The key to eradicating the deflation bias lies in establishing an efficientfinancial intermediation mechanism
The annualised growth rate for China in the first half of 2003was 8.2%comparedwith 8.0%in 2002，and inflation was -0.4%for the first half of 2003comparedwith -1.3%in 2002.Since the growth and inflation rates in the first half of2002were still substantially below their respective averages of 9.4%and 5.5%duringthe period 1979-2002，it appears that China's economy is still operating belowproduction capacity.However ，there are other indications that overheatingmight just be round the corner.Data just released on the third quarter of 2003show that GDP growth had climbed to 9.1%，and that growth in fixed asset investmentspending had remained above 30%，a continuation of the higher investment growththat began in the first quarter of 2003.Jonathan Anderson，an economist with theUnion Bank of Switzerland ，assessed recent growth as understated，saying that“[the]‘true’GDP growth should exceed 11%in 2003”。The perhaps most puzzlingpart is that the inflation rate has ，however，remained at zero.
The fact that the macroeconomy‘s vital signs are ambiguous and are causingconfusion among top leaders is very well captured in two newspaper headlines thatappeared on two consecutive days in August 2003.On August 18th 2003，an articlein the Straits Times of Singapore under the headline“Hu calls for more work creationas jobless rate rises ”reported that the Secretary-General of the Chinese CommunistParty ，Hu Jintao，had called for “stronger measures …[like]fiscal subsidies，tax incentives，insurance subsidies and credit opportunities ”to spur economicgrowth.On August 19th 2003，Hong Kong’s South China Morning Post carried anarticle headlined “Investments soar amid reluctance to rein in growth”which reportedthat the Chairman of the State Development and Reform Commission，Ma Kai ，had“urged the nation to be wary of overheating and unveiled measures to cut back lendingat state-run banks”。
The cost of erring on the overly conservative side is certainly a high one.The official growth target of 7%in 2003could create only 10million new urbanjobs，and there are 24million urban job-seekers.On top of this，150millionof China‘s 500million rural workforce are “effectively ”unemployed—and thisis the most conservative estimate ！The cost of an overheating could also bemajor because high inflation in the past has been seen at times to undermine socialstability.Furthermore，overheating is a sign that the state credit system hasbeen undermining economic restructuring objectives by bailing out inefficient stateenterprises ，and funding investments in sectors with excess capacity.
As if China ‘s macroeconomic managers are not already sufficiently vexed bythe confusing signals of“overheating ”and “below-potential growth”，they nowface tremendous political pressures from Japan，Western Europe and the United Statesto revalue the renminbi substantially.The current round of external indignationover an undervalued renminbi was set off on December 1st 2002when two senior officialsof Japan’s Ministry of Finance wrote in the Financial Times that “China is exportingdeflation …through export growth and a combination of price deflation and an exchangerate pegged to the dollar ”，and they asked China “to allow the currency to appreciate”.By mid-2003，South Korea，Western Europe and the United States have joinedJapan in urging an appreciation of the renminbi to reduce unfair competition fromcheap Chinese imports.How China will respond to this foreign clamour for revaluationof the renminbi will，not surprisingly ，depend on its diagnosis of the currentmacroeconomic situation.If Chinese leaders conclude that deflation is a more probablethreat to China's economic growth than overheating，then there would at most bethe introduction of a minor trading band around the current renminbi-US dollar exchangerate.
In assessing what the appropriate stance of macroeconomic exchange rate policiesshould be ，the foremost relevant analytical issue is whether China is alreadyat the“natural ”growth rate ，i.e.the maximum sustainable output growth ratethat is compatible with price stability.The operational difficulty is that thenatural growth rate of an economy is not immutable over time，e.g.a change inthe rate of technological innovation would change the natural growth rate.In ourview，there are two components to understanding China‘s recent macroeconomic performance.
The first component is that the growth of aggregate supply has slowed down since1997.This view is based on the observation that every growth rate in the 1997-2002sub-period is below 9.4%，the average annual growth rate in 1997-2002.This extendedperiod of below-average growth is unprecedented in China‘s market reform ，whichsuggests that the slower growth phase near the end of the 1990s is the result ofChina having largely exhausted the growth potential created by the economic deregulationand internationalisation.Our interpretation of a growth slowdown upon economicmaturation is based on our more general view that the impressive post-1978growthof China was generated by the steady convergence of a formerly autarkic developingcountry to the frontier of modern science.The closer to the world science frontier，the lower the catch-up rate of growth —which is consistent with the slowing downof the average growth rate in the 1979-96sub-period from 9.9%to 7.8%in the 1997-2003sub-period.
The second component of our explanation of recent macroeconomic performanceis that there was also a large downward shift in the inflation rate between thetwo sub-periods ，an annual average of 7.8%in 1979-1996versus -1.4%in 1997-2002.Clearly ，there must also have been a slowdown in the growth of aggregate demandbecause in the absence of a drop in aggregate demand growth ，a fall in supplygrowth（as identified above ）would have produced an outcome of lower growth-cum-higherinflation （i.e.stagflation）rather than the observed outcome of lower growth-cum-deflation.More precisely，the lower growth-cum-deflation phenomenon in the 1997-2002sub-periodmeans that the slowdown in aggregate demand growth was greater than the slowdownin supply-side growth.In the next section，we will develop the argument that China'sdysfunctional banking system has created a deflationary bias in the economy.
The Retail Price Index（RPI ）showed a price deflation in October 1997，asdid the Consumer Price Index（CPI ）in February 1998.When it became apparent bythe middle of 1998that the economy was slowing down significantly，the governmentbegan to implement monetary and fiscal measures to boost aggregate demand.The interestrate has been reduced eight times in less then six years，with the latest ratecut on February 21st 2001，which brought the one-year deposit rate to 1.98%andthe one-year lending rate to 2.34%.After the jump in government spending the fiscaldeficit increased substantially from 1.1%of GDP in 1998to 1.9%in 1999，2.5%in 2000，2.7%in 2001and 2.9%in 2002.Most government economists，e.g.Jia ，believe that the investment using funds raised through treasury bondissuance contributed about two percentage points to GDP growth each year in the1999-2002period.
With the encouragement of the central bank，especially with the onset of SARSin early 2003，the state banks greatly expanded their loans ，especially to thereal estate sector，and money growth went from 16.8%in the fourth quarter of 2002to reach 20.0%in the second quarter of 2003.The combination of additional fiscaland monetary stimulus to offset the deleterious effects of SARS on aggregate demandcaused the rate of fixed asset investment to jump from 21.6%in the fourth quarterof 2002to over 30%in the first three quarters of 2003.The unfortunate featureabout encouraging SOE investments ，as emphasised by Fan and Woo，is that，in a partially-reformed centrally-planned economy ，there are many institutionalfeatures that motivate SOE investments to veer out of control frequently，and overheatthe economy as a by-product —which might be beginning to happen in the second halfof 2003.
The Deflationary and Current Account Consequences of Inadequate Financial Intermediation
At a superficial level，the systemic deflationary pressures that have plaguedChina since 1997have their sources in，one，a shrinking money multiplier （aphenomenon that many Chinese economists have called “the liquidity trap”），andtwo ，a slowing down in the growth of consumption（a phenomenon commonly knownas“the paradox of thrift ”）。China has tried to boost the domestic economywith successive cuts in interest rates，but the rise in credit creation has beenmuch lower than expected，except for the periods when the central bank leaned heavilyupon the banks.The paradox of thrift refers to the low level of private aggregatedemand because the private saving rate has been increasing.The saving rate wentfrom almost 20%of GDP in 1981to 30%in 1988，and to almost 40%in 2001.
At a deeper level ，however，both of these phenomena，we suggest ，springfrom the same cause ，which is the absence of adequate financial intermediationin China.The liquidity trap made its appearance in the mid-1990s when Zhu Rongjidecreed the removal of the state bank manager if the ratio of non-performing loans（NPL ）in the bank were to go up two years consecutively.As the majority of stateenterprises are either in the red or just breaking even ，the banks became unwillingto lend money to the state-owned enterprises.Lending more to private enterprisesis not really a good option because ，one，their legal status is lower than thatof state enterprises，and，two，there was no reliable way to assess their balancesheets.The only activity that the banks are happy to allocate their funds to isthe purchase of state bonds ，i.e.the financing of the government's deficit.The elimination of the liquidity trap requires that the state removes the barriersto lending to the private sector by ending legal discrimination against them，andestablishing uniform accounting and auditing standards that have credible enforcementmechanisms.
In discussions on the rise of the savings rate，a common view is that the risereflects the uncertainty about the future that many SOE workers feel in the faceof widespread privatisation of loss-making SOEs.We find this explanation to begrossly incomplete because there has also been a rise in the rural saving rate eventhough rural residents have little to fear about the loss of jobs in the state-enterprisesector because none of them are employed there.Based on the work of Liu and Wooon savings behaviour，we conjecture that the desire to invest is an important reasonfor why the rural sector has increased its savings rate.The most dynamic industrialexpansion in China in the 1984-1994period occurred in rural areas.Since non-statefirms in rural areas could not borrow from banks，the only way they could establishthemselves was through self-financing ，which required the would-be entrepreneursto save first.In the very first phase of rural industrialisation ，the amountof capital needed to start a factory workshop was very low.After a decade of rapidindustrial growth ，the Chinese countryside is saturated with labour-intensiveenterprises.As competition among rural enterprises is very fierce at present ，it no longer makes economic sense to invest and open the same type of factory workshop.Rural enterprises must therefore move up to the next stage of value-added productionin order to be more profitable.This new generation of rural enterprises is muchmore capital-intensive，and thus requires a much larger amount of start-up funds.And rural residents have responded to the higher capital requirements by increasingtheir saving rates.
Since the phenomenon of investment-motivated saving must also be present withinthe Chinese urban community the usual pessimism-based explanation for the rise inthe urban savings rate is only partially correct.In fact ，with the steady relaxationof regulations against the establishment of private businesses in the rural andurban areas ，the amount of investment-motivated savings in China could only haverisen more.To sceptics of our investment-motivated savings hypothesis，we wantto point out that Jeffrey Williamson，an economic historian，has summed upthe historical record of Western Europe and North America as showing that “investmentdemand seems to have been the driving force behind private saving and accumulation，past and present”.
Table 2reports the investment trends in China in the post-1978era.Total fixedinvestment has increased as a proportion of GDP ：an annual average of 28.8%in1984-88，34.0%in 1992-1996，and 36.3%in 1997-2001.SOE investment went upin the period 1992-96（19.8%）and then returned to the initial 1984-88level（18.7%）。We are of the opinion，however，that the amount of state-directedinvestment in the 1997-2001period could be more than three percentage points higherthan 18.7%of GDP because many of the big SOEs in 1988had by 1999converted themselves（or components of themselves ）to share-holding companies listed on the stockexchanges —while remaining state-controlled.Furthermore ，many SOES have formedjoint-venture firms with domestic and foreign companies ，with themselves as thecontrolling shareholders.
Contrary to the rise in total investment and the likely rise in state-directedinvestment，rural investment has fallen from 8.2%in 1984-88，to 7.7%in 1992-96，and then to 7.5%in 1997-2001.Our hypothesis is that a major reason for the declinein the rural investment ratio is that the traditional labour-intensive factory isno longer profitable，and rural entrepreneurs have been unable to borrow the moneyto undertake the more capital-intensive investments required for the next generationof rural enterprises.The investment-GDP ratio went up at the national levelbecause FDI rose while state investments（through the budget，state-owned enterprises，and state-controlled enterprises）utilised the higher domestic savings fully.
We now turn to show that another outcome of inadequate financial intermediationis a chronic current account surplus.To see this point ，consider the followingaccounting relationship ：
（current account surplus ）=（government budget surplus ）
+（savings of SOES –investments by SOEs）
+（savings of the non-state sector –investments of the non-state sector）
The facts for the recent period are that the current account surplus（or，looselyspeaking，the trade surplus）is positive，the government budget surplus is negativeat an unprecedented level ，and SOE savings are lower than SOE investments.Thismeans that the savings of the non-state sector must greatly exceed the investmentsof the non-state sector.As documented earlier，the government has sought to fightdeflation by increasing public works（i.e.running record budget deficits ）andencouraging SOE investments to soak up the excess savings.The rise in total investmentshas not been sufficient to use up the excess savings，however，and these residualexcess savings have leaked abroad in the form of an aggregate trade surplus.Inadequatefinancial intermediation has made China a capital exporting country ！
This perverse current account outcome is not new.Taiwan had exactly this problemup to the mid-1980s when all Taiwanese banks were state-owned and were operatedaccording to civil service regulations，which required the loan officer to repayany bad loans that he had approved.The result was a massive failure in financialintermediation that caused Taiwan's current account surplus to be 21%of GDP in1986.
China's proclivity to generate persistent current account surpluses has managedto manifest itself only after 1994because of major policy changes implemented inthat year.Before 1994，with the government budget deficit being usually small ，the voracious absorption of bank loans by SOEs，in the soft-budget environment ，to invest recklessly kept the current account usually negative.In 1994，Zhu Rongjiimplemented stricter controls on the state-owned banks（SOB ）to reduce the then24%inflation rate and the explosion of NPLs.This lower growth rate in SOE investmentsfrom 1995onward is the reason why China's built-in propensity towards a currentaccount surplus came to light only after 1995.The pronounced tendency towards highercurrent account surpluses is mainly caused by the rise in the savings of the non-statesector for the reasons we identified earlier，e.g.rise in the required amountof start-up capital ，improvement in the official attitude to market capitalism.The reason why China is not producing the gargantuan current account surpluses seenin Taiwan in the mid-1980s is because of its record budget deficit and the stillexcessive amount of SOE investments.
Obviously ，increasing budget deficits and SOE investments to counter deflationand reduce the trade surplus can only be a satisfactory solution in the short term.In the long term，the increased public investments could follow an increasinglyrent-seeking path that is wasteful，as in Japan（e.g building a second big bridgeto a low-populated island to benefit a politically-connected construction company），and the increased SOE investments could convert themselves into NPLs in theSOBs.The right solution to the problem of excess savings is not for the governmentto absorb them by increasing its budget deficit but to establish an improved mechanismfor co-ordinating private savings and private investments.This solution is correctregardless of the veracity of our hypothesis about investment-motivated savings.We will argue later in the paper that the formation of domestic private banks andthe entry of foreign banks will correct the problem of inadequate financial intermediation，and eradicate the deflationary tendencies created by the liquidity trap and theparadox of thrift.The fact is that the present banking system is a sinkhole，asituation that we will examine now.
The critical situation of China's banking system
In 1997-98，the government injected new capital into China's banks and transferreda large proportion of the NPLs to the state-owned asset management corporations（AMCs）。These actions raised the capital adequacy ratio（CAR ）of the four largestSOBs from 4.4%at the end of 1996to over 8%at the end of 1998，see Table 3.However ，the rapid appearance of new NPLs after 1998lowered the average capitaladequacy ratio of the four largest SOBs to 5.0%by the beginning of 2002.Thebanking reform efforts of the past several years have failed，and the state banksare now in need of another round of recapitalisation.
In this situation of a fragile banking system ，China has committed itselfto opening up the banking system completely within five years of joining the WorldTrade Organisation（WTO ），which it did in December 2001.Foreign banks couldconduct transactions in foreign currencies from the beginning of WTO membership ，conduct transactions with the local corporate sector in renminbi after two years，and conduct transactions with local households in local currencies after five years.Although foreign banks are likely to compete only in the coastal cities ，at leastin the initial period ，the pressure on domestic banks can be high ，as the bigfour banks extract about 95%of their profits from about half a dozen coastal cities（Shanghai，Peking ，Xiamen ，Shenzhen ，Guangzhou and Tianjin）。Because thereis no depositor insurance in China，the obvious question is whether depositorswill believe that these foreign banks will drive the SOBs into open bankruptcy，and hence rush to withdraw their savings from the SOBs，setting in motion the viciousdownward spiral of credit contraction leading to business failures，rendering soundfinancial institutions insolvent，and contracting credit further.
Our reading is that even if pressures on the state banks do occur through depositorwithdrawals ，there is unlikely to be a full-blown crisis because the central bankwill be able to issue currency to the state banks to meet the withdrawals.Thisexpansion of high-power money cannot be easily translated into a loss of foreignreserves because capital controls ，which we support ，remain in place and arelikely to do so for the foreseeable future.The resulting expansion of high-powermoney will also not have much impact on inflation because this is mainly a shiftout of bank deposits into cash，or from some banks to others ，and not a shiftinto goods.In fact ，in the present deflationary atmosphere ，a run from bankdeposits to goods is a macroeconomically stabilising development！Simply put ，the government has the technical ability to accommodate shifts in bank deposit preferences，even a modest bank run，without risking exchange rate collapse or runaway inflation.
One could therefore argue ，as Fan has，that if the Chinese governmentdecides to keep the SOBs as the dominant financial intermediation mechanism ，thenthe SOBs should not be re-capitalised again.The effective way to slow down thepace of NPL creation in an SOB-dominated financial system and keep the fiscal situationsustainable is to keep the NPLs on the books of the SOBs，with "the financial statusof these loans……constantly watched and openly discussed"in the public media.We think，however，that Fan Gang's solution can be a medium-term solution at best.In our assessment ，China's WTO accession has made recapitalisation of the SOBsinevitable in the coming decade.This is because the large amount of NPLs in theSOBs means that they have much higher operating costs than the foreign banks.SOBshave to pay interest on the deposits that are the counterparts of the bad loans ，whereas all the loans of the foreign banks（at least in the beginning ）will beserviced.With the foreign banks being able to afford to pay higher deposit ratesand to charge lower lending rates ，the demise of the SOBs seems inevitable unlesstheir NPL burden is removed.
In order for Fan Gang's suggestion of no recapitalisation to work at all，itis necessary that the foreign banks （which will no longer face more restrictionsthan Chinese banks by 2007），will not expand aggressively out of the big coastalcities to blanket the rest of the country with branches in a short period of time.Our guess is that Fan Gang's method can work for about seven to ten years becausewe think that only HSBC and Citibank are likely to actively expand their bankingnetwork in China in the next decade ，and even then mostly in the major coastalprovinces.
The most important priority for financial sector reform is the appearance andgrowth of competitive domestic private banks.As China is required by its WTO accessionagreement to allow foreign banks to compete against its SOBs on an equal basis by2007，it would be akin to self-loathing not to allow the formation of truly privatebanks of domestic origin.There is no reason to favour foreign private banks overdomestic private banks，and no reason why China should not allow its best financialminds to compete with ，and achieve the same glorious success of ，the best foreignfinancial minds.We therefore recommend that，right after the recapitalisationof the big four state banks ，at least two of them be broken into several regionalbanks ，and that the majority of these regional banks be privatised.At thesame time ，the laws on the establishment of new banks should be loosened，andinterest rates deregulated.However ，it is most crucial that liberalisation ofthe financial sector proceeds no faster than the development of the financial regulatoryability of the state.Even then ，the danger of substituting financial crash forfinancial repression is still a real one.A modern financial system requires a modernsystem of financial supervision and prudential regulation for its proper functioning.
It would be a good idea to sell a few of the regional state banks to foreignbanks.This will facilitate the transfer of modern banking technology to Chinesebanks.The more local staff the foreign bankers train ，the larger the pool offuture managers for Chinese-owned banks.An accelerated process of promoting thegrowth of sound domestic private financial institutions and allowing the entry offoreign financial institutions would certainly shorten the time it would take forShanghai it to assume its rightful place among the major international financialcentres ，and to contribute to more efficient intermediation of the world's savings.
We should mention that entry of Western banks into China‘s financial marketsis not the same thing as liberalisation of the capital account in the balance ofpayments.We do not believe that China would be well served by a rapid opening ofthe capital account ，since that could subject China to rapid swings of short-termcapital in the same manner that has whipsawed the economies of South-East Asia andLatin America.Just as in financial market liberalisation ，capital account openingshould also proceed gradually and in stages ，because it must be accompanied bysophisticated financial market regulation ，something that is clearly not in placeat this time.The fact is that foreign banks could suddenly become conduits forlarge-scale capital flight，or for rapid swings in short-term lending and repayments，or facilitators of bank runs（in which depositors do not merely switch banks，butactually switch to a foreign currency or foreign assets ）。
The precarious fiscal position of the state
Since the government recapitalised the banks in 1998，and needs to do againnow ，the important question is how many more rounds of bank recapitalisation canChina afford without generating a fiscal crisis ？The simple fact is that fiscalsustainability lies at the heart of whether a banking crisis would actually occur.As long as the state is perceived to be able and willing to bail out the SOBs ，depositors would retain their confidence in the SOBs regardless of the actual stateof their balance sheets.
The stock of publicly-acknowledged government debt comes to only 16%of GDP ，and so it is usual to hear official assurances that the current fiscal deficitsof less than 3%of GDP do not pose a problem for debt servicing by the state.However，the analytically correct measure of public debt is the consolidated debt of thestate sector，which would include at least some part of the contingent liabilities（e.g.，foreign debts of SOEs and SOBs ，and unfunded pension schemes in the SOEsector）that the state might have to assume responsibility for when the state-ownedunits default on their financial obligations.We should note that if an analystcounts NPLs as contingent liabilities ，then they are really computing what thepublic debt will be after one more round of bank recapitalisation ，i.e.the secondbank recapitalisation.According to Fan，the consolidated public debt at theend of 2001was 72%of GDP；and according to Citibank，it could be as highas 115%.So is China's present debt-GDP ratio too low or too high ？
To answer this question ，we note that the central government debt-GDP ratiosin Italy，Sweden and the United States were，respectively ，117.6%，70.8%and50.5%in 1995.So if China does undertake its second bank recapitalisation since1997，its public debt will still be within the range seen in advanced OECD countriesthat are not experiencing fiscal crises.However，there are two important pointsto be made to show that this finding is not an optimistic one.
First ，the forthcoming recapitalisation of China's banks appears to be thelast major one that the government could implement in the short-term without riskingthe stability of the domestic financial markets and its credit standing in the internationalfinancial markets.A third recapitalisation will push the debt-GDP ratio to over150%，well above the OECD norm.
Second，if China recapitalises the SOBs a second time，then it will have tocompromise the expansionary fiscal policy that has been keeping GDP growth above7%since 1997.This is because China raises much less state revenue ，as a shareof GDP，than the OECD countries，and hence has a much lower capacity to serviceits public debt.The revenue-GDP ratio was 16.2%for China in 2001，30%for Italyin 1995，38%for Sweden in 1995，and 21%for the United States in 1996.The additional debt service from the second bank recapitalisation will be about1.5%to 2.5%of GDP.If China increases tax collection or reduces infrastructurespending to cover this increased debt service ，then this second recapitalisationof the SOBs will reduce the fiscal stimulus that has been keeping the GDP growthrate above 7%.Between these two options，expenditure reduction cannot be consideredthe less likely outcome because China's experience in the reform era is that frequentchanges to the tax system have not been able to raise revenue significantly fora sustained period.The reason for the low revenue-GDP ratio could be because increasingtax collection is as much a political challenge as it is an administrative challenge.
In summary，China's consolidated debt-GDP ratio will be relatively high byinternational standards after a second bank recapitalization，while its revenue-GDPratio will remain relatively low.The greatest threat to the stability of China'sfinancial market is fiscal sustainability ，and the biggest threat to fiscal sustainabilityis successive rounds of bank recapitalisation.This precarious outcome is a systemicfeature of the current banking system ，a relic from the era where central planningwas the preferred engine of economic growth.Of course，we cannot attribute thecreation of NPLs entirely to the SOBs ，their chief customers，the SOEs ，deservean equal share of the blame.The fact is that without solving the SOE problem ，the problem of NPLs cannot be solved.
The failure of the latest reform in the state enterprise sector
We must emphasise that the inflationary problem generated by the traditionallybiggest macroeconomic destabiliser—the SOE sector—still exists.If anything ，the SOE sector in 2003has not only become a source of potentially bigger macroeconomicinstability ，it has also emerged as a source of socio-political instability.Tosee the origin of these negative developments ，we review the Fan and Woo（1996）argumentthat the reform strategy for the SOE sector during the 1978-93periodwas inherently inflationary.
The crux of the 1978-93SOE reform strategy was to transfer decision-makingpower from the industrial bureaux to the state enterprises.The increased operationalautonomy of the SOEs reduced the ability of the industrial bureaux to monitor thefinancial situation within the SOEs ，and hence created the incentive for SOEsto greatly increase their demand for investment funds.The reduction in bureaucraticoversight of the SOEs in a soft budget environment allowed the SOEs to use creativeaccounting to privatise profits from good investment projects ，and to receivestate subsidies to cover losses from bad investment projects.Until about 1996，the SOEs were generally able to satisfy their large appetite for investment becausethe local governments ，in the interest of local development ，inevitably lobbiedthe local branches of the state banks to grant the SOEs'applications for investmentloans.The evidence overwhelmingly shows that the local bank branches ，at leastuntil 1995，were unable to resist the demand for easy money.
The losses at SOEs exploded after 1992，when mother Russia officially wentcapitalist，because many Chinese SOE managers saw the same fate for China in thefuture，and concluded that this was their last chance to steal.As a result SOElosses skyrocketed even though GDP grew in the range of 10%to 14%annually in the1992-95period.By 1995，it was common to summarise the SOE situation as one-thirdof them losing money，and another one-third making no money.From the vantage pointof 2003，it seems that continued inefficiency ，and de facto asset-strippingand embezzlement of firm profits by managers and workers are the primary causesfor the general decline in SOE profits，with the latter being the more important.The devolution of financial decision-making power to the SOEs and the steady reductionin discrimination against the private sector have made it increasingly easy forthe managers to transfer state assets to themselves.It is hence，perhaps，onlynatural that of the 327cases of embezzlement ，bribery and misuse of public fundsthat were tried in Peking in 1999，“76%took place in SOEs”。
The increasing public outrage over the inequity of the informal privatisationof the SOE sector is well captured in the book by He Qinglian who wrote that theSOE reform has amounted to：“a process in which power-holders and their hangers-onplundered public wealth.The primary target of their plunder was state propertythat had been accumulated from forty years of the people‘s sweat ，and their primarymeans of plunder was political power.”
The Chinese leadership had，by 1994，recognised the increasingly serious economicand political problems created by the principal-agent problem innate in the decentralisationreforms of Lange-inspired market socialism，and it announced that the clarificationof property rights of SOEs would be added into its SOE reform programme.The CommunistParty of China（CPC ）publicly committed itself in July 1997to converting mostof the SOEs to publicly traded shareholding corporations—a form of industrial organisationthat originated in capitalist economies.The 1994-97decisions to address the loss-makingSOE problem more decisively are why employment in manufacturing fell from 98millionin 1995to 81million in 2001.
The state's decision in 1997to accelerate diversification of the ownershipstructure of the SOEs has to be recognised to be a bold move because the experienceswith mass privatisation in Eastern Europe and the former Soviet Union （EEFSU ）show that the task is an extremely difficult one and that the outcomes have consistentlyfallen below initial expectations.For example，in Russia，the“loans-for-shares”privatisation transferred the country's enormous mineral wealth to a group of oligarchs，and the weak administrative and legal structures allowed many managers to take effectivecontrol of the privatised firms and loot them instead of improving their operations.Furthermore ，the EEFSU experiences warn that mass privatisation is an exceedinglydangerous business politically，no matter how it is done ，be it outsider privatisationor insider privatisation.This is because the mass privatisation of SOEs generatesso much rent that massive corruption has not been avoided ，and the resulting corruptioninevitably delegitimises the government ，e.g.Vaclav Klaus in the Czech Republicand Boris Yeltsin in Russia.
Despite the mediocre to poor privatisation outcomes in EEFSU，privatisationhas been going forward in China ，albeit with occasional stops ，for two mainreasons.The first reason comes from John Nellis who points out that“governmentsthat botch privatization are equally likely to botch the management of state-ownedfirms ”.The answer is not to avoid privatisations but to implement more carefulprivatisations：governments in transition economies should “push ahead，moreslowly，with case-by-case and tender privatisations，in co-operation with theinternational assistance community，in hopes of producing some success storiesthat will lead by example.”
The second reason lies in that the delay of privatisation can be costly to China'sgovernment politically.Stealing by managers does occur during privatisation andcreates a social backlash against the government，but the maintenance of the statusquo has become increasingly difficult because SOE managers in China know from theEEFSU experience that they are in an endgame situation.The widespread spontaneousprivatisation by SOE managers could create grave social instability.
Our opinion is that the solution to the SOE problem in China is not privatisationper se，but a transparent，legal privatisation process that society at large canaccept，at the minimum ，as tolerably equitable.Because an adequate privatisationprogramme must compensate the retired and laid-off workers，permit takeover bycore investors，and respect the rights of minority shareholders，it is importantthat legal reforms be carried out simultaneously.Only with a transparent ，equitableprivatisation process that is overseen by an adequate legal framework ，would Chinabe likely to avoid a state-created Russian-style kleptoklatura that would fuel socialdissatisfaction.
Recently，there has been some questioning as to whether the case for privatisationhas been overstated.When Zhu Rongji was appointed premier in 1997，he announcedthat he would solve the SOE problem in three years.In 2000，he declared victoryon the SOE front when the profits of the industrial SOEs leaped from 53billionyuan in 1998to 241billion in 2000.In a careful study ，Zhou and Wang quantifiedthe sources of the financial turnaround ，and found that：
·the lower interest rate in 2000increased profits by 52billion yuan（28%of the increase in SOE profits）；
·the higher oil prices boosted overall SOE profits by 79billion yuan becausealmost all oil companies are state-owned（42%of the increase ）；and
·the conversion of the bank loans of SOEs into equities held by state assetmanagement companies raised profits by 10billion yuan（5%of the increase）。
About 75%of the increase in the profits of industrial SOEs in the 1998-2000period was not due to actions taken within these enterprises but to external factors.When Zhou and Wang calculated the profit rate after deducting the profits from themore favourable external environment，they found that it had increased from 0.7%in 1998to 1.2%in 2000for the SOE sector，and from 2.8%to 4.8%for the non-SOEsector.Despite the recent good news on SOE profitability ，the fact remains thatthe SOE sector still lags considerably behind the non-SOE sector in efficiency.
To sum up ，while the recent rise in profits surely gives some breathing space，the capacity of SOEs to “dissipate rents ”through high payments to managers andworkers ，if not illegal transfer of assets，should remain clearly in the policy-makers'minds.Thus ，any gains could well be squandered ，if not reversed，in a relativelyshort period of time.It is hence important for China to replace the present uncontrolled（and uncontrollable）process of asset-stripping in the SOE sector with transparentand equitable privatisation in order to improve macroeconomic stability and to defusesocio-political instability.
We draw four key conclusions from our discussion.First ，China's dysfunctionalfinancial system has imparted a deflationary bias to the economy and made Chinaa capital exporting country by constraining the growth of aggregate demand to beless than the growth of aggregate supply.The government has been actively tryingto neutralise deflation through an aggressive fiscal policy.We recommend that itshould now reshuffle and slightly expand its investment programme to incorporatelarge import-intensive infrastructure projects so that the current account surpluscould be reduced as well.The additional infrastructure construction would createjobs，relieve production bottlenecks ，and，on top of that ，preserve employmentin China's export-oriented sectors.However ，the most efficient solution is forprivate investment rather than public investment to recycle the pool of privatesavings back into the economy.The key to eradicating the deflation bias and thetendency towards current account surplus lies in establishing an efficient financialintermediation mechanism.
Second，frequent bank recapitalisation is the biggest threat to China‘s fiscalsolvency.The forthcoming second recapitalisation of SOBs since 1997is the lastone that China can afford.Because fiscal solvency requires that the state keepsinterest rates low through regulation in order to contain the cost of debt service，China faces a difficult trade-off between the maintenance of fiscal stimulus tokeep growth on track and the promotion of financial market development via bankrecapitalisation and interest rate deregulation.
Third ，the latest attempt to reform the SOEs has failed.This dismal outcomehas been masked by the large profits of the state oil companies resulting from thehigh price of oil in the recent period.The losses of the non-oil SOEs from continuedinefficiency and increased embezzlement constitute a serious threat to sustainedhigh growth ，banking sector solvency，price stability，and social stability.
Fourth，while it is important to manipulate aggregate demand via monetary-fiscalpolicies to keep the actual growth rate close to the natural growth rate，Chinais in the fortunate position that it can implement other economic policies thatwill increase the natural growth rate.To use a production analogy，the biggestgain comes not only from keeping an engine running at peak efficiency but also fromhaving the engine with the largest capacity.In short ，the most important economictask for China is to adopt the best economic growth engine that world economic historyhas identified：a market economy where competitive private enterprises constitutethe norm，and where the state focuses mainly on the provision of public goods andsocial insurance.The switch to the new growth engine necessitates that China continuesthe privatisation of nondefence-related state enterprises that are not natural monopolies，begins the privatisation of SOBs，and reduces drastically the legal discriminationagainst the private sector.
This paper is part of an ongoing project on Economic Growth in China conductedby the East Asian Program of the Center for Globalization and Sustainable Developmentat Columbia University.I am grateful to Jonathan Anderson，Martin Fournier，FanGang，He Liping，Huang Yiping ，Liang Hong ，Ma Jun and Yu Yongding for sharingtheir insightful analyses on the Chinese economy with me.I am deeply indebted tothe Citigroup office in Hong Kong for assistance in data compilation.
The inflation rate is calculated from the retail price index（RPI ）。Theaverage inflation rate according to the consumer price index（CPI ）（availablefrom 1985）is 0.6%for the first half of 2003and 7.7%for the period 1985-2002.The CPI is broader than the RPI because it also covers services and housing.GDPgrowth for the first half of 2003is from “National economy faces a string of challenges”，China Daily ，August 26th 2003.The 2003third quarter data are from Jonathan Anderson，UBS Investment Research ：Asia Economic Comment，October 20th 2003.
The inflation here is calculated from the RPI.The CPI inflation rate was-0.8%in 2002，and its predicted value in 2003has been put at 0.9%by Liang（Liang Hong，2003，Goldman Sachs Asia-Pacific Economic Research ：EconomicFlash ，September 17th 2003，newsletter ）and 1.2%by Ma （Ma Jun，DeutscheBank：Emerging Markets Monthly ，October 3rd 2003，newsletter ）—whose respectivepredicted GDP growth rates in 2003are 8.4%and 8.5%.
If realised ，the official urban employment rate would rise from 4%atthe end of 2002to 4.2%at the end of 2003.（“Economy not working hard enough ”，South China Morning Post，August 16th 2003）。However，official data on urbanunemployment are well-known for understating the problem.When the official urbanunemployment rate was 3.6%in June 2002，a Chinese Academy of Social Studies reportestimated the actual urban unemployment rate to be 7%，and Liu Wei of Peking Universityestimated it to be 14.6%.See “China jobless figures enter danger zone ”，StraitsTimes ，June 15th 2002.
“Budget and job woes threaten stability”，South China Morning Post ，December 19th 2002.
For example ，“Snow calls on Beijing to let currency float ”，FinancialTimes ，September 2nd 2003.
Kuroda Haruhiko and Masahiro Kawai，“Time for a switch to global reflation”，Financial Times ，December 1st 2003.
See ，for example，“Behind the debate over China‘s currency”，Barrons，July 28th 2003：“U.S.job losses blamed on China ’s currency”，The New YorkTimes ，August 26th 2003；and“Economic ministers discuss Chinese currency ”，Pacific Business News ，July 23rd 2003.
Our view that China's impressive growth rate has been generated by its steadyconvergence to a normal private market economy is contested ，however.There isalso the popular view that China's growth is the result of successful policy experimentationthat has discovered growth mechanisms （most of which are non-capitalist in nature）that are optimum for China's particular circumstances.This convergence-experimentalistdebate is reviewed in Woo Wing Thye ，“The Real Reasons for China's Growth ”，The China Journal ，No.41，January 1999，pp.115-37，and Woo Wing Thye，“Recent Claims of China's Economic Exceptionalism：Reflections Inspired by WTOAccession ”，China Economic Review，Vol.12，No.2/32001.
Citigroup has projected the budget deficit to be 2.8%in 2003（Citigroup，China Economics 6-Mar-03，newsletter ）。The scale of the fiscal stimulus hasevoked comparisons with the New Deal，and provoked catchy headlines in the media，e.g.“China Gambles on Big Projects for its Stability ”，New York Times ，January13th 2003，and“Public Spending Explodes”，Far Eastern Economic Review，January30th 2003.
Jia Kang ，“Fiscal Policy in China after WTO Entry”，presentation atthe Citigroup Investors ‘Seminars，Shanghai ，May 8th 2002.
Employers in SARS-affected areas were also ordered “not to lay off workers”；see“China Tries to Stanch Economic Fallout as Disease ，Worry Spread ：EmergencyPolicies Boost Public Spending”，Washington Post，May 9th 2003.
Fan Gang and Wing Thye Woo ，“State Enterprise Reform as a Source of MacroeconomicInstability ”，Asian Economic Journal ，Vol.10，No.3，November 1996，pp.207-224.
Keynes coined both terms.Strictly speaking，the Chinese characterisationof the liquidity trap as a“shrinking money multiplier”does not correspond to Keynes'soriginal meaning.Keynes was referring to the situation where the interest ratewould not fall despite the addition of reserves because of the overwhelming dominantexpectation held by investors that the interest rate would rise soon.In brief，the difference is “the shrinking money multiplier”versus“the non-falling interestrate”。
For example，during the SARS period ，the banks faced intense pressurefrom the central bank to extend credit.
The Chinese government has sought to increase bank lending to private individualsby encouraging banks to establish mortgage loans，which are perceived as less riskybecause of their seemingly fully collateralised nature.While it is still earlyto tell ，it appears that the enthusiasm for real estate lending in 2002mighthave started a speculative bubble in that sector.
Liu Liang-Yn ，and Wing Thye Woo，“Saving Behavior under Imperfect FinancialMarkets and the Current Account Consequences”，Economic Journal ，Vol.104，No.424，May 1994，pp.512-527.
Williamson ，Jeffrey，“Comments on Reflections on Development”，inGustav Ranis and T.Paul Schultz（eds.），The State of Development Economics ：Progress and Perspectives ，Basil Blackwell，NY ，1988，pp.24-30.
For a formal model of investment-motivated savings ，and for empiricalconfirmation of this hypothesis ，see Liu Liang-Yn and Wing Thye Woo ，“SavingBehavior…”，op.cit.；Woo Wing Thye and Liang-Yn Liu ，“Investment-MotivatedSaving and Current Account Malaise”，Asia-Pacific Economic Review ，Vol.1，No.2，August 1995，pp.55-68.
Woo Wing Thye，“Improving Access to Credit in Rural China ，”in BaizhuChen，J.Kimball Dietrich and Yi Feng（eds.），Financial Market Reform in China：Progress Problems and Prospects，Westview Press ，Boulder，Colorado ，200，pp.321-346，presents a proposal of how to meet investment financing needs inrural China.
It is important to note that the above equation applies only to China'stotal trade surplus not to any bilateral trade surplus between China and that country.The equation in standard textbook notation is ：
CA =（T-G ）+（S-I ）
Of course，just as the current account outcome is the product of the threeterms in the equation ，multi-variable causation also applies to the savings outcome，e.g.demographic features ，expected future income growth.Our discussion has concentratedon how one of these variables ，the type of financial intermediation mechanism ，can affect the savings rate.
It is unlikely that the additional post-1998NPLs were created entirelyby new post-1998loans turning bad，we suspect that a large proportion of themrepresented pre-1999NPLs that were not recognised as such in order to hide theseriousness of the problem at the time of the 1997-98recapitalisation.
It should be remembered that the major portion of the NPLs transferredto the AMCs in 1997-98still needs to be disposed and is thus still the responsibilityof the People's Bank of China or the Ministry of Finance.It appears that the AMCshave started by concentrating on the“NPLs with the best prospect for recovery”，and that the“average cash-recovery rate”on the small amount processed by June2002is 21%.This recovery rate is expected to drop substantially when the moredifficult loans are processed.See“On the Road to Ruin ”，Far Eastern EconomicReview，November 14th 2002.
Fan Gang ，“China's NPLs and National Comprehensive Liability ”，AsianEconomic papers ，Vol.2，No.1，2003，pp 145-152.
To see how NPLs raise the lending rate ，we note that the cash-flow constraintthat a bank （regardless of solvency）must meet in the absence of state subsidies，of operating costs，and of a required reserve requirement is given by：
rD D =rL [D-NPL]where rD =deposit rate ，rL =lending rate，and D =amountof deposit.This means that if NPLs equal one-third of deposits ，then the lendingrate has to be at least 50%higher than the deposit rate.Since a new bank（domesticor foreign）will not have any NPLs ，it can offer better deposit and lending ratesthan the SOBs.
Partial recapitalisation is likely to occur soon ，and it is likely thatthe target would be the reduction of the NPL ratio from 35%to 15%.The cost isestimated to range from 700million yuan to 1trillion yuan （7%to 10%of GDP）—see “Massive bailout proposed for banks”，South China Morning Post ，August26th 2003.
Fan Gang ，“China's NPLs and National Comprehensive Liability ”，op.cit.
Citigroup，Greater China Insights ，June 14th 2002，newsletter.
The US ratio is for 1996.Ratios were constructed from the IMF's InternationalFinancial Statistics.
The revenue-GDP ratio for China is from Deutsche Bank，Emerging MarketsMonthly ，September 4th 2002，newsletter ，which estimated that it will riseto 16.4%in 2002and 16.6%in 2003.Debt to GDP and revenue-GDP ratios for othercountries are from the IMF database.
This assumes a real bond rate of 4%to 6%.
If the issue of fiscal sustainability is viewed from the broader pictureof debt dynamics，one might be tempted to dismiss the existence of a trade-offbetween bank recapitalisation and fiscal stimulus.Such an optimistic assessmentis based on the seeming fulfilment of the technical condition that would allow thehigh debt-GDP ratio of 115to be reduced over time or to level off；specifically，China's annual trend growth rate of 8%exceeds the real interest rate of 4%.However，our calculations show that the existing policies of ：
·a fiscal stimulus that is 2%of GDP ，and
·an NPL creation rate，（[change in NPL in SOB]/GDP）that is 6%
will produce an internationally unprecedented steady-state debt-GDP ratio of200%，much higher than the 60%target that the European Union has set for its members.We therefore doubt the validity of the reasoning behind the optimism.
Fan Gang and Wing Thye Woo ，“State Enterprise Reform as a Source of MacroeconomicInstability ”，Asian Economic Journal ，Vol.10，No.3，November 1996，pp.207-224.
For an account of the failure of previous SOE reforms，see Huang Yiping，Wing Thye Woo ，and Ron Duncan ，“Understanding the Decline of China's State Sector”，MOCT-MOST ：Economic Policy in Transitional Economies，Vol.9，No.1，1999，pp.1-15.
The institutional reforms of the central bank and the state banks implementedin July 1993as part of an austerity campaign have not been successful in changingthings.Chen Yuan ，Deputy Governor of the central bank，reported that "the enthusiasmfor economic growth in some localities is so strong that it is very difficult tostop completely excessive investment financed through forced bank credit"（emphasisadded ）。See Chen Yuan，“Opening Remarks ”，in Manuel Guitian and Robert Mundell（eds.），Inflation and Growth in China，IMF，Washington D.C.，1996，pp.23-28.
“Judicial Attention to SOEs Pledged”，China Daily，February 19th 2000.
He Qinglian，Zhongguo de Xianjing （China ‘s Pitfall ），Mingjing chubanshe，Hong Kong ，1998.The translated quote is from Liu Binyan and Perry Link ，“China：A Great Leap Backward？”，The New York Review of Books ，October 8th 1998，p.19.
Nellis John，“Time to Rethink Privatisation in Transition Economies ？”，International Finance Corporation Discussion paper No.38，World Bank ，WashingtonD.C.，1999.
See Nolan Peter and Wang Xiaoqiang ，“Beyond Privatization：InstitutionalInnovation and Growth in China's Large State-Owned Enterprises”，World Development，Vol.27，No.1，1999，pp.169-200，for a recent assertion of a turnaroundin SOE performance.
Zhou Fangsheng and Xiaolu Wang ，“The Way of State Owned Enterprise Reformin China”，National Economic Research Institute ，Peking ，China，2002，manuscript.
This estimate has taken into account the additional production cost ofthe non-oil SOEs.