As China experiences a generational change in leadership and its economy adapts to the realities of WTO membership, this is a most appropriate time to be re-examining its future, the investment opportunities and potential pitfalls there. China is the success story of the moment, the decade and despite innumerable, well-known challenges that I will mention shortly, the story has legs. Indeed, it is about the only global growth story left at the present time.
Napoleon referred to China as a sleeping dragon, saying that when China stirred the world will tremble and concluded - let China sleep!
As we all know, the dragon awoke from his slumber almost 25 years ago, he has momentum and the world is trembling, sometimes perhaps a little in fear of the possible economic and political consequences, but more often in anticipation of the opportunities presented by this no longer crippled giant.
Is the growth sustainable?
Predicting the future accurately and consistently is a virtual impossibility. It is said that those who gaze into crystal balls tend to end up living on a diet of broken glass. Soothsayers are also advised to look far into the future and predict frequently whilst providing a time or a price - but never both at the same time. Over the years many have tried and many have failed. One recalls Herman Kahn's books on thermonuclear war over forty years ago - thankfully not yet realised - and the Club of Rome's ludicrous predictions on natural resource scarcity 30 years ago. Despite all those caveats, it is irresistible to try.
A few years ago, the Asian Development Bank, in conjunction with the Harvard Institute, published a book on how Asia might look in thirty years time. I thought then, and still do, that it had some very useful insights.
The book correctly pointed out that in 1820 Asia accounted for 40 percent of the world's GDP. But that was a time when China had entered its long withdrawal from the world, Commodore Perry had not visited Japan, the United States had not purchased Louisiana or Alaska and Britain was fast industrialising.
As Europe and the United States industrialised, Asia's share of global GDP entered a long period of relative decline - despite Japan's turnaround after the Meiji revolution - until it reached 19 percent in 1950 in the wake of the second world war, the ending of colonisation and the end of the Chinese Civil War that had turned that country inside out for the first half of the 20th Century.
In May 1997 when this book was published Asia's share of world GDP had climbed back to 31 percent. With a combination of heroic but plausible assumptions the authors believed that Asia's share of world GDP could climb back to around 40 percent by 2020-25 - an incredible round trip of 200 years. In essence, Asia would be re-establishing its pre-industrialisation global position in a post-industrial world.
Needless to say, China's continued growth, accompanied by a sustained pick- up in India's growth rate, played vital roles in these predictions.
As might have been expected, within 2 months of publication Murphy's Law seemed to question severely the validity of these predictions on the head, when the Asian crisis hit the region setting off a real hiccup in the growth rates of Korea and the South East Asian economies.
In reality though the broader prediction of a growing economic and eventually political weight for the region has not been derailed by the crisis. China and India with their continental-sized economies have continued to prosper and enjoy trend growth rates. South East Asia and Korea have both bounced back to rates that whilst slower than pre-crisis are still respectable by any absolute standards other than their own over-hyped unsustainable pre-crisis levels. Most importantly, their bounce-back has been aided by the strength in China's economy with which their ties grow steadily. The recent ASEAN summit with China and the talk of a free trade agreement between the two are signs of this growing Chinese power.
China clearly represents a very different challenge and opportunity than other so-called emerging economies: the very size of the country, its population and history as the centre of learning and science in the past, place it in a different category: it is a re-emerging country if you will.
It is less than a generation since the Maoist revolution ended and China began it efforts to move from a centrally planned economy to an essentially market oriented system. The first moves were to free the peasants from collectivisation to one of household responsibility with the expected huge beneficial effects on output.
On the industrial side, China first permitted the establishment of a vast variety of small-scale enterprises and allowing foreign direct investment by multinationals in an expanding range of sectors. It has begun a gradual policy of privatisation of state-owned enterprises.
The result has been a quadrupling of GDP since liberalisation began in 1978. China with a per capita GDP (on a PPP basis) of about US$ 4,300 has the second largest economy in the world - a level that places around or above the level of the proposed new entrants to the European Union. It is now the destination for the majority of all FDI in the developing world.
The overall outlook for a continuation of these trends is definitely optimistic. However, before commenting on the substantive issues facing China let me first make a comment on China's statistics.
Chinese Statistics
Whilst this might seem a peculiar off-subject issue to raise, questions are often asked about the accuracy of China's economic statistics.
How realistic are they? Is it feasible to produce accurate GDP statistics within days of the ending of the quarter and to more-or-less within a decimal place of what the planners had predicted. And to do it at a time of unprecedented upsets in the global economy.
Questions have been raised by the divergence between economic growth figures and energy consumption, two series that normally track each other closely. In short, the implied question is whether China is another Potemkin village as Professor Paul Krugman once claimed - quite wrongly as it turned out - Singapore's success to be?
The answer, I believe, is quite simple. The statistics are, of course, unreliable. That is hardly unique; all Government statistics, everywhere, must be taken with a healthy grain of salt. Indeed, the whole US so-called productivity miracle of the 1990s was based on flawed statistics. But the transformation of the Chinese economy, whilst still a work in process, is definitely real.
More accurate statistics are needed and the leaders know it. As an imperfectly transformed planned economy, the economy maintains areas of enormous inefficiency in the state sector and, as a result, the present inaccurate statistics overestimate growth, underestimate unemployment and provide a considerably rosier glow on the economy than justified. This glow, of course, helps encourage the flood of foreign investment. The problem, as always, is getting from here to there. Coming clean with the statistics and showing a country growing slightly slower than portrayed to the world might weaken investor confidence in the short run and thereby reduce its attractiveness as a location for FDI, an essential element to China's transformation. But, conversely, if confidence is to be maintained and the correct policies developed and implemented, improvements in the statistics to present the true picture are essential before too long.
Future Challenges
Growth, however measured, does not make challenges disappear. It merely transforms old ones or produces new ones. At one time China lived in fear of famine and the resulting social instability. Freeing the peasantry and two generations of peace has removed the fear of famine. However, the fear of social instability is still a key motivating force of China's policy makers and planners.
China has vast and growing reserves of unemployed and underemployed in its western rural regions and on the payroll of unprofitable state-owned enterprises. The unprofitable state-owned enterprises are indeed a warehouse for further hidden underemployment.
The transformation of the economy and entry into the WTO are only increasing the scale of this unemployment and underemployment. To show you the size of the challenge facing China, the Ministry of Labour and Social Security estimates that China will have 20 million urban unemployed in a few years together with 150 million surplus labourers - almost 25 percent of the available workforce. China produces only about 8 million new jobs a year whilst 12-13 million enter the workforce to add to the stock of 7 million urban unemployed, 5 million laid off from SOEs and the 150 million surplus rural workers.
To address these issues China needs several things to maintain its growth and stability:
First: Good employment-creating private sector growth to counteract those fleeing the rural areas and let go from bankrupt state owned enterprises. At present, bankrupt SOEs are on life support from the banking industry, creating a mountain of bad debts. The good news is that the private sector has moved from zero to perhaps 60 percent of GDP in the last two decades.
Second: An effective social security system not tied to company employment. At present, those who lose their SOE jobs lose their health benefits and pensions, creating a dissatisfied army and potential source of instability.
Third: An effective credit based banking system as opposed to today's directed credits to zombie companies.
These issues are obviously inter-related and one cannot be solved in isolation of the others. The scale of the problem is huge and cannot be underestimated.
With China's entry into the WTO and the consequent liberalising of agriculture it is difficult to underestimate the scale of the problem. Growth of New Deal-style public works schemes particularly in the poorer western regions seems one likely gambit. But the authorities are also reportedly modernising and building-up the training and equipping of riot police as a precautionary measure.
The domestic banking system is in poor shape. Whilst all figures should be treated with some scepticism, non-performing loans in China continue to grow and are now estimated by Ernst and Young around 45 percent of GDP, the highest in the region and this compares with 38 percent in Thailand, 25 percent in Korea and 15 percent in India.
As a result of the seemingly intractable difficulties of the domestic banks, the authorities are increasingly keen on the entry of foreign banks, which, in any case, is required by WTO membership. Ultimately, a credit culture needs to be developed. Another key to financing future development is the growth of the capital markets and the insurance industry, which has a vital role to play in the provision of social security.
Problems there may be aplenty in the financial sector. But these also represent opportunities for overseas companies with experience of debt restructuring. After all, it is hardly a problem unique to China. The most exciting stories of economic development, including Britain and the US in the 19th and 20th centuries are one of economic progress interspersed with temporary financial challenges. As recently as 12 years ago the US had to bail out many of its own banks and savings institutions. It is far from impossible that the same will occur there again should the present slowdown in the US be more protracted than presently expected.
Other challenges:
China's political development has not proceeded alongside its economic liberalisation. Whilst this may not be a problem at this time, it is one for the future since experience elsewhere shows that an increasingly affluent and educated population will demand more rights if, and when, their economic progress is threatened. Indonesia, post Suharto is just one example of this phenomenon. As the party undertakes its generational handover it must be hoped that there will be continued attempts to experiment with more democratic procedures at the lower levels of government. As these are successful, they can be expanded.
Regional stability, both economic and military is an area where China's voice and vote is growing with its economic might and its integration with the region. At a parochial level, the eventual status of Taiwan remains the great-unresolved question. It has been so for years and will presumably remain much the same as today well into the future. It is the greatest source of tension between the US and China. But on the economic front, which is our concern, China has played an effective and very productive role in the Asian crisis. China's tie-in with the region increases all the time as the Chinese
Summary
As stated earlier, China is the ongoing story of this decade and the challenges are there to be overcome. They represent enormous opportunity for investors alongside the risk. China, with its vast reserves of trainable labour, is becoming the factory to the world. The industries affected are all the way from the traditional low labour cost industries such as textiles and metal bashing to increasingly high tech and knowledge based industries in the new economy.
For portfolio investors, the securities markets are also developing rapidly and before long will represent a very real opportunity for Western investors. At present corporate governance practices are still inadequate and valuations excessive because of restrictions on capital flows. The best valuations at present are probably Hong Kong based and listed companies with a primary focus on the Chinese market. But the Chinese authorities are determined to make Shanghai Asia's premier financial centre and, as the local currency becomes convertible in the next few years, the Shanghai market will almost certainly become much more attractive. As corporate governance and regulation improves, Hong Kong financial centre will face increased challenges to remain competitive.
It is also interesting to note that the first Chinese Gold and Silver Exchange opened earlier this month in Shanghai. China with one of the largest volume of foreign exchange reserves in the world (over USD 250 billion), mostly in US dollars, has started to build its gold reserves as a diversification move. With their well known likeness for gold, the Chinese, as they grow wealthier, they are likely to increase their investment in gold from the present extremely low absorption rate of less than 0.1 gram per capita.
At the same time, China is set to play an ever expanding political and economic regional and, indeed, global role. This process should be largely independent from the expansion of global trade and investment. Neighbouring countries will have to adjust to its expanding power and develop niche areas to remain competitive and service this expanding giant: to give one small example, tourism in Thailand is set to adapt to the rapid expansion of Chinese tourism.
The main risks are in the US- Chinese relations and, in that respect; Chinese- Taiwanese developments will be a key element. These, in turn, will be affected by internal political developments and power struggles between factions within China.
In these, as in other ways, Napoleon was correct; China's continued growth will have an enormous impact on global markets and politics - probably mostly beneficial - in the coming decades.
