China faces a major challenge in sustaining the rapid economic growth that has been the hallmark of its transition from plan to market since 1978. Economic growth, as reflected in the official data, was 7.1 percent in 1999, the seventh consecutive year in which growth was slower than the previous year. The official Chinese government forecast for 2000 is 7.0 percent, which would continue the growth slowdown yet one more year.
The challenge the leadership faces is actually much greater than these numbers suggest. The official data overstate the pace of economic expansion and the gains in real economic welfare that the economy generates, if for no other reason that over the past decade there has been an extraordinary build up of unsold and unsaleable inventories. While these inventories are counted as part of output and thus contribute to the growth of China’s gross domestic product, they are not utilized for either consumption or fixed investment. The real resources that have gone into the production of these goods has been largely wasted. From 1990 through 1998 additions to inventories averaged 5.7 percent of gross domestic product.
In the United States the comparable figure was 0.4 percent.
On average in 1990-98 annual additions to inventories in China absorbed 42 percent of incremental output. While some increase in inventories is needed to support higher levels of output, the disproportionately large inventory build up in China reflects the continued production of low quality goods for which there is little or no demand. Chinese society would have been much better off if the goods had never been produced at all. China’s Premier, Zhu Rongji, in his annual address to the National People’s Congress last month acknowledged that inventory build up was an ongoing problem and that China must “limit the production of non-marketable products.”
Of course, if China’s banks were operating on a commercial basis they would have cut off the flow of additional working capital loans to foundering companies, automatically limiting the build-up of inventories.
There are several other indicators, in addition to the growth slowdown, of the challenges that China’s leadership faces in the wake of the Asian financial crisis. Export growth has slowed dramatically over the past two years. Between 1987 and 1997 exports surged from under US$40 billion to more than $183 billion, an average annual rate of expansion of 16.5 percent. In the past two years export growth has been far more modest, averaging only a little over 3 percent annually. Similarly after watching foreign direct investment inflows soar from a range of from US$3 billion to US$4 billion annually in the late 1980s to $45 billion in 1997, the leadership saw foreign direct investment growth evaporate in 1998 and then witnessed a significant shrinkage of foreign direct investment in 1999. This significant shrinkage, the first ever in the reform period, has continued in the early months of 2000. Similarly, year after year foreign banks were willing to extend larger and larger amounts of foreign currency loans to China. But in 1998 lending to China began to decline and in 1999, in the wake of the bankruptcy of the Guangdong International Trust and Investment Company in January that year, turned sharply lower for the first time in more than a decade. By the end of the third quarter of 1999 total foreign currency lending to China by banks was down by US$20 billion or about one-fourth compared to year-end 1997.
Finally, for the first time in three decades China’s leadership is grappling with the problem of price deflation. The underlying problem has been over investment in many sectors, leading to excess capacity and a tendency for manufacturers to cut prices in an effort to sell enough product to cover the cost of their labor and other variable inputs. Thus price deflation in China for some critical products, such as steel, long predates the Asian financial crisis. But the crisis significantly deepened the deflationary trend since China’s fixed exchange rate vis a vis the U.S. dollar meant that the deflation elsewhere in the region was imported into China. But now, because of a brisk recovery, deflation is over in most of Asia. But in China deflation not only persists but accelerated in 1999.
The Search for a New Growth Paradigm
China’s sweeping bilateral agreement with the United States on the terms of its accession to the World Trade Organization, concluded last fall, reflects the search of the leadership for a new growth paradigm. There is a widespread recognition that repeated short-term fiscal stimuli are no more than a temporary expedient. They may prevent a complete collapse of economic growth but can not be the source of sustained economic growth in the long run. The leadership has come to the belief that sustaining growth in the long run depends critically on allocating resources more efficiently rather than simply maintaining the highest rate of investment of any country in the world, as has been the case for most of the reform era. The leadership sees efficiency gains as stemming in part from reducing the restrictions that have previously constrained the private sector of the economy and in part from the increased international competition that will follow from opening up China more fully to the global economy. To increase competition and stimulate productivity gains the leadership has agreed to continue to reduce both tariff and nontariff barriers and, more importantly, more fully open its service sector to increased foreign ownership. All of these steps will increase competition, thus placing significant additional pressure on domestic firms to lower their cost structures in order to survive. Membership in the World Trade Organization in effect is being used as a lever to achieve fundamental changes in state-owned enterprises and state-owned banks that the leadership has long sought but which have been somewhat elusive.
There can be little doubt that the leadership fully appreciates the risks of the course on which they have embarked. Already tens of millions of urban workers have lost their jobs in state and collective factories as China accelerates domestic economic restructuring in preparation for increased international competition that inevitably will follow it’s membership in the World Trade Organization. Many of those that have been laid off have found new jobs in the competitive portions of the economy—the rapidly growing private, foreign-funded, and export oriented sectors. But those that lack the skills or live in cities long dominated by state-owned factories have little prospect for finding new jobs locally. Rising levels of urban unemployment, compounded by delays in the distribution of both living allowances due laid off workers and pensions due those already retired from failing state-owned companies, have led to widespread urban violence. In rural areas too the prospect is for substantial dislocation as China reduces its subsidies for basic staple commodities, again in anticipation of increased inflows of lower priced foreign products. The willingness of the leadership to incur these substantial short-term economic and political costs in the pursuit of long-term economic gains is a measure of the depth of their commitment to further reforms.
Granting permanent normal trade relations is strongly in the U.S. national interest for several reasons. First, denying China permanent normal trade relations would require the United States to invoke Article XIII of the Final Act of the Uruguay Round, meaning that we would not apply the World Trade Organization Agreement with respect to China, even after it became a member of the organization. The notice to non-apply would have to be delivered prior to the time the General Council of the World Trade Organization meets to approve the terms and conditions of China’s membership. China, in turn, would then almost certainly invoke Article XIII with respect to the United States, meaning that U.S. firms would not benefit from most of the sweeping market opening measures to which China agreed in the November 1999 bilateral agreement.
Although the United States could subsequently reverse its non-application, during the intervening period firms from Europe, Japan, Canada, Australia, and elsewhere would gain a decisive advantage over U.S. firms, particularly in the service sectors that China has agreed to open more fully.
Second, and even more importantly, the failure of the U.S. Congress to grant permanent normal trade relations to China would undermine the position of reformers in China. They have overcome intense domestic opposition to membership in the World Trade Organization, in part by arguing that it was the only means of avoiding the process of annual renewal of their most-favored-nation status in their largest export market—the United States. The United States should embrace the commitment of the Chinese leadership to integrate China more fully in the world economy, to much greater reliance on market forces to allocate resources within China, to the further liberalization of the flow of information on which the market depends, and to allow a much larger role for the private sector. Over a period of time these commitments will have profoundly transforming effects. The most effective way for the Congress to signal support for these developments is to pass legislation authorizing the President to extend permanent normal trade relations status to China when it enters the World Trade Organization. Failure to do so plays into the hands of conservative elements in China that seek to constrain the role of the private sector, to limit the role of the market, and to control more tightly the flow of information.
Finally, the failure of the U.S. Congress to grant permanent normal trade relations to China would significantly undermine the position of our negotiators in the final stage of China’s entry to the World Trade Organization—the drafting of the protocol of accession and the report of the working party. These two documents, which will be negotiated in a multilateral setting in Geneva after China has concluded all of its bilateral negotiations, will spell out in detail China’s commitments on all WTO rules. While some of these already have been specified in the November 1999 bilateral agreement between China and the United States, several critical commitments remain to be set forth and clarified at the multilateral stage. While not all of these remaining issues have been publicly identified, at a minimum they include the details of its commitment to eliminate agricultural export subsidies, which are not set forth in the bilateral agreement between China and the United States; China’s commitment to comply with both the Uruguay Round Agreement on Technical Barriers to Trade and the Understanding on the Interpretation of Article XVII of GATT 1994, which covers the activities of state trading enterprises; and the details of the trade policy review process that will track China’s compliance with its terms of accession once it has become a member. While not wishing in any way to detract from the strength of the bilateral agreement reached between the United States and China, given the importance of the issues that remain to be addressed, it is strongly in our interest that the voice of U.S. negotiators be just as strong in the multilateral negotiations as it was in the bilateral negotiations that led to the November 1999 agreement. The best way to assure this is to provide the President with the authority to extend permanent normal trade relations to China.
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