaders know that both the world and their own people are watching closely.