IS CHINA'S ECONOMIC BOOM A MYTH?

This August, I had lunch at Shanghai's American Club, a posh dining room with a stunning view of the city's restored colonial waterfront, with a Chinese-American executive based in Beijing. All around us, American businesspeople were wooing potential Chinese partners, passing around hundred-dollar bottles of Scotch and demanding private tables so that no one would overhear the deals they were making. Though my lunch companion had worked in China for decades, long enough to grow cynical about any place, he shared the other diners' enthusiasm. "I have invested my assets here," he said, gesturing out the window at Shanghai. "If I had more money, I would put it here too. China's economic development is just mind-boggling."

My friend is not alone. Almost all the foreign businesspeople I spoke with in China--even those whose companies have lost millions of dollars in the country--told me that it would eventually become their most important market. Publications such as BusinessWeek and Forbes have run story after story about China's miraculous economic development. A LexisNexis search of U.S. newspapers turns up thousands of breathless articles.

But what if they're wrong? Look closely at the Chinese economy, and you'll find a far less rosy situation than that portrayed in most of the business press. The country's growth rates are vastly overstated, the result of cooked books and massive deficit spending. Companies selling to the Chinese market--foreign and domestic alike--are struggling just to break even. The economy is plagued by persistent deflation and a useless banking system. "Businesspeople have created a lemming effect," says Graeme Maxton, a specialist on China's auto industry. "They have convinced themselves they have to be in China or their competitors will overtake them, so they ignore economic fundamentals." The Chinese economic miracle, in other words, is largely a house of cards. And, when it falls, the consequences could be catastrophic.

China's reputation as a fast-awakening economic giant does have some basis in fact. Over the past two decades, China has made impressive economic progress. In 1978, when Deng Xiaoping began to open the economy, the country was one of the poorest in the world. One American who visited Shanghai in the early '80s recalled the city as a drab metropolis populated by men and women dressed almost exclusively in Mao suits; today, it is a vibrant city boasting dozens of European fashion outlets. Beijing, meanwhile, features a Starbucks in the Forbidden City. And China's eastern seaboard has developed into a low-value manufacturing powerhouse. The Chinese middle class, which comprises slightly less than 10 percent of the country, has seen its disposable income rise sharply; the annual disposable income of urban households grew from roughly 340 yuan ($41) in 1978 to nearly 6,300 yuan ($761) in 2000.

But, despite all the lattes sold at Starbucks Beijing, China is only making positive economic strides, not revolutionary leaps. The Chinese government claims the economy has grown by 7 percent to 10 percent per year for the past two decades. But, apart from the export sector--China's economic bright spot, but only about 20 percent of GDP--the government's numbers do not add up. Thomas Rawski, a groundbreaking economist at the University of Pittsburgh, notes that over the past five years--a time of supposed breakneck growth--China has been plagued by deflation, rising unemployment, and declining energy use, trends normally associated with low growth if not outright recession. Take falling energy use: China's coal-based industries are not known for conservation--on a summer day in the industrial city of Urumqi, I could not see a building across the street--so it is nearly impossible that the country could grow swiftly while using less energy. Looking at energy data, independently compiled GDP figures, and other statistics, Rawski concludes that, between 1998 and 2001, China grew by approximately 4 percent rather than the 7 percent to 10 percent claimed by the government--decent results, but no better than some other developing economies. By comparison, Bangladesh, not a country anyone associates with economic dynamism, grew an average of 5 percent per year during the late '90s. Four percent growth, moreover, is not enough to mitigate the socioeconomic problems that could accompany China's transition from an agrarian economy. According to several Chinese economists, China needs to maintain more than 7 percent annual growth to keep unemployment rates below 15 percent to 20 percent in rural areas.

How could Rawski's numbers differ so much from Beijing's? The primary explanation is that China's national economic statistics, which are compiled from provincial data, have no safeguards against political meddling. When the central government declares its growth targets early in a year-- in 1998, for example, Beijing announced that 8 percent annual growth was "a political responsibility"--provincial officials simply make up numbers to substantiate them. "China's statistics are based on a Soviet-type system where each town and province reports figures, rather than having a national organization do the reports, and many local officials I have met feel intense pressure to meet targets," says Joe Studwell, editor of the China Economic Quarterly. In 2001 alone, according to the government's own State Statistical Bureau, there were over 60,000 reported falsifications of provincial data.

Other prominent economists share Rawski's doubts about China's reported growth rates. Leading Chinese economist and writer He Qinglian told me that, in 2000 and 2001, she traveled around southern China, stopping into provincial officials' offices. When she asked them for their provincial GDP statistics and their methodologies, many were unable to provide either; when they did provide them, the numbers almost never added up.

In private, and when speaking to certain domestic reporters, even China's leaders admit the fix is in. When Rawski and other leading economists chat with official statisticians in Beijing, they often hear that no one in the government believes recent GDP numbers. "American economists are going around the U.S. praising China's economy, and when I come to Beijing the people there are vastly more pessimistic," says Rawski. A cursory glance at Chinese-language newspapers over the past five years turns up reams of stories vastly different from those in the gushing foreign press--articles about economic stagnation, falling wages, and deflation. (Though the Chinese press is still censored, it has grown more open in recent years, and some groundbreaking publications like Caijing and Southern Weekend regularly print information that reflects poorly on China.) Even top officials know China overstates the figures. In 2000, former premier Zhu Rongji, the straightest-talking mandarin in Beijing, warned that "falsification and exaggeration of statistics are rampant."

A similarly dour picture emerges when one investigates the operations of some of the large multinationals and domestic companies targeting the Chinese market. Many Fortune 500 firms tout their China divisions as linchpins of corporate growth--and it's true that some foreign companies such as Motorola have gained a significant market share selling to China. But, this summer, when I contacted nearly 40 major multinationals that focus on the Chinese consumer market, only two--brewing giant SABMiller and fast-food titan Yum! Brands (parent of KFC and Pizza Hut)--were willing to provide even basic information about their China revenues. "If any of these foreign companies were making money in China, they would be talking about it constantly," says Studwell. He believes that less than 10 percent of foreign companies selling to China are reaping profits, a view shared by several other leading China specialists. (Companies that use China as a platform for manufacturing and exporting are a different story: Many have prospered.) The rest, Studwell says, have expanded too quickly, overestimating China's growth and the true number of potential consumers. Recently, as unemployment rises, personal consumption is actually falling.

Though convincing foreign companies to talk about their China operations can be difficult, finding stories about business fiascoes is easy. When Beijing's American Chamber of Commerce surveyed its members in 1999, it found that less than 15 percent of respondents had China operations that generated returns above the cost of capital, the normal standard for profitability. Several times a week, China's vernacular papers and the South China Morning Post, Hong Kong's leading English-language daily, produce stories about another foreign company's troubles. Picking up just a few random issues of the Post and the regional magazine Far Eastern Economic Review last spring, I noticed articles on Pepsi, which has never made money in China despite investing $500 million over two decades; on DaimlerChrysler's failing jeep venture in Beijing; and on AOL-Time Warner's tribulations in China.

Major Chinese companies often are doing even worse. Smaller private companies with decent business plans find it nearly impossible to get loans, since China's indebted banking system remains focused on propping up state-owned enterprises (SOEs) backed by the Communist Party. (As a result, entrepreneurs are forced to rely on illegal neighborhood lenders; some of the biggest loan sharks in China are old ladies who provide capital to family members' businesses.) Foreign bankers estimate that, because of these deals with SOEs, more than half of the bank loans in China are nonperforming. Rating agency Standard & Poor's has estimated that it would take at least $540 billion--yes, billion--to recapitalize China's banks.

Given their easy access to capital, large state-owned enterprises too often turn into vehicles for asset stripping by upper management or unreformable hulks laden with unproductive workers. Minxin Pei, a China scholar at the Carnegie Endowment for International Peace, estimates that corruption costs China as much as 8 percent of annual GDP. The government auditing body has admitted that more than two-thirds of the biggest Chinese companies falsify their accounting--an astonishing statistic given that investors attacked U.S. stock markets in the wake of this year's corporate scandals, even though most economists believe less than 5 percent of American companies cook their books. In many cases, corrupt Chinese managers have used funds stolen from SOEs to build enormous, virtually useless buildings on China's eastern seaboard as showpieces of their newfound wealth. Parts of Pudong, Shanghai's newest commercial district, look like a ghost town. I ventured into several gleaming buildings that, having drawn no tenants, were just empty shells staffed by guards who spent their time alternating between marching in circles and conducting spitting contests.

Largely because of this excess, China's companies actually are becoming less productive. Despite recent stories in The New York Times comparing India's economy unfavorably with China's, India, which receives only 10 percent as much foreign investment as China, has posted only slightly lower rates of growth because it uses its capital more efficiently. While India now boasts globally competitive private firms like Infosys and Wipro, China has not produced such productive multinationals since its largest companies are SOEs that monopolize certain sectors, receive guaranteed loans, and waste vast sums of money. As one leading China banker notes, the Middle Kingdom has not moved strongly into higher-value production; even China's exports of electronic goods are mostly just re-exports in which China's only role is labor-intensive assembly.

Unable to produce better companies, China's rating on the World Competitiveness Scoreboard, a ranking of powerful countries based on efficiency of economic performance, has fallen sharply over the past five years, from 21 to 31, a drop that signifies China's economy is becoming less efficient and competitive. At the same time, South Korea, a country supposedly hammered by the Asian financial crisis, has risen from 36 to 27 on the scoreboard. Increasingly inefficient, China has been unable to generate enough jobs for the millions of peasants leaving the agricultural sector. Though internal security forces try to prevent unemployed workers from moving around the country, many take their chances, adding to socioeconomic fluidity and instability. Standing outside a Shanghai mall featuring elite European fashion outlets, I bought apples from a shabby group of unemployed farmers who had left their villages. My produce shopping ended abruptly when local police brusquely grabbed the migrants and beat them.

If Chinese consumers are spending less money, Chinese SOEs are becoming less productive, and foreign companies are struggling to make a buck, how is the country's economy growing at all? A constant stream of foreign capital helps: According to a survey by consulting firm Deloitte & Touche, 90 percent of foreign-invested businesses in China plan to expand their operations in the next three years. More important, as in the former Soviet Union, growth in China has become dependent on massive state spending. China has posted record budget deficits the past two years, and government expenditures rose by nearly 20 percent during the first three quarters of 2002. "In the early days of Deng's reforms, just the loosening of the economy generated development, but that growth fizzled, and now the economy is propped up by deficit-spending," says one leading Chinese scholar. Though limited deficit-spending can prove beneficial to an economy, China risks becoming dependent on deficit-financing for growth, a situation similar to what Japan now faces. Ultimately, when public debt reaches high levels, as it has in Japan, it serves as a drag on growth and, like a drug, can reduce the public's desire for economic reform.

Along with pouring increasing amounts of money into the economy, Beijing has continued to direct growth. Although China recently joined the World Trade Organization, Beijing still not only pushes banks to lend to SOEs but also vows to protect companies in key sectors, such as steel, in an attempt to create national champions akin to South Korea's massive chaebol conglomerates, most of which ultimately failed. Former Vice Premier Wu Bangguo, for one, admitted that Beijing would continue to support state-owned companies in vital industries.

The party's desire to manage growth has also included intensifying its hammerlock over the legal system. When I questioned foreign executives like Philip Murtaugh, head of General Motors' China operations, about the rule of law, most repeated the same mantra: Although China still has problems, its legal system is developing. Indeed, in recent years, Beijing has written reams of new laws, pleasing businesspeople who have no idea the legal environment is actually getting worse, since most companies settle rather than go to court. The few foreign lawyers in China who take cases to court know the truth: The new laws mean little as Beijing has moved independent-minded justices out of power. One of the most prominent foreign lawyers told me, "The rule of law has deteriorated sharply. ... There used to be a group of Chinese judges who were dedicated to creating a real legal system, but the party bosses couldn't tolerate them, and they are almost all gone." In the past few years, the lawyer said, she has watched many of her clients lose cases simply because her opponent had ties to certain party figures. When I expressed doubt that China's legal system could be regressing, she forwarded me reams of documents about cases that the plaintiff clearly should have won; in some of the cases, she said, the court recessed, and the judges met in a side room with party officials before announcing their decisions.

This assertion of state control will only further inhibit the economy. Without a decent legal system, China will be unable to encourage risk-taking by private entrepreneurs, break up state-owned enterprises' monopolies, and protect the intellectual property rights central to a higher-value economy. Piracy remains rampant: Walking through a market in Shanghai, I saw hundreds of knockoffs of the latest Hollywood films and CDs.

Meanwhile, domestic debt has reached 60 percent of GDP, an unsustainable figure, and favoring certain sectors will contribute to overproduction and more deflation. Already, Beijing's State Economic and Trade Commission has concluded that there are no goods being produced in China for which demand exceeds supply, another astonishing statistic. Realizing that liberalization is not proceeding as planned, municipalities have set up new trade barriers that only add red tape. To help local shippers, Shanghai has prohibited non-Shanghai trucks from entering the city between 7 a.m. and 9 p.m. Factories in Tianjin, a city less than 100 miles from Beijing, are unable to sell goods in the capital without a license.

Ultimately, China's economic facade probably will crack. And, when it does, the consequences may be disastrous. Any decline in foreign investment could depress growth. Rising unemployment could lead to social chaos. (The number of labor protests quadrupled between 1993 and 1999.) Nicholas R. Lardy, a China specialist at the Brookings Institution, predicts that the rising burden of non-performing loans could make the country's entire banking system insolvent by 2008. This banking crisis could lead to millions of Chinese trying to withdraw their life savings from banks, followed by panic when they realize the banks are insolvent and have no backing for their deposits, and potentially massive social turmoil.

When the cracks become deeper, Washington and Beijing will have to reassess their relationship. Over the past three decades, the China-U.S. interaction has been primarily a transactional one. The language of interaction between the two nations is business, and business leaders often smooth over squabbles. Few foreign nongovernmental organizations operate in China, cultural exchange is limited, American and Chinese politicians rarely mix, and the overwhelming majority of forums between the two nations are related to business issues.

During economic booms, these transactional benefits smooth over America and China's lack of shared values. But, in the future, China's growing economic weakness could force its latent anger at the United States to the surface. Already, Beijing stokes anti-Americanism in order to deflect criticism of its own actions and expends little effort explaining its relationship with the United States to its people. Imams in Xinjiang, a Muslim province in western China that I visited this September, have been forced to attend "reeducation sessions" laced with anti-American propaganda. Party-controlled media companies have produced popular videos glorifying the September 11 attacks. In one video, as the camera focuses on the rubble of the World Trade Center, a commentator says, "Blood debts have been repaid in blood. ... This is the America the whole world has wanted to see."

Combined with China's past two centuries of history, during which foreigners dominated the country, this campaign has created a generation of xenophobic young Chinese. Thus far, as China has appeared ready to become a rising economic power, this nationalism has been kept in check, since most younger Chinese assume their homeland is about to take its rightful place as a major trading and business power.

But, if China stumbles on the way to becoming an economic giant, the pent-up anger could burst. Most Chinese university students I have spoken with get angriest when foreign countries seem to be besting China economically, or foreigners appear to be denigrating China's supposed economic miracle. And these Chinese back up their anger with action. When British brewer Bass closed down some of its operations in China over the past three years because they were unprofitable, Bass managers had to hire bodyguards to visit their own plants for fear of physical violence. When economists like Rawski question China's GDP statistics, they are assailed with biting critiques in Beijing's state-run newspapers. When Taiwanese and U.S. companies have won contracts to provide I.T. services to provincial governments, businesspeople say Chinese workers have physically menaced local cadres for selling out to foreigners.

Unlike Britain, Japan, or even Russia, countries with historical ties to the West, China shares little with the United States other than a desire for commerce. Lacking these shared values, if China's economy tumbles more, Chinese resentment toward the West could increase. Then China might actually become an enemy: an unstable country possessing weapons of mass destruction, less restrained by business ties and more likely to embark on diplomatic misadventures--such as an invasion of Taiwan.

Yet the United States continues to view China as a potential threat because of its supposed growing economic power. The main body reporting on China to Congress, the U.S.-China Security Review Commission, recently offered more than 40 recommendations, many of which dealt with China's economic strength. And so, Washington's finest minds have prepared for a rising Middle Kingdom, spending little time contemplating what would happen if China's economy were to implode. Even some of the most experienced China hands seem to have fallen into this trap. As my lunch companion at the American Club in Shanghai told me later that same afternoon, "If I was IBM, or Microsoft, I'd fear Legend [a Chinese computer-maker]. China is coming on strong. ... The U.S. should be afraid." At least on one of his two counts, my friend is correct: The United States should be afraid.

Not to argue a minor point, but that Franklin was a deist is debateable. If I remember correctly toward the end of his life Franklin wrote about God intervening in human affairs, which is not the view of deism.

Also I rememmber reading several years ago, an article in national review about the effects of protestantism in Latin America. It surprised me since Buckley is a good catholic. The Article talked about there being a theological economic lift. That Protestant churches with their decentralized power structure, emphasis on personal responsibility and personal study (i.e. everyone needs to read), would have a positive effect on the economy.

China suffers from huburis of its ruling elites. They ignores the reality of developing such vast territory with disparate regional histories.

In an all-out attempt to catch up with the major powers of today, they ignore that the best course of development is a slower growth of 5% or less. Phasing out socialist state economy is a time-consuming and painful process. The elimination of surplus farm labor is another explosive problem. China has tens of millions of them all hopping onto trains bound for big cities in the Eastern coast without having anybody waiting there to employ them or house them even temporarily. They just go there and hope that they will get jobs.

But the leadership of China is living a dream of China in 21st centurey high-tech society, joining WTO, being lionized by many Westeners as leaders of soon-to-be superpower. They successfully created the myth of "inevitable Chinese superpower" in near future. This is partly due to the willingness of the West to buy such myth based on centuries of folklores about China in Europe. For people with long memories, they sure hurry too much to make up for time lost in last 100 years.

But that is really dangerous. They let loose the system which does not have checks and balance to ensure smooth economic activities. Economy has many loopholes for state meddling and boundless corruption, which could be at its worst in banking systems. They just began to make some decent inroads into a market economy but they and their western sychopants are already euphoric about the economic superpower. When America business publications go so exhuberant, it usually means that something terrible is around the corner.

So much hype will create the level of expections which will turn into bitter disillusions when things turn sour.

Very interesting article, and extremely important, IMHO.

The first generation of Western investors in China all lost their shirts, because the Chinese simply expropriated everything. Then after a lull they started investing again, and everyone says the Chinese have mended their ways. But this article suggests that the rule of law is once again decaying. You can't have business without enforceable contracts, justly observed.

It wouldn't surprised me a bit if the present generation of investors in China get bitten again, and it would serve them right, profiteering on the backs of persecuted victims in the Laogai and helping to strengthen the country that is potentially our most dangerous enemy. The Chinese only like to see money flowing into their country. They hate to see it coming out.

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