What Will China Do?
Why Devaluation Will Not Solve China's Economic Woes
Bradley D. Belt, Executive Director
Almost a year since the first domino fell, will the Asian contagion claim its latest victim? Declining foreign direct investment, slumping export growth, weak domestic demand, and troubled state enterprises have slowed China's growth to somewhere between 5-7%, well below the 10% average of the last 15 years as well as the government's 8% target for 1998.
With fears of mounting social instability, Beijing has announced an indefinite pause in its efforts to reform state industries to head off rising unemployment.
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"China does not need a devaluation. And its leaders would do well to reject the option squarely rather than use it as a blackmail tool in international poker"
-Rudi Dornbusch,
The Financial Times
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And despite public assurances otherwise, there is increasing concern that the Chinese government may devalue the yuan. But China does not need to devalue. What China must do to avoid an economic crisis is continue its reforms of the massive state-run economic sector and avoid quick-fix remedies such as devaluation that will not solve the country's woes.
The Asian Flu Infects China
In the first half of 1998, China's exports grew at 7.6%, only a third of last year's rate. Weakened Asian currencies and demand have made Chinese goods less competitive, and Chinese exports to the region have fallen significantly- down 30% to South Korea and 13% to Southeast Asia. Cheap Asian goods have also flooded the Chinese market and have hit domestic manufacturers hard. South Korean steel imports for example have jumped 40% and have forced some Chinese steel makers to switch from steel production to importation to take advantage of cheaper foreign goods. Not surprisingly, powerful domestic business interests feeling the crunch from regional competition have begun to pressure officials to help them out. How long can Beijing afford to ignore them?
Devaluation- the Wrong Medicine
As regional currencies remain weak and the yen continues its recent slide, the obvious choice to stimulate growth is to boost exports by devaluing the yuan . . . but it's not that simple:
Any gains that China hopes to secure by a one-time devaluation would most likely be lost to similar competitive devaluations by the rest of the region. And a devaluation would also encourage speculators to test Hong Kong's commitment to keeping its own currency pegged to the U.S. dollar. Undercutting regional economies with a currency devaluation could tarnish China's international reputation, just when the country is pushing its big-power status. Also, with China's trade surplus with the U.S. at $50 billion, a new flood of cheap Chinese imports might renew protectionist sentiment in America, souring China's image here just at the time when Beijing needs U.S. influence to secure its entry into the World Trade Organization. Although a devaluation would increase domestic earnings from exports, it would also raise the costs on critical import components upon which a significant portion of Chinese exports depend. For every dollar exported, China has to import 50 cents of raw material or equipment, which would become more expensive if Beijing opted for devaluation. Moreover, rising component prices could spur inflation. Devaluation does not deal with the real economic problems in the country. A 10% devaluation would only raise exports by 5% or 1% of total economic output, not enough to spark the economy forward.
The Real Problem: Domestic Malaise
While weak export growth has certainly hurt China, it should not overshadow the real weaknesses and structural failings in the domestic economy. Devaluation is only a short-term remedy that will not address the following core problems:
Weak domestic demand has hurt Chinese industries. Consumer spending in a rural economy of 900 million people that normally accounts for 40% of consumer sales has fallen as a result of dropping wages and personal incomes. Rising unemployment and job insecurity has hit urban consumer spending, contributing to a 2.1% drop in retail sales in the first half of 1998. Deflation has been gathering pace since early this year as weak consumer demand and industrial oversupply have forced prices down. The retail price index fell 3.2% year on year in July, further undermining economic growth. Inefficient state owned enterprises (SOE) continue to drain government resources. Profits of SOEs were down year on year 49.5% in the first five months of the year, and industrial output was well below the government target of 11%. The failure earlier this year of the Hainan Development Bank under a mountain of bad debt is an extreme warning of the type of financial dangers China's banks face. Without strict supervision to monitor their activities and wide-spread corruption and cronyism, a quarter of all bank loans in the country may be non-performing.
What the Government is Doing . . .
In the face of economic uncertainty, the government has wavered in its commitment to the ambitious reform package announced earlier this year. To stave off rising unemployment and social frustration, Beijing has delayed policies to liberalize the housing market as well as put on hold sales of small and medium size state owned enterprises. Plans to make the currency fully convertible have been shelved indefinitely. While certain reforms, including bureaucratic down-sizing and limited financial sector deregulation have stayed on track, overall the government has retreated from its earlier pledges.
To bolster the struggling economy, Beijing has adopted various policies. To stimulate the export sector, the government has announced increased export rebates, easier export licensing, and more loans for export credits. Moreover, the Bank of China cut interest rates for the fifth consecutive period to stimulate investment expenditures in the economy. Perhaps most ambitious is the proposed massive infrastructure investment plan that could reach $250 billion to reflate the economy. Already, fixed asset expenditures by the government have grown close to 14% this year, compared to last year's 10% growth. Meanwhile, infrastructure spending jumped significantly year on year in June.
. . . May Not Be Enough
While these policies may prop up the economy in the short run, they still do not address the core problems the country faces. They are quick-fixes to get the immediate pressures off of the government, but half-hearted measures will not succeed in the long-run. And if the yen continues to fall or the U.S. economy slips, China will find itself right back where it started, looking for another quick and easy way out. Rather than these timely patch-ups, the country needs to stick with its reform package, however much that may hurt:
Financial sector reform must continue, and bad loans must be cleared from the banks' books. Despite repeated pledges, increased transparency with the country's banks has not been forthcoming, encouraging more questionable lending by already shaky banks. The government must continue to overhaul the tax system. Currently, government draws most of its revenue from the SOEs, while the private sector manages to evade taxation. But with profits falling at SOEs, the government may soon find itself without sufficient tax revenues to continue its economic reforms. SOEs are dragging down the economy by hoarding credit from the banks to keep themselves afloat. Of the country's 300,000 SOEs, nearly 75% are loss-makers, and unless the government continues to merge and sell off existing enterprises, they will be an anchor for the rest of the economy.
Chinese officials have publicly reaffirmed their commitment to change, but it is all too easy to keep delaying until it is too late. As turmoil in Japan indicates, years of side-stepping necessary but painful reform can lead to a wider, more frightful economic crisis down the road. And any sign that reform has been delayed will only signal that it's business as usual, and corrupt bureaucrats and businessmen will return to their old ways.
Fuad Rana
csis.org |
