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BUS 487 - POLITICS AND ECONOMICS AND DEVELOPMENT
Professor Marvin Zonis




Courtney Bickert

Isabelle Bonneau

Prashant Gandhi

Anthony Haro

Sastry Penumarty


APRIL 2000


ACKNOWLEDGEMENT

We would like to thank our sponsors, who made our trip to China possible:

CNA

DEUTSCHE BANK

DIAMOND TECHNOLOGY PARTNERS

PFIZER

TABLE OF CONTENTS
I. INTRODUCTION 1

Objectives and approach 1

Trip Overview 1

Summary of findings 1
II. A BRIEF HISTORY OF ECONOMIC REFORM IN CHINA 2
III. ANALYSIS OF FIRST TIER ISSUES 3

Political stability 3

Reform of State-Owned Enterprises 5

Banking Reform 6

Development of the West 9

WTO 11
IV. ANALYSIS OF SECOND-TIER ISSUES

Foreign Direct Investment 11

Domestic Private sector growth 12

Corruption 13
V. THE FUTURE OF HIGH TECHNOLOGY IN CHINA 14
VI. OVERALL CONCLUSIONS 15
EXHIBIT A: ITINERARY

EXHIBIT B: CHINA CONTACT LIST

EXHIBIT C: Year-to-Year Change in China’s GDP


Exhibit D: Profitability of State-owned enterprises

Exhibit E: Estimate of the Bank Restructuring Costs(*)

Exhibit F1: Aggregate Balance Sheet of the State-Owned Banks as of June 1998

Exhibit F2: Aggregate Balance Sheet of the State-Owned Banks as of June 1998


EXHIBIT G : TRENDS IN FDI IN CHINA

EXHIBIT H : GEOGRAPHIC CONCENTRATION OF FDI IN CHINA

EXHIBIT I : BIBLIOGRAPHY



I. INTRODUCTION
Objectives and Approach
The purpose of this study was to ascertain both the short-term (12-18 months) and longer-term growth (3-5 years) outlook for China, and to identify some key challenges that lie ahead. The report begins with a brief history of economic reform in China in order to provide a context for current and future economic trends. We then dive into what we have characterized as first-tier and second-tier issues affecting China’s future growth. The first-tier issues include political stability, reform of State-Owned Enterprises (SOEs), banking reform, development of the west, and the effect of China’s entry into the WTO. In addition, foreign direct investment, private sector growth, and corruption will also impact China’s short-term growth although to a lesser degree. Therefore, we have categorized these as second-tier issues. Finally, given all the recent hype and publicity, our report also addresses the future impact of the high-technology industry in China.

From an expenditure approach, any nation’s GDP can be expressed as being the sum of consumption expenditure, government spending, fixed asset investment and net exports.1 Our report will not only explain why we think the chosen set of variables issues are important, but it will also tie their effects back into this fundamental identity.



Trip Overview

Our team consisted of five 1st and 2nd year MBA and IMBA students from the University of Chicago. In order to ascertain the future prospects and to closely study both the first and second-tier issues, we visited four cities, which have several unique attributes. Specifically, we visited Hong Kong, Xiamen, Shanghai and Beijing (Exhibit A). Hong Kong has for many years been a key player in foreign investment in China. For instance, much Taiwanese investment in China flows through Hong Kong. Xiamen is a Special Economic Zone (SEZ), which has special policy rights to foster industrial development and foreign investment. Shanghai is home to the first Special Economic Area, Pudong, where the central government is making targeted investments to build up infrastructure that will attract foreign and local investment. Shanghai is also widely regarded as the economic capital of China, as well as a future competitor of Hong Kong. Finally, as the capital, Beijing is the center of national and international politics. In total we conducted over 35 meetings with a broad cross-section of people, including: government officials, representatives of US and European MNCs, Chinese business school students, industrialists, e-commerce entrepreneurs, bankers, economists, journalists and representatives of the US and French embassies (Exhibit B).



Summary of Findings


The officially reported GDP growth rate in China has been around seven percent for the last few years. We believe that China’s economy will continue to grow at about the same rate in the next two to three years. Our team predicts that the economic growth will accelerate a little to around 7.5% in the next 12 months due to resumption in investment and export growth. The fixed-asset investment growth, which slowed significantly in 1999 is expected to pick-up again in 2000 owing to the official launch of the Western Area Development Program and increase in foreign direct investment. Also, net exports are most likely to increase with China’s entry into the WTO. In addition, political stability will be maintained, allowing for economic growth to continue at its current pace. SOE reform will also contribute positively to short-term economic growth, but, in the long term, this impact will be tempered by the decline in consumption caused by the massive layoffs required for restructuring. The positive impact of banking reform is also likely to be felt more strongly in the longer term (7-10 years) as reforms are completed.

In the longer-term beyond 2-3 years, we believe that the economic growth might moderate if the central government’s direct investment capacity weakens. The debt-to-equity swap program run by AMCs may not be as successful as government expects, while the program may engender some new bad loans. Finally, the long-term difficulties in resolving the unemployment problem during the economic transition period as well as the ensuing social instability in rural regions may also contribute to the slow-down.

We also believe that investment in China is still quite risky for foreigners. The government is aiming to use foreign investments and partnerships to increase exports, improve human capital, gain access to up-to-date technology, and develop the western regions. These goals are not always compatible with those of the average foreign investor, possibly leading to complications. For instance, MNCs attempting to gain domestic market share in China seem to have more trouble with the government than do firms aiming to export their products. In addition, the rule of law in the business sector is weak making it difficult, if not impossible, for investors to recoup money lost through corruption. While the risks are quite high, the returns to investing in China can also be high. Many MNCs have established extremely successful business ventures in China. The Chinese economy will continue to grow and over the long term market reforms will be largely successful. In conclusion, investment in China is risky, but if it is for the long-term, the payoffs are likely to be very high.

II. A BRIEF HISTORY OF ECONOMIC REFORM IN CHINA


For centuries, China’s economy was based primarily on agriculture. In 1949 the Chinese Communist Party (CCP) came to power and founded the People's Republic of China (PRC). The Party leaders decided to focus on the development of heavy industry as they saw this as the means to achieve a self-contained industrial economy. Self-containment was important because of the high level of uncertainty due to the Korean War and China’s military confrontation with the Nationalist Party in Taiwan.

While this development strategy was extremely capital intensive, China’s economy was quite poor. This imbalance between China’s goal and the availability of resources made it impossible to accelerate t economic development through market mechanisms. Therefore, the CCP adopted a planned economy and created institutional arrangements to lower the barriers to the development of heavy industries, i.e., low interest rates, depressed product and factor prices, and a central resource allocation system. While this system quickly established a relatively complete industrial structure and likewise led to economic growth resulting from massive investment (Our research revealed that China’s annualized GDP growth between 1953-1978 was close to 6%2), the costs associated with economic inefficiency were extremely high. For instance, there were no links between the expansion of an enterprise and its economic efficiency, or between workers’ income and their productivity. This lack of incentives severely suppressed productivity and resulted in low economic efficiency.

Beginning in 1978, the CCP, under the leadership of Deng Xiaoping, established a national objective of modernizing agriculture, industry, defense, and science and technology. Since 1979 China’s economic reform has gone through three main phases. The focus of the first phase (1978-1984) was to increase the economic efficiency of all industries by improving the incentive structures. During this period total agricultural output increased by 42 percent.3 The primary goal of urban reform efforts during this phase was to increase enterprises’ autonomy. The objective of the second phase of reform (1984-1991) was to improve resource allocation mechanisms. The main focuses of the reforms were (a) the material management system, (b) the foreign-trade management system, and (c) the banking system. The third phase of reform (1992-present) has focused on the macro-policy environment, including the reform of pricing, exchange-rate and interest-rate policies.

The results of these reform efforts have been astounding. The annual GNP growth rate between 1978-94 averaged about 10 percent,4 which is far higher than the world average of 3 percent during the same period. In addition, the per capita annual income of rural residents rose from 133.5 yuan to 1,220 yuan between 1978-94 with an annual growth averaging 8.25 percent (3.5 times the worldwide average annual growth between 1952-78). However, the growth of the Chinese economy has slowed a bit in the last five years (Exhibit C). Some economists have argued that the first two decades of reform reflected “catch-up” growth for China, and that the country has “run out of easy things to reform”5.
III. ANALYSIS OF FIRST TIER ISSUES
Political Stability
Political stability in China can be defined as the continuance, in the next five to ten years, of the existing governance systems at the federal, provincial and local levels. The government should serve a strong coordination and control function. It is also important that the leadership continue its commitment to economic reforms.

Political stability in China will have a strong impact, direct as well as indirect, on the GDP growth in four main ways. First, it will ensure steadfast commitment to economic reforms, even in the face of short-term challenges. Second, it will help maintain strong consumer and investor confidence in the economy. Third, it will provide a foundation for continued government infrastructure investment. Fourth, it will bolster the development of a strong legal system and minimize problems such as corruption and smuggling. Despite numerous challenges, there are no significant threats to political stability, in the next 1-3 years.

Though it is unlikely that there will be any major shift in the political system in the next three to five years, there are several challenges that the government will have to deal with. One potential threat to stability is a change in the leadership in Beijing.6 Many members of China’s current leadership are septuagenarians, who rose up the ranks of the Communist Party and had taken part in the 1949 revolution. In late 2002, the Chinese Communist Party will hold its 16th National Congress. At that time, all the first-tier members of the current leadership hierarchy are expected to make way for a younger leadership team. Among the leaders whose current terms could expire, in late 2002, are President Jiang Zemin, Premier Zhu Rongji and Chairman of the national legislature, Li Peng. These younger people are believed to be less ideologically shackled than their elders, and so can be expected to increase the pace of current reforms, many of which are in fact designed to strengthen the CCPs grip on power.

In addition, there is a threat from social unrest. The SOE reforms have caused massive unemployment. According to recent statistics from the Ministry of Labor and Social Insurance7, newly laid-off workers in 1999 totaled 56.4 million, while the total laid-off workers in urban areas alone reached 117.4 million. The real unemployment rate in urban areas has reached 8.2% (end of 1999), although the registered unemployment rate was only 3.1%.

The SOEs used to provide health insurance, pensions, housing, and education to their employees. In the absence of an adequate social safety net, many of these benefits have either vanished or decreased substantially since the layoffs. Even though the Chinese government has stepped up its efforts to create a social safety net and has increased the total benefits to the unemployed workers, these efforts are insufficient. With the target to complete SOE reforms within the next three years, these problems will only worsen.

The disgruntlement of these SOE workers poses the most significant threat to China’s political stability in the near-term. There have been numerous reports of protests of street protests and violence across China, especially in the northeastern and western provinces.

Falun Gong8 has also been seen as a threat to the political establishment. Falun Gong is a religious sect that teaches meditation, breathing techniques and self-discipline. While there are numerous such sects in China, Falun Gong is one of the largest with reported membership from 2 million (Chinese government figure) to 100 million (Falun Gong leadership). The membership of Falun Gong consists of intellectuals, laid-off SOE workers, and farmers. In June 1999, about 10,000 Falun Gong members quietly surrounded Beijing’s Zhongnanhai leadership compound. Since the Zhongnanhai incident, Falun Gong has been banned and most of its key leaders have been arrested. Li Hongzhi, Falun Gong’s founder, lives in exile in New York.

Finally, China-Taiwan relations play a significant role in China’s politics. The election of Chen Shui-Bian as President of Taiwan has only intensified China’s sabre-rattling towards its neighbor. The United States government’s close relations with Taiwan combined with the Chinese government’s avid interest in reunifying Taiwan with the mainland make for a lot of tension in the region.

Despite all the above challenges, China’s political stability is in no imminent danger. The reasons for our conclusion are three-fold. First, the Chinese government is aggressively addressing the problem of social unrest by boosting the benefits to the laid-off workers and setting up programs to re-train them. Even though it is not entirely clear that these measures will be adequate in the long-term, they are sufficient for the short-term. Second, the Falun Gong has been banned and most of its key leaders have been arrested since the Zhongnanhai incident. There is no serious threat from these organizations and addressing the economic problems in the country will alleviate whatever tension there is. Third, both China and Taiwan have made some concessions and have indicated a willingness to hold talks. Similarly, the president-elect of Taiwan has announced concessions, saying that he is open to discussing anything (however, Chen has pointedly not agreed to the One-China framework). Therefore, the Taiwan issue does not pose a significant threat to political stability in China in the short-term. However, it could definitely play a very important role in the medium and long-term.
Reform of State-Owned Enterprises (SOEs)
State Owned Enterprises (SOEs), are a main driver of the Chinese Economy as they represent one third of China’s GDP. The other two-thirds consist of the collective economy and the private sector in approximately equal proportions. SOEs also employ a large portion of the population. Effective reform of the SOEs will have a positive impact on the GDP through more efficient allocation of resources gradually over time. This positive impact will be offset, however, by declines in consumption associated with the massive layoffs required for restructuring.

SOEs (mostly large industrial firms) have proven to be extremely inefficient, accumulating debts, in some cases just to pay wages (bad debt is estimated to represent 30 to 60% of the total amount of debt of SOEs). Overwhelmed by the financial burden and willing to develop the market economy, the Chinese government intensified its policy of SOE reforms in 1997.

In pursuing reform, the government has to balance between two potential pitfalls. On the one hand, it has to conduct the reforms fast enough to avoid further debt accumulation and to enable the economy to develop. On the other hand, since SOE reform will lead to massive layoffs, restructuring too rapidly could cause increased political instability and result in a deep crisis for the whole economy by slowing down consumption.

In order to avoid these two pitfalls, the government is conducting the reform progressively. Rather than shutting all non-profitable SOEs at once, the government is restructuring them industry by industry and/or geographic area by area. The policy is to try to make the SOEs profitable through reorganizations and/or collaboration with Western firms. For example, SOEs in the aerospace industry now subcontract with Airbus and Boeing to both improve their profitability and acquire up-to-date technology. If the SOEs do not show a potential for profitability, they are usually closed. Any restructuring or closing involves layoffs. The aim of this step-by-step approach taken by the government is to allow enough time to create new jobs to absorb the surplus labor. China’s entry into the WTO will put additional pressure on the Chinese Government to accelerate SOE restructuring, but it will also provide an explanation to the public for the painful reforms.

There are several factors that may cause SOE reform to fail. First, the government may not manage to maintain political stability in the face of the massive layoffs. As mentioned above, the situation of the unemployed is worsened by the fact that workers lose their social coverage when they are laid off. The government has managed so far to contain the numerous protests happening around the country, but social unrest due to unemployment could hinder SOE reform.

Furthermore, the lack of management skills among SOE leaders could be a barrier to successful SOE reform. The current top managers of SOEs do not have skills to work in a market economy as they were trained in the Communist era. According to some of our interviewees, SOE managers are focusing their “restructuring” efforts on diminishing costs rather than on increasing revenues. Not only does this mean that the underlying unsuccessful structures of these enterprises remain unchanged, but it results in additional layoffs. On the other hand, there is some promising evidence that some of the SOE managers are beginning to focus on increasing revenue (i.e. aerospace ventures mentioned above)

Finally, SOE reform in many geographic regions in China may be hindered by a lack of skilled labor and insufficient infrastructure. According to one of our interviewees, only five percent of the Chinese population has a university-level education and most college-educated citizens live in urban areas. One interviewee told us of a visit to a small western town in which he could not find anyone on the street who could read a set of directions in Mandarin. Moreover, those who do have skills leave the rural areas in search of better opportunities in urban areas. Finally, the lack of infrastructure development makes it fundamentally impossible for rural enterprises to increase their access to inputs or to expand their markets beyond the immediate area. Therefore, SOE reform outside of the major urban centers will be very challenging.

Despite these difficulties, some efficient restructuring will take place in the coming three years. This will be driven by the government’s strong commitment to reform as well as by the pressures associated with WTO entry. Statistical figures confirm this analysis: SOEs reported a 77.7% year-over-year increase in their profits in 1999.

In summary, then, we feel that SOE reform is an issue of central importance to future economic growth in China. A significant portion of the SOE sector is value-destroying and should be restructured, and Beijing knows this. The central government is thus trying to time the closure of SOEs to coincide with the development of jobs for the newly unemployed. Despite the fact that the SOE reform effort has only recently begun in earnest, this discontinuity between job creations and destruction is already creating problems for the economy and the government. We feel that Beijing has the resources to manage this dilemma in the near term, with the advent of new development projects in the west and the center, as well as with a projected increase in FDI. However, such gradualism must eventually give way to an inevitable radical restructuring of the society and the economy. We feel that Beijing has at least five years before it must confront these issues, but when it does, the country may enter severe social turbulence.
Banking Reform
Successful reform of the banking sector is a key prerequisite to building a financial infrastructure that will make China’s economic growth sustainable. The Chinese government has instituted banking reforms9 to overcome the deep-seated structural problems of profitability (Exhibit D), non-performing loans (NPLs) (Exhibits E and F), and capital adequacy plaguing China’s banks. Because of the weaknesses in China’s current banking system, there is a very small chance of a crisis.

Banking reforms have a strong positive impact on the GDP growth in two main ways. First, an efficient banking system ensures the adequate availability and efficient allocation of investment resources (“I” in the GDP Demand equation). Second, a healthy banking system boosts consumer confidence and maintains growth in consumption (“C” in the GDP Demand equation) and the high-savings rates. In China the high savings rate has contributed to rapid growth in the past. Banking reform in China will continue and will contribute positively to economic growth. The positive impact of reform will be felt much more strongly in the long run, however.

China’s banking sector consists of one central bank, four large state-owned banks, thirteen other commercial banks, several hundred urban cooperative banks, and trust and investment companies plus over fifty-thousand urban and rural cooperatives. In addition, there are a handful of small foreign-funded and joint-venture banks, hundreds of branches and representative offices of foreign banks, six finance companies and one joint venture investment bank. We focus mainly on the four state-owned banks: Agricultural Bank of China, Industrial and Commercial Bank of China, Bank of China and Construction Bank of China. Together, these banks account for over 70 percent of loans and over 60 percent of deposits in China’s commercial banking system.

Non-Performing Loans (NPLs) are one of the key problems facing the Chinese banks. The credit rating of Chinese banks is amongst the lowest in Asia. The People’s Bank of China (or PBC, China’s central bank) estimates that at the end of 1997, around 20-25 percent of total bank loans, or about RMB $1,500 billion were non-performing. This is equivalent to about 20 percent of GDP. Of the total NPLs, about 6-7 percent is deemed unrecoverable. It is important to keep in mind that the exact amount of NPLs, in the records of state-owned banks, is not transparent. The NPL problem has a stock and a flow dimension. The stock problem arises from the bad loans undertaken in the past. The flow problem refers to future loans to state-owned enterprises (SOEs) operating at a loss, which will not be able to service them.

Many of the non-performance problems of Chinese banks can also be explained by the directed lending practices prevalent in the centrally planned economy. As provincial governments maintained authority over bank personnel within their localities, they strongly influenced decisions pertaining to credit allocation without sufficient due diligence. Banks were made to lend generously to support ambitious projects of local governments in a race to outgrow neighboring cities and provinces. As credit was allocated to the local SOEs, construction of huge commercial centers, office skyscrapers and luxury apartments for which there was no genuine demand, a significant portion of the loans turned “bad” and became unrecoverable.

The sheer size of the NPLs can be explained by structural factors – under a centrally planned economy, banks acted on behalf of the government to finance investment and working capital needs of state-owned capital enterprises (SOEs). A large proportion of SOEs is suffering losses and therefore, a large proportion of the loans extended to them have become doubtful. Pulling the plug on SOEs would push them into bankruptcy, resulting in massive layoffs. As a result, banks are still carrying the NPLs on their balance sheets.



In 1998, the Chinese government put forward a number of reform measures to deal with the issues of NPLs and to guard against financial risks in the banking sector. These reforms are discussed in detail below:


  1. Strengthening the capital base of state-owned banks

In August 1998, special government bonds were issued to the tune of RMB 270 billion to re-capitalise (Exhibit 3) the state-owned banks. The plan was implemented in conjunction with the reduction of the deposit reserve requirements from 13 to 8 percent. This was aimed at further increasing bank liquidity. The re-capitalization plan raised the capital of the state-owned banks from RMB 208 billion to RMB 478 billion.



  1. Asset Management Corporations (AMCs)

In March 1999, the government established the first of the AMCs to clean up the balance sheets of the state-owned banks and then repackage and sell the loans of the state-owned banks. The Cinda Asset Management Corporation has been setup to manage the bad debts of the China Construction Bank. Cinda has taken over RMB 200 billion of the bank’s bad loans. The goal of Cinda is to

  1. clean up the China Construction Bank’s balance sheet of bad loans by purchasing bad loans at face value,

  2. increase the recovery rate of such loans,

  3. sell assets or extend maturity for partial payments, and

  4. advise on restructuring and operations




  1. New standards for classifying NPLs

The Chinese government has introduced a risk-based classification system for NPLs. The new system follows the international standards of dividing NPLs into four categories: special mention, substandard, doubtful and loss. The old system loosely classified loans as overdue, doubtful, and bad. Under this system, loans would still be classified as “performing” long after an enterprise ceased functioning due to financial difficulties.


  1. Requiring banks to make loans on a commercial basis

Effective from January 1998, the PBC abolished the mandatory quota system for credit allocation. Banks are now free to lend according to commercial considerations, subject to constraints on asset/liability ratios and monetary policy targets of the PBC. The goal of this policy is to reduce the risk of future bad loans.


  1. Independence of the PBC

The PBC has been reorganized and efforts are underway to de-politicize the banking supervision and examination process. Similar to the streamlined structure of the United States Federal Reserve, the PBC’s provincial offices have been combined into regional headquarters overseeing several provinces. The goal is to deter local governments from encouraging banks to finance their favored projects, many of which are over-ambitious and not profitable.
The banking reforms in China are subject to six constraints that will hinder their efficacy. First, the RMB 270 billion injection is not likely to be sufficient to re-capitalize the banks. Moreover, an even greater shortfall is likely to surface if China does not contain the flow problem of NPLs properly. Second, the under-estimation of the real size of the NPLs and the urgency that may result in the event of China’s entry into the WTO may further aggravate this problem. Third, our research indicated that all AMCs seem to have overestimated the real value of NPLs. They also appear to be overconfident about the future of these NPLs after the restructuring. AMCs don’t seem to understand that they will have to sell these NPLs at huge discounts in the future. Also, since most of the NPLs are from the traditional sectors like steel and cement where serious over-capacity problems persist, it would be difficult for AMCs to find markets for these products. Fourth, high levels of NPLs are likely to hold back economic growth as lending behavior turns cautious and losses get recognized and absorbed. Likewise, slower economic growth may impede banking reforms. Fifth, in the next few years, bank lending will still be mostly to SOEs and therefore, the ultimate obstacle to the profitability of the banks is the success of the SOE reforms. The management of banks also has to transform itself from the “directed lending” culture of the past to a credit culture. Developing credit analysis and project evaluation skills among bank personnel will be very critical. Finally, shortcomings in supervisory, regulatory, legal and accounting frameworks need to be addressed and these frameworks need to be brought up to international standards.

In conclusion, despite the weaknesses in China’s banking system, the imminent threat of a crisis is not significant. The reasons for this belief are three-fold. First, the public has strong confidence in the banking system. In addition, PBC funding support is significant and deemed to be stable. Two, China has a high savings rate of over 40 percent of GDP but limited investment vehicles. Therefore, households and enterprises place most of their funds as deposits in the banking sector. Three, banks are generally fairly liquid, with steady growth in deposits and a loan-to-deposit ratio of slightly over 80 percent. All these factors reduce the risk of deposit runs and illiquidity-induced bank failures. The banking reforms will positively contribute to economic growth, especially in the long run.


Development of the West
The Chinese government is paying a great deal of attention to the development of the western region of the country. Zeng Peiyan, the director of the State Planning Commission, recently described a new set of aggressive policies, which may come to be known as the “three seventy percents.” First, Beijing will allocate seventy percent of its revenues from this year’s 100 billion RMB bond offering to western infrastructure development projects. Next, RMB308.14 billion, or seventy percent of the central government’s disbursements to the regions, will go to western regions. Finally, seventy percent of all foreign aid received by Beijing will be spent in the west.10 Though these policies will have a net positive effect on economic growth through investment, their impact will be tempered by factors that make investment in the west difficult and potentially unattractive.

In order to understand its impact on economic growth it is important to understand how this financing (3% of estimated 1999 GDP) will be invested. First, and perhaps most importantly, the government is investing heavily in transportation infrastructure. Many of the professionals with whom we spoke in China indicated that distribution was a major problem confronting their businesses.11 In an effort to improve the situation, the central government is sponsoring the development of at least three major railroads in the west. For instance, Beijing is spending RMB23.23 billion to lay 955 kilometers of track between Xian and Hefei, the capital of Anhui province.12 Furthermore, the central government plans to pave approximately 17,000 kilometers of highway in the west over the next decade.13 This is of great importance from an investor’s perspective as it will reduce the cost, and improve the efficiency, of road transportation. The government is also in the midst of renovating and constructing nineteen airports throughout the country. Finally, Beijing is actively investing in pipelines, water conservation projects, and telecommunications facilities throughout the west.

However, investors, particularly foreign investors, are not rushing into the region. First, the central and western parts of China are among the poorest places on the planet. Guizhou Province, for instance, has a per-capita GDP of only $277, far below the prevailing level in Shanghai ($3,043).14 Furthermore, human capital in these regions is not well developed. One professional with whom we met told of a new factory that his firm had become involved with in Sichuan Province’s capital, Chongqing. In a city of several million people, the firm was unable to locate a single person who was proficient enough in English to work as a receptionist. The firm was forced to hire someone from Shanghai.15

We also heard reports from several sources of political unrest in central and western China. Ninety percent of China’s 80 million people living in poverty reside in these regions.16 Additional social pressures are being generated by a series of agricultural reforms which, while intended to rationalize the sector, continue to force farmers off the land. While the government has created town and village enterprises (TVEs) to absorb the excess labor, there is still a tremendous flow of migrant labor from the farms into the large cities on the eastern seaboard. Several sources reported that the number of undocumented residents of Beijing is close to four million. Finally, we heard of daily peasant protests throughout China’s underdeveloped regions. These issues also negatively affect foreign investors’ interest in western China, while giving the central government good reason to focus its own investment efforts on this region.

However, all is not completely bleak for the west. As Professor Susumu Yabuki of Tokyo University points out in a recent article, “Zhu Rongji has begun to use the word ‘strategic’ to describe the west in the same way that his predecessor Zhao Ziyang used it to describe the eastern seaboard in 1978.”17 Whether the government can or will make good on its commitments vis-à-vis the west remains to be seen. We agree, however, with Professor Susumu’s argument that the stakes in the west are simply too high for failure this time. Clearly, we are not alone. In recent years, western firms such as Boeing, Seimens, Motorola, Toyota, and P&G have all made substantial capital investments in the region. Therefore, in the short run the overall investment strategy for western China will contribute positively to economic growth.


WTO
While it is beyond the scope of this report to comment on the political machinations in Washington and Brussels that will impact the China-WTO issue, we believe that it China’s membership is likely to be approved. China’s accession to the WTO will have a positive impact on economic growth. First, it will increase FDI. Second, it will speed banking reform, which will increase access to capital and thereby the growth of the private sector. Third, it will likely boost exports such as light industrial products, textile, electronics and some of the labor-intensive agricultural products. Finally, it will catalyze the reform of SOEs as surplus labor can be absorbed by new foreign and private enterprises. These positive impacts will be tempered, however, by reform complications that are likely to continue.

Taking as given that China will join the WTO this year, the road ahead will still be rocky. For instance, one of the most contentious areas of negotiation is financial services liberation. Despite the fact that the Chinese government has agreed to open the RMB commercial lending market to foreign institutions two years after WTO accession, The Economist points out that “banks will be able to do serious business in China only if interest rates are deregulated.”18 Many of our contacts in China expressed a more sanguine view, namely that China’s joining the WTO will force it to do things (such as deregulate interest rates) that it wouldn’t have the strength to do without some “legitimate” external pressure.19 Also, while the Chinese government has expressed anxiety over the cellular telecommunications industry, they have agreed to allow U.S. firms to engage in distribution in China. Finally, and most importantly, WTO entry will aid China in what is perhaps it’s most critical effort in the future: the cultivation of healthy private enterprises to soak up excess labor from defunct farms and SOEs, as well as the young people who enter the work force each year.



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