Wall Street Journal: Blindness Over Beijing's Economic Woes

When U.S. President George W. Bush came to Asia this week, the world' leading weekly news magazines seemed only interested in one story--the economic woes afflicting one of the countries he visited. The Economist' cover story was titled "The Sadness of Japan.". Time magazine called it "Japan' Sob Story." Both featured images of Japanese white-faced geishas shedding tears.

Nowhere was there any suggestion that China might be facing similar economic problems. Instead Newsweek' article about Japan was titled "Trapped in a Chinese Box," and suggested its problems had been made all the more acute by "China' emergence as an economic powerhouse."

The message could hardly be clearer. The two countries are utterly different--with Japan going down the tubes while China, workshop of the world in the making and recent entrant into the World Trade Organization, is bursting forth.

In fact, the problems facing both nations are remarkably similar. Both are heavily indebted, and while Japan is ahead on the curve, China is catching up. Standard & Poor', the international credit rating agency, has described both countries' financial systems as "technically insolvent." Nor do all the recent reports about how 2001 was Japan' third consecutive year of deflation cut much ice in China, which has just entered its fifth consecutive year of deflation. [2001 or 2002?]

China and Japan are also both afflicted with the problem of "parallel economies." Both have powerful export sectors, although Japan' is almost wholly Japanese-owned while China' is more than half foreign-owned. Both also have small but rapidly growing private domestic sectors that struggle against frightening odds to build businesses in spite of bureaucratic opposition, asphyxiating licensing regimes and endemic political corruption. But these capitalists are tough people and whether they are Chinese restaurateurs or Japanese operating once-unthinkable temporary employment agencies, they will not give up their struggle.

This is the first of the two parallel economies. The second consists of state monopolies, public-private partnerships that rely on bureaucratic sponsors rather than competitiveness, beneficiaries of state procurement contracts and anyone who is hooked into heavily regulated and politically driven banking systems.

These state economies do the same thing in both China and Japan. They eat cash or--to put it in economic jargon--they destroy capital. In many public enterprises in China, each yuan of investment yields just 20 cents of increased economic activity, according to recent analysis by the government' own researchers.

Yet such businesses (if that is the right term to describe them) continue to operate in both countries because of the potency of the vested interests that support them and, more importantly, because of the fear of what will happen if they are allowed to go to the wall.

The ravenous appetite of state economies means they have to be fed through deficit spending. Japan runs budget deficits as high as 10% of gross domestic product. China says its budget deficit is just 3% of gross domestic product. But the true figure is probably also closer to 10% of GDP since Beijing funds most of its deficit through politically mandated loans in the banking system and loss-making state enterprises that run thousands of schools, hospitals and other welfare institutions.

As anyone who has ever spent too freely on a credit card knows, it does not take long to run up heavy debts. At the beginning of the 1990s, Japan was a low debt nation--now it has cumulative debts equivalent to 130% of its GDP, a proportionately higher debt than confronted Italy in the early 1990s when that country was widely reported to be on the verge of bankruptcy.

Similarly, China was a zero debt nation when it started its economic reforms in 1979. Even now, the government insists the nation' debts are low. The foreign debt attributable to the state is around 10% of GDP, while outstanding central government bond issues add up to another 15% of GDP.

But in China, if you want to know the reality of the situation you also need to look under the carpet. China' banking system is nationalized. It is used to push the savings of the thrifty Chinese people in the directions the government prescribes, usually towards the state economy. This causes the destruction of capital, which shows up in the form of bad debts that are a government liability just like any other.

In 1999, China allowed its four biggest state banks to rid themselves of 1.4 trillion yuan ($169 billion) of non-performing loans. The government is paying for this with interest-bearing bonds that represent the full original value of the bad debts. Another $33 billion was given to the same banks in 1998 to shore up their capital. Together this official largesse is equivalent to nearly 20% of GDP. Most bank analysts and economists reckon that huge amounts of bad debt in other Chinese banks, plus more at the four banks already refinanced, will require the equivalent of 25% of GDP before the system can pay its own way.

Then there are the special "policy" banks that were created in 1994 to make loans to Chinese government projects, such as the development of the western provinces. The institutions have, in short order, made loans equivalent to one-sixth of all banking sector assets and paid for them by issuing around $100 billion in bonds. The loans go to projects that--even in China--no commercial bank would touch, with the liability being left to the state to carry.

It does not take long to produce a list of government liabilities in China that adds up to 75% of GDP. And that is without taking into account the problem of unfunded pension liabilities. With the pension funds of almost every Chinese province in deficit, even the World Bank--a long time admirer of Chinese economic management--concedes that unfunded pension liabilities probably amount to 50% of GDP.

The Financial Times recently wrote: "[The] paralysis partly reflects the country' tradition of consensus: It is extremely difficult for any individual or institution to impose unpopular reform." In fact, this was an article about Japan. But the problems in the two countries are so similar, that this could have been a description of either China or Japan.

Only in the next sentence, did the context become clear: "Many voters feel too comfortable to shatter the status quo"--a clear reference to Japan, as there is no popular voting of any political significance in China.

This is not an obtuse point. In Italy, the country that escaped a debt mountain in the early 1990s, it was voters who finally put paid to the Christian Democrat party and swept away much of the corruption and vested interests that were causing the debt to accumulate.

A similar escape route could solve Japan' problems, although its population shows no signs of taking it so far. But the Chinese populace does not enjoy this possibility, which should make liberal capitalists--knowledgeable as Westerners are about the political struggles that made them rich--still more nervous.

Yet outside observers are not nervous. We look at China, a country with an economy a little larger than Spain and the Netherlands combined, and call it a powerhouse. We look at Japan, a country with an economy four times the size of China' and a GDP-per-capita 30 times, and pronounce it finished.

As John Maynard Keynes once observed about stock markets: "There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world." Looking at the world' double standards in assessing the economic situation in China and Japan, one can only imagine that he would have laughed his posh English laugh and said: "I told you so."

Mr. Studwell is editor of the China Economic Quarterly and author of "The China Dream: the Elusive Quest for the Greatest Untapped Market on Earth" (Profile Books, 2002).