May 2001
Challenges Facing China's Market Reforms 

China’s entry into the World Trade Organization has been repeatedly delayed for political and practical reasons. While China deserves praise for the economic reforms it has already undertaken, myriad issues await attention, including industrial-sector restructuring, development of a private financial sector, policies toward foreign direct investments, and viability of the current exchange rate system. On May 3, AEI hosted a panel featuring commentary from finance and economics experts on China’s attempts to further integrate itself into the world economy.

The Chinese government has created an environment that is hostile toward the development of a healthy private financial sector. Laws and a tax system favoring state-owned enterprises over private corporations challenge the nation’s transition into economic modernity. While the private sector often avoids many forms of taxes, it faces nontax financial burdens in the form of fees. The government has been working to convert fees to taxes, but with limited success.

In addition to offering few tax incentives for forming private companies, China has taken a flawed approach to privatizing state-owned entities; it has turned them into corporations but is reluctant to transfer ownership to the private sector. "Corporatization" causes an overallocation of credit resources to the state-owned enterprise sector while the private sector has limited access to credit, and it causes state-controlled enterprises to be listed on the stock markets as minority shares, which prevents a market for corporate control from emerging.

All of these things lead to higher agency and expropriation costs, which in turn lead to negative economic value added, a concept now used by some Western institutions to measure financial performance. Additional difficulties stem from corruption, the skewing of the taxation system, and a weak tax base, which forces the government to use highly repressive tax-collecting techniques to squeeze out more revenue.

Both private and state banks do poorly in this environment, but the regime is particularly hostile toward banks not owned by the state. Those banks are taxed heavily, and relief for legitimate business expenses, such as write-offs of nonperforming loans, is rare. In addition, interest rates are regulated on both the loan and deposit sides.

How do you run a bank in this kind of environment? You cannot price your products by risk because interest rates are regulated, and you cannot retain your capital because it is leeched out by the oppressive taxation system. You must compete against major government banks that are not held accountable for the cost of capital. What are the consequences of such a banking system for the private sector? The market for corporate finance has been artificially suppressed. Private-sector companies must finance their own activities through their retained earnings rather than from loans, and the sector is starved of banking services because the banks themselves cannot provide them.

China favors markets that generate revenues for the government while preventing a market for corporate control from emerging. It suppresses markets that would provide corporate access to direct finance, and it overtaxes the financial sector, which prohibits the nonstate sector from building capital.

To reverse this course and strengthen the private sector in China, banks should be allowed to generate fee business through corporate debt trading and loan trading, which would provide greater flexibility in releasing long-term loans with higher interest rates to corporations. Corporate debt trading and loan trading would allow banks a wider range of fee-based business, such as insurance brokerage and mutual fund brokerage, that would in turn garner more profits for the financial sector.

China’s entry into the WTO is hindered by domestic economic weaknesses. While the nation is progressing toward integration into the world economy, economic reforms are still needed to enhance growth in the often-neglected private sector.

A discrepancy exists between the progress of China’s external and internal reforms. While investors commonly view China’s economy as tightly controlled and closed to outsiders, China is in fact heavily dependent on foreign direct investment (FDI). FDI has prompted the growth of external trade by encouraging foreign traders to acquire assets that must be contained and managed within the Chinese sphere. Despite China’s reliance on FDI and foreign investment, the country’s domestic private sector frequently receives less attention from policymakers. Logically, the Chinese should trade with themselves first and then with foreigners; however, this situation is uncommon in China. In fact, the Chinese prefer not to trade between themselves because local governments have erected trade barriers against each other that promote isolation of commerce. While external trade barriers currently are disappearing, these internal barriers remain in place.

Whether the FDI strategy will prove beneficial for China’s political and economic arenas remains undetermined. The odds of eventual success are unfavorable, because in the past domestic interests have been sacrificed in favor of foreign concerns, thus creating bureaucratic difficulties when the foreign presence is eliminated. Likewise, current policymakers worry that a dangerous level of economic dependency on foreign countries will cause an unpredictable and unstable political situation.

Speculation is circulating in China that the leadership seeks membership in the WTO only to push internal reforms. In theory, these reforms would occur as foreign management restructures economic firms to become more efficient. However, restructuring would mean an inevitable firing of workers that would in turn cause an eruption of tensions in the labor force. The strategy of inviting foreigners to control firms and assume the political burdens associated with irate workers is unwise because it will force China to constantly cater to the desires of its nationalists.

Presently the WTO is considering adding labor standards and environmental regulations to its repertoire of potential reforms. With these changes in policy, the organization appears to be evolving into a social, rather than economic, institution. The WTO’s facelift into a social organization would conflict with China’s interests, thus providing another reason for decreasing support of China’s membership in the WTO. Joining the institution would also present foreign policy problems for the country, as the concessions promised by the WTO are so vast that they would be impossible to fully implement. China would be held responsible for this incomplete implementation, hindering the nation’s economic progress.

The Chinese economy has undergone an incredible transformation in recent years: Central planning has been replaced by a market economy with a rapidly growing private sector, and even state firms operate in a different fashion than in the past. But the Chinese economy has experienced declining efficiency, in part because of the lack of separation between state firms and state banks. State firms, rather than private ones, continue to command the bulk of intermediated capital in China today.

China’s government, like those of other developing Asian states, has focused on state intervention in the economy and has been reluctant to relinquish its control on the financial front and the ownership front. Political leaders have been reluctant to reform the financial and state sectors because they fear the unemployment that might result during the transition to capitalism. Such problems make it seem as if China is a socialist nation simply in need of capitalist leadership.

Eliminating political problems, however, would not erase the economic paradox China presents to the world. In reality, some of China’s political problems already have disappeared. We see a government willing to push for reforms that have led to unemployment. We see a government that acknowledges its financial problems and that is implementing institutional reforms based on American debt restructuring. Yet we fundamentally do not see progress, and the question is why.

The China paradox stems from a deep yet idiosyncratic faith that many Chinese policymakers have in markets. When those policymakers talk about the market mechanism, they make assumptions and expectations that are quite different from those made by Americans. The West commonly accepts the view that the market is a mechanism for allocating resources: The market takes resources from low-return uses and redistributes them to high-return uses. In the process, we see producers enter and exit frequently. (The extent to which governments protect the losers in this process differs greatly, so a variety of capitalist and welfare states are beginning to emerge.)

An alternative notion is popular in China, in which the market is a set of incentives applied to the firm. If applied correctly, the firm should theoretically perform better. In fact, every modern enterprise, if exposed to the treatment of the market mechanism, should do better according to this view. Everyone should prosper with the rising tide of markets.

Throughout the reform process, China has allowed the private sector to grow, but in core areas, such as the state banking sector and the state industrial sector, we see repeated cycles of so-called market reform policies aimed at strengthening all of the companies within that sector. The response at the enterprise level always fails to meet those expectations. The government response is not to eliminate the poorly performing firms, as would happen in Western-style markets, but rather to toss out the poorly performing policy and try a new form of competition. With each rotation of this cycle, we see more capital allocation problems. A new form of competition has entered China’s markets of late: foreign competition. For all of the concern in China about competition induced by the WTO, there is the usual implicit expectation that the major firms, the core industry, will rise to the challenge of foreign competition.

The Chinese notion that markets will salvage all enterprise has kept the country from eliminating low-return financial products and returns. Although the level of nonperforming loans in the banking system is high, China has put off resolution of bad debt and commercialization of financial flows. According to the Western concept of allowing the market to winnow out the low performers and replace them with the high performers, the cost of undoing these flows will increase over time and the problem will grow rather than recede.

On a final note, we tend to view China as a special case of a transitional or postsocialist economy. But many of the problems China faces and its way of coping with markets might more resemble Japanese behavior, or what we consider a market-oriented, developing-oriented, or fully developed economy. China should be envisioned as being part of that category, as opposed to simply a case of a socialist system that just needs to become accustomed to markets.

Positive growth in the Chinese financial sector for state-owned banks is a recent and pleasing development. Banks now operate in an unprecedented environment of deregulation that should lead to more profits because of the easing of fees that previously prevented banks from accruing large profit margins. The margin between what banks pay to depositors and what they collect from borrowers has reached a historic high. In addition, the amount of lending to new borrowers and the rise of profitability of the mortgage business continue to increase.

However, negative growth also exists in the financial sector. The financial system has declined modestly in recent years because taxation prevents smaller banks from building capital fast enough to compete with the traditionally big state banks. Thus, a lack of competition hampers the market. A lack of improvement in profitability and performance and a low return on assets in the banking sector contribute further to negative growth.

For both large and small financial institutions, the reduction of bank employment remains unresolved. Banks continue to accumulate high costs each year because they maintain unnecessarily large levels of employment. A reduction in bank staffing would be the easiest way for banks to reduce their costs and produce better commercial results.

The big banks also have a number of nonperforming loans. As analysts examine the Chinese financial system, they wonder whether the problem of nonperforming loans might be largely a historic one that, if resolved, would easily clean up the financial system. The fault, however, might alternatively lie with a problem of flow: Loans made in the past two to three years, when banks operated on a commercial basis instead of being the treasury for the government, have also gone bad.

Over time, banks must work to finance the huge amount of nonperforming loans, which are now divided between the big banks and the newly created asset management companies. The leadership must find a new method of financing the venture of nonperforming loans that does not draw on household savings in order to compensate for their losses.