(Reprinted from HKCER Letters, Vol.62, November/December 2000)

 

China: Facing up to WTO Membership

Wing Thye Woo

 

Introduction

The mental picture that I have about China's accession to the WTO is that of a goat standing at the edge of a chasm. The goat sees that the grass on the other side appears not only greener, but also seems to extend infinitely into the horizon. The goat also sees a wooden bridge spanning the chasm. The goat faces at least four questions:

1. Is the grass on the other side really greener?
2. Is the bridge strong enough to carry its weight?
3. Would it be able to walk steadily enough on the bridge so it does not fall off?
4. Should it actually kick the bridge down the chasm so the goats from the other side could not come over and eat up the grass which it now has a monopoly over?

The analogy is of course clear. The goat is China, the grass on its side is the half-reformed centrally planned Chinese economy, the grass on the other side of the chasm is the dynamic capitalist market economy, and the bridge is the World Trade Organization (WTO). When China signed the trade accord in November 1999 with the United States, it has in effect agreed to walk on the bridge to the other side. The focus of my talk will be on whether China can cross this bridge safely. My conclusion is that China stands better than a 70 percent chance of crossing the chasm safely.

Is the Grass on the Other Side Really Greener?

The answer is unambiguously yes. One just has to compare the capitalist market economies in East Asia with the centrally planned economies in East Asia to arrive at this conclusion. The comparison between capitalist South Korea and centrally planned North Korea can leave no doubt that the grass is truly greener on the other side.

After 20 years of impressive economic growth, the present Chinese leadership clearly recognizes what are the two active ingredients in Deng Xiaopeng's recipe for reform. The first active ingredient is introduction of capitalist economic institutions, and the second active ingredient is integration into the world economy.

One of the best testimonies of the efficacy of capitalist institutions is the dynamic performance of the agricultural sector upon easing of price controls in 1978. The diversification of ownership structure after 1984 has made the non-state owned industrial sector the most important engine of growth.

The integration of China into the world economy has enabled its exports to industrialize the Chinese countryside, and pay for the import of new technology. The large inflow of foreign direct investments (FDI) has increased the export capacity of the country and enhanced its technological base. Many rigorous studies have confirmed that international integration has been an important reason for the acceleration of growth in China. Since partial integration has been so favorable for China, total integration will only increase the benefits.

It must be recognized that WTO membership is, in essence, a commitment to become a normal private economy integrated into the international division of labor. WTO is a much more influential and powerful organization than the World Bank and the International Monetary Fund. WTO is set up to regulate trading among market economies. WTO not only specifies what kinds of economic institutions a member country could have, it also enforces these institutional norms on the member country. By signing to become a member of WTO, China has agreed to the convergence of all its key economic institutions to the norms of economic institutions in the developed countries, especially to the institutional forms of its capitalist East Asian neighbors -- Japan and Korea.

Yes, the grass is indeed greener on the other side, and China is consciously speeding up the transformation of its economic system in order to be eligible to cross the bridge to the other side.

Are the Goats on the Other Side a Threat?

This question is wrongly posed. China has a lot less to fear from the world than the world has to fear from China. China is a large country with clearly defined comparative advantage in the production of labor-intensive goods and medium-technology goods. There is less reason for China to fear about the flood of imports from the rest of the world than for the rest of the world to fear a flood of exports from China.

It is interesting to note that India is in the same situation as China in this regard. Likewise, India has less to fear from the world than the world has to fear from India. The amazing thing is how differently India has answered this question. China has welcomed FDI and promoted exports while India has been extremely suspicious of FDI and indifferent to conquering foreign markets. Perhaps, the historical memory of having been the colony of a multinational corporation, the British East India Company, explains India's unfortunate policy choices since independence.

Is the Bridge Strong Enough to Hold China's Weight?

What kind of stresses will the entry of a large player like China place on the international economic system? Can China withstand the domestic political stresses generated by the economic restructuring required for WTO membership?

Entry into WTO will set into motion two events that could break the beams that are holding the bridge. The first event is the lowering of tariffs. This will increase imports which could cause the Yuan to devalue and raise unemployment in the politically sensitive urban areas. For example, China has over 30 car-making firms - a large number compared to the 5 car-making firms in Japan, the most efficient car manufacturer in the world. China is clearly not exploiting the economies of scales in its automobile industry. China's excess capacity exists because the tariff rate on cars, which used to be 200 percent, is now 100 percent. But the tariff on cars is scheduled to be lowered drastically in the next five years.

Thus, one of the first consequences of WTO membership could be a flood of imports into China, turning the current account negative, and possibly rendering the present value of the Yuan to be unsustainable. Would a Yuan devaluation spark off another Asian currency crisis?

There is a flip side to this scenario however. China's entry into the WTO would not only permit the entry of more imports into China, it will also allow several big Chinese exports greater access to the markets in the United States and Western Europe, e.g. the multi-fiber agreement would be ended. Instead of China losing its shirt because of entry to WTO, Chinese textile industry would expand. Labor-intensive exports will expand more generally to offset some of the increase in imports.

In the event that the current account does turn negative, it still need not be a source for serious worry. After the November 1999 signing of the Sino-U.S. trade accord, there has been a sharp rise in the contracted FDI into China. The capital account is expected to show a much larger surplus than before, and this is likely to keep the overall balance of payments in surplus, hence allowing the Yuan peg to be sustainable.

What if our prediction is wrong and China's balance of payments does turn negative? At that point, it is not a bad thing for the Yuan to be devalued. After all, all of China's biggest competitors have experienced devaluation from 1997 to 2000. China did not have an excuse to devalue during the 1997-2000 period because China's trade account was positive, and its capital account was positive. Since China's balance of payments was positive in this period, so there was no valid economic reason to have changed the value of the Yuan. Had China devalued the Yuan to take into account what had happened in Southeast Asia, it would have been accused of exchange rate manipulation by the U.S. Treasury and the IMF among others. In the unlikely event of a devaluation of the Yuan in the aftermath of tariff cuts, it is unlikely to cause competitive devaluations across Asia because the market will take into account that the tariff cuts would also open China's markets to the Southeast Asian economies, resulting in no major loss of competitiveness for these economies.

Another important issue from the tariff reductions is the lost of jobs, which could translate into political instability. The net loss of jobs depends on two factors. One is how large the rise in exports would be in the face of better market access to the foreign markets, and, two, how large the job creation would be from the increase of FDI into China. As long as these two factors are substantial, the lost of jobs would not be as disastrous as some commentators have talked about. Since 1994, China has been laying off workers in the small to medium state-owned enterprises on a large scale. Most of the industrial northeastern provinces have had relatively high rates of unemployment for the last five years, and, yet, social stability has been maintained. From this post-1994 experience, the government appears confident that it is sufficiently capable of containing the domestic disturbances from higher unemployment.

Beside the tariff reduction, another post-WTO event that could knock off one of the bridge's beams is the entry of foreign-owned banks into China. One of the aspects of the trade agreement that has always been commented upon with some surprise is how much the Chinese appears to have conceded in the financial sector. The question is whether WTO finally brings about the meltdown of the state-banking system that the newsletters of some investment banks based in Hong Kong have been predicting since 1997. The bank meltdown scenario is based on the fact that all the state banks are effectively insolvent. There is hence the danger that depositors, realizing the insolvency of the banks, would start a run for the deposits and precipitate a credit crisis that would reduce production and create a recession. This is the oft-predicted gloom-and-doom scenario that has not happened. Now with WTO membership, would competition from foreign owned banks make the insolvency of the state-banks so plainly clear to the general public that the long-expected bank run would at last occur (not savaging the economy but salvaging the reputation of the doomsayers)?

It is far from Panglossian for me to state that even if the profits of the state banks are decreased further, thereby worsening their insolvency, this situation is well within the technical capacity of the Chinese government to handle. A run on the Chinese banking system is a run from M2 to M0. (M2 is cash plus banking deposits and M0 is cash.) This transformation from M2 to M0 need not cause the banks to fail because it could easily be accommodated by the central bank acting as the lender of last resort to the banks. The banking crisis takes a more serious turn only if the increase in M0 is switched into foreign currencies, because then the exchange rate would plummet. But, given the existing capital controls in China, the switch from M0 into foreign currencies cannot take place, and the exchange rate will not collapse.

Because M0 cannot run into foreign currencies, it could run into goods. The frightful scenario is that this would spark off an inflation that would decrease the willingness of the Chinese government to accommodate the bank run. However, given that China is still in a deflationary situation, and expected to remain so in 2001, inflation would not take off even it there was a run from M0 to goods. In a weak domestic economy, it is a good thing if people are running from M0 to goods because it will boost aggregate demand.

The last technical detail is that since M0 cannot run into US$, and if M0 does not run into goods, then it will have to run under the pillows. Money under the pillows, this is what dreams are made of for central bankers all over the world. Money under the pillows means that the crisis will soon blow over provided that the central bank has prevented any bank from failing during the bank run. Just leave the M0 alone, and it will, like little Miss Bo-Peep's sheep, return to the banks with its tail behind it.

Can the Goat Walk Steadily on the Bridge?

In answering this last question, we note that China has been walking unsteadily on two fronts. China is wobbling on the macroeconomic front because it has found it exceedingly hard to utilize the traditional instruments of macroeconomic stabilization. China is wobbling on the political front because of the difficulties of reforming the state enterprise sector.

China's wobbly gait on the macroeconomic front is caused by two Keynesian maladies, the liquidity trap and the paradox of thrift. The liquidity trap refers to the phenomenon of the last few years where monetary policy does not seem to work. China has tried to boost the domestic economy with successive cuts in interest rates, but the rise in credit creation has been disappointing. Credit growth has been much lower than expected, except for brief intervals when the central bank leaned heavily upon the banks.

The paradox of thrift refers to the steady decline in private aggregate demand because the private saving rate has been increasing. The Chinese government has concluded that, because private aggregate demand is falling and monetary policy seems incapable of stimulating it, the key to maintaining macroeconomic stability is government spending. At the recent Central Committee work conference, there was general agreement that the economy will continue to be soft and that continued fiscal stimulus will be needed in 2001 and possibly also in 2002.

However, fiscal stimulus may not be the most efficient way to deal with the current problem of weak domestic demand. The solution lies in eliminating the liquidity trap and ending the paradox of thrift. Both of these phenomena, I will argue, spring from the same cause, which is the absence of adequate financial intermediation in China.

Why is China suffering from the liquidity trap? The reason is that state bank managers have been told that if the ratio of non-performing loans were to go up two years consecutively, they would lose their jobs. The traditional client-base of the state banks is state enterprises, of which, half to two-third, are reporting zero or negative profits. By extending more loans to state enterprises, the non-performing loan ratio would inevitably rise.

At the same time, state banks are also unwilling to lend to non-state enterprises and for very good reasons. First, the accounting practices of the non-state enterprises are neither uniform nor transparent. Second, it is politically more risky to do so. A loan to a state-owned enterprise may be a bad economic decision, but a loan to non-state enterprise that goes bad could potentially be a bad political decision as well. The bank manager could be accused of consorting with the private sector to embezzle the state.

The Chinese government has sought to increase bank lending to private individuals by encouraging banks to establish mortgage loans, which are perceived as less risky because of their seemingly fully collatralized nature. Mortgage lending, however, is a totally new product to be provided to a totally new set of customers, and so the state banks have understandably been slow in setting up this market.

The liquidity trap arises because the banks are not willing to lend money to either the state-owned enterprises or the private enterprises. The only activity that the banks are happy to use their funds on is buying state bonds to finance the government's deficit spending. The fundamental step to eliminating the liquidity trap is to end the bias against lending to the private sector.

In the paradox of thrift, some observers have interpreted the rise in the saving rate to be a sign of general pessimism by the Chinese public. These observers claim that the urban workers are afraid of losing their jobs as a result of the forthcoming state-enterprise reform. With the forthcoming cancellation of free housing, free medical care, and subsidized education, the workers are now saving more for the future. There is something wrong with this reasoning because there has also been a rise in the rural saving rate which should not happen if this line of reasoning is correct. This is because rural residents have little to fear about the loss of jobs in the state-enterprise sector because none of them are employed there. They do not have to fear losing free housing because they never had free housing. They do not have to fear losing their pension and other subsidies because they never had it in the first place.

The reason why the rural sector has increased its savings rate is quite simple. The most dynamic industrial expansion in China since 1984 has occurred in the rural areas. Since these non-state firms in the rural areas cannot borrow from the bank, the only way they could establish themselves was through self-financing, which required the would-be entrepreneurs to save first. In the very first phase of rural industrialization, the amount of capital that was needed to start a factory workshop was very low. After 16 years of rapid industrial growth, the Chinese countryside is saturated with labor-intensive enterprises. Competition is very fierce. It now makes no sense to invest and open the same type of factory workshop, rural enterprises have to move up to the next stage of value added production. This new generation of rural enterprises will be much more capital-intensive, thus requiring a much larger amount of startup investment.

Total fixed investment was 30 percent of GDP in 1987, and 33 percent of GDP in 1997. It rose 3 percentage points in ten years. Fixed investment in the rural sector was 9 percent of GDP in 1987 but was only 8 percent in 1997. The national trend of I/Y went up, but I/Y in the most dynamic part of the Chinese economy went down. There are two reasons for this divergence. First, it makes no sense to establish another labor intensive factory. Second, rural entrepreneurs cannot borrow the money to undertake the more capital-intensive investments required for the next generation of rural enterprises.

Rural residents have responded to the higher capital requirements by increasing their saving rates. The rising rural saving rate reflected not pessimism about the future but optimism about the future. This phenomenon of investment-induced savings is not new. It had happened earlier in Taiwan. Up until the mid-1980s, all Taiwanese banks were state-owned. Every Taiwanese loan officer was personally responsible for any loan that went bad, and so every loan officer minimized lending to small and medium sized enterprises, and lent readily only to big business groups. During the 1960 to 1985 period, there was a steady rise in the saving rate in Taiwan.

The right solution to the insufficient domestic demand in the Chinese economy is not for the government to use up the private savings in public investments, but to set up mechanisms to channel private savings into private investments. This is where the entry of foreign banks will be exceedingly important. Foreign banks will be concentrating their activities in the large coastal cities, where the state-owned banks are now making the bulk of their profits. This increased competition in the profit centers of the state-owned banks will force the state-owned banks to focus on areas of banking where they do have a comparative advantage over the foreign banks.

China's state-owned banks does have a comparative advantage in operating in the inner provinces and the rural areas because of their existing extensive branch systems. The state banks have traditionally neglected the inland provinces and the rural areas. The number of rural banks has actually decreased in the 1985-1995 period. The most dynamic part of the Chinese economy is located in the rural areas, and yet we see a reduction in formal financial intermediation there. This trend is directly against the sustenance of growth. The reason is because the regulated interest rate for loans in China made it unprofitable to extend small loans. Large loans and small loans require the same amount of paper work and time to process. It is only natural that rural banks should charge a higher interest rate since the cost of monitoring and processing the loan is higher. But since rural branches have to charge the same lending rates on small loans as urban branches on large loans, banks have retreated from lending in the rural areas. The liberalization of interest rates combined with increased competition in the coastal urban markets will motivate the state banks to expand their activities in the long-neglected inland provinces and rural areas.

What has been happening in the face of strong rural industrial growth is that a lot of informal rural financial institutions have sprouted to meet the financing needs of the rural industries. Given the illegal nature of these rural financial institutions, they live under the constant threat of closure, and so they tend to focus only on the short run and take more risks. It is not surprising that these risky rural financial institutions often failed. Whenever they failed, the government had to bail them out in order to maintain political stability. The government has therefore been clamping down even harder on these illegal financial intermediaries, because the government does not want to choose between the risk of bailing them out or the risk of having social instability. The government's increasing strict enforcement of the ban on private financial intermediation is exactly opposite to what ought to be done. The efficient solution is to allow private financial intermediaries in the rural area, and bring them under proper prudential supervision.

The general principle, and a trend that will be increasingly costly to prevent for the Chinese government, is to reduce interest rate controls and allow private banks to come into existence. The improvement in financial intermediation will eliminate the liquidity trap and reduce the paradox of thrift. The entry of foreign banks will also improve financial intermediation by enabling the transfer of modern banking technology through a seldom-mentioned channel. In the future, when a successful Chinese enterprise group establishes a bank, it will do by hiring away the local managers employed by the foreign owned banks. This is exactly the Southeast Asian experience, the top managers of all the biggest domestic banks were all ex-employees of foreign banks. This is perhaps what the Chinese leadership sees and why it is willing to allow the entry of foreign banks, giving them national treatment within five years of WTO membership. The Chinese leadership is betting that in the short-run, there could be significant displacement of Chinese state banks by foreign banks, but in the long run, Chinese banks (most likely private ones) will rise in importance. Twenty years from now, the international financial world will have more to fear from Chinese banks than vice-versa.

The second wobbliness in China's walk across the bridge is caused by the uncertainty of how the privatization process should continue. The state-enterprise sector is just too large, and, like its cousins all over the world, is losing money on a large scale. Obviously, the Chinese leadership agrees with this description because it has been expanding the privatization of state-owned enterprises. But the Eastern European experience warns that mass privatization is an exceedingly dangerous business no matter how it is done.

There are two main approaches to mass privatization: outsider privatization and insider privatization. The most common form of outsider privatization is to distribute an equal number of vouchers to each citizen, allow voluntary pooling of vouchers, and then conduct bidding for the assets with the vouchers. This is what happened in the Czech Republic and Mongolia. The chief problem with voucher privatization can be seen in that many senior officials in the privatization agencies in the Czech Republic and Mongolia are now in jail or facing investigations for corruption. Investors are only too willing to bribe the officials involved in the privatization process to learn inside information about the firms. The public outcry over the massive corruption associated with voucher privatization was a major factor for the election defeat of the Czech prime minster, Vaclav Klaus.

If outside privatization can be described as attempting to herd everyone behind the same starting line in the race for the state assets, then insider privatization is to allow people to run to grab the state assets regardless of where they are standing, and, sometimes, regardless of whether the race has officially begun. The most well-known case of insider privatization is Russia. Because insider privatization is unfair by its very nature, the political consequences have generally been bad for the people responsible for it. It helped to delegitimise Boris Yeltsin, and sent its architect, Anatoli Chubais, into political exile.

Corruption leading to political demise appears to be an inevitable byproduct of mass privatization. China has so far avoided widespread organized public dissatisfaction with its partial privatization of the small and medium state enterprises. The central government has given itself an indirect role in the privatization process in order to avoid bearing the brunt of any negative fallout. It works by the central government passing to the local governments the financial responsibility for most of the state enterprises located in their areas. In the case of loss-making enterprises, the local government is forced to either come up with a subsidy or privatize them. The second option is the common choice. The party secretary who gets rid of the loss-makers without arousing local resentment is promoted. But if there is substantial public resentment over the privatization, then the party secretary is reprimanded or replaced for inept implementation of state policy.

The question is whether this strategy can continue to shelter the central government from the public backlash over "inept" privatization, especially when the large state enterprises are privatized? Given the fact that every manager after the implosion of the Soviet Union in 1991 knows that privatization is inevitable, he recognizes that this is the last chance for him to steal. This end game consideration may be responsible for the recent escalation of corruption across China, creating a situation that Party Secretary Jiang Zemin has called the biggest threat to the continued rule of the Communist Party. In short, the ongoing acceleration of the privatization (both formal and informal) process could create a political storm over corruption that would make it difficult for China to walk steadily across the bridge to the greener grass of a private market economy.

While keeping balance on the macroeconomic front and political front would enable China to walk steadily across the bridge, I must point out that the absence of a strong wind is also crucial for making it over to the other side. There are three types of typhoon that would make the crossing more difficult for China.

1. Substantial Slowdown in the U.S. economy

The U.S. economy has been the engine of growth for the world economy. Recent data suggest that continued fast expansion of the U.S. economy is unlikely. Japan grew 0.2 percent last quarter, and seems likely to plunge back into recession. Western Europe shows no signs of dynamic growth that would rival that of the U.S. So, a significant slowdown of the U.S. economy means that there would be a fall in Chinese exports and a drop of FDI into China. Both of which are important for keeping the bridge strong enough for the goat to walk on. More importantly, the slowdown in the U.S. economy could give impetus to protectionism within the U.S., and this would make the WTO adjustment process in China much more painful.

2. Political Conflicts in the Pacific Rim

Two such conflicts come readily to mind, the Chinese occupation of islands in the South China Sea, and mainland-Taiwan tensions over political union. If the situation explodes over either case, sanctions by the U.S. and other Western European countries will hamper Chinese economic performance.

3. Drop in FDI

FDI in China may not grow as rapidly as expected. This scenario depends on changes in the attractiveness of places like India. India has been unusually hostile to FDI, e.g. foreigners cannot hold more than 51percent of equity in a firm. If this was to change, a significant diversion of FDI into India, a country with an English-speaking labor force, could happen.

Conclusion

There are two rules when it comes to talking about the future, and I have broken both of them here. One rule is to always predict a disaster, to be like Chicken Little running around crying that "The sky is falling, the sky is falling." If the disaster happens, one takes credit for predicting it, and if it does not, one takes the credit for preventing it. Contrary to this advice, I am predicting that China stands better than a 70 percent chance in crossing the bridge safely. There will not be a meltdown of the bank sector, the increase in imports will not cause a Yuan depreciation that will mark the beginning of a new Asian currency crisis, and the WTO-induced increase in unemployment will not threaten the overall political stability of China.

The second rule in predicting the future is to always describe the future in terms that resemble the present situation. This is because the audience finds instant verification of the prediction when he or she looks out the window. I have broken this second rule as well. I am predicting that the state sector will be largely privatized because the present situation is fiscally and politically unsustainable, and more private banks will be allowed.

I close with the reminder that the apparent tradeoff faced by China between stability and restructuring is not caused by its accession to WTO membership but by the need to move from a planned economy to a market economy. Joining WTO now is really not bringing forward the date of confronting this tradeoff, this is because the fiscal burden and the corruption problem of the state enterprise sector are now becoming too heavy to bear. The two key WTO-induced developments that will greatly increase the probability of crossing the bridge successfully are the rise in Chinese exports and the rise in FDI. Their occurrence will blunt the job losses in the state sector.

This article is based on the transcript of a lunch talk given by Professor Wing Thye Woo on December 4, 2000. Professor Woo is currently Professor of Economics at University of California, Davis and an Associate at the Center for International Development at Harvard University.

 

	| Index | Research Projects | HKCER Letters | | Speaker Program / Conference | Index of Economic Freedom |
	The Hong Kong Centre for Economic Research School of Economics and Finance The University of Hong Kong Phone: (852) 2547-8313 Fax: (852) 2548-6319 email: hkcer@econ.hku.hk