China is faced with a host of challenges – huge income inequalities, an overvalued currency and an insolvent banking system. But, says Fan Gang, high and stable growth should enable these problems to be solved

Any visitor to China will know that the pace of change in the economy is nothing short of dazzling: gleaming skyscrapers spring up, seemingly overnight. A whole new middle class, with expensive tastes, has emerged. Fixed investment has been galloping along at 30% annually in real terms over the past year. Overall, the economy as a whole has been expanding at around 10% in real terms in the past two years. But, however impressive this heady growth has been, it has been widely acknowledged to be unsustainable. The only question is whether the leadership could engineer a soft landing, or whether there would be a crash-landing, manifested by the bursting of certain bubbles in various industries.

My own view is that, after almost two years of overheating, China is set for a soft landing. The annual rate of growth in gross domestic product (GDP) is likely to fall below 9%. This rate is sustainable, without generating inflationary pressure, at this stage of development. And the growth of fixed investment, which was the main driving force of the overheating, is likely to fall below 18% in real terms by the end of the year.

China’s government has reacted much more swiftly in this cycle than in the last one. It started to tighten the money supply in September 2003 and reduced public spending at the beginning of 2004. It also adopted tight controls on land sales, where land had been at the heart of local urban investment programmes and collateral for borrowing. The objective was to cool down the infrastructure investment fever across the country. Thanks to those successful policies, China’s growth will dip to a sustainable, but still vigorous, 8% to 9% per year by the end of this year, and possibly for the next couple of years.

Crisis? What crisis?
Many outsiders seem to wish secretly that China will fall flat on its face. (And a hard landing is widely touted as a possible prospect for China over the next few years.) But it seems certain that the People’s Republic will not run into either financial or social crises in the foreseeable future, say over three to five years.

People know that China’s poorly instituted state banking system has a non-performing loan ratio of around 35% of GDP – maybe the highest in the world – despite the booming economy. That is the most troublesome problem for China and the world. On the other hand, not many people know – partly because western media do not report it – that China has perhaps the lowest ratio of government domestic debt in the world, at just 18.4% of GDP in 2003.

This low level of indebtedness gives the government the ability to take emergency stabilization measures for the economy, if necessary, or to restructure the banking system. Indeed, the government has already begun to recapitalize two of the four huge state-owned banks as part of the process of bringing them up to international capital adequacy ratios. And now it is running a budget surplus (around 2% of GDP in 2004). This surplus is being used to pay down debt, but also serves to take some of the heat out of the economy.

On the social front, income disparities are getting larger. After 25 years of rapid growth, there are still up to 300 million rural labourers working in agriculture, which is no longer a source of meaningful income growth. However, there continue to be prospects for such workers to move off the land. China’s growth, unlike India’s, has created plenty of jobs for the very poorest. Some 12 million new non-farming jobs have been created each year on average in recent years. This means that most rural families have been better off in absolute terms, due to remittances from family members who have moved to the cities to work.

Of course, poverty is not only a rural phenomenon. In the cities, some 25 million people have lost their jobs at inefficient state-owned enterprises over the past seven years. However, the worst of such lay-offs seems over, and the social security system seems to be working as a safety net against destitution. As long as the majority of the population feels that it has benefited from economic growth, and as long as there is not a major group that is left absolutely worse off, China might avoid unrest in spite of the growing wealth and income disparities.

As for the rest…
Of course, even if China avoids a financial or social Armageddon over the coming years, it still has a host of issues to contend with. The uniqueness of China is that it has many more challenges than any other country in the world. Unlike most “problem” countries, it has two sets of big concerns, rather than one. It is both a poor developing country and an economy in transition from a centrally-planned to a market economy. It is also the only large continental country with only one coastline, and it has the world’s largest population, many of whom live in the remote hinterland. So it is not surprising that we can find all kinds of problems around the country, and that there is no “quick fix”.

China’s future is dependent on its continuing on the reform path. Many tough decisions will have to be taken over the next three to five years. What China needs to do to mitigate the “country risk” that outsiders love to fret about can be briefly summarized:

financial reform, in both the banking system and capital markets that are scarcely functioning. This should be a top priority as the financial system is a bottleneck for further economic growth and institutional reform;

further culling of state-owned enterprises. Although more than 70% of output and more than 50% of investment now come from private or semi-private entities, the state sector still consumes a great deal of resources inefficiently;

administrative and political change. It is wrong to think that China has not had any political reform. There has been a significant increase in representation and participation in decision-making at all levels of government by all main interest groups in society. There has also been a significant improvement in the checks and balances among the most powerful factions within the ruling Communist party, as shown by the increasing number of high-ranking officials who have received life sentences for corruption in recent years. It will be a long-term process for China to reform its political system in accordance with its own culture and its stage of development. But the relationship between the government and the private sector needs to change urgently, as does the relationship between the centre and the regions and the cities, in order to achieve efficiency and stable growth. The political system must also allow for »greater participation by business groups and the working classes to maintain social stability;

tax reform – unifying corporate income tax rates so that Chinese private investors are as favourably treated as foreigners;

addressing inequality through changes in the social security system to prevent those at the bottom of the income scale becoming worse off. However, the government should keep an eye on the affordability of such policies. It would be disastrous if China tried to achieve the levels of social welfare common in the developed world. One of the biggest dangers for a developing country like China is being too eager to do too much to fulfil populist demands;

loosening of the peg of the yuan to the dollar. Under the present fixed peg, China is exposed too much to the financial volatility caused by America’s current account and budget deficits, and the falling dollar.

The bad news is that the list could be endless. The good news is that, with macroeconomic stability in the offing, and high growth over the next couple of years likely, the Chinese leadership seems more confident to face its tough choices. The central government is preparing to make 2005 “year of reforms”. No-one should expect overnight solutions: there is no such thing for China. But each reform will take the country further towards its destiny as one of the great, wealthy countries of the world.

Fan Gang
Fan Gang is professor of economics at Peking University and the Chinese Academy of Social Sciences, and director of the National Economic Research Institute, China Reform Foundation in Beijing.