The Hindu Business Line : Demystifying China

CHINA has always evoked the picture of being a mysterious dragon for most of the world; awed for its strength and wonder about its real source of strength.

One of the reasons for such a response is the inability of the rest of the world to get easy access to information in China. All the data releases are on the behest of the government and with no means of independent verification. However, ever since the Chinese Government signed the world trade agreement, the country has been showing far more openness. Interestingly, the latest Economist carries a piece on India's resurgence and its ability to now consistently grow at above 8 per cent could bring Indian `cobra' in the same league as China. One always hears interesting comparisons between the two economies.

In this article, we would take a close look at the Chinese economy and some issues like exchange rate liberalisation.

There has been a swathe of reforms taking place in China over the past five years. This year the pace of these reforms is set to quicken.

One of the major problems that beset the Chinese economy is its fragile banking system. The system has been plagued by very high non-performing loans. The total loans advanced by the banking sector are around $1.58 trillion.

Out of this, as high as 23 per cent (totalling $365 billion) are non-performing loans. What makes this data even more worrisome is that close to 70 per cent of the non-performing loans are in the big four banks. China had started the reform process in 1998 by capital injection of $32 billion.

This was followed by transferring around $169 billion of bad assets into asset management companies (AMC) in 1999. China has confirmed that it has used around $45 billion of foreign exchange reserves to re-capitalise their two state banks. This is an unconventional way of infusion and speaks for the reform that the country is charting out. They have also announced that another $50 billion of reserves would be used for this purpose in 2004.

There is also an admission that just bailout leads to moral hazard and does not change the way the institutions work and would warrant change in management style. China's foreign exchange reserves (not including gold) were around $403 billion at the end of last year.

The total government debt in 2002 was expected to be only 23 per cent of the GDP. This includes debt of central, state and regional government units. This gives China tremendous flexibility to use its reserves for reforms.

China has a small government bond market and the outstanding sovereign bonds are just 30 per cent of the GDP. The total government bond outstanding at the end of November last year was just $420 billion. Even the corporate bond issuances are an abysmal $16 billion.

This leaves China with the option to revitalise its bonds market and use the borrowing for reforms. One must keep in mind that the national savings rate in China is still a staggering 40 per cent!

There is no doubt that a lot of work that needs to be done to reform the bond market and move away from the existing annual quota of government bond issuances.

The asset management company formation has helping in clearing some balance sheets. However, the AMC have been able to sell only around $51 billion of assets from the $169 billion acquired in 1999 for just under $10 billion. The recovery rate is around 19 per cent. This data also highlights the massive amount of capital that would be required to clean up the banking system. One would now appreciate why China is worried on this count and focusing its energies on it.

Exports have been the main driver of growth in the economy. It grew by 34 per cent in 2003. This year the export growth should slow down to around 18 per cent. In the run-up to President Mr Hu Jintoa's US visit in October last year China had announced a three per cent reduction in the export value-added tax rebate. This may have forced some exporters to increase their prices to protect their margins. This move may work as an effective three per cent revaluation of the renminbi.

The export growth would slow down due to value-added tax rebate reduction, trade protectionist measures by the US and the other countries and drop in foreign direct investment.

There has been lot of pressure from the US on China to allow its currency to trade in a wider band. China has been stemming the pressure and is only committing to broaden the band over the medium term horizon. One would understand the refusal to toe the line due to fear of its impact on fragile banking system and slowdown in exports. The Chinese foreign exchange market is highly regulated.

All the companies and institutions have to surrender 75 per cent of their foreign currency earnings and investments to banks. There is hardly any market for inter-bank trading. The demand for foreign currency remains low due to rigid controls on overseas investment. These controls are now gradually being relaxed and this trend is likely to continue in 2004.

China does not face any problem from inflation but would have to curtail the investment spree. There is a huge rush for investment in property and other sectors. China has hiked the reserve requirements ratio in September last year for lending to property sector.

This has slowed down the pace of the investment and reduces the risk of overheating in this sector.

If one compares the financial health of the Indian banking sector and the growth that the economy is now clocking, one cannot but see reason of the renewed confidence in some quarters.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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