Deepak Lal: The dangers ahead

THE CHINESE ECONOMIC MIRACLE: II

In my last column I delineated the sources of the Chinese miracle: high savings, the growth of labour-intensive small-scale non-state rural export industries in town and village and individual enterprises, a massive increase in infrastructure, a large unilateral liberalisation of foreign trade, and the market determination of nearly all domestic commodity prices.

This labour-intensive growth allowed the transfer of a vast amount of low-wage labour from both the rural sector and the declining state-owned enterprise (SOE) sector.

It enabled China to grow by "walking on two legs": by keeping the SOE sector alive whilst the non-state enterprise leg was growing stronger.

It thus avoided loss in output and employment and the attendant social disorder that had characterised other transition economies' move from the plan to the market. But this strategy now faces serious obstacles.

The heart of the problem lies in the financial repression needed for a capital-intensive heavy industry biased development strategy, requiring government monopolisation of the mobilisation and deployment of savings in the economy.

In China this meant complete control of the economy by the planners. The savings were provided by the profits of the state enterprises. With the reforms these profits collapsed.

In the rural sector they now accrued to private agents. The price reforms and growing competition from efficient non-SOEs turned SOE profits into losses, worsened by continuing the welfare commitments for health, housing, education, pensions, and jobs for life of the planned era.

As a result, the central government's revenues fell from 32 per cent of GDP in 1978 to 11 per cent in 1995. The fall being worsened by the various tax concessions the local authorities offered in their locational competition for joint ventures with foreign investors.

This acute fiscal crisis was met by two fortuitous circumstances. The large increases in private savings with rising incomes in the rural and small-scale non-state sectors were held as deposits in the state banks, whose deployment was determined by the central authorities.

Moreover, the growing incomes led to a rapid monetisation of the economy, with the ratio of money supply to GDP rising from a third to equality from 1978 to 1995. This provided large seigniorage gains. Nevertheless, the government had to run large fiscal deficits funded by bonds held by the state banks.

Apart from public investment in infrastructure, much of government expenditure is on implicit or explicit subsidies to the loss-making SOEs. With savings having reached a plateau and future seigniorage gains likely to be limited, the incipient fiscal crisis of the state requires a reform of the SOEs.

The first danger from the debauching of the financial system is the inefficiencies caused in the deployment of China's massive savings.

Currently, nearly 90 per cent of household savings are still held in deposits with the state-owned banks, in part because of the lack of alternative savings instruments. Most of the deposits in the banks are loaned to the SOEs.

Most of the investment in the viable private non-SOE sector is either self-financed or else dependent on foreign capital. Much of this "foreign" capital is in part the recycled profits of non-SOE enterprises, making use of the legal protections and financial intermediation available in Hong Kong.

With few of these private growth enterprises being willing or allowed to issue stocks in their companies, SOE stocks are the only ones traded on the domestic stock exchanges.

The non-transparent accounting practices of SOEs and perceived non-viability deter households from holding much of their savings in their stocks, leading to thin and volatile domestic stock markets.

The lack of adequate savings vehicles, and the low return households currently get from their savings in the state-owned banks, pose a threat to the maintenance of China's high savings rate, particularly when account is taken of the natural depressant of savings with the projected rise in the dependency ratio""with the ageing of the population""from 6 at present to about 2 in 2040.

But the state-owned banks cannot promote higher savings by raising their deposit rates without a rise in their lending rates to the unviable SOEs, whose losses would increase, leading the banks to further increase their loans to cover these losses and thus to a further increase in the non-performing loans in the banking system.

These micro-economic difficulties in using the interest rate to stimulate savings and for the efficient sifting and deployment of investments through a well-functioning stock market are further compounded by the macro-economic consequences of financial repression.

As the interest rate cannot be used as an instrument for managing aggregate demand, heavy-handed administrative measures, with all their inherent inefficiencies and limited effectiveness (given the self-financed nature of most private non-SOE investment), are needed to cool the economy.

Furthermore, given the fragility of the banking system, fully opening up the capital account of the balance of payments, followed by a move to a fully flexible exchange rate system, is ruled out, because it could lead to a serious financial crisis. I do not think that China's export-led growth has depended, as many other observers believe, on maintaining an undervalued exchange rate.

For, as most of Chinese manufactured exports are processed goods with little domestic value added (estimated to be about 20 per cent of the value of output), changes in the exchange rate would not markedly affect their profitability.

A flexible exchange rate would not damage China's phenomenal export-led growth. It is also required to fend off the growing pressures for a revaluation of the yuan from both private speculators and China's major trading partners.

Behind all these prospective dangers currently facing the Chinese economy lie the "policy" and "social burdens" carried by the SOEs, which need to be eliminated. Fortunately, China's large build-up of foreign exchange reserves provides the means.

China's foreign exchange reserves in October stood over $600 billion, which in a roughly $1 trillion economy amount to about 60 per cent of GDP. They are largely held in US treasuries.

Apart from the absurdity of a relatively capital-poor developing country making these large unrequited capital transfers to a capital-rich country, China must have seen a loss in the real value of these assets with the 30 per cent depreciation of the dollar from its peak in 2002, and a modest return of 2.3 per cent on US treasuries.

There is a much better way to deploy these foreign exchange reserves. Only a small part""say, $100 billion""are at best needed to fend off speculative attacks on the dollar peg.

The rest and future accruals could be put into a social reconstruction fund (SRF) under the central bank. This SRF would be run like many public pension funds. If it matched the 10-year return of 8 per cent p.a. of the World Bank's pension fund, the SRF would yield an annual income of about 4 per cent of GDP.

This could be used to retire the "social" burdens of the SOEs, allowing their privatisation. This would end the subsidies from the banking system, which have led to its fragility, allow a transparent accounting of SOE stocks, allow monetary policy to operate, and, with the restoration of health to the financial system, allow China to float the yuan.

As the SOE problem disappears, the income from the SRF could become the basis for a fully funded pension system for its increasingly aging population. A similar deployment of India's burgeoning foreign exchange reserves in an infrastructure construction fund (ICF) under the RBI would be an obvious Indian counterpart.