China: lots of promise, plenty of risk.

With China's recent entry into the World Trade Organization, many companies have been banking on China as their next big market. The boom in investment, accompanied by unparalleled growth in gross domestic product, can be very persuasive: Some estimates show that growth in fixed investment in certain Chinese sectors has jumped by 170 percent over the past year, and bank lending has increased some 40 percent. At the same time, with the adoption of much stricter corporate governance rules, Chinese regulators are attempting to increase transparency for investors and create a much more stable investment climate.

While this good news should bode well for North American firms doing business with China, the risks are not all on the upside. The exchange rate has been kept artificially low in order to pump up exports to the U.S. and elsewhere, while exerting inflationary pressures on the non-exporting sectors of the economy. At the same time, the liberalization of Chinese financial markets, combined with heavy buying of U.S. treasury bills, has created unprecedented levels of contagion in the international financial markets. Should China fall on economic hard times, it could put the U.S. economic recovery in jeopardy.

In an interview with Financial Executive, Kenneth Rogoff addresses some of these issues and the inherent risks for U.S. firms doing business in China. Dr. Rogoff is Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University. He is also a member of the Economic Advisory Panel at the Federal Reserve Bank of New York and has served as the chief economist and director of research at the International Monetary Fund (IMF).

FE: Much of what we hear about the growth of the Chinese market relates to the huge potential for foreign companies investing within the region. However, the downside of the financial risks is often underplayed. Can you comment on the current state of the Chinese financial markets and what North American companies need to know in considering this their next source of growth?

ROGOFF: Over the next couple of decades, there are a number of regions that are on track to rise from the ranks of poor, developing countries to emerging markets, and China is one of the leaders. In the transition from being a very poor country to a lower middle-income country, inevitably, countries have to change their standards and upgrade their financial systems.

In poor countries, the financial systems are usually highly repressed. The state controls the banks, and typically rams government debt down their throats because there's no market for debt. So, there's a great deal of financial repression. In order to go from an economy where the government stifles all enterprise to where there's a genuine market-driven economy, you need a more sophisticated financial sector. Virtually every country in history that has crossed this bridge has had some accidents along the way.

FE: In terms of foreign direct investment entering the country, what are some of the likely hazards?

ROGOFF: The biggest hazard in terms of foreign direct investment is getting your money out later. People investing in China need to have a 15- to 20-year horizon to think about making high returns. This isn't a country where you can go in and get your pay back in 18 months and it's all profit after that. The process of getting money out of China is a lot harder than the process of getting money into China. Companies and banks that are thinking of going in now are taking a very long-term perspective. If you're not prepared to do that, then the options are very limited in China.

FE: Do you think it's reasonable to look at risks over that long a time horizon in this case?

ROGOFF: If you think that China is going to grow and become the largest economy in the world over the 21st century, which it's on track to do, and if you're a company like Citibank, you're likely to see a need to be on the ground floor, to develop relationships and get ahead of the curve. On the other hand, many companies said that about Argentina 15 or 20 years ago, and they got their fingers burned.

In general, I think people see that there is enormous potential in China, so they're willing to take big chances. Also, if you look at global investing right now, interest rates are very low. It's very hard to find high yields, so investors are very prepared to take a long-term view.

FE: What are some of the practical issues of investing and operating within this environment, where corporate governance practices are clearly not up to international standards?

ROGOFF: To speak about corporate governance practices in places like China, you can't be using OECD (Organization for Economic Cooperation and Development) countries as benchmarks. These are countries that are in transition. The state still has a heavy hand in many industries, [and in] many investments. Corporate governance is very crude.

On the plus side, the government in China has been consistent and reliable; although there has been heavy involvement, it has been relatively benign. There are many countries where corporate governance is clearly much worse. But China is still a long way from having the type of corporate governance that investors would like to see. That's an area where India, for example, is way ahead of China.

FE: Would you say that the culture of corporate governance in American and European companies would create an advantage or disadvantage for those companies entering the Chinese market directly?

ROGOFF: I think it's an advantage, but it's limited because when you're doing business in China, you have to adapt to the local customs, the local environments. I think that if you have good corporate governance back in the U.S., it doesn't necessarily mean you'll be able to manage your problems there.

[ILLUSTRATION OMITTED]

FE: Global manufacturing companies that perhaps originate from the U.S. and have to comply with The Sarbanes-Oxley Act face the challenges of operating within a Chinese business climate while trying to comply with the sorts of rigorous stipulations of Sarbanes-Oxley Section 404, for example. Can you comment?

ROGOFF: A lot of U.S. companies are used to dealing in countries all over the world--Italy, Russia, etc. So I don't think the issues are particularly new. Each company has to find a way to balance the risk and returns.

However, I think Sarbanes-Oxley is an unfortunate piece of legislation that is an extreme over-reaction to events and puts undue burdens on corporations and corporate boards. I feel that eventually the United States will have to unwind that piece of legislation, not just to strengthen U.S. companies internationally, but simply because it's too strict. It's made corporate boards less effective and eventually will make corporate governance worse instead of better. I think something needed to be done, but it was a gross political over-reaction.

FE: Would you predict how the business environment will change over the medium term in China, perhaps with respect to adopting internal standards of corporate practice and governance. Is there a momentum that we can see there?

ROGOFF: I think the operative rule in the region is very gradual change. The leaders are attempting to engineer slow and deliberate change to avoid having to take steps backwards. They do so within an environment that is politically unstable. Ultimately, they will have to have more democracy in China, especially when the middle class becomes wealthier. I think things will gradually get better. However, I don't see any overnight changes from a country where corruption is quite high to one that is squeaky-clean.

FE: There's been a lot of controversy over Chinese exchange rate policy, in which they have pegged their currency to the U.S. dollar. Can you explain this relationship to the U.S. current account deficit and some of the inherent risks to the U.S. financial markets?

ROGOFF: In my view, the U.S. current account deficit has very little to do with China. It has everything to do with the fact that U.S. private citizens save very little and that the government is running huge deficits. If the private sector is not saving, then government borrowing has to be satisfied from abroad. China runs a big surplus with the United States, but if it weren't China, it would be someone else.

If the U.S. current account starts to come into balance, that's going to lead to a big change in the U.S. exchange rate. If the Asian countries don't bear their share of the adjustment, it will fall on the Australian currency, the UK pound, the euro ... and that would be very politically difficult.

FE: What are the risks of China being so closely linked to the international markets at the moment?

ROGOFF: The main risk is that China could have a financial meltdown. I don't believe the odds of that are greater than 10 percent over the next year, or cumulatively over the next five years of over 30 percent. However, if a meltdown does occur, it will have worldwide ramifications. Right now, Chinese citizens save 40 percent of their income, which goes directly into bankrupt domestic banks and is then loaned out to bankrupt state-run enterprises. If this chain is ever broken, it could result in a very precipitous collapse of the Chinese economy.

FE: Would we then see the same thing unfold as we observed in the Asian crisis of the late 1990s?

ROGOFF: No, this would be much worse. The Asian crisis of the 1990s was dramatic but really very short-lived, for all the ink that was spilled over it. The countries bounced back very strongly, and that's why we're talking about Asia again. But a crisis in China would be riskier and deeper.

The fundamental weakness in the Chinese economy comes from savers being locked into the banks. The financial crisis will most likely start in the banking sector, which will spill over into the rest of the economy and into the political sphere, which, in turn, could create long-lasting political instability. Even if 10 percent of Chinese savings start leaking abroad, that alone will be enough to bring down the system.

That's what people are most worried about. This is why Chinese officials are so keen to strengthen their banking sector, to liberalize their financial markets. With the growth in Chinese demand, it will be impossible to repress capital markets the way they are now.

FE: Can you explain the resulting impact on the markets, in the U.S. and around the world?

ROGOFF: China is pushing a $2 trillion economy. Instability in the region would result in a drop in commodity prices; it could lead to a big rise in U.S. interest rates [because] China has been a major buyer of U.S. treasuries. It could lead to a big swing in the U.S. dollar. It could lead to a lot of Long Term Capital Management-type problems.

LTCM was a hedge fund that melted down during the interest rate gyrations set off by the Russian default, and but for effective jawboning by the New York Federal Reserve Bank, could have brought down a couple financial firms with it. For perspective, when Russia had its collapse in 1998, it set off a big chain of events. Russia in 1998 was a minor economy compared to China in 2004.

FE: Do you see that the inflow of foreign capital into China will mitigate some of these risks?

ROGOFF: I think it's the opposite. The foreign direct investment becomes part of the economy that people depend on, but this can dry up very suddenly. We saw that with SARS (the near-epidemic that originated in Asia). While it can't turn around and run away the way the short-term loans can, I don't think it can provide much protection against a financial crisis.

It's important to remember that the chances of a major meltdown in China over the next five years are roughly 30 percent, not 90 percent. Given the upside risk, it still makes China a good bet.

Ramona Dzinkowski ([e-mail]) is a professional economist and business journalist who lives in Toronto. She is also Vice President and Director of Research for FEI Canada.