China's Seven Percent Solution II

China has reported stellar economic growth for 2002. Can the country continue its success in developing its economy?

Growth last year was largely the result of three factors: record investment flows inward, surging exports outward and massive fiscal stimulus. Because trends involving the first two look shaky, we should not be surprised that Chinese Premier Zhu Rongji continues with his program of fiscal stimulus, the only factor completely under Beijing's control.

China started its program of accelerated government spending in 1998 and has promised an end to it many times. Yet fiscal stimulus has not been able to jump start the economy, so the program continues today. Beijing's statistics for the first eleven months of last year show that fixed asset investment, one of the best measures of government stimulus, increased by 23.4 percent, but analysts estimate that the true number may be higher by five percentage points.

Whatever figures are correct, it is clear that the central government is essentially destroying money, with fiscal stimulus increasing three times faster than gross domestic product. And Premier Zhu cannot afford to keep up his stimulus program much longer: Even official figures say that the annual deficit to GDP ratio is 3 percent, just on the international alarm level. Others put the number at a more serious 3.5 percent, and it is probably higher than that, perhaps 10 percent or more.

As much as 10 percent? We just don't know because of the unreliability of statistics on Beijing's finances. Yet even official numbers show the deterioration of the central government's financial condition. According to statisticians in the Chinese capital, the annual deficit to GDP ratio was 0.78 percent in 1997 and its annual growth since then has been 27 percent.

How is it possible for the deficit to grow 27 percent annually? By incurring annual record budget deficits, just like the one that was announced last March at the National People's Congress in Beijing. In this period of political transition in the Chinese capital, the leaders of the regime prefer the easy solutions. They spend money, hoping to get by from one day to the next without fixing the real problems. Today, the central government accounts for more than half of investment in China, a figure that is alarming by any standard.

Chinese leaders, trying to grow their way out of problems, switched their emphasis from reform to development a few years back. The result of their spendathon, excessive building and production, is not the path to enduring prosperity. Chronic deflation, a sign of poor government investment decisions and weak consumer confidence, indicates that they made the wrong choice. Sure, the economy is bigger today, but without a strong foundation it's even more unstable than it was before.

As the traditional stimulus program loses effectiveness, Beijing scrambles to find positive, as opposed to negative, multipliers. The latest tactic is stimulating housing, which is thought to have a favorable ratio of growth to expenditure in excess of 10-to-1. Unfortunately, central planners are simply creating an asset bubble in the coastal cities and burdening China's already insolvent banks with even more loans that will turn bad.

More bad loans? "China's GDP rose by US$80 billion last year," writes analyst Andy Xie of Morgan Stanley in Hong Kong. "But its credit probably expanded by seven times as much." That spells trouble as the famous Mr. Xie knows. "The risk is quite high that the sharp increase in credit over the past five years had lead to [a] huge amount of new bad loans."

If anything can halt the Chinese economy dead in its tracks, it is a complete breakdown of the banking system caused by some US$720 billion in nonperforming obligations. The last thing Beijing should be doing is making its banks even sicker, but that is precisely what it's accomplishing. Each week we hear about how China's largest banks are reducing the percentages of their nonperforming loans, but these unverifiable pronouncements don't square comfortably with all we know about the increases in fiscal stimulus and consumer lending. Rumors in Beijing say that many of the new housing loans, for instance, are bad or with time will become so.

Premier Zhu has proven that he can keep gross domestic product on a constant upward track, but his fixation on achieving arbitrary growth targets prevents his government from accomplishing something more important: developing an economy that can grow on its own.

Moreover, as he's raced to post good growth numbers, he's delayed fixing the problems in Chinese society. In short order his successors, if they want to have a future, will have to repair the finances of the central, provincial and local governments; recapitalize bankrupt banks; fund an insolvent social security system; clean up a severely degraded environment; stop pervasive corruption and lawlessness; reverse hopeless agricultural policies; reform state enterprises and deal with the resulting unemployment; and provide education, health care, and other essential social services to hundreds of millions of citizens who now do without. And there's one more thing: China's leaders must accomplish all these tasks in a declining world economy and during a major political transition.

Is it possible for the Chinese leadership to maintain 7-percent growth indefinitely as Jonathan Anderson and Goldman Sachs suggest? Perhaps, but from the perspective of today, the odds just don't look good. More important, growing 7 percent forever is no solution for China--growth must be real and it must be accompanied by reform.

Gordon G. Chang is the author of The Coming Collapse of China, published by Random House.

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