U.S. News August 17, 1998

China's new threat to the world economy

To save itself, China may worsen Asia crisis

By Steven D. Kaye and Jack Egan

When the Dow Jones industrial average recently plunged 396 points in two days, analysts were quick to cite fears over the growing Asia crisis as a major factor. But while most attention was concentrated on the latest machinations in Tokyo, where the government announced yet another economic rescue plan on August 7, recent developments in China may soon prove even more important to Americans' portfolios.

During the week that ended August 7, as the Hong Kong dollar came under increasing attack from currency traders, Hong Kong's Hang Seng stock market index tumbled by 11.5 percent to just over 7000, close to a five-year low. More ominously, fears spread that deteriorating economic conditions in China will force the country to devalue its main currency, the yuan. With the value of the Japanese yen and other Asian currencies continuing to fall, China's promise to maintain the value of the yuan is imposing a higher and higher cost on the Chinese economy, because a strong yuan makes Chinese exports more expensive than those of competing Asian countries. Yet if China does devalue, it could set off another round of beggar-thy-neighbor currency devaluations, making the Asia crisis much worse by scaring off investors and further lowering consumer confidence.

The price China is paying for supporting the yuan can already be seen in its stagnant export sector. In 1997, Chinese exports grew by just over 20 percent, but in the first half of 1998, they increased at an annual rate of only 7.6 percent, according to Standard & Poor's DRI. Most telling--in a country where selling goods abroad is the engine of rapid economic growth--exports actually fell in May, by 1.5 percent compared with a year earlier, and would have fallen more had not Chinese companies cut prices. The only thing standing between China and a huge trade deficit is the American consumer. A 15 percent fall in exports to Japan in the first half of 1998, for example, was offset almost entirely by increased shipments to the United States. But that could change, too, if the U.S. economy continues to slow or if America's record trade deficits prove to be either politically or financially unsustainable.

The strong yuan also means that Chinese producers face increasing competition from low-cost imports, including many that are smuggled into the country. As Chinese consumers find foreign-made goods becoming cheaper, more made-in-China products sit on store shelves and factory warehouses grow fuller.

Banking blues.
Adding to China's economic woes is a banking system that, by Western standards, is insolvent. For decades, Chinese banks have essentially been little more than props for unprofitable, state-owned enterprises, lending money at below-market rates and hardly expecting it to be paid back. In a banking system with about $600 billion in assets, says David Hale, chief global economist at the Zurich Group, there is now $200 billion worth of nonperforming loans. That sinkhole amounts to a stunning 35 percent of gross domestic product, according to Standard & Poor's DRI. By comparison, Japan's unrecoverable bank debt is officially estimated at only 10 percent of its GDP.

Highly susceptible to political pressures, China's banking system has massively overinvested in key "strategic" industries, such as autos, chemicals, and steel, to the point that factories in these sectors are now operating at only 60 percent of capacity. Chinese bankers have also been unable to resist squandering capital on see-through office buildings. In the Pudong development area of Shanghai, fully 70 percent of the new office space is vacant.

Rumors that the Chinese government will devalue the yuan by spring have touched off widespread hoarding of dollars. Says Gao Jie, a bank worker in Beijing, "Chinese people's eyes have opened to the fact that the American currency represents stability in a way that China's does not."

Because of the extreme damage a devaluation could do to the rest of Asia, China is under intense pressure from the United States and other nations to maintain the yuan's value. It also must consider how much a devalued yuan would discourage direct foreign investment in China, which is already declining as members of the large Chinese diaspora pull back their investments in China to cover losses related to the Asian contagion. For these reasons, most economists believe Chinese leaders will hold off devaluing for at least a year.

But there is also a good chance the devaluation will come soon. In early August, the black-market value of the yuan plunged to depths not seen since Beijing officially devalued in 1994. Says David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn.: "The real pressure to devalue will be a severe slowdown in the Chinese economy, with rising unemployment and social unrest." The Asia crisis, it seems, has only just begun.

With Bay Fang in Beijing and Frank McCoy

Reformatted for mugajava website.
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