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From the Internet to foreign investment, China is reforming its economy big time.

It is increasingly apparent that the second most popular language on the Internet in the year 2005 (after English) will be Chinese. China has only 10 million people on the Internet today, but this number is projected to expand to 300 million in five years. Some of the growth will be spurred by personal computer sales, which could soon exceed twelve million a year. Other important contributors will be Internet convergence with cable television, which already encompasses 100 million households, and cellular telephones, which will exceed 100 million in another three years.

China's dramatically growing presence on the Internet is only a proxy for a far greater process of economic transformation, which will have profound implications for both the East Asia region and the world economy in the Twenty-first Century. China is in the midst of one of the most farreaching economic reform programs to occur in any country during the past 200 years. This reform process will create both the risk of political instability as well as opportunities for dramatic economic advancement.

Two decades after its economic liberalization began, China has developed a hybrid economic structure: The state still owns about one half of the economy, while the other half is far more open and competitive than the economies of Korea and Japan were during those nations' high growth years in the 1960's and 1970's.

China currently has about $350 billion of foreign direct investment (FDI) compared to only about $9.5 billion in Korea and $35 billion in Japan five years ago. The stock of FDI in China is also much larger than the totals in other Asian countries traditionally more open to FDI, such as Singapore ($79 billion), Malaysia ($48 billion), Indonesia ($65 billion), and Australia ($118 billion). In fact, the stock of FDI in China is exceeded only by Britain ($394 billion) and the USA ($1.1 trillion). China also has accounted for 25 percent of all the FDI in developing countries since 1990.

The FDI boom in China during the past decade has helped to set the stage for both a dramatic expansion of Chinese exports and such intense competitive pressure in domestic markets that the country has experienced three years of deflation. Foreign owned firms are now responsible for over half of China's exports and the share is likely to expand further when China's ascension to the World Trade Organization encourages further integration with the global economy. Exports have soared from $2.3 billion in 1970 (2 percent of GDP) to $290 billion in 2000 (21 percent of GDP). As with Mexico's entry into the North American Free Trade Agreement seven years ago, China's entry into the WTO will probably give a further significant boost to FDI by improving financial transparency and strengthening the rule of law. In the case of Mexico, FDI has increased from $2 billion a year before NAFTA to $12 billion recently. Some Hong Kong investment banks are projecting that WTO membership will boost FDI in China to levels as high as $100 billion a year before 2005.

Such high levels of FDI in China will have three important consequences for both China and the region: First, it will accelerate China's integration into the global economy. Secondly, it will prod China's domestic firms to restructure so they will be more competitive. Finally, it will help make China a regional growth leader at a time when other East Asian countries are suffering from reduced levels of FDI as well as the after-effects of the great regional financial crisis of 1997-98.

One of the factors that encouraged China's political leadership to pursue WTO membership was a perception that it would strengthen the movement for economic reform within China itself. If the country is to open itself to much higher levels of trade and investment, both traditional state-owned enterprises and privately owned local firms will have to restructure more aggressively to meet the challenge of foreign competition.

This challenge will also have great social consequence, because during recent years state-owned firms have been laying off workers at the rate of five million per year, and some analysts project that WTO entry will force another forty million job losses.

The government is preparing for the shock by setting the stage for reforms in the banking system and the capital markets that will be as ambitious as any undertaken by an Asian country during the modern period:

Bank Reform. First, it has formed an asset-restructuring agency to help clean up the balance sheets of China's four large state-owned banks. These banks represent about 80 percent of all lending in China and their loans have a value of close to 100 percent of GDP. In the past, they have made loans almost entirely to state-owned firms and about 35-40 percent of those loans are now non-performing. The restructuring agencies have already purchased about $100 billion of bad loans, but the final cost could be as high as $300 billion. Such large outlays on financial restructuring could increase China's ratio of government debt to GDP from 20 percent to 40-45 percent during the next few years. But the liquidation and restructuring of financially distressed state-owned companies will probably also increase the private share of China's economy from just over 50 percent today to 70-75 percent by 2005. The banks are also trying to diversify away from state enterprise lending by promoting loans to households for mortgages and durable goods purchases. Personal loans now represent about 30 percent of new lending and should expand their share of total loans to 1520 percent in 2005 from less than 2 percent recently. The government regards home ownership as a useful spur for promoting consumption.

Stock Market Expansion. Secondly, China is planning to open a new stock exchange, which will be far more open to private companies than the existing stock exchanges in Shanghai and Shenzhen. Despite the dramatic growth of the stock market during the past decade to over 1000 firms with a market value of $520 billion, only about a dozen of the listed firms are privately controlled. There is also only one private firm among the 100 Chinese companies listed on the Hong Kong stock exchange. During the past year, several Chinese Internet and information technology companies bypassed the local markets by listing their shares on NASDAQ to capitalize on the enthusiasm of global investors for the technology sector. But China has thousands of other capital hungry firms that are unlikely to qualify for NASDAQ during the short-term. China also has a large army of eighty million domestic retail investors who would like to purchase the shares of promising technology companies and do not yet have access to foreign stock markets. China has enjoyed dramatic growth of stock market capitalization because the country has one of the highest savings rates in the world and there are few alternatives to the equity market as an outlet for surplus household savings. The deflation of recent years has produced a sharp decline in the return on bank deposits and other fixed income assets.

Capital Control Liberalization. Thirdly, China plans to pursue a liberalization of its capital controls to permit foreign investment in its domestic stock market. When the stock exchange was re-opened nine years ago, China established a two-tier market that made it possible for foreign investors to purchase the B shares of about eighty companies also listed on the domestic A share market. But this market never generated great interest because the firms were small, illiquid, and still subject to state ownership. In fact, the market capitalization of the B shares is only about $5 billion and they usually trade at an 8090 percent discount to the A shares. But Chinese officials have indicated that they plan to introduce a system of exchange control comparable to Taiwan's that will permit registered institutional investors to purchase the A shares of Chinese companies. Such a development could have profound consequences for the evolution of the domestic stock market because foreign institutions will demand more transparency and superior forms of corporate governance than domestic investors have. What remains to be seen is whether the A share companies will also pursue dual listings in Hong Kong to enhance liquidity. At present, the largest market capitalization company in the Chinese world is listed in Hong Kong. It is China Mobile Telecom and has a value of about $125 billion compared to $100 billion for the Hong Kong and Shanghai Bank, which had been Hong Kong's largest market cap company for many years.

Financial Market Opening. Finally, China will permit foreign banks, insurance companies, and fund management groups to play a greater role in the domestic financial system than ever before. The government is opening the markets gradually because of concern about people shifting deposits away from financially distressed local banks. By 2010, foreign financial institutions will be offering far more services than were traditionally allowed in other Asian countries, including Japan, Korea, Thailand, and Indonesia. Such a development will provide new capital as well as improve the management and supervision of the financial system. It will also lessen the risk of China experiencing a financial crisis comparable to the one that devastated countries such as Korea and Thailand three years ago. Those crises did not just result from financial liberalization. They also stemmed from trade barriers, which forced foreign banks to make loans only through domestic financial institutions rather than operating directly in the country importing capital from them.

China's decision to restructure the banks and open the capital markets represents a major divergence with the economic policies that guided the development of Japan and Korea a generation ago. If the capital markets play a much greater role in allocating resources than the state-owned banks, China is more likely to produce productive and profitable enterprises than was the case with her north Asian neighbors. Chinese officials freely acknowledge that they have to improve the process of capital allocation not merely to cope with WTO but to prepare for a retirement funding problem comparable to that in the OECD countries during the next few decades. By the year 2050, China will have 400 million people over the age of sixty-five compared to fewer than 100 million today. At present, China's state enterprises fund retirement on a pay-as-you-go basis, but they will not be able to sustain that approach as the country's elderly population expands. The establishment of pension funds and insurance companies will create an important new market for securities and set the stage for portfolio managers to play a major role in allocating resources to China's new private sector.

A remaining uncertainty is how China will adjust other economic policies to cope with financial liberalization. One major area of concern is its exchange rate. During the Asian financial crisis, China played a stabilizing role by maintaining a pegged exchange rate to the U.S. dollar and injecting over a trillion dollars of fiscal stimulus in the form of infrastructure investment. The announcement of this policy at the 1998 Davos World Economic Forum by senior Chinese officials helped trigger a sigh of relief among other governments in the region and a rally in their stock markets. Many Chinese officials have suggested that the government should introduce a wider target band for the currency. In such a scenario, it might fluctuate by 3-5 percent instead of being stable. It is also unclear whether the currency will rise or fall. During the financial crisis, the government was able to hold it stable because of the country's large foreign exchange reserves and control on capital flows. There was significant capital fight by Chinese companies through trade invoicing, but the currency was not subject to selling pressure from hedge funds, portfolio investors, or private bankers. In the future, it is possible to imagine the currency rallying initially because of a large influx of foreign direct investments and portfolio capital but then weakening as the boom in domestic investment turns the current account surplus into a deficit.

There will be a Congress of the Communist Party in 2002, which will produce major changes in the personnel managing the country. Both President Jiang and Premier Zhu Rongji are expected to retire. Five of the seven members of the Politburo and more than half of the 200 members of the central committee will also step down. But despite the tremendous changes occurring in the Chinese economy, there has been little official discussion about liberalization of the political system. There are an increasing number of experiments with democracy in local elections but the leadership continues to insist on the supremacy of the Communist Party. All that can be said with certainty is that the economic changes underway should eventually set the stage for a more open and competitive political system. China now has more graduates of American universities than Soviet universities. Former political dissidents have emerged from jail to earn large fortunes as private dealmakers. The next or fifth generation of political leadership will have far more experience of the private sector and a market economy than any other generation in Chinese political history. Taiwan has recently set an example of democratic political transition that is unprecedented in Chinese history and has not gone unnoticed on either the mainland or among Chinese communities elsewhere. The issue of Taiwan's political status is a major source of tension, but it has not yet inhibited a rapidly growing level of FDI from Taiwan on the mainland ($45 billion), and there is growing support in both Taipei and Beijing for restoring shipping links in the near future and air service later. In fact, Taiwan is rapidly transforming China into a major player in high technology industry. China now produces half of the high tech output of Taiwan's firms, compared to 28 percent in 1998. As a result, tech products now account for 15 percent of China's exports and China's computer exports will soon overtake those of Taiwan, making China the world's third largest hardware exporter.

Although it will be essential for China to establish a democracy to insure genuine rule of law in the long-term, it is questionable whether a democratic regime today could preside over economic upheavals on the scale of those now occurring. Since economic liberalization is producing large increases in unemployment and other forms of social hardship, it could easily encourage populist political movements rather than parties committed to a market economy and true democracy. China will therefore pose a complex challenge for Western countries monitoring its progress. They will want to encourage human rights and democracy but they also do not want to promote leadership struggles and political conflicts that could jeopardize one of the most far-reaching programs of economic liberalization in human history. A premature experiment with democracy could produce an environment more comparable to the French revolution of 1789 than the incremental transition to democracy that Britain experienced in the run-up to the Reform Bill of 1832. Indeed, the West should recognize that since China's government is now staking its whole political legitimacy on the success of the economy, it is unleashing forces that will evolve inevitably into powerful agents for political transformation.

David Hale is Global Chief Economist at the Zurich Group and a TIE contributing editor.
COPYRIGHT 2001 International Economy Publications, Inc.
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Copyright 2001, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:economic development in China
Author:HALE, DAVID
Publication:The International Economy
Article Type:Statistical Data Included
Geographic Code:9CHIN
Date:Jan 1, 2001
Words:2549
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