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China: What's Going Wrong? (Int'l Edition)


International -- Asian Cover Story

China: What's Going Wrong? (int'l edition)

Plans for reform screech to a halt as it enters a year of economic peril--the most dangerous in a decade

We will prevail. That was the message Chinese Premier Zhu Rongji sent to the world a year ago, when the National People's Congress unveiled a $1.2 trillion, three-year plan to keep the Asian crisis at bay. The public-works spending would keep China's millions employed and the economy expanding by 8% annually. Meanwhile, Zhu would tackle the thorny tasks of shutting down profitless state factories, curbing corruption, streamlining a bloated bureaucracy, cleaning up the banking system, and privatizing housing. With China still growing, Zhu thought the country could absorb the shock of reform.

He was wrong. Instead of embarking on a year of triumph, China is entering a year of peril--its worst in a decade. When Zhu set his plan in motion, he underestimated just how out of control the economy already was; he miscalculated its frailty and the impact of the crisis. Now, millions of unemployed are clogging the cities. Protests occur almost daily. Consumers have stopped consuming. Housing privatization has stalled. State factories still churn out billions of dollars in unwanted goods.

Meanwhile, many foreign investors, burned by Beijing's arbitrary policies, are rethinking their commitment to this turbulent market. "We are wondering if this is a government we can trust," says a Western banker in the southern city of Guangzhou. China has always been a tough place to do business. The threat this time is that investors will funnel their money to more lucrative, more easily managed markets just when China needs outside capital the most. Foreign investment could drop from $45 billion in 1998 to $30 billion this year, according to some government estimates, as investor fatigue deepens and less difficult markets beckon. China cannot afford to lose investors' favor.

Beijing policymakers are deeply worried. China could fall into the same trap that snared Japan: The government tries to reignite spending, but the banks, riddled with bad loans, stop lending. Deflation becomes unstoppable, and the consumer economy grinds to a halt. To get at least some growth, the authorities are forced to devalue the yuan. Meanwhile, social unrest could pose a serious threat. This year marks the 10th anniversary of the bloody night at Tiananmen Square, as well as the 50th anniversary of the founding of the People's Republic. Celebrants can easily turn into demonstrators if they're angry enough and poor enough.

With these threats looming, Zhu has quietly set aside much of his politically destabilizing reform plan. He is also engineering a crackdown on the provinces, shutting down heavily indebted, corrupt investment trusts and sealing the exits for any Chinese company that wants to ship money out of the country.

There's some merit to this crackdown: China needs a better regulated and less corrupt economy. But the moves show Zhu is as much a Party cadre intent on control as he is a reformer. And while Zhu in the past used the levers of state power to curb inflation and promote growth, this time his policies seem likely to lead to even more stagnation. Ministries are changing the rules to favor local players--and sideswiping foreign investors in the process. Foreign ventures are losing distribution deals and forking over more of their profits to tax collectors. "Multinationals have been in the economy for six or seven years, and they're not getting the returns [they want]," says Padraig Lehane of Dun & Bradstreet in Shanghai.WORRIED WORKERS. Somehow, Zhu and his advisers were supposed to avoid this mess. They knew the economy was starting to slow a year ago. But they figured Keynesian stimulus was a tried-and-true formula for growth. The public spending did boost growth for much of 1998, but then the economy started to cool in the fall. Too much of the public-works money was being siphoned off by corrupt officials, and too many of the projects had limited payoff in triggering new economic activity. And workers got spooked as state enterprises continued to shut down. As the number of jobless rose, workers socked more money away and consumer spending evaporated. The central government, suddenly frightened, pulled back from its shutdown of state factories.

Other reforms ground to a halt, especially housing reform. The plan was that the middle class would buy the homes they rented from the government and so create a spending boom, with banks issuing mortgages and makers of everything from washing machines to televisions doing a brisk business selling to new homeowners. But people who had been on waiting lists for years for subsidized housing balked at all those state-owned apartments going private. And saddled for the first time with such costs as health and education, the Chinese middle class hesitated to spend their life savings on flats they were renting for a few dollars a month. Banks were slow to create a real mortgage market and assume new credit risks. The expected housing market never materialized.

With reforms and public spending failing to do the trick, Chinese authorities could only hope China's cheap, skilled labor could keep exports humming. That didn't happen. The vital export zones of the coast started to falter in the second half of last year, after the Asian crisis wiped out China's markets in neighboring Korea, Japan, and Southeast Asia. Suddenly, instead of buying Chinese goods, the Koreans were underselling Chinese steel and petrochemical companies on Chinese soil. Even China's most efficient steel producer, Baoshan Iron & Steel in Shanghai, found itself beleaguered. "We were under heavy pressure from cheap imports," says a Baoshan official, citing Korea's Pohang Iron & Steel as a major competitor. "That brought prices down."

Then, late last year, authorities discovered companies and government agencies on the coast were anticipating even tougher economic times ahead--and trying to smuggle money out of the country as a result. More than $45 billion is believed to have gone missing. As officials tried to stem the outflow, they started examining the books of coastal companies. To their horror, they discovered that many companies had taken on far more hard currency debt than regulators realized. Many international trust and investment corporations (ITICs)--set up initially to trade with the West and raise foreign capital--were awash in red ink. Companies up and down the coast were throwing money into speculative real estate and stocks while borrowing ever larger sums. Other companies were using false trade invoices to get their hands on foreign exchange, and then hoarding it overseas. According to a local official, the Guangzhou city ITIC sunk most of a $10 million Japanese loan into lavishly redecorating one of its buildings.

So in September, Zhu imposed draconian controls on foreign exchange dealings. At the same time, he started putting the squeeze on one investment trust after another. But the unintended damage has been huge. Even legitimate businesses find themselves encumbered by the heavy documentation needed to obtain hard currency. "The regulations have really hurt our efficiency," says a Chinese importer of medical equipment in Shandong province. In Shanghai, an American maker of steel bpeams is so frustrated with forex controls that he wants out of his joint venture. And Procter & Gamble Co. is considering delaying new investments in southern China because of difficultIes repatriating money, according to a Guangzhou city official. P&G denied it but did say regulations were slowing down payments to suppliers.MORE PAIN. The consequences of Beijing's actions keep multiplying as they ripple through China's traditional growth zones, the coastal provinces. In Guangzhou, the crackdown on smuggling and corruption has local leaders constantly looking over their shoulders. But it has also struck fear into the hearts of entrepreneurs, scaring many of them from new investments. One city official now predicts only 3% growth in exports and foreign investment in 1999, half the levels of last year. "We have suffered a serious negative impact," says Weng Wenxiang, vice-chairman of the Guangzhou Municipal Commission for Foreign Economic Relations & Trade.

There will be more pain to come. Guangzhou city's ITIC may also be shut down, if an ongoing investigation reveals serious financial mischief. That could pose big problems for the city government, which parked pension funds for the police force in the trust, according to a well-connected Chinese lawyer. Says a longtime Western resident of Guangzhou: "If Guangdong finds itself in trouble, the rest of China's economy will be heavily hit."

In Dongguan, a southern city known as an export powerhouse, strict foreign exchange rules and the crackdown on smuggling have dampened the economy. Small exporters that relied on relaxed customs and currency controls powered Dongguan's astonishing growth in the 1990s. Now, "many enterprises have already closed down," says an employee of a Hong Kong electronics outfit based in Dongguan. "People are losing confidence in China's economy here."

And it's not just the high-flying South feeling the pain. In the northeastern port of Dalian, once a hot growth area, hard-hit Korean and Japanese companies are freezing new investments worth $2 billion per year. Zhu's public spending plan has resulted in millions of dollars in new infrastructure projects for Dalian. But they are not enough to offset the drop in investment, a big slowdown in exports, and growing unemployment. Today, the city is littered with half-constructed shells of buildings started by companies such as Hyundai Group. The local government has ordered that all building exteriors be finished in an effort to mask the extent of the real estate bust. "The challenges are serious," says Liu Guochen, deputy director at Dalian's investment zone.

While the economy slows, Zhu is resorting to other expedients. Deflation caused by overproduction and cheap imports is ravaging Chinese enterprises. These companies, most of them state-owned, have accumulated hundreds of billions of dollars in unused inventories.

The short-term solution: price minimums in 21 industries, including steel, sugar, glass, autos, and electronic appliances. The tottering state factories are getting a reprieve, but these minimum prices are creating weird distortions. The general manager of a Western chemical factory near Shanghai complains that all local suppliers of polyester chips, a key component for his products, have hiked prices to nearly 75% above world market rates, even though they all faced a glut. "It's definitely a cartel," he says. "No matter what the order is, the pRice is always the same." It's no surprise he has put plans for a second production line on hold.

Even more egregious are new protectionist moves. Late last year, Beijing announced it would curb operations of foreign telecom companies such as Sprint Corp. and Siemens, allowing China's main provider, China Telecom, and small rival Unicom more time to reap profits and cement control over the telecom sector. And Beijing has pushed a "buy local" policy requiring provincial authorities to steer clear of foreign telecom and power equipment.PRICE PINCH. In Dalian, drugmaker Pfizer Inc. is poSting only 5% revenue growth rather than the expected 27% because Beijing is limiting the amount of joint-venture drugs hospitals can buy, to the benefit of Chinese producers such as Shenzhen-based Sanjiu Enterprises and Shandong Xinhua Pharmaceutical. "Of course they're going protectionist," says the head of another Western manufacturer. "Beijing knows 1999 is not going to be an easy year."

Hong Kong knows that, too. The reluctance of foreign investors to put any more money in China is jeopardizing its role as an Asian financial center. "The only deal I am doing [in China] is trying to get my money out," says one Hong Kong-based European banker. Interest in red chips has dried up. Shandong International Power Development Co. became the third mainland company this year to postpone plans for a stock offering in Hong Kong when faced with lukewarm investor sentiment.

To his credit, Zhu has backed a new securities law that is helping to improve the quality of China's bourses. He has helped convert the central bank into a U.S. Federal Reserve-type system that reports to Beijing--not to reckless local officials. And he hopes to increase the coffers of the central authorities, which do not get a fair share of taxes from the provinces, through a nationwide fuel tax and stricter enforcement. He is also supporting a change in the constitution giving more recognition to the role of private enterprise.

None of these reforms will matter if consumers and investors face such difficult times that they either hoard capital or spend it elsewhere. With economic indicators worsening, there's little chance the government will retreat from protectionism or the crackdown. "Zhu wants to remake China," says David Zweig, associate professor at the Hong Kong University of Science & Technology, "but to do that he needs a much more robust economy than he's got."

Political alienation between Beijing and the provinces could also make it tough to reignite growth. Anti-Beijing feeling on the coast is rising rapidly. A source close to the Guangdong ITIC insists the central authorities were gunning for the company when they shut it down, though he admits to weak management. According to this insider, GITIC actually did have sufficient money to cover its debts, but Beijing authorities prevented the company from converting this to foreign exchange. "Beijing wants to pull in the reins and show who's in charge," says Laurence Lipsher, head of the American Chamber of Commerce in Guangdong.

China's lost momentum for reform creates a twofold risk. The first is that China drifts along. While it relies on ad hoc measures and the old tools of central planning to stave off unrest, it loses precious time transforming itself into a market economy. The second is that multinational enthusiasm for China seriously weakens, leaving China without new technology and management skills and ultimately further behind the New Economies of the West. Chinese authorities know that foreign investors are hurting. But they are doing little about it, hoping an economic rebound in 2000 will create new business for foreign and local companies alike. But it's a gamble. The U.S.-China Business Council recently found that 80% of its members are affected by the new foreign exchange regulations. More than 50% of them are delaying new investments in China in response. "The side effects of these immense assaults by the regime on business as usual are proving very painful," says Robert A. Kapp, president of the U.S.-China Business Council. "At the end of the day, American companies have business decisions to take. Some will say, `Let's go home or cut back."'

It would be tragic if China put reform on hold for too long. The country has traveled a long and hard road to reach its present level of prosperity. And a stagnating China would pose a serious threat to Asia's recovery and the global economy at large. Zhu's biggest challenge has just begun.By Dexter Roberts in Guangzhou, with Joyce Barnathan in Hong Kong, Jonathan Moore in Shanghai, and Sheri Prasso in New YorkReturn to top


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