Bursting China’s Bubble

Richard Hornik. Foreign Affairs. Volume 73, Issue 3. May/June 1994.

Part of the problem of analyzing China has long been that any critical view is seen as anti-Chinese. Simply to question the accomplishments of a 4,000-year-old civilization is taken as evidence of bias and, generally speaking, broad-gauge attacks on China’s ancient political culture, particularly by foreigners, are dismissed out of hand.

That said, even those most optimistic about the Chinese economic “miracle” should take a careful look at the present regime’s track record before making sweeping predictions about China’s future economic growth.

In the long debate over the best political and economic path to modernization, an East Asian “model” has seemingly emerged overnight. In the eyes of many, East Asia’s success has proven that democracy, even pluralism, is a luxury to be indulged only after substantial economic progress has been made. Not only that, but economic progress itself is best guaranteed by a “soft” authoritarian regime. Only such a system, it is argued, can enforce the fiscal and monetary discipline that so often eludes democracies, which are forced to pander to public opinion or selfish interest groups.

The benign intervention of wizened authoritarians can drive and direct economic growth, more easily allocate resources, push through austerity reforms that are beneficial in the long term but unpopular in the short, and all the while create an environment conducive to the growth of private enterprise.

The success of China’s neighbors has provided the rationale behind grandiose projections about the Chinese economy becoming the world’s largest in the year 2000, 2010, 2020—take your pick. This model is widely considered to provide grounds for the political legitimacy that Beijing will need if a new social contract is to be written with the Chinese people. East Asia’s success is also the primary argument against efforts to force China to liberalize its political system. Lee Kuan Yew, Singapore’s senior minister, early last year warned the Clinton administration against meddling in China’s domestic affairs, saying, “I would put that as the greatest error that could be made.”

But much is overlooked in this analysis, about East Asia generally and China specifically. In its exhaustive study, The East Asian Economic miracle, the World Bank recently concluded that while the benefits of specific policy interventions could be debated, “getting the fundamentals right was essential.” In other words, key to the success of the East Asian economies are stable macroeconomic policies that emphasize fiscal and monetary stability. Yet, though it possesses a far harsher form of authoritarian rule than any of its successful neighbors, China’s fiscal and monetary policies remain a shambles. Beijing, in other words, has the fundamentals wrong.

China’s government appears no more capable of imposing fiscal and monetary discipline—the supposed advantage of authoritarianism—than a corrupt democracy. The present regime is more akin to the hyperinflationary Peronistas in Argentina than to the fiscally ascetic militarists who wrought South Korea’s rise. Efforts to impose a modicum of financial discipline last summer resulted in but a brief pause before the credit taps once again gushed forth. Fearing a backlash from its urban proletariat and anxious to continue lining the pockets of friends and relatives, China’s rulers will keep rolling the presses, printing an increasingly worthless currency to fuel a dangerously inflated bubble economy.

Bad macroeconomics is not the only reason that China’s boom may be short-lived. Possessed of an admittedly rational fear that it is losing control over society, and convinced that entrepreneurs are politically subversive, the old guard in Beijing has proven incapable of permitting individual enterprise to flourish. Private businesses are kept on the margins of the economy and the law, subject to arbitrary enforcement of regulations, many of which are unpublished.

China’s periodic anticorruption campaigns, for example, invariably target even legitimate private entrepreneurs. At the same time, the central government’s control over the provinces dwindles daily. Beijing is helpless to prevent interprovincial trade wars complete with tariffs and roadblocks. In the end, the limitations of Chinese political culture itself provoke the most profound skepticism about Beijing’s ability to nurture sustained economic growth.

Too Hot Not to Cool Down

Much of China’s economic progress, so visible in its major cities, is ephemeral and based on hot money. Loose fiscal policies have spawned easy growth and fast profits, and a skeletal legal structure has allowed this money to accelerate through the economy as investors take advantage of rampant, unregulated and often illicit speculation. Profits are illegally siphoned off from quick-fix ventures, then injected into new speculative schemes or sent abroad, but always with the primary goal of hiding revenues from Beijing. This get-rich-quick risk-taking eschews the kinds of long-term projects that might nurture sustainable growth—precisely because few Chinese investors believe that the current boom can last.

Despite the risks, Chinese and foreign investors have fallen over themselves to make a quick killing in what many outside “experts” have proclaimed will soon be the biggest economy in Asia, if not the world. But far too often, there is less than meets the eye. Said a European diplomat who has witnessed the remarkable changes of the last few years: “The overall view of China seems so positive and yet every time you look closely at something it is a mess. There must be some missing link.” A Western China watcher in Hong Kong, who lived in Beijing in the mid-1980s, said the problem is that the Chinese are good at creating a false impression: “It’s like Hollywood. The buildings are very impressive from the front, but then you peek behind the facade and find there is nothing there.”

By far the most worrisome element in the Chinese macroeconomy is the lack official and monetary discipline. Despite six years of efforts, macroeconomic levers to regulate rather than control the economy have yet to be put in place. Wu Xiaoling, deputy director of the Banking Reform Department of the People’s Bank of China, admitted, “As far as the financial sector goes, the main instrument of control is still administrative.” The root cause of the problem is a budget deficit that is spinning out of control. China’s Finance Ministry expects the 1994 budget deficit to triple to $7.7 billion. The true deficit, however, will be $14.8 billion—over a fourth of government revenues—if one uses internationally accepted accounting rules and includes debt service payments and excludes “revenues” from bond sales to foreigners.

Last summer, with the renminbi having lost half its value in just months and the money supply up over 50 percent, China’s newly minted economic czar, Vice Premier Zhu Rongji, launched an aggressive campaign to rein in the runaway growth of both the money and credit supplies. Zhu’s policies met with heated resistance from enterprises starved for funds and from investors who saw the price of real estate and stocks begin to fall. The squeeze particularly hurt the already shaky and overmanned state sector, threatening to put thousands if not millions of urban proletarians on the street. Provincial leaders with direct access to capital simply refused to cooperate with the austerity program.

Zhu did manage to stabilize the currency and reduce inflation, although urban inflation in October remained above 20 percent. But under extreme pressure from special interests—provincial and local leaders, state enterprise managers, and friends and relatives with a vested interest in loose money—China’s ruling gerontocrats blinked. At the Third Plenum of the 14th Party Central Committee in November, Zhu’s superiors declared victory over inflation and reopened the credit taps, which had already begun to flow in October when banks and other financial institutions extended $12 billion in new commercial credits. It is only a matter of time before credit and currency expansion spark inflation again.

The populace is sophisticated enough to realize that the value of its estimated $115 billion in individual savings accounts is being whittled away. The government’s offer in early 1993 of three-year treasury notes at 11 percent interest had few voluntary takers—not surprising given the 20 percent urban inflation rate. Despite those difficulties, the Finance Ministry said in March that in 1984 it would sell bonds worth $11.5 billion, three times the amount issued last year.

Government economists argue that there is no danger of runaway inflation. Unlike in 1988 when, according to the People’s Daily, 34.9 percent of urban households suffered a decline in real income, this time there are plenty of consumer goods around and thus less chance of the kind of panic buying that drives up prices. Nonetheless, the low yields offered by government bond sales reveal a dearth of inflation proof investment vehicles. The result is the sort of asset inflation indicative of a bubble economy,

The Flying Yuan

Drive along the new four-lane highway from the airport into downtown Chengdu, capital of Sichuan, and practically every spare bit of land is fenced off behind a big sign proclaiming a new real estate development. But behind the fences very few have broken ground. That has not, however, stopped those companies from issuing shares. And the fact that the central authorities in Beijing refused to sanction a stock market in Chengdu did not prevent up to 30,000 people a day, seven days a week, from trading the shares of 50 companies, more than on either the Shenzhen or Shanghai exchanges. Nor did it prevent the city of Chengdu from providing an auditorium and collecting a three-yuan entrance fee from all-too-willing punters.

Such trading is haphazard, capitalism in its rawest form. But it is also quite dangerous. There is no auditing of the accounts of these companies. Often investors hardly know what they are buying, other than a piece of paper whose value is supposed to rise. Said a 34-year-old employee of a state industrial enterprise, “I bought a thousand shares at 5.50 yuan per share. When the price goes up in a few weeks I will sell them.” But his shares could just as easily prove to be worthless, especially if the market bubble bursts, as has happened repeatedly in hot equity markets in Taiwan and Korea.

While some officials believe that this chaos is part of the maturation process, the mainland’s more sophisticated investors are wary of the downside and prefer to invest their capital abroad. The biggest real estate deals in Hong Kong for the past two years have involved mainland investors. While actual foreign direct investment in China topped $15 billion in 1993, mainlanders were spending well over $1 billion on Hong Kong real estate alone. State-owned enterprises like China International Trust and Investment Corp., and China National Technical Import and Export Corp., are casting their nets farther afield with investments in North America and Southeast Asia. Says a Western economist in Beijing, “One wonders why foreigners are so desperate to invest here when the Chinese seem to be so desperate to invest overseas.”

One obvious answer is that some of the money is hot. It is almost impossible to discover who the true investors are in many of these real estate deals. Several reportedly involve local and provincial government leaders trying to keep their hard currency earnings out of Beijing’s hands or putting aside something for a rainy day. The easiest way to get one’s money out is by double invoicing. A local authority or firm will buy a foreign piece of equipment for $1 million but receive an invoice for $1.2 million. The foreign firm then puts the difference in the Chinese partner’s bank account. “This happens all the time,” said one European businessman, “but now the Chinese have their own middlemen in Hong Kong to handle the double invoicing.”

There are official ways of getting money out of the country as well, if one knows the right officials and has the right connections. According to official Chinese statistics, China’s total capital outflow in 1992 ballooned to $30.5 billion, an $18.2 billion increase over 1991. Thanks to foreign investment, commercial bank loans and a foreign trade surplus, the country still ran a current account surplus of $6.4 billion. But that surplus was $6.9 billion less than in 1991. In 1993 China’s trade deficit ballooned to more than $12 billion at the same time that Chinese investment overseas began to accelerate. As a result, the country’s foreign exchange reserves are declining rapidly.

By far the most interesting official number in China’s 1992 capital accounts was in the “errors and omissions” category, normally a catchall for odds and ends that don’t fit elsewhere. International Monetary Fund experts were reportedly appalled when the Chinese claimed an unexplained outflow of over $6 billion for 1991. Eventually the IMF was satisfied that most of the money was legitimate foreign investment, which China’s statisticians did not know how to account for. But in 1992, by which time the Chinese officials knew how to account for legal capital outflows, the total was over $8 billion. Taken together China’s 1992 statistics raise serious questions about the health of its financial system and the economic sense of lending money to a country whose citizens seem to be aggressively moving capital abroad. Said Diane Yowell, director of Hongkong Bank China Services Ltd., “You could say that these numbers simply reflect the fact that China is becoming more of an open economy, but they also represent all of the elements of a capital flight scenario.”

A Dangerous Bottleneck

China has gotten all the easy increments of economic growth that come from leaving individuals alone to make money. Now it must find ways to provide capital at all levels of the economy, particularly in the countryside. China’s massive capital outflows could not come at a worse time. A capital shortage is already proving to be a potentially dangerous bottleneck to growth, stunting the creation of new jobs and casting vast migrant populations across the country in search of work. It has skewed economic growth by region and slowed the government’s sale of unproductive enterprises. The tragedy is that there is plenty of capital in the country, but China’s decrepit financial system—coupled with a sense of impending hyperinflation—prevents it from getting to productive enterprises.

The shortage of capital in the countryside has been most obvious in the past two years, as the government has been forced to pay some farmers with IOUS that they have not been able to redeem. A report last year by the official Xinhua news agency said the problem was shaking “the very foundation of agriculture.” A veteran China-watching Western diplomat in Hong Kong put it this way: “It was clear that the one thing everyone agreed on [at the spring 1983 session of the National People’s Congress] was that they are facing big problems in the countryside.”

A Western economist working in Sichuan province put it more bluntly: “The agricultural economy is up against the wall. Incomes continue to rise but not real income, and the relative growth rates between agriculture and industry are diverging.” Farmers’ net incomes last year were about $87, compared with about $204 for urban workers. Meanwhile, although industrial output rose by 20 percent, agriculture grew by less than four percent. The only answer is more investment, but domestic capital is not heading for the countryside. In Fenghuang, a village 75 kilometers southwest of Chengdu, per capita incomes soared to $170 five years ago but have stagnated since. The village’s hope now rests on possible Taiwanese investment in a stone-cutting enterprise.

The capital shortage is just as severe for urban enterprises. The fear of unrest has meant that efforts to trim staffs of state enterprises have foundered. In February, the New China News Agency quoted approvingly Zhou Yougui, director of the Fushun Petrochemical Factory: “We cannot lay off workers as in Western enterprises because this means putting a burden on society.” Because money-losing state industries require so much money to keep them afloat, other businesses are crowded out or forced to pay exorbitant interest rates. Even the issuing of corporate bonds was suppressed because the government was unable to market its own paper. Many government officials—national, provincial and local—see foreign investment as their only salvation.

Certainly, foreign capital continues to flood into the region as investment gurus and self-described China “experts” like William Overholt of Bankers Trust continue to advise that China is a buy. But some foreign investors are beginning to have second thoughts about the Chinese gold rush. The legal system offers no protection from unscrupulous Chinese partners, and the incidence of work stoppages is increasing. In 1992, 18 strikes were reported in Guangdong province. Last Rarch in the Zhuhai Special Economic Zone just across the border from Macao, 800 workers at a factory owned by Canon began a strike over pay and working conditions. The workers received about $69 a month, well above even the regional average. But they demanded increases of up to 50 percent plus company-supplied housing. Strikers cited the need for protection against inflation, raging at an estimated 30 percent a year in coastal regions of southern China. But privately they also mentioned that nearby state enterprises were paying higher wages. “China is definitely the place to be,” says one Southeast Asian banker, “but we are not really putting our own money in there. We prefer to act as a bridge for other investors because the risks are very high.”

The net result of the capital shortage is a shortage of jobs and opportunities. Sichuan officials estimate that more than a million of their citizens have gone to coastal provinces seeking work. China’s urban railroad stations are choked with blue-jacketed peasants who are careening around the country looking for jobs. By one government estimate, China’s “floating” population of migrant workers is well over 50 million. Even residents of the more prosperous coastal regions want to migrate, as evidenced by the growing trade in smuggling Chinese into countries like the United States. In spite of the bright future that everyone else seems to see for China, these people are willing to indenture themselves for periods of four years or more in order to pay for passage.

Beijing has thus far followed the imperative for greater reform and increased economic freedom as a matter of simple economic and political survival. Said Richard Margolis, a former British diplomat now active in developing China’s securities markets, “The leadership is driven by the simple mathematics of jobs versus job seekers.” China has more than 150 million redundant rural workers and expects at least 50 million more by the end of the century. In addition, it adds 10 million new urban workers to the labor force every year. The prospect of mass unemployment and the potential for social unrest that would result has forced the old guard in Beijing to discard not only their vaguely held Marxist tenets, but also their innate fear of the chaos that can result in China whenever central controls are relaxed.

Hammering Down the Highest Nail

While most experts have focused on China’s explosive economic growth or its potential for a political explosion, by far the biggest change is its openness—not of the regime, perhaps, but of its citizens, and not just to foreigners. The Chinese people, if they are finally to succeed in modernizing their land, must not only open themselves to the outside world but also to each other in order to take advantage of the remarkable talents suppressed for at least a millennium by a succession of authoritarian regimes.

Analyses of China’s potential invariably cite its 4,000-year-old civilization, with an aside to explain the country’s lengthy stagnation and more recent crises. In fact, Mao’s so-called communism was just the latest variant of an ancient social, political and economic structure that seems designed to throttle individual initiative and progress. Government is presumed to be interested only in the welfare of its people. Change is to be avoided because it might lead to chaos. And individuals must always take a back seat to the interests of the group. A fear of individualism is even ingrained in the language. The Chinese expression for “individual” has a pejorative connotation. Chinese children have drummed into them dozens of proverbs that warn of the dangers of being different—it’s the long roof pole that is sawed off; it’s the highest nail that gets hammered down; it’s the first bird to take flight that is shot.

Thus despite burgeoning individual initiative, individuals themselves have few effective rights or powers. A successful commercial lawyer in Beijing says that the explosion in the registration of new companies is partly due to that very situation: “Everyone is setting up companies because as an individual you can do nothing but as a company you can do everything.” But officially encouraged or not, individualism is the driving force in the country today. Explained Meng Peiyuan, a specialist in Confucianism at the Institute of Philosophy of the Chinese Academy of Social Sciences, “A market economy is a release of the energy of individuals, so any social value system today must be based on individuals.”

In fact, economic freedom has encouraged a new openness among Chinese. In the old China, it was not so much the state who controlled people but rather their employer. Without a danwei, or work unit, you were nothing. Your danwei provided your housing, medical care, education for your children, your pension, your vacation spot, and most of the food you ate, for there was little to buy on the open market. If you lost your job, you were finished. Now there are many other ways to make money. Many private and collective enterprises as well as foreign ventures offer higher salaries but without providing any of the normal perks of a state enterprise. Said one Beijing resident, “It was always possible to quit your job if you were willing to suffer the consequences. Now people just don’t care.”

The new emphasis on the human spirit is not just an economic phenomenon. Part, too, is long-term fallout from the May-June 1989 uprisings, which touched practically every city in China. The violent crackdown succeeded in cauterizing public dissent, but it could not erase the general realization that millions of other Chinese felt just as strongly about the shortcomings of the regime. The openness takes different forms. Newspapers, for example, are now more likely to carry articles that present more than one opinion on an important issue—like whether or not the economy is overheating—without endorsing one side or the other. In a March 1983 session at the Chinese Academy of Social Sciences, several of the forum’s half-dozen philosophy researchers took public issue with each other on the role of Confucianism in creating a modern social value system.

This sense of liberation extends to all sectors of society. Artists and writers who used to worry about official acceptance so that they could join the Fine Arts Academy or the Writers’ Union now thumb their noses at the cultural troglodytes who once arbitrarily anointed society’s creative talents. In the countryside, freedom is more circumscribed and tends to follow the more traditional patterns of clan-based villages operating as independent units. Still, it is a start and a considerable one, since 73 percent of the population lives in the countryside. There are over six million communities in the countryside towns and villages—all operating independently.

Haunted by the sense that they are losing social and economic control, China’s gerontocrats are trying to reassert political influence. In 1992 top government and party posts were recombined just six years after a formal decision for a split. All five members of the politburo’s standing committee have been given top government jobs and responsibilities. The rejoining of party and government functions has reached down to the provincial level as well. Former provincial party secretaries have been made governors. In addition, according to Father Yves Nalet, a Jesuit Sinologist who heads China News Analysis, “They are putting in ideological and security people at all levels.”

But the effort is probably too late. Almost daily, people are becoming more independent. A major influence is satellite TV, particularly STAR from Hong Kong. Although technically illegal, 500,000 satellite dishes were sold in China last year. It seems that every third or fourth apartment block in Chengdu has a dish on the roof. “This place has been global-villagized in a minute,” says a Western diplomat in Chengdu. Even large towns in the countryside now have satellite dishes. Moreover, in Guangdong province an estimated six million homes watch Hong Kong TV on a regular basis without benefit of satellite dishes. That is more than in Hong Kong itself. There are even some products advertised on Hong Kong TV that are sold exclusively on the mainland.

The local authorities belatedly tried to control the proliferation of satellite dishes and instituted licensing regulations in late 1992. But One only has to say that the dish is needed to watch Gansu TV, and approval is forthcoming. The central government subsequently issued its own decree outlawing satellite dishes, but it has no way to enforce the ban outside the capital. Much of the central government’s authority in the past came from control over purse strings. By cutting government offices at the local level adrift it has lost its call on their loyalty.

The Regime Cannot Reform

This opening up within China was not what Deng Xiaoping had in mind when he began his reforms more than a dozen years ago. Deng is first and foremost a social conservative. The spontaneity of the Cultural Revolution left its mark on him. The original reforms were based on the “household” responsibility system in which whole families contracted with the state to provide grain, produce or some service or handicraft. That provided a nice halfway house between the rigidity of a command economy and the chaos of a free market. To this day, Beijing insists that it is creating not a free-market economy but what is euphemistically called a socialist market economy.

In fact, Deng’s limited reforms played themselves out rather quickly. By the mid-1980s the rural sector had achieved all of the gains that were to be had from simply eliminating counterproductive steps like forcing farmers to grow the wrong crops at the wrong times in the wrong places. It also helped to actually pay peasants to grow a crop. In addition, the urban economy had gotten nowhere because private entrepreneurs were completely hamstrung by bureaucratic restrictions and prejudices. What little progress was made came from the so-called collective or cooperative sector, many units of which were thinly disguised private enterprises. But by now, reform-induced prosperity is requisite for the legitimacy of Deng’s successors, especially if they continue to interfere with individual initiative.

The noted political scientist Lucian Pye has written, “An ethical-moral dimension of the Confucian sense of legitimacy…seems to make the East Asian governments feel that they not only have the right to intervene in people’s lives but that they have a definite obligation to do so if it can help improve the people’s condition. At one time such interventions tended to be detrimental to economic growth, but that is no longer the case now that government officials know more about how economies grow.”

Except in China. Even if the present rulers are not venal, they are certainly ignorant. Some members of the so-called Third Generation of leaders like Zhu Rongji may be better versed in economic theory, but that phalanx will not take over complete control any time soon. And the eventual paramount autocrat from within that group will probably not be someone foolish enough, as Zhu apparently was, to take on entrenched interest groups in the name of macroeconomic stability. Such political bravery, rare enough in stable periods, will be even less likely in the midst of a succession struggle, which has already begun.

China’s immensely talented and motivated citizens clearly have the attributes necessary for their country to exceed even the rosiest predictions put forward by true experts on China and naive investment advisers alike. But that was also true in the late nineteenth and early twentieth centuries. The evidence available today suggests that, while chastened, the Chinese Communist Party is no more capable of harnessing the nation’s productive potential for long-term development and growth than were its predecessors. But who will dare tell that truth to a “hard” authoritarian regime? More importantly, who could change it?

Both communist and latter-day Confucian states have always faced a dilemma when choosing public servants. In Stalin’s day the choice was between “Red or expert.” The Confucian conundrum has been between “virtue and merit.” The collapse of the Soviet empire was due at least in part to the fact that Stalin and his successors invariably chose the Reds over the experts. Likewise, the success of modern Confucian economies has come in part because, as Pye has written, “In traditional Confucianism stress was placed mainly on the virtues of the upright man who embodied leadership. In recent times the idea of rule by an educated elite has meant the legitimization of technocrats in government.” As long as China’s rulers insist on complete political control, they will always choose loyalty over competence. As long as that is the case, it is difficult, given its present political structure, to argue that China will replicate the economic success of its neighbors.