China's transition merits caution: after the 'WTO euphoria' wears off, disillusionment awaits.

THE JAPANESE FOREIGN MINISTRY was miffed at a New York Times report in August announcing that foreign correspondents were leaving Tokyo for China, drawn by the promise of a more compelling story: the rise and threat of China versus the near endless stagnation in Japan. China appears to be the one spot of economic vitality in a world of gloom. Words of advice often heard at Tokyo cocktail parties are, "It's time to learn Chinese." Should businesses in Japan move operations to China, too?

Clearly, there are good reasons for companies to move their more labor intensive tasks to China. With its abundance of cheap labor, China offers precisely what Japan lacks. Indeed, China could play a role in moving the Japanese economy away from manufacturing and toward upstream and downstream activities like research and marketing. Investments in China could provide the returns--based on economic growth--to pay for pensions for Japan's rapidly aging population.

Studies suggest that returns on investment in China over the last decade are comparable to those in other major emerging markets such as Brazil, despite stories of foreign businesses getting burned in China. In many ways foreign companies are even at an advantage compared with non-state domestic companies, as they enjoy preferential tax treatment and easier access to government officials.

Hidden risks

Yet the future does not exactly resemble the past, and the same dramatic transformation that brings prosperity for many Chinese and opportunity for Japanese companies also carries risks. One reason why these risks have been less appreciated so tar might be called "WTO euphoria": China's entry to the World Trade Organization last December has brought real improvements to the business environment but also hype based on promises and vague hopes. Foreign investors would be well advised to remember that previous waves of euphoria since China began opening up in the late 1970s have been followed by disillusionment.

A second reason is that the social system has been absorbing the risks associated with economic reform, lulling the observer into a kind of complacency in thinking that such risks will easily be absorbed in the future. But investors should remember that dramatic political change such as the collapse of the Eastern bloc is rarely anticipated, even though, with hindsight, the signs were there.

The establishment--members of the political, government and military elite in Belling and, at the senior provincial levels, senior managers and owners of state and non-state enterprises--share a primary fear: that economic reform will bring about social disorder stemming from economic dislocation and hardship. The official number of collective protests had risen nearly fourfold since 1993 to 32,000 in 1999 (the latest available figure), and there has been similar growth in protests attracting crowds of more than 10,000. Grievances include official abuse of authority, layoffs, late wage or pension payments, unfair taxes and fees, and the arrest of figures deemed responsible for organizing the protests.

In the countryside, many of China's 800 million people who are farmers or family members of farmers will struggle to earn a living. Most plots of land are too small to he farmed efficiently, and increased imports that followed WTO accession have put pressure on the prices of some agricultural produce. Farmers are also unhappy with the imposition by local officials of a raft of arbitrary and sometimes unlawful fees and charges, some of which go into officials' pockets.

The government in Belling will take steps to prevent a flood of imported agricultural produce that would disrupt the farming economy--for instance, no more than 5 per cent of grain consumption is to be imported for reasons of national security--and it is replacing fees with a unified tax. Urbanization acts as a release valve, allowing young migrants to supplement their families' incomes by remitting part of their factory wages back home. But the gap between rural and urban incomes is widening, and there is a danger that if the central government's policies go awry, it will face a large and unhappy group based in the heartland of Mao's own revolution.

But farmers will only provide a backdrop of discontent. Rural areas aren't going to be the source of political opposition because people are too spread out, social organization is limited and education levels are low. Revolutions begin in the countryside only when the security and military apparatus of the state is weak, and although the Chinese state is weak in other ways (especially when implementing central policy against local official resistance), it does not suffer from weak security. Green shoots of political opposition will be stamped out efficiently in the countryside.

Boiling point 

In certain urban areas disaffection is boiling. The two most serious examples of social protest since nationwide unrest in 1989 took place in March this year in Liaoyang and Daqing in the northwest. People in Liaoyang remember days in which the surrounding Liaoning province, now part of the rust belt, was one of the richest in the country, owing to the state's prioritization of heavy industry under Mao. Now that there is a glut in the world steel market, factories are closing and unemployment runs at 20 or 30 percent in some areas. Wage arrears in Liaoning at the end of 2000 amounted to Rmb4.3 billion ($120 million) owed to 1.8 million workers in more than 7,000 firms.

But among the workers here, the main cause of dissatisfaction was not unemployment per se. It was their former employers, state-owned enterprises, failing to pay benefits and severance packages, and the lack of alternative sources of income. Labor protests here are usually small and dominated by pensioners. Younger people can usually find some way to make a living, but the older unemployed have no other hope of income.

Typical response tactics by local officials to labor protests are to jail the ring-leaders and pay off the demonstrators with cash and promises. Only the truly desperate--usually those with no employment prospects are likely to keep protesting in such circumstances, especially when they realize that their former employer probably has no money left. Any government compensation at all would then be better than nothing.

In the areas that have declined the most, however, the laid-off have little to lose, and resentment is fueled by the holier that enterprises can't pay benefits because of managerial and official corruption. According to one estimate by Tsinghua University professor Hu Angang, economic losses stemming from corruption amounted to an average of 14.5-14.9 percent of Chinese gross domestic product (GDP) in 1999-2001. This estimate is probably conservative as it is based only on instances of corruption published in official sources.

Not-so-quiet desperation

In the immediate future the number of desperate people is liable to grow. According to the government, many of the 25.5 million urban workers laid off from state-owned enterprises in the last three years will soon no longer be eligible for benefits from the state. Laid off workers usually have some portion of their basic wage paid by their former employer for three years, after which they may receive much smaller benefits. As wage payments cod, and as a growing number of former employers run into arrears in paying former workers, the number and severity of protests will mount.

As the party leadership transition approaches the line up of the new leadership for the next five years was announced at a party congress that opened on November 8th--the government will forestall social instability by slowing the industrial restructuring that generates urban unemployment and by generating short-term jobs through spending on public works and infrastructure construction projects.

But this strategy has its limits. The budget deficit is not big, but there are myriad off-budget expenses, and the government has been pump-priming the economy since it was rocked by the Asian financial crisis of 1997-98. Contingent liabilities in the form of bad loans at banks and expected pension obligations, if accounted for in public debt, could push that debt to around a dangerous looking 100 percent of GDP based on fairly pessimistic assumptions.

In the extreme case, it public debt servicing costs spiral out of control, a fiscal crisis will ensue. Usually this leads the monetary authorities to print money to pay public debt, sparking rampant inflation and the collapse of the financial system, which is already fragile in China. The government says that less than 30 percent of the loans held by China's four largest banks are bad, a level that would be very risky except for the fact that households have few alternative places to place their large savings.

It is likely that the true ratio is higher: Standard & Poor's, the international credit rating agency, reckons that the true figure is more than 50 percent. Nonperforming loans are a major drag on economic growth in Japan, yet China's financial sector is much more poorly capitalized than Japan's and risk is concentrated in a handful of institutions. Shanghai's skyline is impressive, but many of the luxury apartment buildings, near the airport for example, are empty, a visible manifestation of China's nonperforming loans that is reminiscent of Bangkok circa 1997. Empty skylines are generally bad omens.

Crowding out

Even if government spending does not lead to a crisis, there is evidence of crowding out: Government lending and government-directed lending to politically sensitive state-owned enterprises, arguably a kind of welfare system, leads banks to charge higher lending rates and cut off credit to non-state borrowers, which are often the firms with the best prospects. Expensive foreign direct investment and foreign credit may fill in the growth gap somewhat, but they are not a panacea, and foreign-invested companies do not have the capacity to absorb as many workers as the government would like (the government is considering offering tax incentives for foreign companies to employ workers laid off from state enterprises).

Social stability in China is premised on a sustained high rate of growth. If growth were to slow drastically, state payoffs to those who lose their jobs would at some point become unsustainable. The government could stave off disaster for a while by running a large deficit, but in the end it would probably have to print money to finance the deficit, and this would lead to ram pant inflation. In the 20-odd years of economic reform China has experienced, the economy has entered slow downs, perhaps recessions, but they have not been sustained. The nightmare scenario in China would be that its government coffers run dry, the banking system collapses and protests turn into a national movement. What does this mean for the businessman or investor in Tokyo?

In the 1995 movie Heat, Robert De Niro, playing a bank robber, advises Al Pacino, playing a detective, to never get involved in something that he cannot get out of in 30 seconds. The Chinese economy is not on the verge of collapse, but neither is high growth and social stability assured. Warning signals would appear in the years leading up to the nightmare scenario. Lesser risks for businesses and investors include partial nationalization of an industry dominated by foreign companies, a slowdown in the government's reform policies, and the possibility that the government and the people place the blame for China's woes on foreigners. As people in Japan assess risk around Asia, the wrenching transition that China will be going through does merit caution.

Devin Stewart is special assistant to the president of the Research Institute of Economy, Trade and industry in Tokyo. Duncan Wrigley is deputy economist for the Economist Intelligence Unit in London. The Japanese version of this story appeared in the November issue of a monthly magazine Sentaku.

DEVIN T. STEWART (co-author, China's Transition Merits Caution) is special assistant to the president of the Research Institute of Economy, Trade and Industry in Tokyo. He is chairman of the Korea Japan Study Group and managing editor of Miyakodayori. His essays have appeared in The Asian Wall Street Journal and The International Herald Tribune. Previously, Mr. Stewart was a researcher for the Japan External Trade Organization  (JETRO) New York. He was an aide on the US Senate Committee on Foreign Relations and to Senator Barbara Mikulski in Washington, D.C. He earned degrees from The Johns Hopkins School of Advanced International Studies and the University of Delaware.

* DUNCAN WRIGLEY (co-author, China's Transition Merits Caution) is deputy editor for China at the Economist Intelligence Unit in London. His essays have appeared in The Asian Wall Street Journal, The International Herald Tribune and Business China. He has given interviews to BBC World (TV and radio), Reuters and the National Post in Canada. He has given lectures at such places as Tsinghua (Beijing), Fudan (Shanghai) and the Inter-American Defense College (Washington, D.C.). Previously, Mr. Wrigley was a researcher for the Asia Program at the Center for Strategic and International Studies, Washington, D.C., and the editor of the CSIS Hong Kong Update. He studied at The Johns Hopkins School of Advanced International Studies and Oxford University.