CourcyInt

To: All Courcy's Intelligence Service subscribers

Date: 20 February 2003

From: Joe de Courcy, Chief Executive, Courcy's Intelligence Service

Subject: KEEP ONE EYE ON CHINA

SUMMARY:

There have been two main pillars to world confidence since the end of the Cold War: the underlying stability of the global security environment and the rapid economic transformation of China, the world's most-populous country.

Everyone recognizes that the first pillar is being put under the most intense strain by the Iraqi crisis, however judging by the vast amounts of foreign direct investment (FDI) still flowing into China there are few concerns about the second pillar. We would like to issue a note of caution.

ANALYSIS:

China remains the pre-eminent magnet for foreign direct investment, absorbing around $53bn in 2002, more even that the United States and at least 10 times more than the only other comparable developing economy: India.

The attraction is cheap labour, a huge domestic market, and growth of around 8% per annum. Our concerns are fivefold:

1. Unreliable figures. The economic figures that underlie much of the enthusiasm for China are unreliable. Work done by Thomas Rawski of the University of Pittsburgh, for instance, suggests that while figures up until 1997 are more or less reliable, that "confidence in official GDP measures ends abruptly in 1998" - the year in which the government launched a series of policy measures aimed at sustaining rapid growth.

According to Rawski's work, the Chinese economy grew by no more than 2% in each of 1998 and 1999 when official figures recorded growth of 8% and 7%. Some economists even believe there might have been a contraction in those years given that aggregate energy use fell by 4.3% in 1998 and by 7.7% in 1999. And even though performance has improved since 2000, there are good reasons for believing that growth could still be only about half the reported figure.

Rawski points out: "A persistent pattern of declining commodity prices, near-zero employment growth, sluggish consumer demand, low expectations on the part of Chinese households, slow growth of private investment, repeated postponement of plans to wind down fiscal pump-priming, and widespread excess supply of both commodities and production capacity…[are all real] phenomena… None is in dispute. And none is consistent with the historic experience of high-speed growth in Japan, Taiwan, Korea, Hong Kong, Singapore, South-East Asia, and, prior to 1998, in China."

Of course Rawski has his opponents, but the uncertainty about China's true economic performance is real, and this on its own must be a reason for a high degree of caution.

2. Public finances. If there is uncertainty over the performance of the Chinese economy, the problem is compounded by concerns over the degree to which performance (whatever it might be) has become dependent on huge government deficit spending on unproductive projects. The deficit was a record $37bn in the fiscal year ending March 2002, up 19% on the previous year.

Although the deficit is only 3% of GDP, and while the cumulative burden might officially amount to only 17% of GDP, when pension liabilities and bad loans of state-controlled banks are included, the real burden is more like 100%-150%. Bad bank loans are now estimated to total $400bn-$600bn, or about half of annual economic output. Unfunded pension liabilities from defunct state companies also total some $600bn.

3. Unemployment crisis. The desperate need for further reform of state-owned enterprises and the banking sector (under China's WTO-entry agreement, the banking sector should be fully liberalized by 2006) will further exacerbate an already serious unemployment crisis.

It is estimated that there are 36m unemployed Chinese in urban areas, and it is thought that 35% of the 140m workers employed in the state sector are surplus to requirements. In addition, there are thought to be 100m surplus rural labourers (the same number as the entire population of Bangladesh), with WTO accession threatening a further 20m rural jobs.

4. Weak leadership. All the above and other problems will be compounded by the transitional nature of China's present leadership following the changes in November - a transition that could take as much as five years to work its way through.

5. The military. Finally, one positive about China over the years has been that (unlike the Soviet Union) it has not over-burdened itself with military expenditure. But with the leadership in flux, the military has been reasserting its position within the Chinese power structure, winning double-digit budget increases.

Given growing fears over American military power (certain to be exacerbated by an attack on Iraq), continuing concerns over Taiwan, and the fact that the only position of power that former leader Jiang Zemin is likely to retain is chairman of the Central Military Commission, it seems highly likely that the burden imposed by the military on the Chinese economy will increase.

CONCLUSION

We are currently witnessing a major upheaval in the global security environment, with the fissure between America and Europe, a loss of faith in the United Nations, the further radicalization of the Islamic world, uncertainty over how to deal with North Korea, and the likely coalescence of countries fearful of American power around China and Russia.

A simultaneous crisis over China's economic advancement would be a further major blow to confidence and stability. It is not certain, but it is possible - and subscribers need to factor it into their calculations.

FURTHER READING

The following reports produced by CourcyInt's sister organization - the Asia Intelligence Service - are relevant and should be of interest. Just click on the links below to access these reports:

* China's banks face competition deadline - AsiaInt Economic Intelligence Review, (EIR) February 2003, http://www.asiaint.com/arl/arl1708.asp

* China preparing for next stage of land reform - AsiaInt Economic Intelligence Review, January 2003, http://www.asiaint.com/arl/arl1563.asp

* The transitional appearance of China's new leadership - AsiaInt Political & Strategic Review, December 2002, http://www.asiaint.com/arl/arl1481.asp

* China begins to face unemployment crisis - AsiaInt Economic Intelligence Review, December 2002, http://www.asiaint.com/arl/arl1500.asp

* The struggle to modernize rural China - AsiaInt Economic Intelligence Review, October 2002, http://www.asiaint.com/arl/arl1354.asp

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