Can China Avert Crisis?

Challenge, July, 2000 by James Dean

The Asian financial crisis stoked fears in China, argues this economist. The window of opportunity to further reform has narrowed recently. China now faces difficult decisions about how to reform its state industries.

IF THE East Asian financial crisis of 1997-98 sparked One Great Debate, it was a debate over "Asian" versus "Western" capitalism. Or, more precisely, it sparked a debate about whether the root cause of the crisis was a failure of Asian capitalism or a failure of Western capitalism (Dean 2000a, 2000b). Western economists were prone to vacillate, and the most influential of them changed his mind midcrisis (Krugman 1998a, b; 1999).

Had practicing the evil arts of Asian capitalism been sufficient to trigger a crisis, China should have been Asia's leading candidate for Armageddon. But China survived, while the East Asian "tigers" did not. Compared to the tigers, China was still shielded from the disciplines of global trade and finance. Admission to the World Trade Organization (WTO) will strip that shield away. This article asks whether China can survive much longer without financial turmoil, or worse. China has performed admirably. It has adopted serious reforms. But its window of opportunity to make further reforms has narrowed. It remains to be seen whether the nation can still climb through.

Asian capitalism as presently practiced in China is bleeding its economy badly. China's leadership has been acutely aware of this for some time--at least since the early 1990s. But the leadership has no plan for a decisive and final leap toward Western capitalism since it fears that this might trigger a profound crisis--not just economic but social and political as well. The plan instead is to "restructure" the most palpably unsustainable aspects of Asian capitalism--notably the loss-making state-owned enterprises (SOEs)--while continuing to move gradually and judiciously closer to Western capitalism.

The final destination envisaged by the Chinese Communist Party is not Western capitalism. Rather it is a state of being that the fourteenth party congress called, in October 1993, the "socialist market economy": an oxymoron that stuck and is still today very much part of official rhetoric. Nevertheless the East Asian crisis has raised more doubts than ever about the sustainability of the "socialist" part of China's emergent market economy, not least, one suspects, in the minds of many in the top ranks of the Communist Party. Put politely, the socialist market economy is a moving goalpost. Put less politely, China's policymakers are increasingly schizophrenic. [1]

The schizophrenia is, first, about making a final leap toward a market economy internally--in particular about privatizing the SOEs. Second, it is about embracing the market economy externally--whether or not to permit unrestricted access to foreign goods and services and unrestricted inflows and outflows of capital. Moreover, internal liberalization and external liberalization are intertwined.

In summer and early autumn of 1999, schizophrenia was just below the political surface, as China waffled about joining the WTO. Rumor had it that Prime Minister Zhu Rongji was so frustrated with his conservative colleagues, who oppose opening China further to the West, that he contemplated resigning. For his part, President Jiang Zemin waited for President Clinton to telephone three times before returning his calls and ultimately agreeing to resume negotiations. Zhu and his liberal constituency have apparently prevailed, but the liberalization that will be mandated by the WTO poses far greater risks to financial and political stability than most Western observers appreciate.

For example, the terms of putative admission to the WTO cede greatly enhanced access to foreign banks. But all that forestalls the collapse of China's domestic banks is forbearance by Chinese depositors. If deposits move en masse to foreign banks, the SOEs will collapse too. In short, China is now more vulnerable than ever to financial crisis. [2]

Why Financial Crises Matter

To understand why China has thus far been willing to pay a high and rising price to avert financial crisis, I will begin by characterizing a "financial crisis" and explaining why it might be costly to the real economy. A financial crisis typically involves sharp, negative, and unexpected drops in the price of financial assets, such as currencies and stocks, a sharp rise in interest rates, and often widespread bank failures.

The reason that financial crises are costly is not simply that wealthy holders of the wrong currencies, stocks, or bank shares lose money. Rather it is that sharp price changes in the financial sector usually spread to the real sector. Currency, stock market, and banking crises usually lead to sharp declines in exports and in investment and consumption spending, which in turn result in sharp drops in output, incomes, and employment. Contraction in the real sector inevitably causes misery for millions of people. Consider the massive unemployment, malnutrition, and displacement of populations in Indonesia resulting from a crisis that began simply as an attack on their national currency.