China: From mismanagement to collapse

China's problems are far more serious than a superficial study would suggest. There are structural problems. In The Coming Collapse of China, Gordon Chang suggests that China's entry into the WTO will 'shake the government to its foundations.' Of the banking system, he writes: 'It is here that the end of the modern Chinese state might well begin.' His scenario includes a cocktail of woes: massive unemployment, failed banks and runs on them, collapse of state-owned enterprises, violent protests and riots, increasing vulnerability to oil imports, and a ruling class unable to deal with all this. The Chinese State is essentially unviable.

One might say this is an internal problem for the Chinese, and outsiders should not worry. This is not so. Especially for India, now that Tibet has been thoroughly dissolved and Han Chinese troops are on the Indian border for the first time in history, there is a growing military threat. Ditto for all of Southeast Asia, wary about Chinese adventurism and ultra-nationalism as already expressed in land-grabs in the Spratlys and Mischief Reef. From near-self-sufficiency in 1993-96, China will need to import 60 per cent of its oil needs by 2020: this explains the urgency of grabbing possibly mineral-rich economic zones around these islands. And, of course, this explains their overtures to Kazakhstan and other Central Asian republics.

What better way to distract people's attention from economic folly and an ideologically bankrupt polity than by going to war? I predicted in The Danger from China in 1998 that China would attack Taiwan, Russia (in Siberia) and Japan (an electro magnetic pulse in the atmosphere) in the next few years. They are building ballistic-missile-armed nuclear submarines, which they will have by the end of the decade. China has 20 intercontinental ballistic missiles that can hit Los Angeles and San Francisco, so the Americans had better worry too.

And speaking of the law of unintended consequences, The Economist of June 20th had a story about 30 million surplus men in China by 2020, a result of the strict one-child norm and son-preference. These men will never find a wife, as that many women are 'missing,' victims of selective abortion and female infanticide. History suggests that so many testosterone-driven young men will be highly restless: married men are more sedate. China may go to war to channel their aggression and, frankly, to kill off some of them. China, goes this logic, may have no option but to go to war. Demographics has its own ruthless logic: some say Arab and Pakistani terrorism is largely a function of the population bulge -- they have large numbers of unemployable young men who have nothing better to do than kill and be killed.

Therefore, what happens in China is of considerable interest to China's neighbours and those farther afield (see M L Sondhi and Ashok Kapur, The Caged Dragon, The Pioneer, April 3rd, thanks to reader Gopi). Furthermore, there is a theoretical slant. Conventional wisdom suggests that China's totalitarian model works, and that India's chaotic semi-laissez-faire is absurd. If this is shown to be erroneous, the implications for India and China alone (collectively about a third of humanity) are enormous. It will mean the final and irrevocable collapse of the missionary Church of Marx, among other pleasant and much more important prospects: eg, a decent life for many poor people.

It is widely estimated by the Chinese themselves that millions of peasants have been and will be uprooted from the countryside ('In the next ten years, I predict 150 million farmers will move to cities looking for work,' says Chen Huai, a senior research fellow at the Development Research Center, a government think tank.) The Economist used to suggest 100 million people were thus unemployed/underemployed, and in fact permanently unemployable as they are unskilled and unneeded in an efficient market system. They have now increased the number: 'the huge amount of surplus labor in the countryside -- at least 150 million people.' Imagine this: it is the size of the entire workforce in the US. This is the stuff revolutions are made of.

Who are these people? They are inefficient peasants displaced from uncompetitive farms, and under-skilled labour displaced from massive, inept State-owned Enterprises. The Economist again, speaking of the farmers of Henan province: 'the price of their grain is 15-20% higher than world prices. In the next few years nearly 60% of Henan's peasants expect their income to fall or at best remain the same.' They will be decimated by the likes of American mega-agribusinesses, which expect to benefit from the WTO accession.

Urban unemployment is already estimated unofficially to be anywhere between 8 per cent and 20 per cent, as compared to the rosy official estimate of 3.6 per cent. After reaching a peak of 113 million employees, urban SOEs have cut down their employment by more than a third. This is the situation today; what will happen when more and more SOEs downsize, when there are millions more on the street to join the striking laid-off steelworkers of Daqing?

In any case, the SOEs are a tremendous millstone around the neck of China's economy, as I discussed in Two strikes. They are so monstrously good at losing money that a wag suggested that China would be better off by shutting all of them down and continuing to pay workers their full salaries: at least that way they would not consume raw materials and occupy warehouse space with unsellable merchandise!

India has the same problem with its Nehruvian public sector albatrosses, but the rot has not set in so deep: there is still a functioning system of cost accounting. Although Arun Shourie's recent exposes about his experiences as divestment tsar are sobering, at least India has begun to privatise vigorously. There is determined opposition, for example from the Congress' Mani Shankar Aiyar, who made the ridiculous statement that Arun Shourie had no right to sell off things of value that he had not created.

Now exactly what value did the Nehruvian State create? Entities that have lost their entire capital? Maybe Indian Tourism Development Corporation hotels that run at 24 per cent occupancy when break even is at 60+ per cent? The Kovalam Ashok Beach Resort in Trivandrum, sold for Rs 43.68 crores as a (barely) running entity, when its stunning beach-front real estate alone might have been worth five times as much, if only the hotel had proper title to it? Thankfully, the Indian government is cutting its losses, not throwing good money after bad, unlike China.

The State-owned Enterprises are a major drain on China's economy because of the effect they have on the state-owned banks. The state-owned banks are forced to lend to SOE industries without any expectation of either profit or even of the capital being returned to them. In other words, for SOEs the cost of capital is zero, which means they have an incentive to be as profligate and wasteful as possible: there is no day of reckoning for them, or so they have believed, prior to the trauma of WTO accession.

Here's more from Gordon Chang, in 'China: The Big Four Banks Head Towards Collapse' (International Herald Tribune, April 2nd, thanks to reader Gopi), he argues that 'the massive transfer of assets from the banks to the enterprises is a matter of indifference to the central government: the state owns all of them. It is, however, a matter of concern to the Chinese people. Year after year, hundreds of millions of Chinese place their spare cash with the Big Four. At the end of 2001, household savings in China, according to official statistics, amounted to the equivalent of $894.1 billion, up 14.7 percent from the year before and 24.0 percent from 1999.'

Chang continues: 'The Chinese can deposit, but can they withdraw? Every once in a while China's docile savers withdraw their money in stampedes. In April 1999, for example, depositors withdrew $108 million in just a few days from a state-owned bank considered to be one of the strongest. Rumors posted on the Internet about embezzlement triggered the massive withdrawals. The Chinese people have withdrawn money from banks for the craziest of reasons or for no reason at all. Yet unbeknownst to most of them, they already have the best rationale to start a run: Their banks are insolvent and sometimes even illiquid. What will happen when they find out?' Blood in the streets, more than likely.

In a sense, the phenomenal savings rates exhibited by the average Chinese-on-the-street is going to come back and haunt their government. Their thrift is being misused to fund profligate investment. For instance, those highways and skyscrapers in Shanghai are built on the savings of the common man. In effect, some $250 billion has disappeared into the pockets of apparatchiks, into SOEs, and into all the pump-priming and public sector infrastructure construction (white elephants in the making) that so impresses visitors. Some expressways and ports have indeed made it easier for Chinese exports -- and this is a clear failure on the part of the Indian government; however, it is not obvious that a 'Field of Dreams' strategy -- build it and they will come -- makes sense.

The Chinese Communist Party is caught between a rock and a hard place: their promise of the 'iron rice bowl' -- that is, lifetime social security and guaranteed employment -- in return for absolute power, is now turning into a nightmare. If there is no social security, then why give absolute power to the party? It is true that Chinese seem accultured to be docile serfs to an imperial center, but with the subversive Internet and television coming in, how long will they remain obedient?

In addition to the problems of unemployment, they face another threat from their rapidly aging population. It is estimated by McKinsey that there will be a deficit of $15 billion in 2005 and $110 billion in 2010 in the provisions made for pension liabilities. The elder dependency ratio, that is the number of retired persons per 100 working people (defined as those between 15 and 64), is about 10 in 2000, and will rise to almost 40 by 2050: that is, there will only be 60 people supporting 100, including 40 pensioners. There is no simple way this gap can be handled by anything other than the government, because Chinese capital markets are weak. India is in better shape, as the dependency ratio will continue to be higher for longer; and there are evolved capital markets.

But the SOEs and their impact on the banking system and the government are the worst threats faced by China. A recent study by the OECD quoted by The Economist survey of June 15th suggests that a 'severe vicious circle' has developed in China. The banks cannot restore their solvency unless enterprise performance improves substantially, but the high level of non-performing loans is a problem. Officially Non-Performing Loans are only 25 per cent of total outstanding loans, but Nicholas Lardy of the Brookings Institution suggests that the real figure might be 50 per cent, way over the danger mark. In March, the chief of the central bank, the People's Bank of China, Dai Xianglong, admitted in public that the bad loans of big state banks could be up to 30 per cent of their total lent. Officially, 30 per cent of some $950 billion lent -- that is $280 billion. Money that has no chance of being repaid.

The OECD study calculates that the cost reducing NPL ratios to 10 per cent will be as much as 30 per to 60 per cent of GDP -- which translates to $300 billion to $600 billion -- a gigantic amount of money by any count. This figure is probably after the transfer of $170 billion in NPLs (18 per cent of the total loans) to asset management companies in 2000. Although these are set up on the model of the Resolution Trust Corporation that handled the savings-and-loan meltdown in the US, these (unfortunately just like a similar attempt in Japan) are half-baked and unlikely to provide much relief. So far the AMCs have managed to sell the loans at about 20 per cent of their face value; however, this ratio will plunge in future because the best assets in their portfolios were sold first. All this is a cautionary tale for India, as it continues to figure out what to do with its own perpetually 'sick' units. The best bet is probably to sell them off at fire-sale prices when someone is actually foolish enough to buy them.

The NPLs affect a key ratio, the government's debt-to-GDP ratio. The official ratio is 16 per cent. But if you take into account the NPLs, pension commitments and bonds issued to capitalise the asset management companies, the debt-to-GDP ratio may be as high as 100 per cent. In March, Dai Xianglong, head of the central bank, announced it might amount to 60 per cent. 'You are heading towards [a situation like] Russia in 1998 with a default on the domestic bond market,' says Nicholas Lardy of the Brookings Institution.

In comparison, the NPLs of India's public sector banks are about 15 per cent (gross) and 7 per cent (net, after provisions for bad debt); the more efficient private banks have brought this below 2 per cent. According to ABN Amro's chief economist Ajit Ranade, India has a domestic (rupee) debt-to-GDP ratio of 62 per cent. Add to this an external debt ratio of 21 per cent (according to ASSOCHAM) thus a total debt-to-GDP ratio of roughly 83 per cent. All this is a lot more sustainable than China's. America's debt-to-GDP ratio is 38 per cent, Canada's 50 per cent and Japan's 140 per cent, incidentally.

To conclude, there is a tremendous economic (and political) crisis brewing in China. Furthermore, regional imbalances will continue to worsen, with the richer coastal areas increasingly unwilling to subsidise the dirt-poor interior. There have been some signs of war-lordism, with local satraps unwilling to jeopardise their prosperity on Beijing's orders. There are many instances of exploitation of workers (see my column 'Two strikes,' as well as 'Worked Till They Drop: Few Protections for China's New Laborers,' Philip Pan, The Washington Post, May 13th). Conflict seems inevitable.

These problems (along with opportunities) have been brought about by globalisation. Unfortunately for China, the Communist Party is stuck in a time-warp, living in a time when they were supreme masters of the universe. This is no longer true. Their lives will be affected dramatically by things happening in far-away places. A hide-bound, dogmatic entity like the Communist Party may not be able to adjust in time. This is where India's messy democratic process will stand it in good stead: there is already a general acceptance of the need for growth, despite occasional mumblings from leftists.

If you were to ask about leadership, most people would suggest that China's leaders like Deng Xiaoping out-performed their Indian counterparts who have to deal with rambunctious Opposition parties. And India's politicians are anything but accomplished. However, sensible ones among now are attracting their forward-looking countrymen; and over time a consensus is emerging on aggressive pursuit of economic growth in the national interest. In a strange way, it is the Indian way of organic chaos that seems better suited than the regimented way of the Chinese to the challenge of uncharted territory.

I read somewhere an apt nautical metaphor: India as a shallow, flat-bottomed boat, and China as a sleek speedboat. India wheezes along with difficulty, and takes on a little water with every passing swell. You worry about disaster all the time, but the craft is essentially unsinkable. China races ahead, seemingly unstoppable, but bring on some rough seas, and the craft capsizes suddenly and catastrophically. Appearances can be deceptive, and the steady, sure-footed elephant may yet prevail over the glitzy dragon.

The fundemental and endemic structural problems for China's growth and prosperity are similar to Japan's just prior to WWII. These problems facilitated Japan's decision to expand throughout SE Asia and at the time, Japan regarded the US as it's major impediment to expansion, thus, they attacked Pearl Harbor to prevent our Pacific Fleet from blocking their expansionist goals.
China is now in the same position.
Hopefully, we have not been lulled into the same false sense of security by our "friends".......
NeverGore

China about to collapse economically? Why? Favorable trade balance, strong recent advances in technology (either simply GIVEN to them, or stolen through reverse-engineering and sold as pirate copies), relatively little unrest in their homeland (except for a few dissidents, largely kept under control by the local Posse Comitatus), and a BIG influx of Western capital, how could they fail?

This is just a wordy treatise to lull us into believing China could not engage nor long prosecute military engagements with potential antagonists.

Without our help ... meaning our manufacturing plants, our technology, the flooding of our markets with their very cheaply produced (translated into dirt poor labor policies we would neve countenance here) ... they would go bankrupt. Just like every other marxist/communist/maoist based regime.

The Chicomms are still in control ... they have just found a new place to fleace and its us. They will continue to do so until they reach what they percieve to be critical mass ... a point here they believe they can continue to produce, continue to export, continue to grow without the need of our "ownership". Then I am afraid many companies will find that there investment in the PRC was truly risk capital.

They are building their military as fast as they can against that day. When it comes, they will attempt (IMHO) to evict us from the region entirely.

If we were to "engage" then right now as Reagan engaged the Soviets ... we could forestall and prevent this IMHO.

Otherwise, I am afraid e are one day going to look at DRAGON'S FURY

FRegards.

When it comes to Chinese finances, here are a few things that I believe will be of importance:

- money losing state enterprises, bad loans and subsidies.
- money funneled into the country by ex-pats, Hong Kong, Taiwanese, Japan, etc. This counts as foreign direct investment but is in some cases money that was initially taken out or money used by Asians to move manufacturing into China. Eventually this money will slow down.
- money raised in North America/EU. You mutual funds probably hold potentially worthless equity of debt, re-packaged by financial institutions to "eliminate" the risk, the proceeds of which went to China.
- current account surplus (I am assuming they are in surplus).
- military technology. We usually hear about them buying stuff from the Russians, but there is a huge market for Chinese (copies) weapons in Pakistan, North Korea, Burma, Bangladesh, Egypt, Iran, Iraq, and many other third world countries.

Great points, and I agree. There are many ways we can still hurt them and drive them to reform (the PRC leadership) if we just had the will. At the same time, if allowed to go on too long, those same "ways" will work against us when the Chicomms turn off the spicket later.

BTW, here's a good link for the post above ... my bad on the typo.

DRAGON'S FURY

Democracy is great in theory, but all of today's Third World democracies are dysfunctional jokes. Democracy, for whatever reason, doesn't seem to work very well in countries with majority-poor populations. Such populations inevitably elect socialistic politicians who, of course, oppose capitalist reforms, raise taxes, support big government, and scare away foreign investors. Despite 50 years of democracy, India has yet to implement basic labor and land reforms that allow companies to hire and fire workers and buy and sell land when they want to. In addition, the inherent legislative gridlock of the democratic legislative process needlessly delays such capitalist reforms even further (and further motivates foreign investors to invest in China). The result is generation after generation of poor people in India and every other Third World democracy. On the other hand, one-party rule in most of E. Asia helped them implement capitalist reforms quickly, develop majority middle-class populations relatively quickly, and achieve modern, First World living standards quickly. Honestly, I can't think of a single Third World democracy today which isn't a mess. Democratic Latin America seems to be imploding as we speak due to politicians who talk too much but never act. Then, there's democratic Turkey, Indonesia, S. Africa, Russia, and India. Eastern Europe is actually voting to put the communists back into office! For a democracy not to be a joke, it needs to develop a middle-class first, and the best way to develop a middle-class in Third World countries is pro-capitalist, authoritarian rule. 18th century Europe saw pro-capitalist, authoritarian rulers in the so-called "enlightened despots" who codified the laws and made other reforms which allowed capitalism to flourish and a middle-class to grow. America's and France's middle classes (bourgeoisie) led their respective Revolutions and ushered in the era of modern democracy.

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