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China is in a squeeze. The domestic cause is the same familiar one that sparked the recent Asian crisis: government use of the credit system to give special privileges to certain firms (in China's case, the state enterprises). Excessive credit has subsidized underproductive sectors of the economy and inflated a financial bubble. As in South Korea, the favored enterprises have used their access to excessive, low-cost funding to create vast empires of overcapacity and inefficiency. As in South Korea, the availability of funds regardless of profit supports a labor system that assures workers in favored sectors lifetime employment and a wide range of social benefits, even if their companies provide no useful output. And as in South Korea, the banks that underwrite this system now confront a daunting accumulation of bad loans that threaten the viability of the entire financial system and jeopardize decades of improvement in the standards of living.
China's financial bubble differs from South Korea's in important ways, however. Whereas South Korea's bubble was punctured by a foreign debt crisis in December 1997, China has proportionately far less foreign debt and proportionately far greater foreign exchange reserves, an advantage that shields the bubble to some degree from external pressures, but that provides no protection from significant internal problems. Secondly, China's state enterprises are also far less efficient and competitive than Korea's chaebol, and the squeeze comes at a much lower level of administrative and technological development. Thirdly, the sheer scale of management problems involved in conducting reform, given China's vast size and population, is orders of magnitude greater than in South Korea. Finally, given China's lower level of per capita income and political development, the consequences of a major economic setback could include extensive starvation and political upheaval, neither of which is at risk in South Korea.
Ironically, the timing of the squeeze results from good policy--the most proactive economic reform program in the world. Because the stakes are greater in China than elsewhere in Asia (except perhaps Indonesia), and because it currently has a forward-looking leadership, Beijing has attacked its problems before the onset of a crisis, rather than waiting to be overwhelmed by events as Indonesia, Thailand, and South Korea were. Notably, although China is learning from the smaller countries' experiences, it adopted a reformist posture well before the onset of the "Asian flu." In fact, China's successes in the four years prior to the regional crisis rank among the most inspiring achievements in the history of economic management. From 1994 to 1997, China pressed inflation down from 22 percent to negligible, maintained growth in the 9 percent range, stimulated a series of record grain harvests, raised foreign exchange reserves from U.S.$21 billion to $140 billion, attracted foreign direct investment that reached m ore than $40 billion per year, and initiated wide-ranging tax, legal, and banking reforms. Such achievements would have been noteworthy in the history of almost any country, but are particularly stunning in a country with a population roughly equivalent to those of the former Soviet Union, Eastern and Western Europe, the Middle East, and South America put together.
Having achieved all this, China nonetheless finds itself in a quagmire. As in South Korea and the other great economic success stories of Asia, the methods of guiding the economy that created the great economic takeoffs have also led to overcapacity, deflationary pressures, banking breakdowns, rising unemployment, and severe social strains.
The Momentum of Reform
It seems to be taken for granted in much of the press that Chinese reform has stalled. Certainly, the state enterprise reforms are behind schedule. The Asian financial crisis, coinciding with some of modern history's worst floods in the summer of 1998, exacted a heavy price because the pace of reform is ultimately constrained by the economy's ability to employ laid-off workers. But reform has continued at an extraordinary rate. During 1998, central government ministries were downsized by half. Although the plan was to do this within three years, it was largely accomplished in a single year. Virtually all of the dismissed state employees still live in government housing. Many are being supported by retraining programs or are going back to school at government expense, and most get two to three years of income and benefits comparable to those they enjoyed on their jobs. But there have still been vast savings and efficiencies. Some 30--40 percent do not get full retirement benefits, and no officials have been h ired back (as would have happened in Washington, D.C.) under the guise of consultants or contractors. Hard budget constraints have been imposed.
The downsizing has so far excluded the military and the Communist Party, but all levels of government will eventually be affected, with four million jobs eliminated. Moreover, this huge reduction has so far been accomplished without creating a collapse of morale or a burgeoning political opposition. In interviews, government officials did not appear gravely disheartened by the changes. Asked how their former colleagues were faring, they answered that virtually all central government officials had quickly been employed, usually at higher incomes, by the private sector, where their skills and connections were badly needed. Only in China's 2,400 county-level governments is there more of a backup.
Military reforms also continue apace. The Chinese military has been heavily self-supporting, following the examples of Thailand and especially Indonesia in developing a vast array of businesses. The People's Liberation Army (PLA) not only produced armaments, but grew cotton, sold Baskin-Robbins ice cream, bottled soft drinks, co-owned Beijing's plushest hotel, and ran karaoke bars in major cities. Indeed, the PLA was the best partner a foreign investor could have, since army generals could "make things happen," commanded a national transportation and distribution system, provided excellent security--and could ignore the law. In 1998, the Chinese government decided to get the military out of business, a task so vast and delicate that it seemed impossible. But the impossible has apparently happened. China has many patriotic officers who recognized that soldiers who peddled ice cream were probably forgetting how to shoot straight, and the army was no doubt glad to get out of some businesses simply because they were losing money. Still, the politics were complex and the financial cost huge because the administration paid trust funds to army headquarters for the businesses it expropriated. But in the end the job was largely completed--again, within a year.
China has initiated a total reorganization of the PLA. Some 500,000 soldiers will be discharged--a huge cut that is particularly painful when the economy is slowing and many soldiers' wives are simultaneously losing their jobs. Conscription for three to four years is being reduced to two years. Professional noncommissioned officers are becoming more important, political commissars less so, and civilian education and reserve-officer training programs are getting new prominence in an effort to produce higher-quality officers. Division-level management is frequently being eliminated altogether. The strategic doctrine is being changed. Research and development and acquisition processes are being revamped, and civilian outsourcing is being introduced for equipment, hospitals, restaurants, and other needs. Finally, the military is being subjected to firmer civilian control: for the first time no military officer serves on the Standing Committee of the Politburo.
These breathtaking changes bode well for the economy as well as the military, and for the next seven or eight years will so preoccupy the PLA that China will need to avoid trouble with foreigners. What is more, the military reform has sharply reduced smuggling and permitted more accurate import statistics. This explains the amazing jump in imports that was reported as soon as the military was "put out of business." In March 1999, imports of beverages and tobacco rose 39.2 percent over March 1998, food oils rose 58.5 percent, and machinery and transportation imports rose 52.3 percent despite a weaker economy. As a result, government revenues will rise substantially because more tariffs will be collected, foreign exchange reserves will rise because less foreign exchange will be hidden offshore, and politically sensitive trade deficits with the United States and other countries will be revealed to be substantially smaller than previously believed because smuggled goods were not in the statistics.
Still, the ultimate cause of Asia's, and China's, financial bubbles is misallocation of capital. The most disastrous consequence of a popping bubble is collapse of the banking system. Hence financial reform, defined broadly as movement towards more efficient use of capital, must constitute the core of any reform. China's banks are sick, and it is uncertain whether they can be cured before a South Korean-style collapse occurs. China has chosen to emphasize that the banks cannot be made sound until their customers, namely, the state-owned enterprises (SOEs), are cured or allowed to die, because the …