China Trader Report, August 1999 Volume 37

Weathering the storm

world bank report offers economic strategy for china

BY PAUL MOONEY IN BEIJING

While China has not been as severely affected by the Asian financial crisis as other countries in the region, the difficulties of dealing with its main economic challenge—weakened domestic demand—has been compounded by the crisis, according to a recent report by the World Bank.

    The authors of the report, titled China: Weathering the Storm and Learning the Lessons, say that China can learn from the lessons of other countries that have experienced difficulties, and hopefully mitigate the risk of a crisis, despite “the new storm clouds that are gathering.”

    The report urges policymakers to focus on pro-growth reforms that support the development of the labour-absorbing service sector. At the same time, restructuring of enterprises and strengthening of corporate governance must remain high priorities to both tackle the corporate debt problem and release assets to productive activities. Finally, the reports says, China’s strategy needs to support structural measure that increase household demand by rasising rural incomes and providing adequate fiscal support to safety-net programes. “Increasing household demand is essential to growth recovery and to successfully transforming China into a deman-driven economy that serves Chinese households,” says the report.

    Chinese policymakers must walk a tighterpe of trying to maintain growth between two narrow extremes, say the World Bank economists. Lower growth—the greater risk in China at this time—could hamper job creation and exacerbate financeal problems embedded in the corporate sector. Higher growth could cause inflation and the need for sharp adjustments in the future.

    Growth will be affected by two major uncertainties, says the report: changes in the global environment and the extent to which the domestic economy—in particular household consumption and non state investment—responds to the government’s macroeconomic stimulus package.

    Given the large share of GDP accounted for by investment from the non state sector (16% of GDP) and rural and urban household consumption (45%), sustainable growth will depend on structural measures that can stimulate their growth. Further reliance on centrally-driven public investment as the primary fiscal instrument of reform could reduce the quality of investment, warn the authors.

    Growth in household consumption is important to both increase demand and to restructure the economy away from heavy and supply-driven investments toward a production structure that responds to market demand. The report said that the economy has begun to reflect the needs of Chinese households, but that “the legacy of past imbalances remains.”

    “Policies that encourage greater rural and urban consumption are essential to both near-term growth and the recovery and the quality of that growth,” the authors said.

    They also noted that one of the major factors constraining consumption for many households is uncertainty with respect to future income security. Creation of adequate safety nets for households experiencing temporary adjustment problems would increase public confidence in future household economic security, which in turn would stimulate urban household consumption.

    According to the World Bank, less than 0.5% of GDP would be required to fund the social protection programs already established by the government. It said that these programs must also reach fiscally distressed localities, especially if a continued slowdown continues to disproportionately affect provinces with the greatest urban-labor imbalances. The 1998 public investment stimulus program, which relied largely on traditional large-scale investments, missed the opportunity to target areas in need, the bank said.

    Should growth and employment slow significantly, adequate fiscal support for social protection programs will prove even more vital, said the authors, who urged the Chinese government to develop a contingency plan for reaching the rising number of distressed rural and urban households.

    The report urges the government to switch its focus to the more dynamic sectors of the economy, especially the service and informal sectors. The World Bank says that in other low- and middle-income countries, the service sector accounts for more than half of nonagricultural employment and two-thirds in large developing countries. In China less than half of nonagricultural employment is generated by the service sector. The authors say that slightly faster growth in this sector could add an additional 2 million jobs by 2000, reducing the job shortfall by half. They see telecommunications and tourism as two areas that are growing rapidly, and in which service activities could be expanded, adding that a wide array of other business-related activities, such as accounting, legal, secretarial, media, public relations, information technology  and communications, also needs to be developed.

    The World Bank also calls for the creation of a financial sector that serves dynamic domestic markets, arguing that the more vigorous enterprises need greater access to capital so that they can increase the returns to the large pool of domestic savings. Such access could be increased by approving public issues of debt or equity for private firms; promoting leasing; introducing a venture-capital investment mechanism; supporting development of smaller financial institutions, which traditionally serve smaller, more dynamic clients; developing over-the-counter equity markets; and expanding the corporate bond market.

    Meanwhile, enterprise reform must be closely coordinated with banking reform and capital market development. The authors urge that a framework be established for resolving bad bank debts and attracting investors. Because the bulk of loans are with the four large state-owned banks, the government has selected reform of these institutions as the key entry point for tackling the bad-debt problem. The initial impact so far, however, has been to create budget constraints on state-owned enterprises.

    Unemployment is likely to be acute in the next two to three years, say the authors, but can be reduced by strong economic growth. For example, if the economy grows by 7% a year, the expected annual urban job shortfall of about 4 million jobs could be dealt with by a sizable absorption through the informal sector. Growth of 4% to 5%, however, could have a more severe effect on employment. Even with a growth of 9%, however, China is likely to face an unemployment shortfall of 2 million jobs a year, according to the World Bank. The authors did not, however, make reference to growth figures by Western economists, who put actual GDP several percentage points lower than official figures due to what is believed to be widespread misreporting.

    The report says the unemployment figures point to the need to develop labor-intensive enterprises. Furthermore, it says that reforms that help develop the service sector, private sector employment, the urban informal sector, processing industries and non grain agricultural production are also essential to reduce the job shortfall.

    On the positive side, the bank says the labor surplus appears to be a transitory problem. If current rates of natural attrition and lay-offs continue, it says, the surplus will disappear as early as 2001, and no later than 2004.

    The report says that although the overall interest by foreign direct investors has declined since the Asian crisis, there is scope for making up the shortfall by encouraging investment in the more dynamic sectors of the economy (many of which remain on the restricted list), promulgeating the BOT (build, operate and transfer) law and other steps to liberalize foreign and private investment in infrastructure, and introducing clear enabling legislation for foreign investment to help restructure state-owned enterprises.

    China was also warned that while the Asian financial crisis showed that caution must be used in encouraging international short-term capital flows, “another lesson is that excessive restrictions over foreign participation in the provision of domestic financial services can impede healthy development of the domestic financial system.”