China's transition merits caution: after the 'WTO euphoria' wears off, disillusionment awaits - Research

Japan, Inc., Dec, 2002 by Devin T. Stewart, Duncan Wrigley

It is likely that the true ratio is higher: Standard & Poor's, the international credit rating agency, reckons that the true figure is more than 50 percent. Nonperforming loans are a major drag on economic growth in Japan, yet China's financial sector is much more poorly capitalized than Japan's and risk is concentrated in a handful of institutions. Shanghai's skyline is impressive, but many of the luxury apartment buildings, near the airport for example, are empty, a visible manifestation of China's nonperforming loans that is reminiscent of Bangkok circa 1997. Empty skylines are generally bad omens.

Crowding out

Even if government spending does not lead to a crisis, there is evidence of crowding out: Government lending and government-directed lending to politically sensitive state-owned enterprises, arguably a kind of welfare system, leads banks to charge higher lending rates and cut off credit to non-state borrowers, which are often the firms with the best prospects. Expensive foreign direct investment and foreign credit may fill in the growth gap somewhat, but they are not a panacea, and foreign-invested companies do not have the capacity to absorb as many workers as the government would like (the government is considering offering tax incentives for foreign companies to employ workers laid off from state enterprises).

Social stability in China is premised on a sustained high rate of growth. If growth were to slow drastically, state payoffs to those who lose their jobs would at some point become unsustainable. The government could stave off disaster for a while by running a large deficit, but in the end it would probably have to print money to finance the deficit, and this would lead to ram pant inflation. In the 20-odd years of economic reform China has experienced, the economy has entered slow downs, perhaps recessions, but they have not been sustained. The nightmare scenario in China would be that its government coffers run dry, the banking system collapses and protests turn into a national movement. What does this mean for the businessman or investor in Tokyo?

In the 1995 movie Heat, Robert De Niro, playing a bank robber, advises Al Pacino, playing a detective, to never get involved in something that he cannot get out of in 30 seconds. The Chinese economy is not on the verge of collapse, but neither is high growth and social stability assured. Warning signals would appear in the years leading up to the nightmare scenario. Lesser risks for businesses and investors include partial nationalization of an industry dominated by foreign companies, a slowdown in the government's reform policies, and the possibility that the government and the people place the blame for China's woes on foreigners. As people in Japan assess risk around Asia, the wrenching transition that China will be going through does merit caution.

Devin Stewart is special assistant to the president of the Research Institute of Economy, Trade and industry in Tokyo. Duncan Wrigley is deputy economist for the Economist Intelligence Unit in London. The Japanese version of this story appeared in the November issue of a monthly magazine Sentaku.