A Silver Lining to Hard Times in China

The northeastern sky is clear and blue, and hawkers fill the streets in the winter sunshine--two bad signs for this industrial city where, in its heyday, belching smokestacks and full factories meant economic health.

Today, Zhang Qinglin, 34, sells teapots and cups by the side of the road to make ends meet. She has not been paid by her textile factory in two months.

“We’re struggling to survive,” says her husband, a mining bureau worker who has been paid only twice in five months himself. “But we have to depend on ourselves and not on anybody else.”

The Zhangs are workers in China’s ailing state sector, toiling for government enterprises that have been manufacturing products that nobody buys, existing on loans from government banks that they can’t pay back.

The result, as China begins a future without the late “paramount leader” Deng Xiaoping, is a banking system effectively insolvent--and a nation at a turning point. How China handles the problem-plagued state sector will probably make the difference between its emerging as an economic colossus or sinking into economic crisis.

Some top China economists see the wobbly banks as a financial time bomb looming in the shadow of the vast country’s dramatic growth.

“A collapse of the banking system would threaten fundamentally to destroy China’s economic miracle, and a collapse cannot be ruled out,” leading China economist Nicholas Lardy told U.S. business leaders, academics and government officials in January.

Such pessimism is not universally shared. Other China observers dismiss the woes of the banking sector as an inevitable part of the transition from a state-controlled economy to one that is nominally more open. These experts see a steady privatization bringing more positives than negatives.

But it might be a far rockier road than many observers, fixated in recent years on China’s stunning economic growth, have expected.

“The problem is, the high growth rate makes one think everything is going well, but it’s a political time bomb,” says Wing Thye Woo, a China scholar at UC Davis.

Since Deng’s death, even China’s own leaders have made rare admissions of trouble.

Finance Minister Liu Zhongli told the National People’s Congress on March 1 that the state sector is in chaos and said its reform is “a major political issue which is of importance for the destiny of the socialist system.”

According to Lardy, a Brookings Institution analyst, the state-run industries’ debts now stand at 95% of their assets. And nearly $1 of every $3 in loans held by China’s state-run banks is considered uncollectable.

Lardy notes that China’s debt--with the banks’ outstanding loans equal to 93% of the country’s gross domestic product--has reached the level of Japan’s in the late 1980s, shortly before the Japanese “bubble economy” burst, sending real estate values plummeting and driving the country into recession.

China’s state-run industries “hold their huge debts like hostages,” says Shan Li, executive director at Goldman, Sachs (Asia), “forcing the banks to keep paying ransom in the form of new loans in order to avoid having to write off the old loans.”

The gravity of the problem became clear last fall when the Chinese government shut down a small farm-lending agency, the China Agricultural Development Trust & Investment Corp., after it ran up nearly $2.5 billion in bad loans and other debts.

China’s banking sector is dominated by four state banks: the Industrial & Commercial Bank, the People’s Construction Bank of China, the Bank of China and the Agricultural Bank of China.

All have traditionally acted more as cashiers than as commercial banks, making loans based on government policy goals--subsidizing high employment and political stability in a socialist system--rather than a venture’s worthiness.

Deng’s plans for removing the cushion of state subsidies stalled as his health faded, and his nervous successors focused on maintaining political power and stability rather than pushing through unpopular changes. In the wake of Deng’s death, however, Chinese leaders are renewing vows of reform.

In a surprise announcement Tuesday to China’s parliament, economic czar Zhu Rongji said the government had earmarked about $12 billion for the next three years to write off uncollectable loans, signaling the government’s growing willingness to let state businesses fail. Last year, China’s banks wrote off $2.4 billion in bad loans. Last month, Beijing also cut the tax rate on overburdened state banks to 33% from 55%.

“This is a good sign,” says former government economist Fan Gang, who now heads the China Economic Reform Foundation, a think tank in Beijing. “It shows that the leaders have the consensus they need to make unpopular but necessary changes.”

But to stop the spiraling losses, economists say, the Chinese leaders still have to take two politically onerous steps: dismantling the system that guarantees workers lifelong employment and benefits whether they work hard or not and loosening the government’s control over the banks, which observers perceive as the soul of the free-market system.

So far, it is China’s most productive citizens who are keeping the banking system afloat, since they account for 80% of all bank deposits. That leaves China’s banks extremely vulnerable to anything that would spook their customers, from political unrest to a major bank failure.

Most observers remain convinced that the Chinese government will not allow a major bank to go under. But the government has begun to permit failures elsewhere. Last year, an estimated 6,000 state-owned enterprises went bankrupt after state banks tightened credit.

Of the remaining 75 million state enterprise employees, an estimated 13 million are working only part time.

The speed of the reforms depends partly on how much belt-tightening people can take before their unhappiness turns to unrest.

Already in Shenyang, unpaid workers wave protest signs in front of City Hall about once a week while police look on. A rhyme heard in China days after Deng’s death reveals people’s gloomy expectations under successor Jiang Zemin:

Mao Tse-tung: Xia fang (Under Mao, we go to the countryside).

Deng Xiaoping: Xia hai (Under Deng, we go into business).

Jiang Zemin: Xia gang (Under Jiang, we go out of business).

But many people, like the teapot-selling Zhangs, have taken several jobs to survive.

“What’s the use of working at the factory if they don’t pay me?” Zhang’s wife asks. “I’d like to start my own business.”

Desperate entrepreneurship like the Zhangs’ encourages some observers. While policies have stalled at the top level, people on the ground scrambling to survive are forging the first real steps of reform. Improvised solutions are working better than expected, and China’s fiscal resilience confounds most doomsaying experts.

“On the local level, people are going ahead and trying new things that may not be technically allowed,” says Fan of the Beijing think tank. “The government is watching but not stopping them and sometimes endorsing what works.”

The quiet reforms include large enterprises raising funds through stock or bond issues--trading debt for equity--and workers taking shares in state-owned enterprises. And the more companies that shift to making money on their own instead of relying on state subsidies, the healthier China’s banks--and basic economy--will be.

To be sure, “privatize” remains a dirty word in China’s nominally Communist lexicon. So now that Li Chingzhen and the employees of the formerly state-run Shenyang Five-Three Construction Material Co. have become its new owners, officials prefer to call it a “workers’ enterprise.”

Last year, Li, the general manager of the 44-year-old company, cut a deal with the government to take the money-draining enterprise off its books. Li bought 50%, factory workers acquired 30%, and the rest of the company was purchased by other executives.

The Shenyang factory had built a reputation for producing quality bricks and cement, and its managers believed that it could do better if it did not have to hew to a state-created business mandate.

“Now we don’t have to talk to the government if we want to change our plans,” says Li, an earthy fellow with an easy smile who started in the factory’s lowest ranks 17 years ago. “We can respond to what the market wants like a sampan, not a big ship.”

And the worker-owners have new incentive to do their best, because their pay is tied to profit.

“The more you work, the more you earn,” Li says. “If the factory loses, you will lose.”

Barry Naughton, a China scholar at UC San Diego, says it is small shifts like this, from public to private, multiplied on a wide scale that will spur China’s restructuring--and ultimate survival.

Naughton, author of a book on China’s economic reforms titled “Growing Out of the Plan,” says that since reforms began under Deng, the state enterprise share of the Chinese economy has dropped from 80% to 34%. The contribution from foreign joint ventures and private firms has grown from virtually nothing to 25%.

Naughton predicts that China’s new economic structure will expand fast enough to cover the costs of restructuring, including bailing out the banking system.

“If someone was saying, ‘Would you like to buy a share of a Chinese bank?’ I’d think twice about it,” he says. “But is it likely these financial problems will derail Chinese economic growth? I’d say it’s not likely.”

The Chinese government’s preference is to have its stronger state-owned enterprises merge with the weaker ones, creating companies that are able to stand on their own.

The process could be hastened by China’s bid to join the World Trade Organization, which would require the dismantling of many remaining barriers that protect the state-owned sector from competition.

To compete, the Chinese government is slowly weeding out the “dinosaurs of Chinese industry” so that it can focus its finances and support on 1,000 key enterprises, following the models of Japan and South Korea.

“What funds are left are being given to the new Samsungs, the Daewoos and Acers of China,” said Denis Simon, head of the China strategy group for Chicago-based Andersen Consulting. “They are going to be the key players who are going to achieve the dynamism that will drive China’s future.”

Simon says the survivors of China’s economic purges badly need new factories and equipment, modern management systems and technology. Given the competition for capital and talent, many Chinese managers are looking abroad for their white knights in exchange for a captive market or already established distribution networks.

“Whoever becomes our partner will get all of China’s market,” declares Li Ruyuan, general manager of the Shenyang No. 3 Rubber Plant, opening up a glossy brochure printed in both Chinese and English to court foreign investors. “There isn’t anybody else.”

The plant makes tires for airplanes and military vehicles, and bulletproof wheels for the Red Flag limousines once favored by Mao Tse-tung. The client list includes steady customers like McDonnell Douglas, which can pay a premium for the hard-to-get products.

It is doing well--paying its employees and repaying its loans on time. But along with the plant’s promise come a few difficulties.

Li doesn’t just operate a company, he runs a small village. In addition to its 3,000 employees, the firm is responsible for 382 retired workers still receiving pensions and medical payments and thousands of family members with housing, health care and school expenditures.

“We have a social role, not just an economic one,” Li says, “but it makes it much harder to compete” with newly formed township-based lending enterprises that do not have the flotilla of dependents affecting the bottom line.

While those like rubber plant manager Li, entrepreneur Shen and the Zhangs on the street show a willingness and drive to find ways to survive, many other people are clinging to the state system for survival, particularly retirees with no other means of support and unskilled laborers.

The state remains China’s political and economic backbone, a means of providing social welfare but also a way to exert social control. In facing reforms, the government must calibrate how many benefits it can afford to take away before people protest--and how much control it can afford to give up.

The state banks, meanwhile, are beginning to face competition, and some say that is the only way to pressure them into reform. Banks will be the big losers as other financial institutions and stock markets become more powerful and consumers start demanding a better return on their money.

In Shanghai, for example, new cooperative banks free of lingering bad loans can offer better services and can make better lending decisions. They are winning depositors away from the old banks.

“Eventually, people will realize that getting 2 or 3% interest on deposits in the bank is ridiculous and will start spending money on other things or put money in the stock market,” says Daniel Lynch, a visiting fellow at the L.A.-based Pacific Council on International Policy.

The danger is that wide-scale, uncontrolled competition would cause the old banks to deteriorate.

But there are signs that the state-run banks are responding.

Although two-thirds of China’s existing bank loans are believed to be “policy loans,” the state-owned banks are now making fewer of them, according to China watchers.

Analyst Li of Goldman Sachs suggests that the safest solution would be the creation of a bank that straddles state and private sectors, to ease the system into a truly commercial way of operating.

“The banks should be privately owned but with a few well-run state-owned institutions to act as shareholders,” Li says. “Eventually the state shares can be privatized, but the path will be long and slow.

“There’s no free lunch if you want to clean up the balance sheets. The banks have to pay one way or another.”

Farley reported from Shenyang and Iritani from Los Angeles.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

China’s Debt Rises . . .

Since launching its economic reforms, China’s indebtedness has nearly doubled as a share of economic output. The only comparable example was Japan in the late 1980s, just before its “bubble economy” burst.

Debt as a percentage of GDP

1996: 93%

****

. . . as State Control Fades

State share of industrial output

‘95: 34%

Source: Nicholas R. Lardy, from his soon-to-be published book on China’s unfinished economic reforms; China State Statistical Bureau; “Growing Out Of The Plan,” by Barry Naughton