THE US-CHINA BUSINESS COUNCIL: CHINA OPERATIONS '99

China's Economy Analysis

March 4, 1999

The PRC government has acknowledged that despite its ongoing and fairly successful efforts to boost the sagging economy, growth in 1999 is unlikely surpass last year's levels.

• Fears of job loss and overproduction of consumer goods are dampening domestic demand, and state-owned enterprises (SOEs) are performing as poorly as ever.
• The Asian slowdown is expected to result in low or even negative growth in exports and foreign direct investment.
• These conditions are bringing down many analysts' growth forecasts for 1999. As a result, Beijing has announced it will continue stimulating the economy in the coming year, primarily through government bond issues.
• Foreign firms with business interests in China are likely to find the economy in the coming year as trying as the last.

Overall Economic Performance in 1998

• GDP China's 1998 GDP growth came in just under the official government target of 8 percent, though some economists believe that number to be high. This rate would not have been possible without the government's stimulus efforts. Measures included increased investment in infrastructure, lower interest rates, somewhat better access to credit for small and medium enterprises, and relaxed restrictions on the scale of investment projects. In the second half of the year, reconstruction following summer flooding also helped boost output. Despite plans for continued economic stimulus, officials are already warning that growth will be slower in 1999. Given the external economic slowdown, which leaves the PRC's economic growth dependent on domestic demand, GDP growth as low as 6 percent is possible in 1999.

• Prices Retail and consumer price indices fell throughout the year, reflecting slack demand, higher savings rates, and excess capacity in industry. But success in the anti-corruption campaign, which has caused low-cost smuggled goods to become less available, reportedly has led to slightly higher prices for some key products, such as rice and steel. Whether this trend will continue remains uncertain. Perhaps as a result of this uncertainty, Beijing also enacted price controls on a number of goods to head off price wars among domestic manufacturers.
• Output Industrial output was up by year-end. SOE output remains sluggish, however, and accounted for less than half of all output in the month of October, despite greater access to credit (see below). Output figures are likely to benefit again this year from the growth of township-and-village enterprises (TVEs), projected at 18 percent for 1998. Analysts warn, however, that if this output is of low quality, it will end up as unsold inventory (a severe problem in recent years) that will not contribute much to long-term economic health.
• Investment A consequence of the government stimulus policy has been a steady increase in investment in fixed assets in 1998. Investment in capital construction, facility upgrades, and real estate development all rose about 20 percent, largely in the state sector. Investment in the private and cooperative sectors remained flat, though enterprises in these sectors tend to be less capital intensive. The Ministry of Finance (MOF) has said such government-driven investment will continue in 1999; the Chinese Academy of Social Sciences predicts that fixed investment will grow at least 15 percent.

• Government finances The central government expanded its domestic bond issues substantially, assuming a higher level of debt than projected at the start of the year. The government announced it would increase the budget deficit almost 10 percent next year, from Yen96 billion ($11.6 billion) to Yen105 billion ($12.7 billion). While government officials have reported a significant increase in 1998 tax revenues--a total of Yen855.1 billion was collected, up 13.3 percent from 1997--they have warned that tax collection will remain difficult in 1999. Fortunately, China's reported debt-to-GDP ratio is below the internationally accepted threshold of 3 percent. Its external debt is also weighted more toward longer-term instruments than that of the hardest-hit of the Asian crisis countries. Some economists believe China's official external debt figure is understated, however.

• Foreign currency and the value of the renminbi (RMB) Foreign-exchange reserves remained high in 1998, but Beijing appears to have grown concerned about the discrepancy between the growing trade surplus and relatively slow rise in government reserves (see China's Foreign Trade). The late-1998 crackdowns on smuggling and illegal foreign-exchange dealings reflect an awareness that high levels of PRC funds may yet reside offshore. Though foreign-exchange reserves reached $145 billion by year-end, billions are still unaccounted for. Such offshore funds undermine confidence in the strength of the currency, though Beijing has successfully deflected calls to adjust its exchange rate downward and remains committed to holding the RMB's value steady.
• Agriculture Despite the devastation wreaked by flooding last summer, China reported a good harvest, bringing in the second-largest recorded grain crop, at just over 490 million tons. Though cotton production dropped, that of oil-bearing crops, animal husbandry, and fisheries all rose. Production of sugar, dairy products, meat, eggs, and beer also increased. One major 1999 development will be the replacement of the cotton monopoly with a cotton exchange. Low cotton prices worldwide, high inventories, and oversupply apparently motivated Beijing's decision.Rural incomes rose less than 4 percent to Yen2,150 ($260), in part because of the year's large grain surpluses. The slow rise of rural incomes relative to urban incomes, which could lead to widespread instability, is a worry for Beijing, especially when combined with massive job losses in the state sector. Corruption in the grain bureau may exacerbate matters--over Yen2 billion ($241.5 million) is reportedly missing. In an effort to improve economic growth and stability in the countryside, the government plans to extend land contracts to 30 years in all areas and implement policies to strengthen TVEs and the rural economy in 1999 (see Foreign Direct Investment).

Hands-on Government Economic Policy

• Stimulus The PRC government issued $12 billion in special infrastructure bonds to stimulate the economy in the second half of 1998. Such bond issues could occur again in 1999. The revenue from these bonds appears to have bolstered state enterprises, which received the largest portion of fixed investment funds last year. MOF Minister Xiang Huaicheng announced that to finance government spending, Treasury bond issues will rise to Yen316 billion ($38 billion) in 1999 from Yen280 billion ($34 billion) in 1998. Some analysts question whether the government's funds will succeed in raising not only production, but also confidence levels--to induce consumers to resume spending on big-ticket items produced domestically. Greater spending on construction and household items, expected as a result of housing reform, failed to materialize in most areas of the country but could emerge as a force in the long run.
• Corruption and the economy The government has combined its aggressive spending policy with a concerted effort to crack down on corruption. The highest-profile moves have been the closure of Guangdong International Trust and Investment Corp. (GITIC) and the dismissal of officials in the Public Security Bureau and local grain bureaus. Beijing also demanded that all military, security, and Communist Party authorities divest themselves of their business interests. The success of such efforts is essential if SOE and financial sector reforms are to proceed smoothly, without large-scale theft of state assets. Lack of progress in cleaning up corruption would kindle already smoldering discontent among PRC citizens, particularly those in rural areas and those employed by the state.
• Backtracking on reforms? Early 1998 plans to accelerate SOE and financial-sector reforms have clearly been put on hold. The economy's inability to absorb the significant number of the unemployed, combined with corruption that threatens all reform efforts, likely factored into Beijing's decision to move cautiously. Some incremental moves in the financial sector continue, however, most notably the passage of the securities law. Other steps included the restructuring of the People's Bank of China (PBOC); the creation of an independent insurance regulator, the China Insurance Regulatory Commission; the slight expansion of foreign commercial bank activity; and a partial recapitalization of the state banks. GITIC's closing seems to indicate the government's willingness to start reinforcing its weak financial system by cleaning up endemic misbehavior. But GITIC's bankruptcy, and the possibility that other ITICs are soon to follow, have made foreign investors skittish. PRC entities reportedly are experiencing increasing difficulty borrowing from abroad, and Beijing may have a hard time overcoming foreign bankers' loss of confidence in the safety of lending to PRC borrowers.At the same time, the government appears to be propping up SOEs--the least productive entities in the economy--by funneling funds to them through the state banks. The state banks are, in turn, the victims of this policy, as their indebtedness only deepens as they must continue lending to nearly bankrupt SOEs instead of more productive firms. Some analysts point out that SOE reform is already further along than some analysts may realize (see The China Business Review, July-August 1998, p.8). Nonetheless, government warnings about the state of the economy indicate that 1999 is unlikely to be the year in which Beijing resumes swift action on reform.

Scenarios for the Economy in 1999

• The upside If government anti-corruption efforts make headway; if more investment reaches more productive parts of economy; and if, as a result, the quality of output improves, the economy could hold steady in 1999 despite poor export performance.Moreover, if the new securities law signals new momentum in financial-sector reform, and the government makes some progress on the SOE reform agenda, confidence could well hold up through hard times in 1999. Key indicators will be whether Beijing is able to continue shifting enterprises' social welfare burdens to the local-government level, and whether private and collective firms recover sufficiently to start absorbing large numbers of laid-off SOE employees.
• The downside If investment continues to prop up SOEs at the expense of collective and private enterprises, and SOE and financial reforms fail to move ahead steadily, the late-1998 increase in output is likely to be temporary. Indeed, the government has said that output in 1999 could well be below last year's levels, though, for the first time, the government appears to be backing away from establishing an official growth target. Absent a resurgence of consumption, the economy will continue to struggle with price deflation and overcapacity in manufacturing sectors. Meanwhile, MOF's Xiang has said that exports are likely to remain dismal this year. If exports and foreign direct investment fail to rebound, confidence in the PRC economy--both domestically and abroad--could falter.

China's Economic and Financial Indicators
China's Output and Investment 1994-1998

Hong Kong SAR

Very little went well for the economy during Hong Kong's first full calendar year as a special administrative region of the PRC. The property, tourism, and retail sectors slumped, exports fell, and consumer confidence slid. Not only did GDP contract each quarter and unemployment rise, but the government faced a coordinated, speculative attack on the Hong Kong dollar in August. To defend the Hong Kong dollar peg to the US dollar, as well as the stability of the economy as a whole, the government intervened in the Hong Kong stock market to the tune of $15 billion. Hong Kong financial institutions were shaken again in the autumn with the news that Beijing was closing GITIC. While Hong Kong banks may have the most to lose, analysts suggest that they could survive even total write-offs of their GITIC debts. Nevertheless, GITIC's bankruptcy has come as a shock to many, and banks are exercising much greater caution in their lending activities on the mainland.

• GDP The International Monetary Fund estimates that Hong Kong's 1998 output contracted 5 percent, despite the stimulus package announced last July. Latest Hong Kong statistics put the third-quarter GDP growth rate at -6.7 percent. As the property sector suffered, the government, which owns much of the SAR's land, suspended formerly lucrative auctions to prevent property values from sliding further. The current recession is in part a result of the Hong Kong government's commitment to defending the dollar peg (see below).
• The Hong Kong dollar peg Although questions continue to swirl around whether the peg is defensible, the SAR government can be expected to maintain the peg in the near future. Attacks cannot be ruled out as long as the economic slump continues. The currency's inability to fluctuate in response to regional economic changes has forced interest rates up, drying up liquidity and, in turn, economic activity in the SAR. But allowing the peg to fall risks provoking another loss of confidence among international investors. These investors rushed back into Asian capital markets in the last few months of 1998, after their mass pullout of all emerging markets following Russia's collapse last summer. Also helping to shore up the peg are Hong Kong's foreign exchange reserves, which are among the highest in the world, and the strong international political support for maintaining the currency link.
• Prices By year end, inflation in Hong Kong was sharply down from last year, and prices actually fell in the last two months of 1998. The ongoing economic recession in Asia was largely responsible. But a government rebate, price freezes in government fees and utility charges, falling world commodity prices, and low inflation in supplier economies also contributed to the low price level. With the recession expected to continue, the forecast for inflation in 1999 is only 0.8 percent.
• Unemployment Hong Kong's unemployment rate reached a 23-year high of 5.8 percent in the October-December period. Though several dominant sectors lost jobs as a result of the poor economic situation, the ranks of the under- and unemployed were also swelled by significant labor force growth. Nevertheless, with many sectors retrenching and downsizing, unemployment is expected to remain high in 1999.
• Interest rates Despite several cuts during the second half of 1998, in real terms, interest rates are still high relative to those of other economies. Maintenance of the dollar peg and the currency-board system will force rates to remain high for the near future, or until the threat to the peg eases.
• Prospects for 1999 Many Hong Kong economists believe that the economy is bottoming out, regardless of the continuing recession among its Asian neighbors and the mediocre prospects for China. They cite rebounding prices on the Hang Seng, falling interest rates, and increasing numbers of tourists as the main sources of optimism. Though growth is expected to continue falling in the first half of 1999, analysts are predicting that it will pick up slightly in mid-1999, finishing with a growth rate of around 1 percent for the year.

Major Economic Indicators for Hong Kong SAR, 1995-1998

(All figures are in billions of Hong Kong dollars unless otherwise indicated)